Don’t press your bullish bets

Posted by Cam Hui -

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

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

Normalizing from panic

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

 

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

 

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

 

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

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

 

Neither of those signals are in play today.
 

Playing the odds

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

 

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

 

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

 

The NASDAQ 100 tested that level yesterday, and stalled.
 

 

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

Disclosure: Long SPXU

 

Time to sound the all-clear?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Has market psychology turned?

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

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

A look at sentiment

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

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

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

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

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

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

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

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

Limited valuation support

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

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

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

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

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

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

Still ugly any way you look at it.

Market internals: A mixed bag

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

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

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

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

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

Signs of stabilization

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

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

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

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

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

Disclosure: Long SPXU

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

Posted by Cam Hui -

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

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

 

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

 

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

Unemployment at 32.1%?

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

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

 

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

 

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

Length matters more than depth

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

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

 

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

 

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

A continuum of outcomes between V and L

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

 

Pandemic history lessons

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

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

 

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

In fact, NPI measures helped growth, not hurt.

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

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

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

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

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

 

Rising wages sparked a consumption boom.

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

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

 

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

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

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

 

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

 

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

 

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

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

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

A difficult 2020

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

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

 

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

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

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

 

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

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

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

 

A “square root” recovery

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

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

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

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

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

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

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

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

 

The bear market rally stalls

Posted by Cam Hui -

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

 

Deteriorating internals

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

 

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

 

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

 

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

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

Disclosure: Long SPXU

 

For traders: 3 bullish, and 1 cautionary signs

Posted by Cam Hui -

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

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

 

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

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

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

 

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

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

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

 

 

One word of caution

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

 

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

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

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

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

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

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

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

Disclosure: Long SPXL

 

The dawn of a new bull?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A new bull?

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

 

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

Earnings, earnings, earnings!

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

 

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

 

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

 

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

 

Macro outlook

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

 

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

 

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

 

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

 

Technical outlook

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

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

 

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

 

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

 

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

 

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

 

Still a bear market

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

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

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

 

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

 

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

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

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

Disclosure: Long SPXL

 

Handicapping the odds of a V-shaped recovery

Posted by Cam Hui -

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

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

What are the odds of a V-shaped recovery?

The situation report

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

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

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

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

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

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

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

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

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

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

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

The policy response

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

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

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

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

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

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

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

The public health policy response

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment conclusions

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

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

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

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

Please stay tuned tomorrow for our tactical trading analysis.

The makings of a primary low

Posted by Cam Hui -

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

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

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

Historically bearish

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

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

Why I am leaning bullish

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

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

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

Don’t fight the Fed

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

Where to hide in this bear market

Posted by Cam Hui -

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

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

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

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

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

Time for gold to shine?

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

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

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

US investors

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

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

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

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

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

Non-US markets

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

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

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

Here are my main takeaways from this analysis:

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

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

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

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

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

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

Disclosure: Long EWH, EWY

This is insane! Where’s the bear market rally?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Where’s the rally?

For several weeks, I have been saying that a bear market rally could happen at any time, but the market keeps weakening. One of the challenges for the bulls is to put together two positive days, which they have failed to do. Another is to stage an upside breakout through the declining trend line.
 

 

The market closed Friday in the red. One constructive sign that can be found in the above hourly chart is the index closed while testing a support level. Should it stage an upside rally from here, the logical first resistance level is the first Fibonacci retracement at about 2700, with additional resistance at the 50% retracement objective of about 2840.

This is insane! Where’s the bear market rally?
 

The bad news

Let’s start with the bad news. There have been reports trickling out from the state level of a tsunami of unemployment claims due to the loss of service jobs from social distancing edicts. Consequently, the Street is now bracing for a moonshot-like surge of initial jobless claims next Thursday.
 

 

The reverse side of the unemployment coin is new hires. The Upjohn Institute reported that February new hires hit a brick wall:

Employers cut back even sooner than we thought: New hires fell over 200,000 in February, and that’s a 12-month moving average. In the raw numbers, we went from 5.59 million in February 2019 to 3.85 million in February 2020. 

 

FactSet reported that the market is trading at a forward P/E of 13.9. which is below its 5-year average of 16.7, and 10-year average of 15.0. That sounds cheap, right? But there’s a catch.
 

 

The E in the forward P/E ratio is only beginning to fall.
 

 

FactSet reported that companies are only just beginning to quantify the effects of COVID-19. Only 213 of 479 S&P 500 companies cited “coronavirus” or “COVID-19” in their quarterly earnings calls.

While many of these 213 companies discussed the current negative impact or the potential future negative impact of the coronavirus on their businesses, 76 companies (36%) stated during their quarterly 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 for the current quarter or current year. On the other hand, 58 companies (27%) included some impact from the coronavirus in their guidance or modified guidance in some capacity due to the virus.

In other words, only 58 companies in the index were able to give any guidance on the negative effects of the pandemic during their earnings calls. To be sure, some of these earnings calls occurred in January and February, before the full effects of the pandemic reached American shores. Have they given any additional guidance since then? The answer is not really.

