How to trade a frothy momentum market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A momentum driven market

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

 

How should investors and traders react to such circumstances?
 

Reasons to be cautious

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

 

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

 

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

 

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

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

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

 

SentimenTrader also provided a similar warning of market frothiness.
 

 

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

A TINA advance?

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

 

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

 

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

 

More gains ahead?

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

 

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

 

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

 

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

 

The week ahead

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

 

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

 

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

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

 

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

 

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

 

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

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

Disclosure: Long SPXL

 

The guerrilla war against the PBOC

Posted by Cam Hui -

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

 

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

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

Swim like a fish

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

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

 

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

 

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

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

 

Here is the traffic report for Shanghai.
 

 

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

 

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

 

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

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

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

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

 

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

The enemy camps, we harass

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

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

 

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

 

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

 

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

 

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

 

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

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

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

 

When the enemy camps, we harass.
 

What next?

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

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

 

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

 

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

 

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

 

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

Investors can win either way.

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

Please stay tuned.

 

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

Posted by Cam Hui -

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

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

 

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

 

Should traders be bullish or bearish?

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

The bull and bear cases

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

 

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

 

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

 

A fear trade

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

 

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

 

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

Disclosure: Long SPXL

 

ESG challenges to energy investing

Posted by Cam Hui -

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

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

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

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

Solar cycle analysis

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

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

 

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

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

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

Sector outlook: An ESG stampede

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

 

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

 

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

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

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

But this move is being driven by big real money.

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

 

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

 

Energy investing in the ESG era

How should energy investors approach the sector?

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

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

 

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

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

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

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

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

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

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

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

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

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

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

 

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

Where’s the sentiment reset?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Is sentiment too bullish?

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

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

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

 

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

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

 

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

A “sort of” sentiment reset

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

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

 

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

 

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

Fragile market internals

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

 

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

 

Cross-asset analysis: A muddy picture

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

 

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

 

Cautiously bullish

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

 

Short-term momentum is resetting from an overbought reading.
 

 

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

 

Disclosure: Long SPXL

 

Is the melt-up back?

Posted by Cam Hui -

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

 

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

 

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

A coronavirus report card

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

 

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

 

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

 

The view from outside China

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

 

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

 

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

 

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

 

Climbing a Wall of Worry?

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

 

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

 

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

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

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

 

A renew melt-up?

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

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

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

 

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

 

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

 

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

Stay tuned.

 

An animal spirits revival?

Posted by Cam Hui -

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

 

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

Lines in the sand

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

 

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

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

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

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

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

 

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

 

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

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

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

 

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

Alternative bull trap scenario

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

 

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

 

TLRY
 

 

SLV
 

 

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

Disclosure: Long SPXL

 

A key test: The Zero Hedge bottom?

Posted by Cam Hui -

The website Zero Hedge has built a successful franchise on the internet highlighting bearish and market crash narratives with a series of half-truths, misinformation, and conspiracy theories. A recent screenshot of Zero Hedge headlines gives you an idea of their editorial bias.
 

 

In other words, it occupies the supermarket tabloid niche of financial news.

A recent Buzzfeed story revealed that Zero Hedge, which had 670,000 followers, was permanently banned from Twitter for violating its platform manipulation policy. In one article, Zero Hedge accused a Chinese scientist of releasing the coronavirus from a bioweapons lab, released the scientist’s email and phone number, and invited readers to “pay the scientist a visit”.

Notwithstanding the controversy over Twitter’s actions, could this incident may be a sign of the Zero Hedge market bottom, marked by peak hysteria over the coronavirus threat.

Here are the bull and bear cases.
 

Peak bearishness?

Some anecdotal signs are emerging that sentiment is becoming panicky. John Authers at Bloomberg laid out on January 26, 2020 the signposts of peak panic, based on the magazine cover indicator.

While the sample size is extremely small (N=2), here is the cover of The Economist at the height of the SARS panic.
 

 

Here is the magazine cover at the height of the Ebola panic.
 

 

Here is the latest cover of The Economist.
 

 

Still not convinced. Callum Thomas has been conducting an (unscientific) Twitter sentiment poll every weekend since 2016. Sentiment has fallen to the second most bearish reading since the poll began.
 

 

Policy support

The Chinese stock market opened after a one-week Lunar Near Year holiday, and the Shanghai Composite was down -7.7%, which parallels the movement in H shares in Hong Kong, which did trade last week. However, many of the issues went limit down by the maximum -10%, which means that the index could not have fallen much further.

On the other hand, Hong Kong’s Hang Seng Index, which had traded last week, manage to steady itself with a 0.17% gain.
 

 

The USDCNH offshore yuan rate weakened past the 7 to 1 level.
 

 

Policy makers have promised massive market support. Major investors are banned from selling their stock holdings. The PBOC unexpected cut the reverse repo rate by 10 bp, and injected a total of 1.2 trillion yuan (US$173 billion) into money markets to stabilize the markets.

Could the worse be over? Watch for massive “whatever it takes” stimulus in the coming days.
 

A “false rally”?

I have made the case that the actual reason for the correction is mainly attributable to excessive bullish sentiment and overly bullish positioning by the fast money traders. The coronavirus panic was just the excuse for the sell-off (see Trading the coronavirus panic). If Chinese policy support were to put a floor on stock prices, and the stock market rises to test or exceed its old high, it would set up a situation where the excessive bullish positioning is not unwound. As a reminder, a rally would worsen the tensions from the Rule of 20 Indicator. At the current estimate of 20.7, this indicator is already flashing a valuation warning sign for stock prices.
 

 

Under such a “false rally” scenario, I would watch for a rally, marked by a negative NYSE Summation Index (NYSI) divergence, which are conditions that were seen in the last two major market tops.
 

 

This “false rally” is consistent with the observation that the Citigroup Panic/Euphoria Model remained in euphoric territory as of last Friday.
 

 

As well, it is consistent with the inability of the Fear and Greed Index to decline into the oversold target zone of 20 or less, which are readings consistent with durable market bottoms.
 

 

Seriously, can the market make a bottom without a “Markets in Turmoil” program from CNBC?
 

 

A key test of psychology

The market action in the next few days will be revealing of the psychology. Traders will start to focus on the Iowa Caucus tomorrow, and the New Hampshire primary next week. Bernie Sanders is currently the frontrunner to win the Democrat’s nomination for President. How will the market react a Bernie win in Iowa?

In the meantime, Bernie Sanders’ odds of winning the nomination has been soaring in the betting markets.
 

 

A more detailed bottom-up aggregation of PredictIt odds by Millenarian at the state level shows that Sanders has the edge.
 

 

If the coronavirus news was the actual reason for the market sell-off, then expect short-term stabilization and revival in stock prices, followed by a decline later. On the other hand, if it was just the excuse for an overvalued, overowned, and overbought market to go down, then a Bernie Sanders win could provide the next catalyst for further market weakness.

Stay tuned. My inner trader is maintaining his short position for now.

Disclosure: Long SPXU

 

Whistling past the graveyard (doji)

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Neutral (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.
 

A disappointing January

The month of January turned out to be a disappointing. Stock prices roared ahead out of the gate and pushed major market indices to fresh all-time highs. By the end of the month, the market had retreated to end the month slightly in the red. More importantly, the monthly chart printed a graveyard doji, which is often interpreted as a sign of trend reversal.
 

 

Steve Deppe studied past instances when the market rose 3% or more, set a fresh new all-time high, but finished in the red for the month. While the sample size is not high (N=10), the historical results reveal a heightened probability of large drawdowns in February.
 

 

The melt-up hangover may just be beginning.
 

Bearish trend reversals

Signs of bearish reversals are found everywhere. The UK officially exited the European Union on Friday. The FTSE 100 managed to fall below both its 50 and 200 day moving averages (dma) last week. More importantly, the small cap to large cap ratio flattened out and it has been range-bound since December, indicating lessening enthusiasm over the prospect of a booming local British economy.
 

 

Over on this side of the Atlantic, credit market risk appetite has plunged and flashed a negative divergence warning for the stock market.
 

 

The USD Index rallied through a bull flag formation last week. USD strength is a bearish sign for EM assets, because some fragile EM economies have excessive USD debt, and a rising greenback hampers their ability to repay.
 

 

Both the copper/gold and platinum/gold ratios, which are key cyclical and risk appetite indicators, are breaking down.
 

 

Friday’s stock market action was also disappointing. The index violated the lows of the week, indicating the bears had taken control of the tape.
 

 

As a consequence, the signal of the Trend Asset Allocation Model has been downgraded from bullish to neutral.
 

Silver linings

Nevertheless, the bulls can find some silver linings in a dark cloud. Both fundamental and macro momentum remains positive and constructive.

The latest Q4 earnings season update from FactSet revealed both good news and bad news. The bad news was, despite selected strong headline beats by large cap stocks like AAPL and MSFT, both the EPS and sales beat rates fell from last week, and they are now below their 5-year historical averages. The good news is forward looking indicators, namely the forward 12-month EPS estimate, rose strongly last week.
 

 

The bulls may find some solace in the ISM Manufacturing print to be scheduled for Monday morning. Aneta Markowska of Cornerstone Macro found that all five Fed regional manufacturing surveys improved in January, which suggests an upside ISM surprise.
 

 

The 3m10y yield curve has inverted, which has caused some consternation among investors. Similarly, the 2s10s has been flattening rather rapidly, which is another sign of slowing growth expectations. However, the 10s30s spread at the long end of the yield curve has steepened, even as the 30-year yield fell below 2%. The long end of the curve is not confirming the flattening and slowing growth thesis.
 

 

Rob Hanna at Quantifiable Edges pointed out his Capitulative Breadth Indicator (CBI) had rose to 9 just before Friday’s market close.
 

 

In the past, he had used a CBI reading of 10 or more as a buy signal. However, he conducted a study based on a CBI reading of 9 or more, and the market closed at a 20-day low, and the results were encouraging.
 

