Page 6 – Humble Student of the Markets

So much for the prelude (to a correction)

Posted by Cam Hui - September 4, 2024

Mid-week market update: When I wrote on the weekend that the stock market was undergoing a prelude to a correction, I never dreamed that the S&P 500 would skid -2.1% on the first trading day in September to test its 50 dma.

What happened?

Unsatisfactory answers

None of the conventional explanations appear satisfactory. You could blame it on weak ISM Manufacturing report, but it’s difficult to reconcile how a weak ISM print could spark a -2% downdraft.

You could blame it on excessive bullishness on NVIDIA, along with the news that the U.S. Justice Department sent subpoenas to the company alleging it is making it difficult for customers to switch to other vendors. Indeed, the Semiconductor Index has pulled back to test a key relative support zone.

A quick and powerful downdraft like the one yesterday is more likely to be attributable to positioning. A group of traders were probably caught offside and everyone had to suddenly rush for the exit. Here’s Nomura’s Charlie McElligott derivatives analyst:

And similar to the end July NFP / U-Rate “Fed Policy Error” scare which lead to the “Hard Landing” Tail being repriced sharply hire helping to then set-off a chain of events in the Vol space, this latest (and admittedly much smaller) U.S. Economic “Landing Path” uncertainty around “any” U.S. Growth data (like today’s B- and C- list releases) then too coincided with some spicy Hedging –flows in the VIX Options space from this past Friday which seemingly helped to get things rolling downhill.

If that is indeed the most likely explanation, then today’s lack of bearish follow-through of -1% or more is good news as it is a signal that the market is stabilizing.

Ryan Detrick pointed out that while September usually experiences negative seasonality, the weakness usually shows up in the second half of the month.

Waiting for NFP

Looking ahead, the August Payroll Report due to be released Friday morning will be a source of potential market volatility. The July JOLTS report today showed a worsening trend of quits to layoffs (red line), which tend to lead employment (black line). If we get a weak jobs report Friday, will bad news be bad news (for stocks)?

Prelude to a correction

Posted by Cam Hui - September 1, 2024

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 that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

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 email alerts is 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 (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Neutral (Last changed from “bullish” on 20-Aug-2024)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.

Subscribers can access the latest signal in real time here.

Glass half full?

Is the glass half full or half empty? Is breadth back?

The S&P 500 continues to test a key resistance level. While the equal-weighted S&P 500 rose to an all-time high, the small-cap Russell 2000 is struggling below its all-time high.

I believe the stock market is stalling and investors are seeing the prelude to a correction.

Long-term bullish

Let’s start with the good news. There are few signs of a long-term cyclical top. The S&P 500 just made a monthly closing all-time high in a well-defined uptrend after staging a convincing upside breakout at 4800 in early 2024.

As well, both the S&P 500 Advance-Decline Line and the NYSE Advance-Decline Line made fresh all-time highs. Market tops don’t look like that.

Negative divergences everywhere

An analysis of breadth and price momentum tells a slightly different story. On one hand, the percentage of stocks above their 200 dma (top panel) rose above 75%, which is a sign of positive price momentum. On the other hand, the measure never reached 90%, which is the characteristic of a “good overbought” condition and an extended advance. In addition, both the percentage of stocks above their 200 dma and 50 dma (bottom panel) exhibited a series of lower highs, which are negative divergences and warnings of an imminent market stall.

The daily chart is exhibiting similar negative divergences as the S&P 500 tests overhead resistance. The 14-day RSI and NASDAQ 52-week highs-lows are also showing signs of flagging momentum, though the NYSE 52-week highs-lows equaled its recent high on Friday.

Risk appetite indicators are turning down. The ratio of high beta to low volatility stocks is and the ratio of consumer discretionary to consumer staples are rolling over.

The market’s negative reaction to NVIDIA’s earnings beat underlines the failure of the high octane of the Magnificent Seven’s leadership. Even as the S&P 500 tested overhead resistance, the Magnificent Seven ETF (MAGS) is well below its highs and is struggling below its 50 dma.

More ominously, the relative performance of defensive sectors is turning up. Not only have they all made rounded saucer-shaped relative bottoms, defensive sectors are all leading the market even as the S&P 500 traded sideways (shaded areas).

Putting it all together, these are all warnings that the market is due for a pullback and correction. I pointed out last week that election year seasonality tends to see weakness in September and October, and the current market structure confirms that view. While I don’t know what the trigger for a correction might be, investors should be prepared for a period of short-term weakness and a possible buying opportunity in October.