Of the combined 134 companies that either stated it was too early to quantify an impact from coronavirus (76) or did include an impact from coronavirus in their guidance (58) during their quarterly earnings calls, only 13 companies have issued quarterly or annual guidance since their call with a revised impact from the virus. On the other hand, 11 companies have withdrawn, suspended, or not confirmed previous quarterly or annual guidance since their quarterly earnings call.

In other words, expect further wholesale earnings downgrades in the near future.

That’s the bad news.
 

Bearish exhaustion?

Here is the good news. The technical internals of the market are improving. As an example, the relative strength of the high beta factor compared to the low volatility factor is bottoming and turning up, indicating improving equity risk appetite.
 

 

Other market internals are also improving The Advance-Decline Line is starting to bottom out and it is exhibiting a positive divergence. NYSE new lows are contracting, % bullish is improving, and 14-day RSI is showing a positive divergence. All of these signs point to bearish exhaustion.
 

 

The NASDAQ 100 chart tells a similar story. While the NASDAQ A-D Line is not exhibiting a positive divergence, the other three indicators are showing bullish divergences.
 

 

Deutsche Bank’s analysis of hedge fund equity positioning reveals an extreme crowded short position, which is consistent with our thesis of bearish exhaustion. Should any bullish catalyst appear to spark a rally, expect a short covering stampede to rapidly rocket stock prices upward.
 

 

Short run breadth is currently oversold, and the market is ripe for a rally on Monday. Even if the market does rise, let’s just see if the bulls can muster market strength for more than one day.
 

 

My inner investor is positioned for maximum defensiveness. My inner trader is on the sidelines. He is waiting for signs of a relief rally before jumping in on the long side.

 

Where’s the bottom?

Posted by Cam Hui -

There is little question that the stock market is wildly oversold. My intermediate term bottom spotting model has been flashing a buy signal for over a week. This signal is based on the combination of an oversold signal on the Zweig Breadth Thrust Indicators, and the NYSE McClellan Summation Index (NYSI) turning negative. In the past, this model has shown an uncanny ability to spot an intermediate bottom, but stock prices have continued to fall despite the buy signal.
 

 

Where’s the bottom?
 

Insiders are buying

There are a number of constructive signs that equities are starting to look interesting from a fundamental perspective. The most important of which is the appearance of an insider buying cluster (via Open Insider).
 

 

I would warn, however, that insider buying is an inexact fundamental signal. A study of past insider buying signals since the data set began in 2004 tells the story. Consider, as an example, how this group of “smart investors” behaved in 2008. They began buying heavily as the market skidded in October 2008, but the ultimate low did not occur until March 2009, when prices were 30-35% lower than when they began buying.
 

 

Insiders were more timely buyers in 2011, when the market convulsed over the prospect of the combination of a budget impasse in Washington, and the prospect of the breakup of the eurozone over the Greek Crisis. The 2011 episode was marked by a buy signal that coincided with a period of low downside risk.
 

 

Insiders were early to buy into the initial decline in 2018. To be sure, they bought heavily in a second cluster as the market reached the Christmas Eve bottom.
 

 

This brief study shows concentrated insider buying can be a useful signal for long-term oriented investors to start edging into stocks. However, this group of “smart investors” seem to focus mainly on valuation, and they behave like the classic value investor, who tends to be early in their investment decisions.
 

Cheap enough?

The S&P 500 peaked in January at an astounding forward P/E ratio of 19.0, but index has deflated considerably since then. Are stock prices cheap enough to be buying?

It depends on how you define cheap. The Leuthold Group analyzed valuations o n several metrics using two lookback periods. They considered historical valuation from 1990 to present, and 1957 to present. They found that the market is undervalued based on the 1990-2020 time frame, but overvalued on the 1957-2020 time frame. I interpret this analysis as the market nearing fair value, with the caveat that markets tend to overshoot to the downside in a bear market.
 

 

How far can it overshoot? Josh Brown highlighted analysis by BAML’s Savita Subramanian:

PEs are pretty useless: wide range At prior bear market troughs, trailing Price to Earnings (PE) multiples have ranged from 11x to 18x (today’s is 15x) and forward (NTM consensus) PE multiples have ranged from 10x to 15x (today’s is 16x). But historically, the market has troughed at an average PE multiple of 13x to 14x actual trough earnings, a posteriori. Applying this to our recently introduced 2020 recession EPS forecast of $138 yields a floor (worst case scenario) on the S&P 500 of 1800. But note that this is a much lower outcome than applying the typical peak-to-trough bear market decline of ~35% to February’s S&P 500 peak of 3393, which would yield a floor of 2200 (still below today’s levels). Our year-end 2020 target for the S&P 500 remains 3100.

Brown concluded that the estimated range of 1800-2200 is extremely wide.

Savita notes that if we go by the typical bear market decline of 35% peak to trough, then 2200 makes sense. If we go by Merrill’s new S&P 500 recession earnings forecast, and apply a PE at the midpoint of the above mentioned range, we’re talking more like 1800.

Regular readers will recall that I have a ballpark estimate of 1600-2160. This range was based on reducing peak forward 12-month EPS estimates by -10% (which is consistent with the 1982 and 1990 recessionary experience), and applying a 10 P/E multiple (2011 bottom) and 13.5 multiple (2018 bottom) to forward EPS.