 

The market may be oversold enough to stage a relief rally next week.
 

Resolving the bull and bear cases

Here is how I resolve the short-term bull and bear cases. The sell-off can mainly be attributed to excessive bullish positioning, and the news of the coronavirus was only a convenient trigger. The market will not make a durable bottom until sentiment gets washed-out.

We are not there yet. We have not seen the classic signs of capitulation. The Citigroup Panic/Euphoria Model (via Barron’s) remains in euphoria territory.
 

 

The Fear and Greed Index closed Friday at 44, which is constructive but the reading is still neutral, and it has not reached the sub-20 levels normally seen at market bottoms.
 

 

In the short run, much depends on positioning, and how momentum players react to events. Macro Charts recently highlighted the estimated dealer positioning based on gamma hedging (see Kevin Muir’s post as a primer on gamma. To make a long story short, dealers who are short gamma need to sell to hedge, which can create a cascade). Gamma turns negative at about SPX 3250. With the market closing 3225, gamma is modestly negative. but we will need further market weakness of 1-2% to spark a rush for the exits.
 

 

Analysis from Callum Thomas of Topdown Charts shows that the reflation and high beta trade is vulnerable to more de-risking. We have not seen the “margin clerk” price insensitive liquidation phase of the market yet.
 

 

An alternative scenario under consideration is a short-term bounce to test the old highs, accompanied by a negative NYSI divergence. The past two major tops have been characterized by such negative divergences.
 

 

If I had to guess, I would assign a 20-30% probability to such an outcome. Mark Hulbert, who also characterized the spark for the current weakness as a retreat in excess bullishness, tried to estimate the size of the correction this way:

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

A short-term rally to test the old highs is paradoxically bad news for the bulls, and would likely resolve in a deeper correction. This “retest the old highs” scenario could very much be in play, and it has the potential to fake out a lot of traders. The market is testing trend line support, and it is just above its 50 dma.
 

 

As well, the market is oversold for a bounce, but it does not appear to be oversold enough for a durable bottom.
 

 

My inner investor is bullishly positioned, but he will sell any rallies to re-balance his portfolio to an allocation that is closer to his long-term asset mix allocations. My inner trader is short the market, and he plans to short into any rallies next week.

Disclosure: Long SPXU

 

Trading the coronavirus panic

Posted by Cam Hui -

Mark Hulbert made a terrific point last week. The coronavirus was not the real reason for the market sell-off. The real reason was excessively bullish sentiment. The coronavirus news was just the excuse.

That real culprit is market sentiment: Short-term stock market timers, on balance, have been extraordinarily bullish for a couple of months now. Even a few days of such excessive bullishness would normally lead to market weakness, much less a few months of such exuberance. So conditions were ripe for a pullback.

If it weren’t the coronavirus, in other words, something else would have been the straw breaking the camel’s back.

 

I had made a similar point in the past. Fast money positioning had become too extreme. Readings were at a crowded long, and portfolio leverage was highly elevated. The market was just ripe for a bearish catalyst.

In that case, how should you react to the coronavirus pullback?
 

Short and long-term outlooks

The answer depends on your time horizon. While I am not blind to the human effects of a possible pandemic outbreak, the purpose of this publication is to analyze the investment impact of such events. Ray Dalio of Bridgewater Associates recently outlined the issues well in a recent essay.

As for the spreading of this virus, as with any sort of unknown, there are 1) actual events and 2) the expectations of events that get reflected in market pricing. Generally speaking these once-in-a-lifetime big bad things initially are under-worried about and continue to progress until they become over-worried about, until the fundamentals for the reversal happen (e.g., the virus switches from accelerating to diminishing). So we want to pay attention to what’s actually happening, what people believe is happening that is reflected in pricing (relative to what’s likely), and what indicators that will indicate the reversal.

In other words, what are the risks? In the short run, here are the questions that investors need to answer:

  • Economic slowdown: Market base case is the SARS outbreak. Will the actual be better or worse?
  • Trade tensions: How will the coronavirus outbreak affect China’s ability to make the purchase committed to under the Phase One trade deal, and how will the US respond?
  • Other excuses: If the market was just overbought, are there other excuses for it to go down?

In the longer term, how does the coronavirus outbreak affect the global growth outlook?
 

Short-term threats

Since we are mostly in uncharted waters, a first order approximation of the effects to GDP growth is the SARS outbreak, whose effects were felt most acutely in Hong Kong, and the nearby Chinese province of Kwangtung.
 

 

However, there are a number of key differences between the SARS episode of 2003 and the Wuhan coronavirus epidemic of 2020.

China is a much bigger part of the world economy today. Disruptions in China today has a much bigger disruptive effect on the global economy because of its participation in global supply chains, as evidenced by the numerous announcements of overseas companies either curtailing or shutting down their operations in China. A partial list include household names like Starbucks, General Motors, Ford, Nissan, Apple, Honeywell, and Ikea.
 

 

As well, the government’s lockdown of activity during the Lunar New Year has cratered Chinese consumption, which is a much bigger portion of the Chinese economy today compared to 2003. As an illustration, box office receipts have cratered to zero during this period.
 

 

Another key difference between 2003 and 2020 is the increased level of debt in China, which makes that economy more fragile and vulnerable to unexpected shocks.
 

 

Comparing SARS and the Wuhan coronavirus can be problematical in other ways. There is some good news and bad news here. The bad news is the coronavirus infection rate is much higher than SARS.
 

 

The good news is the fatality rate is much lower. The SARS fatality rate was about 10%. Initial estimates of the Wuhan coronavirus fatality rate was 2-3%, but it is likely to fall further because of the higher reported infection rate.

Even then, the combination of high infection and low fatality rates have caused concerns at the WHO. The mildness of the virus could help it spread undetected until it reaches a highly vulnerable population. This may be the kind of virus that makes people sick enough so that it spreads, but not so sick that the infected are noticed by health authorities. So far, most of the infected countries are classified as either “most prepared”, or “more prepared”. What happens if the virus migrates to a country that is least able to deal with such outbreaks?
 

 

As an example of the effects of different levels of preparedness, a recent WSJ article documented the differences in response between two Canadian cities, Vancouver and Toronto, to the SARS outbreak.

In Vancouver, by contrast, “a robust worker safety and infection control culture” enabled the hospital to contain the virus, the report found. The Vancouver man with SARS felt ill after a trip to Asia and went to the hospital. Because of his symptoms, the staff whisked him out of the crowded ER within five minutes. Caregivers wore tight, moisture-proof masks and disposable gowns to protect themselves.

The same evening, the Toronto man, whose mother had come from Hong Kong two weeks earlier, went to the hospital with feverish symptoms. For 16 hours he was kept in a packed emergency department. His virus infected the man in the adjacent bed, who had come to the ER with heart problems, and another man three beds away with shortness of breath. Those two other men went home within hours but were later rushed back to the hospital, where they spread the virus to paramedics, ER staff, other ER visitors, a housekeeper working in the ER, a physician, two hospital technologists and, later, staff and patients in the critical-care units.

Poor adherence to infection-control protocols was to blame. Staff failed to wear masks and disposable gowns and didn’t wear face shields while inserting breathing tubes down patients’ airways. After the initial Toronto patient was finally admitted to a hospital room, it took five more hours for him to be isolated.

American hospitals, which are ranked as “most prepared”, have their shortcomings:

A June 2017 literature review of shortcomings in U.S. emergency rooms found a lack of adequate distance between patients, use of contaminated equipment, failure to use shields to protect health-care workers who are intubating patients, and failure to ask coughing patients to wear masks…

The CDC conducted “mystery patient” drills at ERs in 49 New York City hospitals, sending in 95 patients pretending to have symptoms of measles and Middle East respiratory syndrome. In 78% of cases, the ER staff gave these patients masks and isolated them quickly. Even so, only 36% of health-care staff washed their hands. The CDC found “suboptimal adherence to key infection control practices.”

The nightmare scenario is the Spanish Flu of 1918, which killed millions. The effects of the Spanish Flu was exacerbated by poor sanitation and containment protocols. Already, the virus was identified in India, which could be an at-risk country because of its vast population and uneven healthcare standards. What if it shows up in the countries marked as “least prepared”?

So far, the Chinese government has gone all-in with relatively draconian quarantine measures to combat the spread of the virus. This is in stark contrast to the initial response of denial during the SARS outbreak. While policy response and transparency is positive, which the market values, perceptions could easily turn negative at any time. (Recall Ray Dalio’s comment about “what people believe is happening that is reflected in pricing”). However, the government’s public response could turn defensive if unflattering questions and news articles start to emerge. Consider as an example this New York Times opinion piece which concluded that the government cannot be trusted:

Behind all this lies the feeling that most other people in the party can’t quite be trusted. This has been reinforced over the past few days by reports that at least eight people who were detained in Wuhan in early January on charges of spreading rumors are in fact medical doctors, not fear-mongering ne’er-do-wells. This startling fact is now leaking out in online reports that are sometimes, but not always, being blocked. At some point, the government will have to admit to a partial cover-up.

Considering the underlying distrust, it’s hard for the government to say what many epidemiologists are saying: This outbreak is serious but not catastrophic. Because if the state leveled with the people, it would also have to admit that there is no need for this degree of social control. Fewer than 200 people were reported to have died as of Thursday evening, in a country of nearly 1.4 billion, and there is no indication that we are at the start of a Hollywood disaster-style movie.

The government’s inability to formulate a measured response will turn this outbreak into a direct successor of the SARS epidemic. That hardly was a huge public health disaster — fewer than 800 deaths — yet it has taken on a legendary reputation as a catastrophe of unimaginable proportions, one that should never be allowed to recur.