LBO insights: Why these deep value stocks have become even cheaper

Posted by Cam Hui - August 31, 2024

Mark Hulbert recently published an ominous warning at MarketWatch about excessive valuation in the U.S. equity market. Most valuation ratios are in the top 90% since 2000 and “as overvalued as it was at the market top on Jan. 3, 2022”.

How worried should you be?

Hulbert admitted in his article that “valuation has relatively little predictive power at shorter-term horizons”. Take, for instance, the forward P/E ratio. While the S&P 500 forward P/E is at similar levels as the market top in early 2022, it was higher and for a prolonged period for nearly two years before the top and stock prices kept on rising during that time.

When valuation and value matters

While valuation doesn’t matter much in the short run, Hulbert pointed out that “each of the indicators featured in the chart has an impressive record forecasting the stock market’s return over the subsequent decade”.

If valuation only matters in the long run, it follows that value investing has to be a patient discipline. This analysis from GMO argues that only deep value stocks are cheap. Even shallow value is at the top 80% of historical norms, while deep value is in the bottom 10%.

This makes some sense, as a recent academic paper by Haddad, Huebner, and Loualiche, How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing, concluded that the advent of indexing has made the demand for individual stocks more inelastic, or price insensitive. Translated, stock picking matters in the middle of the valuation distribution matters less (shallow growth and value) because of indexing. It is at the extreme tails of the valuation distribution that alpha can be found.

If GMO is correct and only deep value is cheap, what if I told you I have a quantitative screen that found a group of companies with strong balance sheets, strong cash flows and trading at a median forward P/E of 11?

Insights from LBO modeling

I first wrote about leveraged buyouts, or LBOs, in May (see How To Buy A Company If You Have No Money). Here is how my LBO model works. First, you eliminate financial companies from consideration because these companies already have highly leveraged balance sheets and you can’t LBO a bank or insurance company. The way you LBO a company is to pay equity holders with the company’s own money.

LBO value = Cash + Extra borrowing power

Where

Extra borrowing power = Allowable borrowing power – Existing debt – Leasehold obligations

To calculate allowing borrowing power, I calculated the 5-year standard deviation of EBITDA margin divided by median EBITDA margin as a measure of the underlying volatility of the business. I then divided the results into deciles. The most volatile decile was assigned an allowable EBITDA interest coverage of six and least volatile an allowable interest coverage of two. From that:

Allowable borrowing power = EBITDA / Allowable interest coverage / Financing rate

While it is said that growth stocks are highly rate sensitive because they are long-duration assets, so are LBO stocks.

Here is what’s happened since my initial publication in May. I screened the non-financial stocks in the S&P 1500 using my LBO criteria. There are only 10 stocks that you could buy with no money down. But if I relaxed the criteria to 30% down, the number of stocks that passed my screen rose dramatically from 25 in the last month to 40. Most of the increase is attributable to falling junk bond yields, as proxied by the 5-year Treasury yield + High Yield spread. Funding costs for junk bonds have fallen by about 1% since I began this study.

As LBO candidates tend to be deep value stocks, investors will need to exercise some patience with these names. As one of several examples, coal stocks, which are in a hated industry, have begun to appear as LBO candidates owing to the beaten up valuation and cash flows.

SunCoke is a producer of coking coal that is statistically cheap, but investors may need to be patient with the stock in light of widespread steel overcapacity in China, which has also been reflected in weakness in the price of iron ore.

To be sure, there were some unusual quick successes. I identified the old dot-com darling Cisco Systems as a possible LBO candidate at the height of the early August panic (see What Will Lead the Expected Market Rebound?). The stock rallied soon afterwards on a strong earnings report.

In conclusion, the stock market appears to be overvalued by a number of metrics, valuation doesn’t matter over the short term, but they are predictive of long-term returns. Deep value stocks in the U.S. are still cheap. My list of LBO candidates, which tend to have strong cash positions, strong balance sheets and cash flows, represent a pocket of deep value. In particular, the retreat in junk bond yields has made these stocks even more attractive as investments.

However, many of the stocks identified by the LBO screen are blemished, each in a different way. A deep value screen like the LBO should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk which will be difficult to diversify away.

The list of LBO stocks that passed my screen is a specialized report designed for institutional investors. Readers who would like to see a full list should contact Ed Pennock at ed@pennockideahub.com.

Risk budgeting ahead of NVIDIA’s earnings report

Posted by Cam Hui - August 28, 2024

Mid-week market update: Several readers asked me for comments going into NVIDIA’s earnings report Wednesday night, so I thought I would publish my mid-week update a little earlier than usual.