My range of 1600-2160 is even wider than BAML’s 1800-2200. Since no one knows the level, depth, or length of disruption COVID-19 will impose on the economy, investors will have to live with the wide range until we can see a greater level of certainty.

To illustrate my point, FiveThirtyEight surveyed a number of infectious disease experts about the likely effects of the COVID-19 epidemic in America.

Collecting responses in this form captures both the best-guess estimate from each respondent and the uncertainty surrounding it. It also lets the people in charge of the survey — Thomas McAndrew and Nicholas Reich, both biostatisticians at the University of Massachusetts, Amherst — convert the responses to a probabilistic consensus forecast,1 something that can answer questions like, “According to these researchers, what is the probability that we will have 50,000 reported cases by March 29?”

Expert consensus forecasts give you what a model does — a forecast that gives a measure of its uncertainty — without being overly reliant on just one way of thinking about a problem. In this instance, each expert has their own assumptions about how likely the virus is to spread or to be fatal, as well as assumptions about the ways humans might try to mitigate its damage

The estimates vary wildly, and so are the ranges of each expert’s estimates. In other words, everyone is only guessing.
 

 

If the healthcare experts don’t know anything, how can the rest of us possibly hope to estimate the economic effects?
 

Technical analysis: More downside?

From a technical analysis perspective, I see more downside for stock prices before a long-term bottom can be seen. The market’s weekly Percent Price Oscillator (PPO) reached -3 last week. This extreme level was seen at the 2011 Greek Crisis bottom, and the 2018 Christmas Eve panic bottom, but PPO never even reach this level during the Russia Crisis. That said, sub -3 PPO readings were seen during the post-NASDAQ Bubble bear market, and the 2008 market crash.
 

 

The moral of this story is that sub -3 PPOs mark panic bottoms during corrections in bull markets, but may only mark the start of a decline in bear markets. As we are in the middle of a recession induced bear market, there may be further downside in the future. As well, the above chart shows that the index is now testing the first Fibonacci retracement support level. Additional support can be found at the 50% retracement level of 2000, and 61.8% retracement of about 1670.

That said, short-term indicators are off-the-charts oversold, and a relief bear market rally can occur at any time. I recently reviewed a series of past bear market bottoms, starting from the Crash of 1929, and found that the stock market generally either came back down to retest the initial bottom, or formed a complex W-shaped bottom. The retest may not always be successful (see 2020 bounce = 1987, or 1929?).

In summary, it is difficult to know when and where this bear market will bottom. My review of fundamental and technical factors comes to two conclusions. While the market can bounce and stage a bear market rally at any time, the historical record indicates it will return to retest the previous low, and the retest may not be successful. Until we can estimate the full extent of the damage caused by the pandemic, it is also difficult to estimate a level the market is likely to bottom. Estimates based on top-down fundamental estimates and technical analysis range from a 1600 to 2160.

Be prepared for further downside risk, and for longer than the consensus expectation of a V-shaped recovery. As Ryan Detrick of LPL Financial has shown, recessionary bear markets last for an average of 18 months, compared to 7 months for non-recessionary bears.
 

 

So bad, it’s good?

Posted by Cam Hui -

Mid-week market update: This bear market has astonishing in its ferocity, but we may be reaching the it’s so bad things are good point. Here are some “green shoots” that are starting to show up.

Baron Rothchild was famously quoted as saying, “The time to buy is when blood is running in the streets, even when the blood is your own.” We seem to be at that point of blind panic. Realized maket volatility is now on par with the Crash of 1929 and the Crash of 1987.
 

 

Is sentiment bearish enough for you?

The NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, is now below its 52-week Bollinger Band. Historically, that has been a good intermediate term buy signal. In the current circumstances, we have seen other “historically good” buy signals fail as stock prices continue to crater.
 

 

Another constructive sign is the spike in %Bears in II sentiment. The rising level of bearishness is another sign of washout and capitulation. While I interpret this latest reading as constructive, I would not regard it as outright bullish as there are still more bulls than bears.
 

 

Waiting for the sustained bounce

I am still waiting for signs of a sustainable oversold bounce. The hourly S&P 500 charts shows the index tracing out a bullish falling wedge pattern. An upside breakout would be a positive development, but I would watch for confirmation in the form of two consecutive positive days before getting overly excited on the bullish side.
 

 

There are hopes for a positive day tomorrow. Rob Hanna’s analysis of 5% downside gaps shows a slight bullish edge the next day (Thursday), but the sample size is small (n=5) and therefore not very dependable.
 

 

Bottom-up reports indicate that tomorrow morning’s initial jobless claims reports will show an immense surge. If sustained, it would translate to a rise in the unemployment rate of 1% or more. Watch how the market reacts to that print.

My inner investor is at his level of maximum defensiveness. My inner trader is on the sidelines. The market will eventually stage a “rip your face off” relief rally at some point. My inner trader is waiting for two consecutive days of gains before taking action to jump in on the long side.

 

The 9/11 market template

Posted by Cam Hui -

In my last post (see 2020 bounce = 1987, or 1929), I had been searching for a template for the current bear market. I had suggested in the past that the roots of this bear has thematic similarities to 2008 (see A Lehman Crisis of a different sort). Today, health authorities are urging the use of social distancing to mitigate COVID-19, while financial institutions practiced similar social distancing at the time of the Lehman Crisis, which ended by seizing up the global financial system.