Anything that threatens the authority of the Party is a threat, and the standard Chinese response would be censorship, which would rattle the markets as they hate uncertainty. Imagine the following scenarios (and to be clear, they are made-up and speculative) where questions are asked:

  • Stories circulate of drug-like deal behavior for surgical masks and other medical supplies that the authorities either turn a blind eye to, or unable to control.
  • Embarasing questions about the government’s response to a coronavirus outbreak in Xijiang, and the uneven healthcare provided the Uighur population, compared to the majority Han Chinese.

We would go into the second phase of the fight against the virus, where a veil of censorship goes up, and the world becomes unsure of China’s ability to control the outbreak.

For now, the base case adopted by most analysts is one quarter of very soft or negative GDP growth, followed by a rebound as the virus scare burns itself out. At this point, these are only guesstimates, and investors should monitor how the consensus shifts in the future.
 

 

Political and electoral considerations

Another key question is how the US will react to a Chinese slowdown. The Phase One targets of Chinese imports of American goods were already very ambitious. Any soft patch in Chinese growth, even if it’s confined to just one calendar quarter, will make them impossible to meet. How will Trump react, especially in an election year when he is politically pressed to show progress in a trade war? Will trade tensions rise again?
 

 

As well, I began this report with the thesis that the market was ready to fall, and the coronavirus news was just an excuse. Supposing that news begins to emerge that the outbreak is becoming well contained, could the market still go down?

The answer is yes. There are other threats that could rattle the markets. The Iowa caucus is coming up next week, to be followed by the New Hampshire primary the following week. The latest PredictIt odds now show Bernie Sanders in the lead to win the Democrat’s nomination for President.
 

 

Would that be enough to spook Wall Street? You bet!
 

The long-term outlook

Looking out longer term, the outlook is much brighter. There are numerous indications that the global cyclical rebound scenario that I outlined is still valid (see How far can stock prices rise?). The market should be able to look through the valley of a one quarter hiccup to Chinese and world growth under the base case coronavirus scenario.

Consider, for example, this Gavyn Davies FT article, “Signs of a global recovery in manufacturing are starting to show”. Davies referred to the Fulcrum nowcast, which has unambiguously turned up. He did, however, add the caveat of an assumption that “there will be no meaningful impact on GDP from the coronavirus”.
 

 

There are also other numerous signs that the cyclical revival is still alive and kicking last week (see How my Sorcerer’s Apprentice trade got out of hand), so I will not repeat myself here.

In the absence of definitive recessionary signs, these indications of a cyclical rebound are bullish for the long-term equity outlook. In the short run, however, prices may have gotten ahead of themselves and the US market is overvalued.

How overvalued? The Rule of 20 provides some guidance. Recall that the Rule of 20 flashes a warning sign whenever the sum of the market’s forward P/E and the CPI inflation rate exceeds 20.
 

 

At a minimum, how far does the market need to correct for the Rule of 20 indicator to fall to 19.9? Based on today’s headline CPI inflation rate of 2.3%, and my forward 12-month EPS estimate of 178.71, the S&P 500 would have to correct to at least 3145 before the Rule of 20 sound the all-clear signal. This represents a peak-to-trough correction of about -5.5%. However, the historical evidence shows that the Rule of 20 indicator has fallen much further in the past before bottoming. In other words, pencil in a 5-10% peak-to-trough correction.

However, investors can find cheaper valuations outside the US. While the forward P/E of the US market is at nosebleed levels, developed market P/E ratios are more reasonable at about 14, and EM equities is trading at a forward P/E of 12.8. In the short-term, however, I would avoid EM because of their exposure to China and the uncertainties associated with the coronavirus.
 

 

While the above chart shows the valuation differential between US and non-US equities, the following chart illustrates the tactical price differential. US stocks have surged on a relative basis against MSCI All-Country World Index (ACWI), while non-US stocks have all tanked by comparison.
 

 

In conclusion, traders and investors need to consider their time horizons in order to navigate the latest coronavirus panic. In the short run, the market is falling because of excessive bullish positioning, and the risk-off unwind is not complete. There is more unfinished business to the downside for equity prices.

Longer term, I believe that the global growth outlook remains intact. Investors with longer time horizons should use any market weakness to add to their equity positions. In particular, they should focus on non-US markets, which are more reasonably valued.

In other words, buy the dip, but not yet.

Disclosure: Long SPXU

 

Time to sound the all-clear?

Posted by Cam Hui -

Mid-week market update: I am old enough to remember that one of the burning question for the January FOMC meeting was be whether the Fed would make a technical adjustment on Interest Paid on Excess Reserves (IOER) by 5 basis points. (They did).

Those were simpler times! The stock market rose relentlessly, day after day, and all was well in the land.

Now that stock prices have turned back up again as I had suggested (see Buy for the Turnaround Tuesday bounce), is it time to sound the all-clear and jump back into equities again?
 

 

Based on the historical experience, here are some questions that should be answered.
 

Down Friday/Down Monday

For some perspective on market history, Jeff Hirsch at Almanac Trader found an important historical pattern on what he called “Down Friday/Down Monday”. Most of the time, this pattern proved to be ominous, except when it wasn’t:

Today’s retreat triggered the first DJIA Down Friday/Down Monday of 2020. The combination of a DJIA Down Friday* followed by a Down Monday** has been a rather consistently ominous warning, but they have also occurred at significant market inflection points (interim tops and bottoms). The last occurrence was in August of last year. That declined proved to be a good entry point for new long positions as the market enjoyed a solid rally through the end of the year.

How can you tell the difference? According to Hirsch, here is the key “tell”:

if DJIA recovers its recent losses within about 4-7 trading days, then the DF/DM that just occurred was likely the majority of the decline. However, if DJIA is at about the same level or lower than now, additional losses are more likely sometime during the next 90 calendar days.

In other words, price momentum will tell the story. As guidelines, the DJIA has to recover back to 29167 and SPX has to recover to 3326 by next week. Otherwise the odds favor another leg downwards.

 

Remember sentiment?

Another key question for investors and traders is the evolution of sentiment, particular fast money sentiment and positioning. I wrote on the weekend (see A market stall?) that a market decline was more or less inevitable due to excessive hedge fund bullish positioning.

Risk-adjusted returns, as measured by 3-month equity returns divided by standard deviation has one of the best readings dating all the way back to 1928. This is attributable to two factors. The stock market has been rising steadily, and the low realized volatility of the market, which has encouraged risk taking by hedge fund traders. Positioning is now at a crowded long, which makes the market vulnerable to a setback. Should prices start to recycle downwards, the potential for a disorderly unwind of long positions is high.

 

 

Now that the risk unwind appears to have begun, how has sentiment evolved? While it’s difficult to get any real-time estimates of hedge fund positioning, there are some updates of sentiment that may be useful. The latest update of II sentiment shows some retreat in bullishness, but readings are still elevated.
 

 

Callum Thomas has conducted an (unscientific) weekend Twitter poll since mid-2016, and the survey provided a snapshot of sentiment on the weekend when the anxiety over coronavirus infection was at its height. The survey showed equity bullishness plunged to near all-time lows. However, it would be highly unusual for the market to turn up based on a one-week precipitous decline in bullishness. Wait for the 4-week average to catch up to lower levels of bullishness.
 

 

That said, cratering bullishness has historically been associated with VIX readings of over 20, which has not occurred yet.
 

 

The bulls have not suffered enough pain yet. We need more for capitulation to occur.
 

Market internals

A review of the relative strength of the top five sectors reveals a weakish picture. As a reminder, the top five sectors comprise nearly 70% of index weight, and it would be difficult for the market to make a major move without the participation of a majority of these sectors. Of the five sectors, only one (Technology) is unambiguously bullish, one (Communication Services) is neutral, and the other three are bearish. This gives the market a slight bearish tilt, though the market is volatile, and leadership shifts can happen at any time.
 

 

Looking beneath the surface, even the strength of Technology stocks is problematical. An analysis of the equal vs. cap weighted performance of technology stocks shows that the equal-weighted to cap weighted ratio within the sector is tanking. This is a sign of narrowing leadership by large cap FAANG stocks.
 

 

Further breadth analysis of the top five sectors also reveals how market breadth has deteriorated. Net highs-lows are all falling, and one sector (Communication Services) is showing negative net highs-lows. Can the market rally to new highs with internals like this, or are these signs of an oversold bottom?
 

 

In conclusion, the weight of the evidence indicates that the market has unfinished business left to the downside. My inner trader took partial profits on his short positions on Monday (see Buy for the Turnaround Tuesday bounce), but he remains short the market.

Disclosure: Long SPXU
 

Buy for the Turnaround Tuesday bounce?

Posted by Cam Hui -

I just wanted to put out a quick note this morning. The markets are obviously very chaotic this morning and they have taken on a risk-off tone. The VIX Index has spiked above its upper BB, and its term structure has inverted. Both are indications of high fear.     Should traders step in and […]

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A market stall?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Bearish

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

A market stall?

For the last two weeks, I have been warning about the extended nature of the stock market (see Priced for perfection and Froth everywhere!). Now that the advance is pausing over concerns the Wuhan coronavirus, is this the start of a market stall?

It’s starting to look that way. The SPX violated its 5 and 10 day moving averages, and printed an outside reversal day. These are all indications of a possible change in trend.
 

 

Here are bull and bear cases.
 

The bear case

Let’s start with the bear case, which is more obvious from a tactical perspective. First, equity risk appetite as measured by the ratio of high beta to low volatility stocks has rolled over. This has been a reliable trading signal in the past of market weakness.
 

 

The signal from credit market risk appetite is similarly worrisome. Both high yield and emerging market bonds are underperforming their duration-equivalent Treasuries. While these indicators are tracing negative divergences to equity prices, their readings have tended to be volatile.
 

 

The price of the long Treasury ETF has staged an upside breakout from a falling trend line. Rising Treasury prices are an indication of diminished risk appetite, which is equity bearish.
 