Bottom line, I have no idea about NVIDIA’s fundamentals. You can study the chart pattern, but event-driven market moves are “roll the dice” moments. Instead of trying to focus on what how stock and the market will move after the earnings report, my inclination is to focus on portfolio risk during these binary events. How is your portfolio positioned relative to your risk budget?

Even though I can offer no insights on market direction, here are some thoughts on risk from the option market.

Estimating risk

Here is a snapshot of NVIDIA’s options that expire this Friday from the CBOE website. The implied volatility (IV column) of at-the-money options is between 1.47 and 1.48. For the uninitiated, you convert from an annual to a daily volatility by dividing the annual implied volatility by the square root of 252, which is roughly the number of trading days in a calendar year. That implies a one-day standard deviation move of 9.3%, which would occur about two-thirds of the time, and a two standard move of 18.6%, which would occur about 95% of the time. That’s quite the range to be rolling the dice on.

In addition to the NVIDIA earnings report Wednesday night, the other major market moving event is the PCE report on Friday morning. We can estimate market expectations of volatility of these events based on option pricing.

Here is the option pricing for SPY options that expire Thursday night, which would be one trading day after the NVIDIA report, and Friday, which would be one trading day after the PCE report. The market is discounting a one-day SPY volatility of 1.0% on Thursday, and volatility declines to 0.9% on Friday. Translated, the market is expecting a decline in volatility of 0.1% after the PCE report compared to the NVIDIA report.

That’s an example of how to risk budget.

Bullish sentiment?

Here’s a sentiment insight from the option market. The accompanying chart compares the 10-minute bars of the S&P 500 on Tuesday (top panel) and the 9-day VIX (bottom panel). From about 2pm onward, the index was flat to slightly down, and so was VXST, which is somewhat unusual as the stock market tends to be inversely correlated to volatility. I interpret this as a slightly bullish sentiment bias going into the NVIDIA earnings report. Keep an eye on how this relationship evolves Wednesday as a way of measuring overall market sentiment.

My inner investor is neutrally positioned at roughly the investment policy stock/bond target mix. My inner trader has stepped to the sidelines ahead of this potential market moving event.

Bullish momentum vs. bearish seasonality

Posted by Cam Hui - August 25, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Neutral (Last changed from “bullish” on 20-Aug-2024)

Subscribers can access the latest signal in real time here.

Negative seasonality ahead

Now that the rally off the early August low appears to be stalling, what are the odds of a re-test of the August lows?

The accompanying chart from Jeffrey Hirsch of Almanac Trader shows that the stock market pattern in 2024 has closely followed the historical election year seasonal pattern. We are about to enter a period of negative seasonality until late October. Is this a sign the S&P 500 could weaken back to its early August low?

Here are the bull and bear cases.

Momentum, momentum!

The short-term bull case rests on price momentum. The market came within a hair of a Zweig Breadth Thrust buy signal. As a reminder, the ZBT buy signal triggers when the ZBT Indicator surges from oversold to overbought within 10 trading days. Historically, such displays of strong price momentum tend to persist for at least a year.

The ZBT Indicator plunged to a near oversold condition on the day of the August panic. It reached an overbought condition last Monday, which was exactly 10 trading days later. It was a breadth thrust, just not a Zweig Breadth Thrust. Breadth thrusts deserve some respect.

Along with the impressive display of strong price momentum, sentiment readings are not stretched and could rise further. The CNN Business Fear & Greed Index has only recovered to neutral. Frothy markets don’t look like this.

The short-term bear case

The short-term bear case rests on a combination of overbought conditions and a series of negative divergences.

If the market is exhibiting strong price momentum, it’s not showing up at the stock or sector level. The accompanying chart shows the relative performance of the top five sectors in the index comprising 75% of index weight. If overall momentum is so strong, where’s the relative momentum at the sector level? The market can’t meaningfully rise without strong relative performance from a majority of these major sectors.

The sectors that are possibly showing signs of emerging leadership are the defensive sectors. They appear to be trying to make rounded bottoms (blue lines). While the evidence isn’t definitive, some of them began to turn up in relative strength slightly before the S&P 500 began to stall (red lines).

In addition, the NYSE McClellan Oscillator reached an overbought condition and recycled downwards, which is usually interpreted as a short-term sell signal.

What to watch

Short-term bullish or bearish? I believe the jury is still out on that score. Here is what I am watching.
How will breadth evolve? Even as the S&P 500 stalled just below the resistance level defined by its all-time high, the equal-weighted S&P 500 broke out to an all-time high, indicating that the average stock in the index is dragging the index upwards. That’s bullish, right?