As the growth of COVID-19 cases continues outside of China, one other template comes to mind. 9/11.
 

 

The 9/11 analogy

As most of Europe and America go into lockdown to start the week, a review of The Transcript, which is a compilation of earnings calls, brought to mind a 9/11 analogy for the current situation.

COVID-19 is now a global pandemic with Europe as the epicenter
“We have therefore made the assessment that COVID-19 can be characterized as a pandemic. Pandemic is not a word to use lightly or carelessly…Europe has now become the epicenter of the pandemic with more reported cases and deaths than the rest of the world combined apart from China” – WHO Director-General Tedros Adhanom Ghebreyesus

Daily life has come to a halt in many places
“Daily life has come to a halt, it certainly appears if you are a human being on this planet.” – Korn Ferry (KFY) CEO Gary Burnison

This is a fear-based event more akin to 9/11 than 2009
“I think this event is very similar to 9/11 in terms of the psychology of what’s driving it. It’s a fear based event” – JetBlue Airways (JBLU) CEO Robin Hayes

“This is a fear event, probably more akin to what we saw at 9/11 than necessarily what we saw in 2009. I think you’re seeing a suspension of activities, whether it be corporate activities, group activities, events where people get together in large numbers, all of which impact our demand set. So, I think it’s really premature to try to be drawing too many corollaries.” – Delta Air Lines (DAL) CEO Ed Bastian

“We are in a situation which is exceptional in every respect…more exceptional than at the time of the banking crisis, I would say.” – The German Chancellor Angela Merkel

with significant demand deterioration for airlines worse than after 9/11
“when I look at how the demand has deteriorated last couple of weeks, it appears to be worse than what we saw after 9/11.” – JetBlue Airways (JBLU) CEO Robin Hayes

What caught my eye was the comment, “This is a fear-based event more akin to 9/11 than 2009”. Indeed, Open Table restaurant bookings are down -36% year over year globally, -36% in the US, -40% in Canada, -61% in New York, and -49% in Toronto.
 

 

Bloomberg also reported that most airlines could be bankrupt by the end of May.
 

Limitations to the 9/11 analogy

However, there are limits to the 9/11 analogy. The post-9/11 sell-off occurred in the middle of a bear market and recession. The latest COVID-19 shock is the spark for a new recession. The market bounced as fear subsided, but didn’t bottom until about a year later with a double bottom in July and October 2002.
 

 

Today, Wall Street is just coming to to grips with a sudden slowdown which is only just starting, and analysts are scrambling to estimate its magnitude, but the situation is so fluid that any estimates are virtually worthless by the time they are published.

Joe Wiesenthal at Bloomberg made a sensible comment this morning about the fears gripping the market: Physical social distancing is creating financial difficulties for households and the corporate sector, which is worrisome for financial solvency [emphasis added]

The House passed a bill on Friday night to provide relief to some people who are affected by the virus, but it’s far short of the fiscal bazooka that several economists believe we urgently need. What’s weird about this situation is that we need massive fiscal help from DC, but we don’t exactly need stimulus, per se. Stimulus typically implies an attempt to get the economy moving positively again. But that’s not exactly what we want right now, because in the ideal scenario everyone could just wait this thing out by spending a month or two in their homes eating canned goods, watching Netflix and facetiming. Then when the virus is mostly gone, go out and have a bacchanal for the ages in the warmer weather. The problem, as Larry Summers eloquently put it, is that “economic time has been stopped, but financial time has not been stopped.” In other words, if we all cocoon for two months, we might physically survive, and the infrastructure of the modern world would be waiting for us upon our re-emergence, but in the meantime the bills pile up. The rent’s due. The mortgage is due. Or the landlord’s mortgage is due. The credit card bill is due. Taxes are due. For a business, paychecks must go out. Suppliers must be paid. Sp we don’t need economic stimulus right now. We don’t need people out shopping or building new infrastructure or building new homes. Every one of those things involves people congregating and risks spreading the virus. What we need is cash to keep people from going bankrupt or evicted. Cash to keep the lights on. Cash to keep people employed; to keep their healthcare. Cash to buy basic necessities, like food and medicine. So let’s not think in terms of reviving growth for now. Let’s think in terms of cash, so that for as long as we’re in deep freeze, people can stay alive and continue to meet their financial obligations.

Former Bush era CEA chair Greg Mankiw recently made the following sensible policy prescriptions:

  • A recession is likely and perhaps optimal (not in the sense of desirable but in the sense of the best we can do under the circumstances).
  • Mitigating the health crisis is the first priority. Give Dr. Fauci anything he asks for.
  • Fiscal policymakers should focus not on aggregate demand but on social insurance. Financial planners tell people to have six months of living expenses in an emergency fund. Sadly, many people do not. Considering the difficulty of identifying the truly needy and the problems inherent in trying to do so, sending every American a $1000 check asap would be a good start. A payroll tax cut makes little sense in this circumstance, because it does nothing for those who can’t work.
  • There are times to worry about the growing government debt. This is not one of them.
  • Externalities abound. Helping people over their current economic difficulties may keep more people at home, reducing the spread of the virus. In other words, there are efficiency as well as equity arguments for social insurance.
  • Monetary policy should focus on maintaining liquidity. The Fed’s role in setting interest rates is less important than its role as the lender of last resort. If the Fed thinks that its hands are excessively tied in this regard by Dodd-Frank rules, Congress should untie them quickly.