 

The bull case

While bearish red flags are beginning to be raised, there are a number of neutral to bullish indicators to consider. The USD Index has staged an upside breakout out of a multi-year base, and it is tracing out a bull flag formation. Should the USD break out of the bull flag, it would be bearish for emerging market assets, and therefore negative for risk appetite. Keep an close eye on the greenback. The jury is still out on that question.
 

 

The latest BAML Global Fund Manager Survey shows that EM is the largest equity overweight position among managers. A USD rally and EM retreat has the potential to cause the maximum amount of pain, and a disorderly unwind and risk-off stampede.
 

 

The latest update from Q4 earnings season remains upbeat. EPS and sales beat rates are neutral to positive relative to history. More importantly, forward 12-month earnings estimates are rising, indicating positive fundamental momentum. However, the magnitude of the EPS beats was slightly disappointing. They came in at a rate of 3.2% above expectations, which is below the 1-year average of 4.5% and 5-year average of 4.9%.
 

 

Just as importantly, the market is behaving as expected by rewarding EPS beats and punishing misses.
 

 

Breadth and momentum indicators are still strong. The % of stocks above their 50 day moving average is not behaving in a way similar to past major market plunges. Arguably it is still early and this indicator could fall dramatically in the near future.
 

 

As well, NYSI has barely begun to roll over. Past major market tops have been characterized by negative divergences in NYSI, which is not evident this time. In the past, rollovers by the high beta to low volatility ratio have been followed by 5-10% corrections, but this time could be different. The possibility exists that, in the absence of a NYSI negative divergence, any pullback could be shallow in the order of -2%. This would be followed by a market rally and negative NYSI divergence that marks the final top.
 

 

The verdict

After considering the bull and bear cases, what’s the verdict?

The recent market melt-up was characterized by excessively bullish sentiment and a bullish stampede by traders. This chart from SentimenTrader (via Andrew Thrasher) makes a great point. Risk-adjusted returns, as measured by 3-month equity returns divided by standard deviation has one of the best readings dating all the way back to 1928. This is attributable to two factors. The stock market has been rising steadily, and the low realized volatility of the market, which has encouraged risk taking by hedge fund traders. Positioning is now at a crowded long, which makes the market vulnerable to a setback. Should prices start to recycle downwards, the potential for a disorderly unwind of long positions is high.
 

 

For a longer term perspective, consider the evolution of long bond yields. The 30-year Treasury yield has staged a recent tactical retreat, but the level of macro concerns outside of the Wuhan coronavirus is relatively low compared to past episodes of falling bond yields. Indeed, the St. Louis Fed Financial Stress Index hit an all-time low, and the Chicago Fed National Conditions Index isn’t that far behind.
 

 

This is compressing real bond yields, which is bullish for gold, and the reflation trade. My interpretation is that while the market is at risk of a short-term pullback because of excessive risk positioning, investors should consider market weakness to be an opportunity to buy the reflation trade.
 

 

In the short run, we may not be at a tipping point in the market just yet. In the past, significant market downdrafts have not occurred without the Fear and Greed Index recycling from above 60 to below the 60 mark. While we are close, that bearish tripwire has not been triggered yet.
 

 

While I am leaning towards a bearish resolution, the signals of a major downdraft are not yet in place. Traders could dip their toes in the bearish pond, and await further developments. My inner trader had already initiated a short position, and he raised his shorts when the market violated its 5 dma on Friday.

While my inner trader is tactically bearish in his trading account, the week ahead may not be as easy as anyone thinks. Earnings season is in full swing, and a host of macro releases could have market moving consequences. The Fed and the BoE meet next week. We will also see the US and the eurozone report initial estimates of Q4 GDP, and China will report its official PMI.

Consequently, the week ahead could be very volatile and difficult to navigate from a trader’s perspective. Monday could see further downside as the weekend news is filled with stories of the seriousness of the Wuhan coronavirus. The market is already mildly oversold as of Friday’s close, and could see a Tuesday turnaround after more weakness on Monday.
 

 

Keep an open mind, and adjust the size of your trading positions to the expected heightened volatility.

Disclosure: Long SPXU
 

How my Sorcerer’s Apprentice trade got out of hand

Posted by Cam Hui -

Remember the story of the Sorcerer’s Apprentice from Fantasia (click link for YouTube video)? Mickey Mouse played the role of a sorcerer’s apprentice tasked to carry buckets of water. Instead of doing it himself, he stole the sorcerer’s hat and animated a broomstick to carry the buckets for him. To speed up the work, he animated more and more broomsticks, until everything got out of hand.
 

 

While I don’t claim to be a prescient genius who can see the future of the market, I was fortunate to spot the beta chase early. Bloomberg reported on December 18 that Stanley Druckenmiller had turned bullish, and Druckenmiller would not have gone on television to proclaim his embrace of risk if he hadn’t fully entered into his entire position yet. As Kevin Muir at The Macro Tourist pointed out, “It is also probably safe to say that Druckenmiller, on the whole, is way ahead of most investors.” In other words, the fast money crowd was stampeding into the reflation and cyclical recovery trade.

Nevertheless, the subsequent melt-up does feel a bit like a “sorcerer’s apprentice” rally that got out of hand. Now the equity risk appetite seems to rolling over, and the steady advance seems to pausing on the news of the Wuhan coronavirus, what’s next?
 

 

A melt-up recap

To recap the events of the last few months, let’s go back to last August. The 2s10s yield curve had inverted, and there was widespread concern about a recession. While I was skeptical about the recession narrative, I did expect a deeper valuation reset that did not materialize.
 

 

The market eventually recovered and broke out to all-time highs in late October. On November 10 (see How far can stock prices rise), I speculated about the possibility of a market melt-up. The Street had become overly defensive in its positioning, and evidence of a global cyclical recovery was emerging, which would lead to a beta chase stampede to buy stocks.

A more reasonable scenario is a bubbly market melt-up, followed by a downdraft, all in a 2-3 year time frame.

On December 1, I confirmed the melt-up scenario (see Buy signal confirmed: It’s a global bull):

The SPX may be undergoing a melt-up in the manner of late 2017. It is unusual to see the index remain above its weekly BB for more than a week, which it did two weeks ago. The melt-up of late 2017 also saw similar episodes of upper weekly BB rides, punctuated by brief pauses marked by “good overbought” conditions on the weekly stochastic. The technical conditions appear similar today, and I am therefore giving the intermediate term bull case the benefit of the doubt.

Even though the bullish stampede was in my forecast, its sheer breadth was astonishing. In particular, the fast money crowd had gone all-in, both on risk and leverage. The degree of leverage undertaken by hedge funds was exacerbated by a compression in realized volatility, which was the result of HF steady buying. The compression in implied and realized volatility served as an input to trading desk risk models, which encouraged even more leverage to fund long positions. In other words, the sorcerer’s apprentice was animating more and more broomsticks.
 

 

The slower moving institutional investors were also buying into the cyclical recovery trade. The BAML Global Fund Manager Survey showed a spike in global expectations that began late last year.
 

 

Equity positioning, however, was not as extreme as hedge funds. Readings are only in neutral territory and nowhere near crowded long levels. By contrast, the 2017/18 melt-up episode began with global institutional equity positioning already bullish, and readings then surged to a crowded long.
 

 

Another difference between the current melt-up and the 2017/18 experience is the lack of participation by retail investors. The TD-Ameritrade Investor Movement Index, which tracks the custodial position of the firm’s clients, shows that while individual investors did buy into the rally, their level of exuberance was nothing compared to the last melt-up episode.
 

 

What next?

So where do we go from here?

The fast money crowd front ran the institutional cyclical recovery trade, and hedge funds are now in a crowded and leveraged long on risk. Market valuation became extended. The stock market is now trading at a forward P/E of 18.6. The Rule of 20, which flashes a warning whenever the sum of forward P/E and inflation rate exceeds 20, is warning of a market pullback.
 

 

The cyclical recovery narrative is also showing some cracks. In the US, the relative performance of cyclical groups are mixed. Semiconductor stocks are still on fire. Industrial stocks have been soft against the market, but much of the weakness is attributable to the well-publicized problems at heavyweight Boeing. An equal-weighted analysis, which reduces the effects of Boeing, shows that the sector is performing reasonably well. However, homebuilding stocks were underperforming during a period when the cyclical recovery theme was dominant, though they have since begun to rise again and remain in a relative uptrend. Transportation stocks, on the other hand, have done nothing except to lag the market during this entire period.
 

 

In Europe, the rally of cyclically sensitive have paused. Industrial stocks did stage an upside relative breakout, but they have paused and begun to move sideways. Similarly, the financial sector broke out of a relative downtrend, but they are also consolidating sideways. By contrast, a defensive sector like consumer goods are bottoming on a relative basis, and it is starting to show signs of life.
 

 

As the European markets have begun to take on a defensive tone, bond yields have fallen (and bond prices have risen). Falling bond yields are detrimental to European banking profitability, and it is therefore no surprise to see European banks start to underperform. The recent price recovery of the Austrian century bond is an example of the shift in risk appetite.
 

 

Normally, at this point I would turn to an analysis of China and Asia’s markets for completeness. However, the recent panic over the Wuhan coronavirus makes analysis difficult. It’s all noise until we get more clarity on the situation.
 

The cyclical trade still alive and kicking

In summary, the market is tactically poised for a pullback. Valuations are extended, and fast money positioning is too bullish. But that doesn’t mean the bull is dead, once we see a valuation reset. All fundamental and macro signs show that the cyclical recovery trade is still alive.

From a top-down perspective, the Citi US Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations, is rising and indicating that the cyclical recovery is showing strength.
 

 

G10 ESI is also showing a similar pattern of strength.
 

 

Calculated Risk reported that the Chemical Activity Barometer, which is a leading indicator of industrial production, is turning up.
 

 

Renaissance Macro Research also pointed out that the word count of “weak” and “slow” are falling in the latest Fed Beige Book survey, which is another sign of cyclical strength.
 