Not necessarily. The small-cap Russell 2000 is well below its all-time high and its lack of momentum is disappointing. I am waiting for greater clarity to see how breadth indicators evolve.

Other risk appetite indicators are giving off mixed signals. Even though credit market risk appetite (green line) is holding up well, equity risk appetite (red dotted line) is flashing a negative divergence.

More ominously, Bitcoin prices continue to track the relative performance of the ARK Investment ETF (ARKK), which is an indicator of speculative growth stocks. Bitcoin can also be thought of as a liquidity proxy and its downtrend is bad news for the bull camp.

Over at the bond market, yields fell when Fed Chair Powell stated in his speech Friday that it was time to cut interest rates: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

It was a dovish speech. Powell opened the door to half-point rate cuts by raising concerns about the cooling jobs market: “We do not seek or welcome further cooling in labor market conditions.” In particular, there were no coded signals of gradualism in the pace of cuts as “gradual”, “gradualism”, “measured (pace)” were notably absent from his speech.

I have many questions. The market is discounting a 1% decline in rates until year-end and a half-point cut at one of the three remaining FOMC meetings between now and December. Notwithstanding Powell’s dovish tone, can he even manage a September rate cut without any dissents?

Are market expectations overly ambitious? Both the 10-year and 2-year rates are testing key support zones. Is this as good as it gets? Bond bulls need to push yields below the support zones to sustain a risk-on rally.

In summary, I can think of two scenarios for the short-term path of stock prices. The market could continue to rise, supported by positive momentum and a neutral sentiment backdrop. On the other hand, overbought readings and a lack of leadership could resolve in the typical pattern of seasonal weakness. I am waiting for greater clarity as to how market internals develop in the coming days. Even if stock prices were to pull back, it doesn’t mean that the market is on the verge of a major top. My most cautious case calls for a period of consolidation and correction until late October, followed by a rally into year-end.

Gold: Fakeout or generational buying opportunity?

Posted by Cam Hui - August 24, 2024

I highlighted the accompanying chart before. Gold staged an upside breakout at 2100 out of a cup and handle pattern. It recently rose above 2500 to an all-time high. In addition, the cup and handle breakout of 2024 is highly reminiscent of a similar breakout in 2005. Not only did the gold price stage upside breakouts, but also the gold/S&P 500 ratio made a rounded saucer shaped bottom (bottom panel) that resolved in over a decade of positive relative performance.

In December 2023, I studied the factors driving gold strength and concluded that they “should be bullish for the price of risky assets” (see The Market Meaning of a Gold Breakout). In June 2024, I focused on the inflationary pressures behind fiscal dominance and looked forward to the November election. I concluded that gold prices should benefit regardless of who wins the White House, but a Trump win would be especially inflationary (see Why the November Election Matters to Gold).

Now that gold has reached another all-time high at 2500, will history repeat itself? Is this another generational buying opportunity or a bull trap fakeout?

Reasons for caution

Let’s begin with the reasons for caution. Conventional drivers of gold prices have lagged the yellow metal and they are forming negative divergences that warn of excessive frothiness.

Gold has traditionally been inversely correlated to the USD. But USD weakness (inverted chart scale) doesn’t explain why gold is at an all-time high. As well, gold is thought of as a hedge against inflation. However, the price of TIPS, or inflation-linked Treasury bonds, made a lower high even as gold breached 2500. A similar negative divergence can be seen in RINF, the inflation expectations ETF linked to the price of the FTSE 30-year TIPS Index.

Should investors be worried about these technical warnings of possible weakness?

New bullish factors

The bull case can be summarized this way. Even as the conventional factors affecting the gold price have stumbled, other factors have emerged to support demand for gold.

In particular, gold prices have soared because of central bank buying for geopolitical reasons. Central bankers saw the effects of how America could weaponize the banking system by denying access to SWIFT after the onset of the Russo-Ukraine War. The most prominent central buyers of gold were Russia and China as they sought to diversify their holdings away from USD assets in the event of a geopolitical conflict.

For some perspective on the magnitude of fund flows, central bank buying has strongly supported gold prices in the last few years.

Aside from PBOC demand for gold, Chinese households have also been buying. I pointed out in the past the softness of the Chinese economy (see China Slowdown = Reduce Risk). The Chinese yuan is overvalued, but the PBOC dare not allow it to weaken too quickly as it has the potential to start a capital flight stampede. The downward pressure has shown up in Chinese private demand for gold. Reuters reported that Chinese buyers are back after a brief two-month hiatus:

Several Chinese banks have been given new gold import quotas from the central bank, anticipating revived demand despite record high prices, four sources with knowledge of the matter told Reuters.