The analysis from Wiesenthal and Mankiw leads to the idea that the economy has suffered a sudden shock, and recovery will take some time. Wall Street analysts have not fully modeled or even had the time to estimate the full impact of the COVID-19 pandemic. It will therefore take time for the market to adjust to new expectations. This leads to the following market scenario:

  • The market will bounce as fear fades (but don’t ask me when the bounce occurs).
  • Watch for a rally and a test of the old lows several months in the future as the realization that the global economy is slowing, and the magnitude of the slowdown.

I am reiterating my downside estimate for the S&P 500 of 1600-2160 (see My recession call explained), which is based on applying a range of 10x to 13.3x P/E multiple to a forward 12-month EPS discounted by -10%.

 

2020 bounce = 1987, or 1929?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

The long awaited bounce?

Is this the long await bounce for the stock market? The SPX traced out a strong bullish reaction to Thursday’s ugly action while exhibiting positive RSI divergence. If this is the long awaited bounce, the most logical resistance level is the 50% retracement, which is also the site of the 200 day moving average.

This retreat into bear market territory, as defined by a -20% decline, was the fastest in market history, even compared to the Crashes of 1987 and 1929. Bear in mind that if this was the capitulation low, the market bounced at the initial low in 1929, and in 1987. Each had very different results. Both were market crashes, one went on to mark the start of the Great Depression, the other was just a blip in a continuing economic expansion.

A review of market history

A tour of market history of past market bottoms and crashes is in order. Let’s start with some past market crashes.

The market reaction to the crash of 1929 was a relief rally. The Dow pulled back after the initial bounce, but the old 1929 low was not tested and broken until over a year later. The rest, as they say, is history.

The crash of 1987 saw the market bounce, followed by a re-test within a few weeks. The market continued to advance after that event as the market crash did not spark a recession.

The shocking events of 9/11 was a special case. The economy was already in recession. The market bounced after 9/11, but it weakened after the bounce and made a new low in 2002. The 2002 bottom was a classic bounce-and-retest bottom.

Here are some other examples of market bottoms that occurred in recessions. The ugly 1974 bear market was another bounce and retest bottom.

The market bottom of 1962 was marked by an initial low sparked by the Cuban Missile Crisis. The market was already falling owing to the “Kennedy Slide” because of the administration policies on steel. The market bounced, and saw weakness and a near retest of the Cuban Missile Crisis bottom a few weeks later.

The bottom in 1982 is best described as a complex W-shaped choppy low.

The recession low of 1990 was also a complex W-shaped bottom.

Here are the lessons of this stock market history review. After an initial bottom:

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

Sentiment cycle supportive of a bottom

Where do you think we are in the sentiment cycle?

My personal assessment is we hit unbridled panic last week, based on the comments on my social media feed. Consider how the tone of Barron’s covers have changed in a few short weeks, as a classic example of the contrarian magazine cover sentiment indicator. A few weeks ago, Barron’s was constructive in the face of the market weakness.

This week, they are *ahem* less constructive on the markets.

We will see confirmation early next week whether last Thursday represented the first low of this sell-off.

A low, but THE LOW?

We saw the initial low in the market last week, was it the bottom, or a level at which investors can start buying?

Here is the bull case. FactSet reported that the market’s forward P/E ratio fell to 14.0, which is below the 5-year average of 16.7, and 10-year average of 15.0. A 14x multiple is close to the multiple achieved at the Christmas Eve bottom of 2018.

Moreover, insiders are buying.

The market is starting to look cheap, and insiders are buying. What are you waiting for?

Not so fast, say the bears. This was the fastest market decline in history. Past market bottoms were characterized by slower and gradual weakness. The estimated E had no chance to catch up with the rapid deterioration of the P of the P/E ratio. Forward 12-month EPS had been mostly flat since late 2019, and they have only begun to fall. The weakness in forward EPS is nowhere nearly as negative as the experience of 2014-15 when the economy experienced a shallow industrial recession.

A more detailed analysis of sales estimates tells the story. The softness in estimates is concentrated in the cyclical part of the market, industrials, energy and materials, which is reflective of the weakness emanating from China and oil price war. Consumer discretionary sales downgrades are only in line with the market. The discretionary stocks are likely to be most affected by the demand shock that hits the economy as the COVID-19 epidemic spreads in the US. In short, EPS downgrades have a lot further to go because they have not fully reflective of the damage from the coronavirus epidemic.

While the signs of insider buying can be viewed as constructive, we have not seen the kind of concentrated insider buying clusters that have marked durable bottoms in the past. In addition, insider buying is not an actionable buying signal. While they may be necessary conditions for a long-term bottom, insiders signals are often early.

Here is how I estimate a range where the S&P 500 may bottom. If we were to throw out the recessions that began in 2000 and 2008 as finance sparked recessions, the recessions of 1982 and 1990, which are more classic recessions experienced in the post-war period, saw forward EPS decline by about 10%.