 

From a bottom-up perspective, consider the latest excerpted comments from The Transcript, which is a summary of company earnings calls:

Business sentiment is improving
“We see some resolution to those issues and that combined with continued consumer strides, leads us to expect to see businesses continue their solid activity and we’re hearing more optimism.” – Bank of America (BAC) CEO Brian Moynihan

“There’s no question in the fourth quarter the environment improved. Based on the data or information we can see across activity and dialogue with clients, I would say that it’s improved in the fourth quarter and the trends that we’re seeing early into 2020 are a little bit more positive.” – Goldman Sachs (GS) CEO David Solomon

” the fourth quarter definitely, I would say, stabilized. Things trade certainly stabilized. Things, broadly speaking, stopped getting worse and so, we saw sentiment improve a bit” – JPMorgan Chase (JPM) CFO Jennifer A. Piepszak

Manufacturing seems to be turning a corner
“last year we did see a little bit of weakness in manufacturing, but we’re starting to lap that and we’re starting to see some positive momentum coming out of that sector. So generally, we’re seeing some very good signs from our corporate.” – Delta Air Lines (DAL) President Glen Hauenstein

” For most of calendar year 2019, the weakness in global manufacturing was exacerbated by the inevitable inventory destocking that companies undertook in response to the weak demand conditions…As we enter 2020 however, we are seeing signs of an improvement.” – Schnitzer Steel Industries (SCHN) CEO Tamara Lundgren

Significantly, the US consumer is doing fine
“our results continue to reflect the strength of the U.S. consumer in the biggest economy in the world…We also continue to see healthy consumer trends in spending and asset quality. ” – Bank of America (BAC) CEO Brian Moynihan

“Our outlook heading into 2020 is constructive, underpinned by the strength of the U.S. Consumer.” – JPMorgan Chase (JPM) CFO Jennifer A. Piepszak

China headwinds are moderating
“In Europe, growth continues to remain relatively low given manufacturing weakness. However in China trade headwinds appear to have moderated with both monetary and fiscal stimulus supporting growth estimates of nearly 6%” – Goldman Sachs (GS) CEO David Solomon

Across the Atlantic, the latest flash PMI release shows signs of green shoots in manufacturing. Manufacturing PMI edged up, and the new orders/inventory ratio rose strongly, indicating that the inventory de-stocking cycle is over.
 

 

As well, the latest ZEW survey from Germany rose unexpectedly. While ZEW is a sentiment survey, it has historically led eurozone GDP growth by about 12 months.
 

 

In conclusion, the stock market is tactically poised for a pullback and valuation reset. However, fundamental and macro indicators all point to a continuation of the global cyclical recovery. I have pointed out before that the highly reliable long-term monthly MACD buy signal for US equities remain in play.
 

 

Similarly, the buy signal for non-US markets is also still valid.
 

 

Any market weakness should only a hiccup. Investors should be preparing to buy the dip, while traders should position themselves for a correction.

Disclosure: Long SPXU
 

Cruisin’ for a bruisin’

Posted by Cam Hui -

Mid-week market update: Bloomberg reported that BAML strategist Michael Harnett wrote a report back on December 12 forecasting a melt-up. He believed the market’s gains would be front loaded in 2020. and he projected an S&P 500 target of 3,333 by March 3. The index reached that level intra-day today, and it’s still January. Are the front-loaded gains over?

Sentiment is certainly extended. II %bulls rose to 59.4% this week, and the bull-bear spread has reached the highest level since October 2018.
 

 

SentimenTrader observed that Trump’s tweets about the stock market had reached a new record.
 

 

As well, Macro Charts pointed out that further analysis from SentimenTrader showed that option buy-to-open volume reached a record high for a second week in a row.
 

 

It certainly seems that the stock market is “cruisin’ for a bruisin'”.
 

Stage set for a volatility spike

I have been warning about the possibility of a pullback for nearly two weeks (see Priced for perfection).  It isn’t just that the market is overbought and valuations stretched, fast money positioning is set up for a sharp response should any unexpected fears, such as a coronavirus induced economic slowdown, spook the market.

A week ago, Macro Charts reported that the market had gone 66 days without a 1% decline. The clock is still counting as both implied and realized volatility have compressed.
 

 

Callum Thomas at Topdown Charts also documented the case of suppressed FX volatility.
 

 

As overall asset volatility falls, the volatility, or risk, estimates that go into Value At Risk (VaR) models for trading desks also falls. This encourages traders to take more risk. Indeed, as volatility declined and the prices of risky assets rose, both systematic and discretionary hedge funds have piled into equities.
 

 

Moreover, they have also increased leverage in accordance to the reduce risk estimates from their VaR models.
 

 

We all know what happens next. Should volatility normalize, the level of risk and leverage allowable by VaR models declines. If such an event is accompanied by a risk-off episode, the potential for a disorderly sell-off is high. Credit Suisse documented what happened to the EURUSD exchange rate after past periods of suppressed FX volatility.
 

 

All the market needs is a trigger.
 

A coronavirus trigger?

Could the coronavirus news be the trigger, or the excuse, for a volatility spike? As a reminder, the SARS coronavirus infection of 2003 infected thousands, and killed hundred. It also cratered the Hong Kong economy, and sliced 1% off China’s GDP growth,
 

 

It is revealing that the editor of Global Times, which is part of the Chinese official media, would admit to the spread of the virus. The timing of the outbreak is unfortunate, as widespread travel during the Lunar New Year festivities is likely to encourage the spread of the infection.
 

 

Business Insider reported the scope of the infection is widening quickly, and nine fatalities have been confirmed so far. The virus has migrated to the US. The Center for Disease Control announced its first case of infection yesterday.
 

 

Equally worrisome is the news that Wang Guangfa, a respiratory expert of Peking University First Hospital, has been infected with the virus (story in Chinese here). He is reported to be in stable condition.

Bloomberg Asia Chief Economist Tom Orlik pointed out two sources of fragility that Chinese economy faces today as a result of the coronavirus infection. First, services suffered the most during the SARS epidemic. Services comprise a far larger part of the Chinese economy today, which makes it more sensitive to consumption shocks.
 

 

As well, the financial markets were far more orderly then subject to more government control. Today, the markets play a bigger role in the price discovery mechanism. Consequently, volatility risk is far higher today compared to 2003.
 

 

To be sure, the current outbreak is less virulent than SARS. The apparent infection rate is far lower than SARS, and the Chinese authorities have been more proactive in dealing with the problem compared to the 2003 episode.
 

 

On the other hand, even the Ebola outbreak of 2014, whose economic effects were regionally isolated, panicked the market and spiked the VIX Index from 11 to 31 in the space of about a month (see The Ebola correction? OH PUH-LEEZ!).
 

Trade war trigger?

If the coronavirus is not enough to rattle the markets, another bearish trigger might be the threat of a transatlantic trade war. The fur is flying in a trade spat at Davos. In an unplanned news conference, Trump characterized the EU as “worse than China” on trade. The dispute over the French tax on digital companies remains unresolved, and Trump has threatened to impose tariffs on European cars in retaliation. The UK managed to get into the act, too. The Chancellor of the Exchequer Sajid Javid vowed to impose their own digital tax in April.
 

 

Stayed tuned.
 

Bracing for volatility

Another source of volatility might be the Iowa caucus. The WSJ reported that implied volatility usually picks up around elections, and traders are buying volatility ahead of the Iowa caucus.

Options markets are bracing for big swings in stock prices around the U.S. presidential election.

Traders are picking up options that would pay out after the Iowa Democratic caucuses on Feb. 3, betting on volatility, according to Wells Fargo Securities. That’s based on options tied to the S&P 500 expiring on Feb. 5. Traders have also paid up for options on the Cboe Volatility Index, or VIX, expiring that month, which would profit if market turbulence jumped through February.

Ahead of the Iowa caucus on February 3, another source of volatility might occur the week before. The FOMC meeting is scheduled for Wednesday, January 29.
 

Technical warnings

From a technical perspective, I have been monitoring the high beta/low volatility factor pair (see Froth everywhere!). In the past, rollovers in this pair trade has led market declines. It just breached a rising relative trend line to confirm a shift in regime from risk-on to risk-off.
 

 

Equally worrisome is the behavior of the DJ Transportation Average. Even as the DJIA made new all-time highs, the Transports has been stubbornly weak, and it has been unable to rally to fresh highs as confirmation.
 

 

Econbrowser confirmed the softness of sector fundamentals by highlighting the weakness of the Cass Freight Index and BTS Freight Services Index.
 

 

My inner trader initiated a short position based on the rally of TLT, the long Treasury bond ETF, through a declining trend line. As rising Treasury prices tend to be risk-off signals, a bond market rally is bearish news for risk appetite. TLT fell below the trend line, but recovered Tuesday and strengthened Wednesday.
 

 

Having taken a partial short position, my inner trader is now waiting for the S&P 500 to decline through its 5 day moving average, as an additional bearish signal to increase his short position.
 

 

My inner trader is bearishly positioned. My inner investor remains bullish. While valuations are stretched, the longer term macro outlook remains bright, and downside risk is probably no more than 10%. If an investor is afraid of a 10% pullback, than he should re-think his commitment to equities.

Disclosure: Long SPXU

 

Froth everywhere!

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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.
 

Will history repeat itself?

Looking to the week ahead, there is no doubt that the stock market is becoming more and more frothy. While I did alert readers to the potential for a melt-up in early December (see Buy signal confirmed: It’s a global bull), the magnitude of the price surge has caught me even by surprise.

I remain bullish on an intermediate term basis. The SPX may be undergoing a melt-up in the manner of late 2017. It is unusual to see the index remain above its weekly BB for more than a week, which it did two weeks ago. The melt-up of late 2017 also saw similar episodes of upper weekly BB rides, punctuated by brief pauses marked by “good overbought” conditions on the weekly stochastic. The technical conditions appear similar today, and I am therefore giving the intermediate term bull case the benefit of the doubt.