The new quotas, aimed at helping the People’s Bank of China (PBOC) control how much bullion enters the world’s leading consumer of the precious metal, were granted in August after a two-month pause largely due to slower physical demand in the wake of a bullish market.

In addition to central bank and Chinese private demand, the conventional drivers of gold are also tactically turning up. Central banks are cutting rates as inflation falls, which has the effect of reducing real rates, which is supportive of higher gold prices.

In addition, estimates of global liquidity are turning up, which is reflationary and supportive of higher gold prices.

Too frothy?

As a consequence, western investors of the gold ETF (GLD) have returned to the party. This can be judged bullishly as either as the start of a momentum stampede or in a contrarian bearish fashion as the dumb retail money piling in.

There is no question that gold is extended in the short term. SentimenTrader observed, “It’s rare to see sentiment toward gold more optimistic than other major markets. April 2020 is the only time in the past decade when sentiment toward gold was higher than that toward stocks, bonds, and crude oil.”

On the other hand, my analysis of gold sentiment has a more nuanced view. The bears will argue that the percentage bullish on point and figure of gold mining stocks (GDX) is above 80% (bottom panel), which is in the overbought zone and a sign of a frothy market. The bulls will argue that the gold miner to gold ratio is only in the middle of its three-year range. More importantly, junior gold mining stocks (GDXJ) are near the bottom of their range against the senior miners (GDX), which is hardly a sign of excessive speculation.

Here is my view. The upside breakout in gold prices has more room to run, though the market is extended and could pull back at any time.

For some perspective, a point and figure analysis of the daily gold chart using a 1% box and 3-box reversal shows a measured objective of 2826, which is a rough indication of the upside potential over a 12–18-month time frame.

A long-term point and figure analysis of monthly prices using a 5% box and 3-box reversal shows a measured objective of 4406, which is a rough indication of the upside potential on a multi-year time frame.

An almost Zweig Breadth Thrust buy signal

Posted by Cam Hui - August 21, 2024

Mid-week market update: The market almost flashed a Zweig Breadth Thrust buy signal this week, though there is some dispute over the calculations. As a reminder, a ZBT buy signal is triggered when the market rises from oversold to overbought within 10 trading days. According to StockCharts, the market never reached the oversold condition on August 2, the day of the market panic, but did become overbought on Monday, which was exactly 10 trading days later.

However, Ryan Detrick observed that there is a considerable difference in advancing and declining stocks on August 2 between StockCharts and NDR. According to NDR, the ZBT buy signal was triggered on Monday. Ed Clissold of NDR admitted that data issues may cloud the picture. The use of all securities traded, common stock only, or a “transaction only” dataset could account for the difference.

In the interests of conservatism, I will call it a near miss, but the market action can still be characterized a a breadth thrust, just not a ZBT. Generally speaking, breadth thrusts are characterized by strong price momentum that persist for months. Though the market often pauses to take a breather after the initial buy signal. The accompanying chart shows eight instances when both the ZBT Indicator and the NYSE McClellan Oscillator were overbought. Six (pink) of the eight saw the market pause afterwards.

In the absence of major macro news, this week’s stock market action can be described dominated by technicals and waiting for Fed Chair Powell’s Jackson Hole speech scheduled Friday.

A Jackson Hole preview

The market will be waiting for bated breath to hear what hints Powell might drop on the future trajectory of interest rate policy. As the Jackson Hole symposium is supposed to be a discussion of policy approaches, Powell’s speech will likely be short on specifics. With inflation falling, I would expect him to start discussing the balance of risks. Watch for comments on the Fed’s full employment mandate.

The Fed has described the employment market as “balanced”, but the latest New York Fed Labour Market survey shows increasing anxiety about job loss and a corresponding decline in workers expecting to move to a new employer, particularly among workers aged 45 and under.

Equally important for Fed policy makers is the latest BLS revisions to the NFP establishment survey. It revised down by -818,000 jobs over the 12 months ended March, which translates to an average reduction in monthly payroll gains of 68K a month and the biggest revisions since 2009. Bloomberg’s U.S. chief economist Anna Wong pointed out that the Q1 QCEW county data implies an even bigger revision of -958,000. These figures are consistent with the FOMC minutes that the “vast majority” of members “observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting”,

Stock market reaction

What does that mean for the short-term outlook for stock prices?