If we apply a -10% discount to S&P 500 forward EPS we get roughly $160. The market bottomed out in 2011 at a forward P/E of 10, and in 2018 at a forward P/E of 13.5. Apply those multiple to the discounted forward EPS of $160, we arrive at a target range of 1600 to 2160, which represents downside potential of -20% to 40%.

I would add that a -10% haircut on forward EPS is a conservative estimate. The consensus top-down earnings downgrade is in the high teens, and possibly as high as 20%.

If last week was the initial panic low, don’t expect the retest to be successful. Under a recession scenario, there is more valuation downside potential.

Recessionary bear

This is a recessionary bear market. Recessionary bear markets last longer and prices decline more than non-recessionary bears. Investors should act accordingly and be in a position of maximum defensiveness/ My inner investor was already at his minimum equity weighting entering the week. The decline in equity prices put him below target, and in light of a possible bounce, he will re-balance and buy so that he is at his minimum equity target.

Ryan Detrick of LPL Financial pointed out that recessionary bear markets last longer and see deeper pullbacks than non-recessionary bears. Investors need to respect that lesson from market history.

My inner trader got stopped out on Thursday’s panic sell-off and he therefore missed Friday’s recover. Traders should pay special attention to the high degree of market volatility and size their positions accordingly. The FOMC is meeting next week, and the Fed’s decision could be a source of volatility.

Even if last week’s low was not the final panic low, the odds does favor a bounce in the very near future. An analysis of stock/bond relative performance shows that stocks have dramatically underperformed bonds. As we approach quarter end, we should start to see equities to be bid as institutional re-balancing programs kick in.

My inner trader is on the sidelines, but he is poised to return to trading by dipping his toe in on the long side. He just needs some price momentum confirmation that the bottom is in.

My recession call explained

Posted by Cam Hui -

In the past week, I have had several discussions with investors about my recession call (see OK, I’m calling it). Since the publication of that note, Bloomberg Economics’ US recession probability estimate spiked recently up to 55%.

The odds of a 2020 recession at betting sites are even higher.

To reiterate, I would like to clarify the reasoning behind my recession call, which is based on a triple threat:

  • The emergence of COVID-19 in China has created a supply shock that disrupted supply chains all over the world.
  • The Saudi-Russia oil price war, which has devastated the oil patch in the US.
  • The COVID-19 pandemic, which is expected to result in both a supply shock and demand shock in the US.

China’s supply chain shock

I covered most of the effects of the COVID-19 epidemic in China in a previous publication (see Don’t count on a V-shaped recovery), so I will not repeat myself. The Chinese leadership was faced with a painful trade-off between the health of their population, and economic growth. Once the bureaucracy got over the denial phase of the epidemic, Beijing chose to focus on the health of their people with a containment strategy of quarantine, mass-testing and contact tracing. These measures effectively shut down their own economy for Q1, and likely part of Q2. Once the infection rate stabilized, they pivoted to economic growth as a priority.

Nevertheless, the slowdown created supply chain bottlenecks all over the world, and threatened the global growth outlook. Axios reported that the coronavirus disrupted supply chains for nearly 75% of US companies. Bloomberg reported that the effects of the slowdown is worldwide:

U.S. seaports could see slowdowns of as much as 20% continue into March and much of April, according to the American Association of Port Authorities. The same trend is seen in more distant places, with Rotterdam — Europe’s economic gateway to Asia and beyond — seeing a similar cut of about 20%.

China is recovering from the virus. Even if you are dubious about China’s official statistics, consider this NY Times interview with Dr. Bruce Aylward, who led World Health Organization (WHO) team that visited China and found no apparent evidence of fudged numbers.

During a two-week visit in early February, Dr. Aylward saw how China rapidly suppressed the coronavirus outbreak that had engulfed Wuhan, and was threatening the rest of the country.

New cases in China have dropped to about 200 a day, from more than 3,000 in early February. The numbers may rise again as China’s economy begins to revive. But for now, far more new cases are appearing elsewhere in the world.

China’s counterattack can be replicated, Dr. Aylward said, but it will require speed, money, imagination and political courage.

Indirect market and anecdotal evidence does show that the worse of China’s downturn is over. Hong Kong has the epidemic well under control. Neighboring Macau announced last week that they were discharging their last COVID-19 patient.

The Baltic Dry Index, which measures shipping costs, is recovering after a deep slide.

As well, Bloomberg reported that American exports of chicken is starting to return to normal:

U.S. chicken exports to China are flowing freely again as logistical bottlenecks caused by a deadly virus dissipate and the Asian nation issues tariff waivers to buyers, according to Sanderson Farms Inc.

The U.S.’s third-largest chicken producer has shipped 522 loads to China of mostly dark meat and paws, Chief Executive Officer Joe Sanderson Jr. said in a presentation Wednesday.

That’s up from 420 at the end of February, when the company reported earnings for the first quarter
.
The coronavirus outbreak, which has claimed more than 4,000 lives globally, disrupted transport operations in China and left thousands of meat containers piling up at ports. While retaliatory tariffs were until recently a hurdle for U.S. shipments, China is now giving duty waivers to buyers, Sanderson said.