The melt-up of 2017/18 ended in late January, 2018. Will history repeat itself? As a reminder, here is the latest cover from Barron’s.
 

 

Today, market conditions are characterized by:

  • Excessively bullish sentiment: While crowded long sentiment readings are warnings of downside risk, they do not act well as timely trading indicators.
  • Waiting for a catalyst: While there has been plenty of good news, there has also been bad news lurking in the background. This brings investors and traders to ponder the question of, “Is the glass half full or half empty?”
  • Overbought markets: But overbought markets can indicate either “good overbought” markets dominated by price momentum, or overbought markets ripe for a reversal.

 

Too bullish?

\
Signs of excessive bullishness are everywhere you care to look. The Fear and Greed Index has been stretched, but readings have been at nosebleed levels for over a month. While these conditions warn of contrarian bearishness, sentiment models are much better at spotting bottoms than tops. They are simply not actionable as sell signals for trading accounts.
 

 

Macro Charts pointed out that the Daily Sentiment Indicator (DSI) for VIX, which tends to be inversely correlated with stock prices, printed at 9% bulls for three times last week. The historical record for such episodes have been bearish for stock prices. On the other hand, Macro Charts had been cautious since this run-up began in December. That said, DSI for both the SPX and NDX have been over 90, which are warning signs.
 

 

Callie Cox observed that the market is undergoing a period of prolonged equity volatility compression.
 

 

As a reminder, the last two episodes were resolved in a bearish way.
 

 

Callum Thomas at Topdown Charts also pointed out that volatility compression has not been restricted to equity volatility. FX volatility has also been suppressed, which tends to end with a volatility explosion.
 

 

File these indicators under “this will not end well”, but the market is unlikely to fall without a bearish catalyst.
 

Glass half full, or half empty?

A lot of important market moving news had hit the tape in the past week. While the market has reacted mostly positively to news, we have also seen bad news that have lurked under the surface. This is setting up a dilemma for investors and traders when interpreting news.

Is the glass half full, or half empty?

Consider the Phase One deal signed by Donald Trump and Liu He last Wednesday. While our trade war factor, which measures the relative performance of domestically oriented companies, is flashing a huge sigh of relief. On the other hand, soybean prices are retreating they are testing a major support level. Is the glass half full, or half empty?
 

 

In addition, the Senate is about to pass legislation to ratify USMCA, or NAFTA 2.0. At the same time, EU chief trade negotiator Phil Hogan called out Trump for being obsessed with the trade deficit. Treasury Secretary Mnuchin is scheduled to meet with French finance minister Le Maire at the sidelines of the Davos World Economic Forum next week. They have set a deadline of next Wednesday to settle the dispute of the French digital tax, which Trump has threatened to retaliate by imposing 100% tariffs on French wines and other imports. We could see a new transatlantic trade war break out by next weekend.

Is the trade tension glass half full, or half empty?

From a valuation perspective, the market is now trading at a nosebleed forward P/E multiple of 18.6. However, the 10-year yield at the January 2018 peak was 2.6%, compared to 1.8% today, indicating that the market may not have reached a similar level of peak valuation because the discount rate on earnings is lower.
 

 

Here is another perspective on the valuation question. According to Morningstar, the market is roughly 7% overvalued. This degree of overvaluation is high relative to its history, and the only episode that eclipsed the current period was the melt-up of 2017/18.
 

 

The very early results from Q4 earnings season have been neutral to positive. The EPS beat rate is in line with historical averages, while the sales beat rate is above average. Moreover, forward 12-month EPS is being revised upward, indicating positive fundamental momentum.
 

 

Is the valuation glass half full, or half empty?

The message from the credit markets is similarly ambiguous. On one hand, the performance of both investment grade (IG) and high yield (HY) relative to their duration-adjusted Treasuries have roughly matched the stock market in the past year, indicating a confirmation of the new highs. On the other hand, both the relative performance of IG and HY have been flat since mid-December while stock prices have soared, which is a negative divergence.
 

 

Is the credit market risk appetite glass half full, or half empty?

From a technical point of view, the analysis of the relative performance of the top five sectors of the market is revealing. Since these sectors comprise nearly 70% of the weight of the index, the market cannot make a major move without signs of either bullish or bearish leadership from these sectors. Of the five sectors, one (technology) is in a bullish relative uptrend, two (heathcare and communications services) are range bound, and two (financials and consumer discretionary) are weak. The net weight of strong sectors compared to weak sectors is roughly zero. In short, the internals from sector leadership is not as positive as the progress of the major market averages.
 

 

Is the technical analysis glass half full, or half empty?
 

An overbought market

Breadth indicators from Index Indicators show that the market is simultaneously recycling from an overbought condition on different time horizons, which is unusual.

On a short (1-2 day) basis, the market is turning down from an overbought condition based on % of stocks above their 5-day moving average (dma).
 

 

On a 2-5 day horizon, the market is also recycling from overbought condition based on % of stocks above their 10 dma.
 

 

Similarly, readings are the same based on the net 20-day highs-lows, which is an indicator with a 1-2 week horizon.
 

 

Are these “good overbought” signals exhibited by a steady price momentum based market advance, or the signs of an imminent market stall?
 

On the edge of a precipice

The market’s prevailing thinking at this time is a glass half full, but even a minor change in psychology could turn the paradigm to a glass half empty. Tactically, the market environment is highly risky, and prices could turn down with little or no warning at any time.

My inner trader initiated a short position last week when long Treasury prices rallied above a falling trend line. Since Treasuries represent the safety trade, UST strength would be bearish for risk appetite and therefore bearish for stock prices. Unfortunately, bond prices reverted below the trend line on Friday.
 

 

However, I am not ready to close out the short position just yet. The market has begun to recycle from an overbought position. More importantly, equity risk appetite, as measured by the ratio of high beta to low volatility stocks, is testing a rising trend line and may be rolling over. In the past, such rollovers have preceded bearish episodes.
 

 

Traders should monitor how these indicators develop over the next few days. This may be the start of an inflection point for stock prices.

Disclosure: Long SPXU

 

Energy: Value opportunity, or value trap?

Posted by Cam Hui -

Callum Thomas recently highlighted an observation from BAML that the market cap of Apple (AAPL) is now larger than the entire energy sector.

AAPL is now the largest stock in the index, but its weight at 4.5% is not especially extreme in the context of the historical experience. The fact that AAPL’s market cap has eclipsed the aggregate weight of the energy sector is telling.

Is this an inflection point for the energy sector? Do energy stocks represent a value opportunity that should be bought, or a value trap to be avoided?

I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

The Sun is about to undergo a period of low sunspot activity, which has shown to have a cooling effect on the Earth’s climate. The climate data that emerges over the next decade should show that the effects of human-induced warming to be partially or fully offset by the effects of the solar cycle. Public concerns about climate change, and policy surrounding a global climate emergency, are likely to abate, but that process will take time.

I conclude that while the sector is acquiring a value characteristic, sentiment is not yet a wash-out and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade set-up. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.

The new tobacco?

In this era of hyper-sensitivity about climate change, energy stocks are being shunned in a way that they are becoming the new tobacco stocks. The topic has grabbed the attention of top policy makers and major investors. Canada’s Financial Post reported that BoE Governor Mark Carney warned financial services companies need to take action to cut CO2 emissions:

Financial services have been too slow to cut investment in fossil fuels, a delay that could lead to a sharp increase in global temperatures, Bank of England Governor Mark Carney said in an interview broadcast on Monday.

His remarks painted a big cross-hair on the energy sector.

Carney cited pension fund analysis that showed the policies of companies pointed to global warming of 3.7 to 3.8 degrees Celsius, compared with the 1.5-degree target outlined in the Paris Agreement on climate change.

“The concern is whether we will spend another decade doing worthy things but not enough… and we will blow through the 1.5C mark very quickly,” Carney said in a radio program guest edited by teenage environmental campaigner Greta Thunberg.

“As a consequence, the climate will stabilize at the much higher level.”

The Economist reported that Jeremy Grantham of GMO echoed Carney’s assessment.

Late last year Jeremy Grantham, an investor routinely described as “legendary”, spoke about esg (environmental, social and governance) investing at a conference in London. His presentation was slick; his accent floated somewhere in the mid-Atlantic (Mr Grantham is English but has lived in America for ages). “I love s and g,” he began. “But e is about survival.”

As a consequence, Grantham is uber-bearish on oil stocks, to the extent that he believes investors need to make the oil industry a pariah.

Is there also a moral case for disinvestment? An argument against is that oil firms are best placed to speed the transition to solar and wind power. They have experience of managing big projects in difficult terrain. And many would say that dumping oil stocks is a pointless salve to the eco-warrior’s conscience. Bill Gates, a software mogul and philanthropist, has argued that people should not waste idealism and energy on a policy that will not cause any reduction in the use of fossil fuels. What matters are incentives set by governments: tax breaks to fund research in green energy; tax rises to discourage carbon use. But this misses the point, says Mr Grantham: “You have to make the oil industry a pariah for bad behaviour.” Only then will politicians feel the need to act.

BlackRock CEO Larry Fink released a letter to CEOs to assert, “Climate change has become a defining factor in companies’ long-term prospects.” It is time for fiduciaries like Blackrock to act.

Over the 40 years of my career in finance, I have witnessed a number of financial crises and challenges – the inflation spikes of the 1970s and early 1980s, the Asian currency crisis in 1997, the dot-com bubble, and the global financial crisis. Even when these episodes lasted for many years, they were all, in the broad scheme of things, short-term in nature. Climate change is different. Even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis. Companies, investors, and governments must prepare for a significant reallocation of capital.

While Fink did not come out and say it, his term, “a significant reallocation of capital” is code for divestment to force up the cost of capital of companies that contribute to climate change and global warming. As BlackRock’s assets under management total about $7 trillion, this statement will bound to have a chilling effect on the energy sector.

Cheap enough?