Some of it will depend on how the market reacts to Powell’s speech. Will it be disappointed by the lack of specifics? How much is priced in? According to the CME FedWatch Tool, the market is expecting a half-point cut some time this year which sounds overly ambitious.

Marketwatch reported that Nicholas Colas of DataTrek studied the market reaction to past Jackson Hole speeches by the Fed Chair, and it tended to have a bullish bias,

However, averages can vary greatly. Specific to this year, the market is just starting to consolidate sideways after a breadth thrust, and it faces possible uncertainty ahead as it looks forward to the election in November.

From a technical perspective, the S&P 500 appears to be pausing its advance as it approaches its all-time high resistance with a possible significant market moving event Friday morning. This is a time to exercise some caution and reduce overall portfolio risk.

4 reasons why you should be tactically bullish

Posted by Cam Hui - August 18, 2024

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)

Subscribers can access the latest signal in real time here.

A “good overbought” advance?

The rebound off the August 5 panic bottom has shown an astounding level of price momentum. The S&P 500 printed a William O’Neil Follow Through Day, which is an indication of strong positive price momentum with a 1.7% advance on higher volume than the previous day. It went on to break out through its 50 dma and a falling trend line by gapping up through those levels. The next test to exceed the bearish engulfing pattern on August 1.

The market appears to be on its way to start a “good overbought” advance. Here are some other reasons why this rally could continue.

Strong momentum

The stock market is exhibiting evidence of strong price momentum. The market came within a hair of a buy signal. As a reminder, the ZBT buy signal flashes a buy signal when it recycles from oversold to overbought within 10 trading days.

The Zweig Breadth Thrust Indicator plunged to a near oversold condition on the day of the August panic. Last Friday was day 9 of the almost breadth thrust window, and the indicator is near overbought.
Call it an almost, or incomplete, breadth thrust.

A sentiment reset

Investor sentiment has reset in the wake of the market panic. Analysis by Deutsche Bank shows investors’ aggregate allocation to stocks is now in the 31st percentile and underweight, compared to the 97th percentile of the historical range three short weeks ago.

Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual client funds, has fallen below its 26-week Bollinger Band. This has been a virtually foolproof tactical buy signal.

The 10 dma of the CBOE put/call ratio spike above its 1 standard deviation Bollinger Band, which indicates fear and a contrarian buy signal.

VIX spikes are bullish

There have been numerous studies showing that VIX spikes are contrarian bullish. The VIX Index touched 65 on the day of the market panic on August 5 and fell below 20 soon afterward. A study of VIX action that fall from above 40 to below 20 shows strong positive returns, though one-year returns were below average.

Positive internals

Technical internals are flashing bullish signals. The equal-weighted relative performance of the consumer discretionary stocks and global consumer discretionary to global consumer staples are turning up, which are indications of positive risk appetite and cyclical buy signals.

Breadth indicators are confirming the market advance. Both the S&P 500 and NYSE Advance-Decline Lines have made fresh all-time highs.

What about leadership?

I continue to favour a tilt away from Magnificent Seven leadership for this next bull phase. Magnificent Seven has led profit growth for several quarters, but the other 493 stocks in the S&P 500 are projected to deliver their first profit growth since Q4 2022.

In addition, small-cap indices are breaking out of their trading range, which is a constructive sign that they are out of the penalty box and poised for further gains.

In conclusion, the stock market is poised for continued strength. I can think of at least four reasons to be tactically bullish on stocks: price momentum; a sentiment reset from bullish to caution, which is contrarian bullish; the historical bullish record of VIX spikes; and positive and supportive internals. I continue to favour non-Magnificent Seven leadership for the next bull phase.

In normal circumstances, my inner trader would have exited his long positions by now as technical conditions have normalized from an oversold extreme to neutral. However, the strength of price momentum has convinced him to hold on until readings become overbought. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclaimer: Long TNA

Back to the soft landing

Posted by Cam Hui - August 17, 2024

The latest BoA Global Manager Survey is a dramatic illustration of market anxiety. In July, 18% of respondents believed that a U.S. recession was the biggest tail risk. That figure surged to 39% in the August survey, which was taken August 2–8 right at the height of the market panic.

During the market panic, the market went from pricing in a soft landing to rising odds of a hard landing. About two weeks later, the consensus has shifted back to a soft landing, which should be friendly to risk assets.

Here is my macro assessment of the U.S. economy in the aftermath of the growth scare.

Back to Goldilocks

The backdrop for the U.S. economy can be best described as a combination of decelerating inflation and moderating growth. Notwithstanding the recent growth scare which sparked an unwind of leveraged positions, that “not too hot, not too cold” Goldilocks trend remains intact.