China is returning to work, albeit slowly.

The Saudi-Russia oil price war

If the Chinese COVID-19 epidemic wasn’t enough, the global economy was unexpectedly hit with a oil price war when Russia could not come to terms with OPEC on oil price cuts in the face of falling global demand. Saudi Arabia responded by not only pumping at capacity, but selling above their production capacity with sales of their reserves.

This sparked a different sort of supply shock. The market saw the effects of an oil shock in late 2014 when the price skidded from over $100 to about $40 in short order. The US economy experienced a shallow industrial recession, which was especially evident in the oil patch. Earnings estimates fell, and stock prices weakened in the latter half of 2015.

Forward 12-month consensus EPS estimates have been flat, and they have just begun to decline as a result of the Chinese supply chain disruption, indicating negative fundamental momentum. What will happen once the full effects of the oil price shock work their way through earnings expectations?

Can America flatten the curve?

Even worse, COVID-19 has landed upon American soil and it is expanding its beachheads and spreading all over the country. Since there is no cure or working vaccine, health authorities use two types of strategies to combat the virus in order to “flatten the curve”, containment and mitigation. As shown by the stylized diagram, the infection can either run rampant in an uncontrolled fashion (yellow curve) or in a slower way (violet curve). Each country has a limit on healthcare resources, and an uncontrolled epidemic will quickly reach and overwhelm care capacity, in hospital beds, healthcare providers, and so on. Strategies to slow down the outbreak buy time so that care capacity does not become constrained.

Anecdotes from northern Italy, which has a first-rate healthcare system, indicate a society that is in a desperate fight against COVID-19, as reported by Bloomberg:

More than 80% of the region’s 1,123 acute care beds are dedicated to coronavirus, after many other patients have been moved elsewhere and 223 extra places have been opened to cope with the emergency. About half of those are occupied, Gallera said.

Newspapers and WhatsApp groups are rife with personal accounts from doctors on the front lines of the epidemic. When new patients come in with pneumonia, a symptom of advanced coronavirus infections, doctors have little time to decide whether to assign them intensive-care beds, ventilation machines or respirators that could make the difference between life and death.

Some doctors have said that they sometimes make the call on who gets treatment based on the age of the patient. In some areas, hospitals are suspending other treatments to focus personnel on the contagion.

A doctor who asked not to be named because of potential repercussions painted a dire picture of the situation in a hospital in Milan. While the coronavirus is best known for causing severe disease in elderly patients, even some young people are affected, the doctor said, and without sufficient beds and ventilators, some can’t be treated.

The hundreds of patients needing treatment for pneumonia have swamped the supply of available specialists, the Milan doctor said. Physicians such as gastroenterologists, who normally focus on the digestive system, have been conscripted to help out with lung patients, and they’re still not enough, the doctor said.

This NY Times account of a Seattle area hospital provides a glimpse of what will probably be common scenes all over the US in the very near future:

While much of the country is just starting to see clusters of cases emerge, the hospital east of Seattle offers a window into the challenges set to cascade through the nation’s health care system, testing the resilience of workers, the readiness of institutions and the flexibility of supply chains.

The past few weeks have seen medical workers operating at the very edges of their capabilities, facing a virus so virulent that some patients were dying within hours of coming down with their first symptoms.

Caregivers who had been sent home into quarantine had to be called back to work to face the overwhelming task at hand. Engineers spent late nights scrambling to overhaul rooms so that contaminated air could not escape. Sanitation and janitorial crews struggled to swab down rooms where even a trace of the virus could infect the next patient. Supplies were so strained that nurses turned to menstrual pads to buttress the padding in their helmets.

If an outbreak is caught in its initial stages, health care authorities can utilize the containment, or quarantine, strategy to prevent the virus from spreading to other patients. This approach can be useful if patients from infected regions, e.g. China, can be identified and isolated. Once the infection spreads into the community, a combination of isolation and mitigation strategies have to be employed. Mitigation include personal hygiene practices such as frequent hand washing, and wearing a mask in order not to infect others. Social distancing is another mitigation technique, which includes closing down public events where crowds gather, such as schools, arts and sports events, and any other large gatherings. The downside of social isolation strategies is an economic shock that significantly reduces the demand for goods and services.

China has been relatively successful with draconian isolation and mitigation strategies, and so did Singapore. South Korea managed to contain its outbreak with a combination of mass testing to identify patients so that they could be isolated, and social distancing strategies that made most of the country virtual ghost towns. For some perspective, read this American ex-pat’s account of living in Seoul in the Dallas Morning News, which she described as “living in end-times”.

One way of measures the success of COVID-19 countermeasures is the time it takes for confirmed cases to double, as shown at Our World in Data. Outperforming countries include China (doubled in the last 32 days), South Korea (12), and Singapore (15). By contrast, the same metric for Italy is 4, Iran is 6, France 3, and the US is 3, which is probably affected by an under-counting of cases due to a shortage of testing capacity.

While the American healthcare system is generally thought of as first rate, access is uneven. In particular, many rural counties lack primary care doctors, or even hospitals. Notwithstanding the problems of insurance coverage, and lack of sick days, which can be an obstacle to a patient seeking care, the lack of proper facilities in these under-served rural areas highlight a key US vulnerability.