Are energy stocks sufficiently washed out? Investors have been shunning energy stocks for over a decade. The sector has undergone over 10 years of poor relative returns.

Is their valuation cheap enough? FactSet reports that the energy sector trades at a forward P/E ratio of 17.5, which is well below its 5-year average of 29.1 and 10-year average of 20.4. Before anyone writes me to complain that oil and gas stocks trade on cash flow multiples, I would point out that, on a cap weighted basis, the US energy sector is dominated by integrated companies with substantial downstream refining and marketing assets. In such instances, the use of a P/E multiple to value integrated stocks is entirely appropriate.

Moreover, the most liquid energy sector ETF,XLE has a dividend yield of 3.7%, compared to 1.7% for the market, as represented by SPY.

A long-term bullish factor

There is no doubt that energy stocks are cheap, but cheap stocks can become cheaper in the absence of a bullish catalyst, especially if investors perceive them to be in an industry in decline. However, I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

Cosmic rays.

An important article at Electroverse explains how cosmic rays (CR) and the solar cycle affect the Earth’s climate.

During solar minimums –the low point of the 11-or-so-year solar cycle– the sun’s magnetic field weakens and the outward pressure of the solar wind decreases. This allows more cosmic rays to penetrate the inner solar system as well as our planet’s atmosphere:

The solar cycle has a regular ebb and flood pattern of 11 years. The Sun is about to undergo a period of low sunspot activity. The level of cosmic ray radiation is inversely correlated with the level of sunspot activity, which affect the Earth’s climate.

More crucially however, CRs hitting Earth’s atmosphere have been found to seed clouds (Svensmark et al), and cloud cover plays perhaps the most crucial role in our planet’s short-term climate change.

“Clouds are the Earth’s sunshade,” writes Dr. Roy Spencer, “and if cloud cover changes for any reason, you have global warming — or global cooling.”

The upshot of this current solar minimum (24) –the sun’s deepest of the past 100+ years (NASA)– is a cooling of the planet, with the coming solar cycle (25) forecast by NASA to be “the weakest of the past 200 years“:

In fact, the forecast calls for a prolonged period of low sunspot (high cosmic ray) cycle that is reminiscent of the Maunder Minimum. Studies by NASA have attributed low sunspot activity to be the cause of prolonged cooling periods like the Maunder Minimum, otherwise known as the Little Ice Age of the 17th Century. For some perspective, here is a painting by Hendrick Avercamp entitled “A Scene on the Ice” documenting life in Holland during that period (see link for source).

Subsequent to the Little Ice Age, the Earth experienced another one of the Sun’s extended periods of low sunspot activity called the Dalton Minimum. This particular minimum lasted from about 1795 to the 1820s. The year 1816 was in the middle of the Dalton Minimum period. It is still known to historians as the “year without a summer”, the “poverty year”, or “eighteen hundred and froze to death”. Poor conditions were said to have been caused by a combination of a historic low in solar activity and the Mount Tambora eruption of 1815, which spewed extensive amounts of volcanic ash around the world.

It was a time of ecological disaster. 1816 saw snow in June in the U.S. and Europe. Crops failed and starvation followed, many Europeans spent their summers huddled around the fire. It was during this bleak summer that Mary Shelley was inspired to write Frankenstein and John William Polidori, The Vampyre.

The Electroverse article continued:

Solar cycle 25 is predicted to be a mere stop-off in the suns descent into its next full-blown GRAND solar minimum cycle. (GSM).

NASA has linked GSM episodes to prolonged periods of global cooling, like the Maunder Minimum. or Little Ice Age.

Viewed in this context, Anthropogenic (human caused) Global Warming, or AGW, is a blessing in disguise that offsets the effects of the cooling effects of the solar cycle. The magnitude of the cooling observed during that era dwarves the worst case scenario of climate activists. These offsetting factors would represent good news for the human race for the rest of this century.

Investment implications

What does this mean for investors?

NASA’s models for the current solar cycle, which lasts 11 years, calls for the Earth to undergo a cooling period from rising cosmic ray radiation. The models calling for a Grand Solar Minimum cycle are more speculative.

Nevertheless, the climate data that emerges over the next decade should show that the effects of AGW to be partially or fully offset by the effects of solar cycle 25. Public concerns about climate change, and policy surrounding a global climate emergency, is likely to abate, but that process will take time.

While this development is bullish for energy stocks (and agricultural commodities) in the long run, it does nothing for the energy sector over the next one or two years. The effects of the solar cycle represents only a trade setup, and not a full-blown buy signal. While political pressures are rising for solutions to climate change and global warming, the market reaction to these pressures is only beginning. As an example, CNBC reported that Microsoft aims to become carbon neutral by 2030, and eliminate its historical carbon footprint by 2050. Amazon has pledge to be “net carbon neutral” by 2040. These calls to action are reminiscent of the atmosphere during the dot-com era of the late 1990’s, when even mining companies would not dare to present to investors without a “broadband strategy”.

ESG investing is still a nascent theme. At only 2% of the market, it has much more room to expand, especially in light of Larry Fink’s call to action.

Looking over the next 12-24 months, the BAML Global Fund Manager Survey shows that while managers are underweight the sector, they have not been in such a prolonged underweight position that these stocks are hated. We have not seen the classic signs of investor capitulation and wash-out yet.

From a trader’s perspective, both US and European energy stocks remain in relative downtrends, punctuated by a brief spike owing to Iranian tensions. Until the relative downtrend shows some signs that it is ending, an underweight position remains tactically warranted.

I began this article with the rhetorical question of whether energy stocks represent a value opportunity, or a value trap. While the sector is acquiring a value characteristic, sentiment is not yet washed-out, and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade setup. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.

The 2017/18 melt-up: Then and now

Posted by Cam Hui -

Mid-week market update: The stock market is over-extended. I warned on the weekend about the market’s nosebleed valuation (see Priced for perfection). The market’s forward P/E ratio of 18.4 matched the levels last seen at the 2017/18 market melt-up.
 

 

But there are some crucial differences between the last melt-up episode and the one today.
 

Crucial differences

One crucial difference is each rally was sparked by different fundamentals. As the chart below shows, the last melt-up coincided with surging EPS estimates from Trump’s tax cuts. The market cratered when the pace of upward estimate revision slowed. Today, estimate revisions are flat to slightly up. Today’s melt-up was mostly attributable to P/E expansion, not rising earnings estimates.
 

 

I had identified the nascent bull move in early November (see Buy the breakout, recession limited and How far can stock prices rise?). Investors were caught offside with excessively defensive portfolios. As it became evident that the economy was not falling into recession, a beta chase began, and cyclical stocks soared (see Here comes the beta chase).

Fast forward two months. While the slow moving institutional money is raising their market beta, the fast money is in a crowded long (h/t Liz Ann Sonders).
 

 

The Rule of 20, which raises a warning flag whenever the sum of the market P/E and inflation rate exceeds 20, is coming into play.
 

 

In addition, the relative performance of selected cyclical industries have been faltering, especially the industrial and transportation stocks.
 

 

It is time for a pause in the rally.
 

Estimating downside risk

To be sure, price momentum is still very strong right now, and I have no idea when the market will correct in the short run. However, we can estimate downside risk in a couple of ways.

As the chart below shows, the corrective phase in the last melt-up was halted at the red upward sloping trend line, which represented an -11.8% downdraft. A similar projection today yields a downside target of about 2970, or downside risk of around 10%. Secondary support can be found at about 2850, or downside risk of -14%.
 

 

From a valuation perspective, a 10% correction would translate to a forward P/E of 16.6, which is just below the 5-year average of 16.7. A decline to secondary support at 2850 means a forward P/E of 15.9.
 

 

Much will depend on how earnings estimates evolve during the latest earnings season, and the tone of the outlook corporate management gives in their earnings calls.
 

A correction, not a bear

In the short run, I had waiting for the lines in the sand that I outlined on the weekend to be crossed before turning tactically bearish. Subscribers received an email alert this morning that one of my bearish lines in the sand had been crossed, but I was waiting for the closing bell for confirmation of the signal. TLT and the 30-year yield crossed their trend lines. Since a rally in Treasuries tend to be a sign of falling risk appetite, this is a cross-asset negative risk-off signal for stocks. I therefore initiated a small short position in the stock market in my trading account.
 

 

However. the other bearish tripwire that I outlined has not been triggered. The SPX has not fallen below its 5 day moving average on a closing basis despite exhibiting negative RSI divergences.
 

 

Looking further ahead, I believe that this market is only facing a correction, and not a bear market. Despite the recent setback suffered by cyclical stocks, top down macro indicators of a global cyclical rebound  The Global Economic Surprise Index is still rising, indicating more positive than negative economic surprises.
 

 

In particular, data out of Asia is seeing a more positive tone. South Korea’s cyclically sensitive first 10-day exports rose 5.3% YoY in January, compared to -5.2% in December, though some of the positive surprise was attributable to the effects of a low base. In addition, China’s December exports rose 7.6% (vs. 3.2% expected) and imports rose 16.3% (vs. 9.6% expected), indicating strength in the Chinese economy, even before the effects of a Phase One trade deal kicks in. However, be prepared for some volatility in the January data, as the Lunar New Year falls in January this year compared to February last year.
 

 

My inner investor remains bullishly positioned. My inner trader has dipped his toe in on the bearish side.

Disclosure: Long SPXU

 

Demographics beyond the 2020s

Posted by Cam Hui -

I received some thoughtful feedback to my recent post (see The OK Boomer decade). In particular, one reader referred me to an article by Greg Ip of the WSJ regarding the demographic headwinds affecting the American labor force.

The U.S. will run out of people to join the workforce. Indeed, this bright cyclical picture for the labor market is on a collision course with a dimming demographic outlook. While jobs are growing faster than expected, population is growing more slowly. In July of last year, the U.S. population stood at 327 million, 2.1 million fewer than the Census Bureau predicted in 2014 and 7.8 million fewer than it predicted in 2008. (Figures for 2019 will be released at the end of the month.)