The July CPI and PPI reports showed the disinflationary trend is continuing. Now that the components of CPI and PPI are known, it’s relatively easy to estimate PCE, which is the Fed’s preferred inflation metric. These latest set of readings should allow the Fed to start shifting its focus from its price stability mandate to its full employment mandate and cut rates. Unless the August Payroll Report shows a dramatic fall in employment, expect a quarter-point cut at the September FOMC meeting.

As for growth, the Atlanta Fed’s nowcast of Q3 GDP stands at 2.0%, which is hardly recessionary.

More importantly for equity investors, forward 12-month EPS estimates are still rising.

Investors may recall the roots of the growth scare. It began with a higher-than-expected initial jobless claims print, followed by a disappointing July Payroll Report. Since then, both initial and continuing claims have moderated.

Since the onset of the growth scare, a number of data points have appeared that are supportive of continuing growth. As an example, the Cass Freight Index, which measures the North American freight market, ticked up after four months of weakness.

Small business confidence increased, which is an important barometer of the economy as small businesses have little bargaining power. Both the soft and hard data components rose. To be sure, the surge in soft confidence may be attributable to (then) optimism about Trump’s electoral prospects in the wake of his assassination attempt. Nevertheless, I find it constructive that both components showed increases.

The Transcript, which monitors earnings calls, summarized the state of the U.S. economy as undergoing moderating growth:

The stock market was the elephant in the room on earnings calls last week. After the recent volatility, many analysts were asking CEOs if they had seen a change in the environment and whether a recession was forthcoming. Most CEOs said that there has not been a change, but some were slightly more cautious. Even though there hasn’t been a change, consumers are still fatigued and segments that had been strong, like travel and restaurants, are reporting more softness. The industrial economy has already been in a recession for 4-5 quarters. But with interest rates likely to come down, that may be closer to the end than the beginning.

Putting it all together, we have an economy that’s showing decelerating, but not recessionary, growth, and the start of a rate cutting cycle. Even though forward P/E valuations are somewhat elevated compared to historical norms, this should not be a concern as interest rates fall and EPS growth continues.

Key risks

There are two key risks to the Goldilocks bullish scenario. The first is the continuing growth malaise in China, which is exporting deflation to the rest of the world. Despite its efforts at target stimulus, credit growth has stagnated.

Chinese economic weakness can be seen in the slump in iron ore prices, which looks like it has more room to run.

Another key risk to consider is rising geopolitical tensions that could spike energy costs. Russia, a major energy exporter, is already engaged in a war. Iran is on the verge of retaliating against Israel for two assassinations that could spark a regional conflict and disrupt the oil market. The oil market has barely reacted to these potential risks and the 52-week rate of change is negative, which is positive for U.S. consumer confidence. But consumer confidence could take a hit if oil prices spike, which could spark another round of growth scares and rattle financial markets.

The bulls are gaining back control of the tape

Posted by Cam Hui - August 14, 2024

Mid-week market update: I wrote on the weekend that investors should watch for signs of an O’Neill follow through day for bullish confirmation of the rebound.

A follow through day can occur as soon as day 4 (last Friday) of a rally. It’s defined as the index rising 1% or more on higher volume than the previous day. The most powerful follow through days occur between day 4 and day 7 of the rebound.

We got the follow through day on day 6 yesterday when the S&P 500 rose 1.6% on higher volume. This is an indication that the bulls are seizing control of the tape. Even as the S&P 500 tests overhead resistance at the 50 dma, the follow through day raises the odds that the market will break up.

In addition, Helene Meisler ran a poll on the weekend. While she found that most respondents were bullish, there was a slight plurality of opinion that the market would weaken and possibly re-test the old lows. The follow through day, which is a sign of strong price momentum reversal, significantly reduces that risk.

Technical recovery

I am seeing other signs of technical recovery. Breadth is coming back. NYSE new highs-lows is positive, NASDAQ new highs-lows is negative but turning up.

Risk appetite indicators are also turning up after a sudden fright.

Preface: Explaining our market timing models

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)

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Poised for a rebound

Numerous historical studies of volatility spikes have concluded that such episodes are good buying opportunities for stocks.

The accompanying chart shows just one example of what happens when the VIX Index surges above 45 and recycles below 30. The market has been higher every single time. The only question is whether the market re-tests its old lows.

If stock prices are poised for a rebound, the next question is the nature of the leadership of the ensuing rally.

The crowded trade reset

Let’s first begin with a review of the market backdrop.