The policy response

In the face of this triple threat, what can American policy makers do?

Former New York Fed President Bill Dudley laid out what the Fed can do under these circumstances in a Bloomberg op-ed. Dudley believes that lower rates is a no-brainer.

At this point, more short-term rate cuts seem certain. After all, the outlook has deteriorated since the Fed’s 50 basis point cut on March 3. Moreover, historical experience indicates that rate cuts between Federal Open Market Committee meetings have typically been followed by rate cuts at the subsequent FOMC meeting. Finally, the language accompanying the last rate cut — that the FOMC would “act as appropriate” — also has been a reliable predictor of future rate adjustments. Thus, it would be very surprising if the FOMC didn’t cut its federal funds rate target by 50 basis points, or possibly more, at next week’s meeting.

QE would be the next tool once rates have reached the zero lower bound.

The decision to use the monetary policy tools such as forward guidance and quantitative easing will be straightforward. If the Fed has pushed short-term rates to zero and the economic outlook suggests the need for greater monetary stimulus, these tools will be used. They are now part of the Fed’s standard tool kit.

Like other central bankers, Dudley called for fiscal policy support in addition to monetary policy. Monetary policy is of limited utility under the current conditions.

The stresses that emerge as a result of the coronavirus are likely to be very different from those that occurred during the financial crisis. This time we are likely to see considerable stress on small businesses that encounter cash-flow problems and on households, especially if unemployment spikes.

These types of problems probably are better addressed through fiscal policy than monetary policy. Payroll tax cuts, sick-leave pay, extended unemployment benefits, and block grants to state and local governments to forestall layoffs should all be considered.

Governments face policy trade-offs between the health of their population and economic growth, but much of the US focus has been on growth (Wall Street) over public health policy (Main Street). A coronavirus bill is working its way through Congress. as the Democrats and Republicans bargain over its many provisions. A WaPo article outlined the policy choices that lawmakers face:

The first is spending aimed directly at stopping the spread of the virus: buying masks, producing a vaccine, paying for testing and so on. Everyone, Republicans and Democrats, agrees that’s necessary.

The second set of actions is focused on the people most directly affected by the economic fallout. Some of that can be done by extending existing programs such as unemployment insurance and food stamps and paying for sick leave, but it can also include simply giving people money.

Up until Friday’s dramatic declaration of a national emergency, it appeared that the Trump administration was prioritizing economic growth (Wall Street) over public health (Main Street). It remains to be seen how quickly the federal government can make the Main Street pivot.

What’s next for Main Street?

How bad can things get for Main Street? As a reminder, I previously highlighted the results of a CBO pandemic study (see A Lehman Crisis of a different sort).

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

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

In all likelihood, somewhere between one-third and two-thirds of the population will be exposed to the coronavirus. Using the Chinese experience as a guide, 81% of the cases will be mild, 14% severe, 5% critical, and 2.5% will die. As it is set up, the healthcare system will be overwhelmed.

Add to that the recent hit to the US energy sector, which became a net exporter as fracking techniques took hold in the oil patch. We saw in 2014-15 that plunging oil could cause further weakness in business investment. In addition, China’s decision to shut down its economy to battle the COVID-19 pandemic has caused supply chain disruptions that rippled throughout the global economy. It is difficult to see how the US can avoid a recession under these conditions.

Investors should brace for an equity bear market. Ryan Detrick of LPL Financial pointed out while not all bear mean recession, bear markets that accompany recessions tended to last longer and the drawdowns are more severe.

Please stay tuned tomorrow for our tactical trading commentary.

Testing the lows

Posted by Cam Hui -

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

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

Ripe for a rally

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

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

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

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

Tactically constructive

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

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

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

Disclosure: Long SPXL

OK, I’m calling it…

Posted by Cam Hui -

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

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

 

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

Recessions are bull market killers

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

 

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

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

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

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

 

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

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

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

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

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

 

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

For investors

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

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

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

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

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

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

For traders

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

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

 

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

 

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

 

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

Disclosure: Long SPXL

 

A stock market roller coaster

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Here we go again?

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

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

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

Sentiment buy signals everywhere

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

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

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

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

Sentiment models are very washed out.

Momentum sell sginals

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

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

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

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

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

Bull or bear?

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

Has the bull caught the coronavirus?

Posted by Cam Hui -

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

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

Is the bull dying? Has it caught the coronavirus?

Possible recession ahead

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

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

Leading economist Ken Rogoff is already forecasting a recession.

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

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

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

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

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

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

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

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

Ed Yardeni also issued a warning for the stock market:

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

Recessions kill bulls

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

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

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

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

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

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

Trump’s Waterloo?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment implications

What does all this mean for investors?

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

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

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

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

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

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

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

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

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

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

Stay tuned.

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

Waiting for the re-test

Posted by Cam Hui -

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

 

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

Buy signals everywhere

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

 

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

 

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

 

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

 

This should all be wildly bullish, right?
 

Fundamental caution

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

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

 

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

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

 

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

 

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

Chop, chop, re-test

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

 

Here are my takeaways from that study:

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

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

 

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