 

 

Population growth is dependent on two factors, fertility rate and immigration, but the US is fading in both areas:

The U.S. has had two longstanding demographic advantages over other countries: higher fertility and immigration. Both are eroding. Since 2008, the U.S. fertility rate has gone from well above to roughly in line with the average for the Organization for Economic Cooperation and Development, a group 36 mostly developed economies…

Meanwhile, the inflow of foreign migrants to the U.S. has been trending flat to lower, while trending flat to higher in other countries. Last year, the foreign-born population expanded by a historically low 200,000, according to the Census Bureau. The exact reasons are unclear. The illegal immigrant population had stopped growing before President Trump took office. Legal immigration remained above 1 million through 2018.

Indeed, the FRED Blog recently highlighted the difference between prime age population growth in the US and Canada and hinted that the widening spread may be explained by differences in immigration policy:

While fertility rates have declined a little, immigration has helped sustain population growth. Immigrants are typically of working age, so immigration can increase the working-age population specifically.

 

 

The 63 Canadian passengers (out of a total of 167) who died on the doomed Ukrainian airliner in Tehran provides a window on Ottawa’s skilled immigration policy (via Bloomberg):

They were doctors, engineers and Ph.D. students. The Canadians who lost their lives in the plane crash in Iran were mainly highly educated professionals and students, a reflection of the country’s push to attract skilled workers in the face of an aging population.

As governments around the world grapple with how to make immigration work without fanning political flames, Canada has taken a different tack, welcoming newcomers last year at the fastest pace in decades. About 12% of Canada’s post-secondary school population is made up international students, according to the country’s data agency…

“It’s really difficult to train someone on that level, integrate them and absorb them as high talent,” Parisa Mahboubi, a senior policy analyst at C.D. Howe Institute, a Toronto-based research firm, said by phone. “Doctors and dentists for example, to be able to obtain the degree that they are able to work in Canada. It takes time. It is really sad for both countries, losing those brains,” she said.

Mahboubi is Iranian-Canadian and has lived in Canada for more than 13 years.

Last year, Canada added a net 437,000 people from abroad, despite being only a tenth the size of the U.S., helping to drive its fastest population increase in decades, even with declines in fertility.

“Immigration has been a driver of Canada’s economic and cultural development. And with natural population’s slow growth, immigration contribution to growth in the labor force and even the tax base has been becoming more important,” Mahboubi said.

If labor force growth is being hampered by population growth, what does that mean for the rest of the world, and the world’s long-term economic growth potential?
 

How population drives economic growth

We know from basic economic principles that real economic growth is a function of population size, physical capital, and technology (productivity). Everything else being equal, lower population growth will mean lower real economic growth.
 

 

As these charts from Our World in Data shows, global population growth is decelerating. Birth rates are flat, while death rates are rising as older people die out.
 

 

Global population is expected to top out around 2060, with Africa as the only region showing sustained population growth.
 

 

It is always difficult to make specific forecasts, but productivity is a function of physical capital, technology, and education. Therefore all eyes are on Africa as a source of growth starting the middle of this century, and much will depend on how quickly African countries industrialize and become more affluent and educated.
 

 

For planning purposes, investors will have to begin penciling in lower global real economic growth in the models, at least for the last half of this century. This will have profound effects on expected risk-free rates, fiscal and monetary policy, and risk premiums when calculating asset price returns.

It is possible to envisage a radical shift in the economic paradigm. If growth rates are slowing, then the current regime of low and negative interest rates might become a permanent feature of the financial and economic landscape. Economists and policy makers will have to struggle with new models of how to either spur growth, or broaden and better share the gains from growth. Otherwise they will risk either financial or geopolitical instability from the effects of inequality in a low-growth environment.

 

Priced for perfection

Posted by Cam Hui -

I have been in the habit of writing a weekend publication consisting of a relatively long research piece combined with a tactical trading commentary, which has at times been very long. As an experiment, I am splitting the two up. Please let me know if you prefer the format of two shorter posts, or a combined longer publication.

As the market advanced to another fresh high, the forward P/E rose to 18.4, which roughly matches the level last seen at the melt-up high of early 2018.
 

 

From a pure valuation perspective, stock prices have risen too far, too fast. Oliver Renick, writing in Forbes, justified the elevated valuations this way:

Actually, if there’s anyone for the bears to blame, it’s themselves.

Economic data in the U.S., China and Eurozone are beating expectations by the biggest gap since early 2018 and on the longest win-streak since mid-2017, according to the sum of Citi’s economic surprise indices I compiled using Bloomberg. Geopolitical risk between the U.S. and China is fading, Brexit is on some path toward completion, a dropping dollar is providing relief to emerging economies, and the global banking system is still intact despite an unnerving foray into the land of negative interest rates. So stocks are rallying as things improve. It’s as simple as that.

Macro concerns have been resolved bullishly, one by one. The reduction of macro risk has compressed risk premiums, and conversely, boosted P/E ratios.

In other words, the market is being priced for perfection.
 

Market potholes ahead?

Here are some possible potholes that investors should be concerned about. A Chinese delegation is expected to arrive in Washington next week January 13-15 to ink a Phase One trade agreement. Could any last minute details hold up the signatures?
 

Caixin reported that China will not raise its annual low-tariff grain import quotas, which could be an impediment to its commitment to purchase more American goods as part of the Phase One deal. To be sure, there are some ways that it could fudge imports, such as diverting current indirect Hong Kong imports from the US to direct imports. Nevertheless, this development could become a last minute roadblock to a deal.
 

Fathom’s China Exposure Index (CEI), which measures the performance of US-listed firms that do business in China against their domestic peers, is already at highly elevated levels. What could possibly go wrong?
 

 

Even if the Phase One deal is concluded on time without any hitches, American trade negotiators are expected to turn their sights on the EU, which Trump has called “worse than China” on trade. EU trade negotiator Phil Hogan is scheduled to be in Washington next week for what could prove to be the start of contentious trans-Atlantic trade negotiations.

In addition, Friday’s weakish Jobs Report highlights the market vulnerability to weakening employment. Initial jobless claims has been inversely correlated to the SPX during this expansion cycle, but initial claims (blue line, inverted scale) are rolling over while stock prices (red line) continue to rise. How long can this negative divergence last?
 

 

New Deal democrat, who has done a stellar job of monitoring high frequency economic indicators, believes the jobs market is telling the story of a slowdown, but no recession.

This remains consistent with a significant slowdown. But there have been similar readings in 1967, 1985-6, 3 times in the 1990s, and briefly in 2003 and 2005, all without a recession following. So the threshold for continuing claims being a negative (vs. neutral) has not been met.

 

Giddy sentiment

Even as macro risks lurk, the sentiment backdrop tells the story of a market that is excessively bullish and vulnerable to a shock. Three of my real-time sentiment indicators are in the red. Each of these indicator capture a different dimension of investor and trader sentiment, but they are all flashing warning signs.

  • VIX Bollinger Band width narrowing, indicating volatility compression.
  • 10-day moving average of equity-only put/call ratio at historical lows, indicating bullish complacency.
  • 10-day moving average of TRIN at historical lows, indicating persistent buying pressure.

 

For the ultimate sign of giddiness, here is a tweet by Helene Meisler, market commentator and contributor at Real Money.
 

 

Joe Kennedy reportedly sold all of his stocks before the 1929 Crash when his shoeshine boy started giving him stock tips. Is this the modern day shoeshine boy moment?
 

Negative divergences everywhere

At the same time, the market is flashing negative technical divergences even as the index pushed to fresh all-time highs. The 5 and 14 day RSI, NYSE Advance-Decline Line, and % above the 50-day moving averages all failed the confirm the new highs.
 

 

This is a market that is increasingly vulnerable to a setback. Valuations are stretched, the market is priced for perfection, sentiment is positively giddy, and market internals are bearish. We just need a bearish catalyst. While price momentum remains dominant in the current environment, and the major market indices could rally further, risk/reward is unfavorable,

That said, I believe that investors and traders should react to these conditions differently. For some context, the trader at Macro Charts recently warned about how “extreme and historic complacency [is] building in markets”. He concluded:

If history is a guide, the risk-reward over the next 1-2 months is moving towards “extremely poor”, and we shouldn’t rule out a compressed (front-loaded) decline either. All that’s needed is a “catalyst”, as always just a narrative/excuse to trigger deleveraging.

Sounds dire, right? However, he examined past episode during the 2001-2005 and 2009-2020 periods when he spotted similar conditions. Maximum peak-to-trough drawdowns ranged from -4% to -17%, with an average of -8.7% and a median of -7.5%. In many of the cases, the market edged higher by about 1% before falling, so downside risk was slightly smaller than those statistics. In effect, average downside risk is in the 5-10% range.

Should investors be worried about a pullback of that magnitude? Doesn’t that just represent normal risk of holding equities? We therefore believe that investment oriented accounts are advised to remain invested but to wait to deploy new cash. The risk of a prolonged bear market is low, and downside risk is limited to a 5-10% correction and valuation reset. My inner investor is therefore still bullishly positioned.
 

Lines in the sand

On the other hand, traders should exercise caution, and take steps to either de-risk their portfolios, or set up risk management triggers to de-risk or possibly go short.

Subscribers received an email alert on Thursday indicating that I had taken profits in all of my long positions and I was in 100% in my trading account. Here are two lines in the sand that I am watching to become more aggressive and go short. The first is an SPX close below its 10 dma.
 

 

The second is a bond market rally. Either the 30-year yield or TLT has to break through the pictured trend lines. Since bond prices are roughly inversely correlated to stock prices, an upside TLT breakout is a signal that stocks may be in trouble.
 

 

My inner trader plans to take partial short positions in equities should either of these events occur. If both occur, he will take a full short position. Since both of these signals are a function of closing prices, I may not have sufficient time to alert subscribers with an email alert before the market close.