Admittedly, psychology had become a little too giddy and was due for a reset. The Euphoriameter from Callum Thomas of Topdown Charts shows that sentiment had become a little too frothy and the recent market setback can be considered to be an opportunity for a welcome reset.

Longer term, growth stocks have been on a tear against value stocks since the GFC. The trend may have become excessive. The divergence between U.S. growth and value and EAFE growth and value became evident with the onset of AI investing mania in early 2023.

The recent risk-off episode may be the signal of a reset of the growth and value relationship.

The rotation continues

The accompanying chart shows the relative performance of the value and cyclical sectors of the S&P 500. All turned up when the S&P 500 topped out in early July.

By contrast, here is the relative performance of growth sectors. Only Communication Services have been flat against the S&P 500 in the past year. Technology and Consumer Discretionary, which are dominated by heavyweights Amazon and Tesla, turned down when the market topped in July.

In particular, the absolute and relative performance of technology stocks has been weak, and so is their relative breadth indicators (bottom two panels).

Growth stocks, as represented by the NASDAQ 100, aren’t sufficiently washed out to form a relative bottom (black line).

By contrast, a bottom-up review of deep value stocks is presenting greater buying opportunities. My Leveraged Buyout screen of non-financial stocks in the S&P 1500 (see How to buy a company with no money) revealed 38 candidates that pass the screen of buying the company with no more than 30% of the stock price and borrowing the rest, compared to 25 candidates at the end of July and 25 at the end of June.
The biggest surprise on the LBO list was the Tech Bubble favourite Cisco Systems, which is trading at a forward P/E of 12.7.

Small-cap stocks also look intriguing. If we use the relative performance of high yield (junk) bonds to their duration-equivalent Treasuries (black line) as a proxy for risk appetite, the small-cap/large-cap ratio (red line) began to diverge from high yield in early 2019 and recently fell to 20-year lows.

Tactically, small-cap indices have retreated back to their absolute and relative trading ranges after failed upside breakouts. Upside breakouts would be confirmations of renewed leadership by these stocks. I remain constructive.

Welcome signs of normalization

Since the recent volatility storm originated in the derivatives market, I am seeing welcome signs of normalization in the option market that lays the foundation for a stock market rebound in the week ahead.
The VVIX, which is the volatility of the VIX, has begun falling in line with the decline in the VIX. I interpret this as falling expectations of higher future volatility.

In conjunction with a falling VVIX, the term structure of the VIX has also normalized from inversion, indicating receding fear levels.

The SKEW Index, which measures the relative cost of tail hedges, rose above its 200 dma even as stock prices rebounded. Rising cost of downside protection in the face of market strength is a useful contrarian signal.

As always, there are no guarantees in trading, but these are constructive signs that the bulls are taking control of the tape. Look for an O’Neil Follow Through Day in the coming week for bullish confirmation. A follow through day can occur as soon as day 4 (last Friday) of a rally. It’s defined as the index rising 1% or more on higher volume than the previous day. The most powerful follow through days occur between day 4 and day 7 of the rebound.

In conclusion, the market is poised for renewed strength. A review of market leadership shows weakness by technology and other large-cap growth stocks. I believe the rotation from growth to value and from large caps to small caps will continue and these stocks will be the new leadership in the next leg up.

My inner trader continues to hold a long position in small caps. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

Disclosure: Long TNA

Unsatisfactory answers

Waiting for NFP

Glass half full?

Long-term bullish

Negative divergences everywhere

When valuation and value matters

Insights from LBO modeling

Estimating risk

Bullish sentiment?

Negative seasonality ahead

Momentum, momentum!

The short-term bear case

What to watch

Reasons for caution

New bullish factors

Too frothy?

A Jackson Hole preview

Stock market reaction

A “good overbought” advance?

Strong momentum

A sentiment reset

VIX spikes are bullish

Positive internals

What about leadership?

Back to Goldilocks

Key risks

Technical recovery

Repricing risk

Poised for a rebound

The crowded trade reset

The rotation continues

Welcome signs of normalization

A complacency unwind

Volatility spike = Panic bottom

Key risk

Insufficient fear

Downside catalyst

A leveraged position unwind

Spotting the panic crescendo

Watch the Yen

What’s the downside risk?

Nearing a bottom

A question of leadership

What’s bothering markets?

Too little, too late?

A soft landing

Mag 7 weakness

Broad market strength

Farrell’s Rule 2 in action

The currency market unwind

Stocks are oversold

Buy small caps for the bounce

Key risk

Market-based signals

Inadequate rebalancing

Investment implications

A market bottom signal

Trust the Great Rotation