Page 8 – Humble Student of the Markets

Is good news good news, or bad news?

Posted by Cam Hui - June 8, 2024

Is good economic news good news for equities or bad news? We know how to interpret macro news for the bond market. The Citi Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has been a bit weak. Historically, a weak ESI has meant lower bond yields.

What does it mean for equities? Investors saw a string of weaker-than-expected macro prints last week, starting with an anemic ISM PMI on Monday, followed by a miss on job openings in JOLTS Tuesday and another miss on ADP employment Wednesday. In each of those cases, bond prices rallied and equities initially weakened, followed by price recoveries later in the day.

I interpret events from the perspective of three trading desks: bonds, commodities and equities.

The bond market reaction

Let’s start with the view from the bond desk.

The Bank of Canada did it, and so did the European Central Bank. Both announced quarter-point rate cuts last week — when will the Fed follow suit?

Up until Friday’s May Jobs report, Treasury yields fell across the entire yield curve in response to the trend in weaker-than-expected economic data. The 2-year yield bounced off a key technical support level, while longer-term yields tested support.

The closely watched employment picture is showing mixed signals. Fed Chair Jerome Powell has cited the number of job openings per available worker as an indicator of labour market tightness. The April JOLTS report shows that this metric has normalized back to pre-pandemic levels.

Even though the headline nonfarm payroll establishment survey and average hourly earnings release surprised to the upside, the noisy household survey was deeply negative and the unemployment rate actually rose. As well, the quits to layoffs ratio, which is a leading indicator of nonfarm payroll employment, has flatlined since last summer, with the caveat that this is a noisy data series.

The jobs market may be much weaker than the headlines show. Bloomberg Chief U.S. economist Anna Wong argued that the Establishment survey is overstating employment by about 100,000 because of errors in the birth-death adjustment from the Quarterly Census of Employment and Wages (QCEW), which is reported with a significant delay.

How should investors interpret this data? For now, the consensus view is mildly dovish. Fed Funds market expectations calls for the first cut expected at the September FOMC meeting and almost a coin flip as to whether we will see a second cut at the December meeting.

The commodity market reaction

The view from the commodity desk is one of economic weakness.

Commodity prices have been either trading sideways or in decline, depending on what index you use. The headline commodity indices, which tend to be heavily weighted in energy because of their higher liquidity, have been falling in the wake of last week’s OPEC+ decision to gradually allow the potential return of OPEC barrels to production. The cyclically sensitive copper/gold and base metals/gold ratios are also pulling back after a surge during the April–May period.

Precious metal investors were blindsided when the PBOC announced that it had stopped buying gold after an 18-month stretch of accumulation.

However, investors may want to take the commodity desk’s view of cyclical weakness with a grain of salt. Commodity prices are undergoing a period of negative seasonality, which should end about mid or late July.

The equity market reaction

By contrast, the view from the equity desk is bullish.

From a fundamental perspective, global EPS estimate revisions have turned positive, with the sole exception of China.

Analysis from John Butters of FactSet confirms this view. S&P 500 EPS estimate revisions have been strong.

Moreover, references to the term “recession” on earnings calls are fading.

The market’s price momentum has been strong. Ryan Detrick pointed out that the historical evidence indicates that strong price gains tend to beget more price gains.

Growth deceleration or disinflation?

In summary, the bond and commodity markets are signaling weakness while equity markets are signaling growth. How should you reconcile these disparate views?

I think investors should distinguish between economic growth deceleration, which would stand in direct contrast to bottom-up Street expectations of rising EPS estimates, and disinflation. A growth deceleration would pose headwinds to equity price gains, while disinflation would be a positive factor. That’s how you determine if good economic news is good news or bad news for equity prices.

As the economic indicators stand today, job openings have come down without a significant rise in unemployment. That’s what the fabled soft landing looks like, and it should be equity bullish.

A well-telegraphed market advance

Posted by Cam Hui - June 5, 2024

Mid-week market update: The S&P 500 has risen to a new all-time high, and this move was well-telegraphed. I wrote on the weekend and characterized conditions “half-hearted buy signals that indicate low downside risk”.

The S&P 500 subsequently staged an upside breakout from a bull flag to a fresh all-time high.

The move was even more impressive on the S&P 500 hourly chart. The index staged a furious last hour ramp on Friday on no news. The market retraced about half of the advance on Monday on an intra-day basis on concerns over a weak ISM report, but reversed upwards to close the day in the green. It saw a similar pattern of weakness and reversal Tuesday in reaction to an anemic jobs openings print from the JOLTS report. And on Wednesday the S&P 500 blasted off to a new all-time high.

Bullish confirmation

The upside breakout was confirmed by cross-asset return patterns. Treasury bond prices broke out of a minor resistance level. The USD, which has been inversely correlated to stock prices, was rejected at resistance. Oil prices weakened in reaction to this week’s OPEC decision, which should be positive for the headline inflation outlook.

The relative performance of equal-weighted consumer discretionary stocks, which is a cyclical indicator, has turned up. If history is any guide, this is the start of a significant advance.

That said, I am a little concerned that breadth isn’t broadening out.

However, NYSE 52-week highs-lows have turned positive, indicating bullish momentum.

In conclusion, these are all risk on signals, though Friday’s Jobs Report could be a source of volatility.

The market’s dance of thrusts and dips

Posted by Cam Hui - June 2, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-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.

A failed breadth thrust?

Is the Triple 70 breadth thrust that triggered on May 6 in trouble? As a reminder, a Triple 70 breadth thrust occurs when the percentage of NYSE advances exceed 70% for three consecutive days, which is a bullish momentum signal. If history is any guide, Rob Hanna’s study of such events has seen strong bullish momentum follow through.

On the other hand, the short-term warning signs have been appearing everywhere. Even as the S&P 500 advanced to new all-time highs, the 5-week RSI flashed a negative divergence, and so did the VVIX/VIX ratio.

Is this evidence of a failed breadth thrust? How should investors react to the simultaneous appearance of bullish price momentum signals like a breadth thrust and the risk of dips from negative technical divergences?

Warning signals

The warning signs were plain to see. I highlighted the excessive bullishness of the put/call ratio last week.

Moreover, the daily S&P 500 chart was flashing warning signs. It’s not unusual for the index to consolidate sideways for a few days after reaching its upper Bollinger Band before making the next directional move. The latest move was foreshadowed by a bearish recycle of the stochastic from overbought to neutral. However, the market did show a constructive reversal candle on Friday, which needs to be confirmed by bullish follow through next week.

Limited downside risk

In light of the short-term warning signs, how far can the market pull back?

The bulls can be consoled by the fact that the market is already showing near oversold readings, indicating a relatively shallow pullback. Of the five components of my Bottom Spotting Model, one, the NYSE McClellan Oscillator (NYMO), flashed a buy signal when it reached an oversold condition last week. A number of other indicators are close to buy signals. The VIX Index is nearing the top of its Bollinger Band, and the intermediate-term overbought/oversold indicator is also near an oversold condition. Historically, the market is close to a bottom when two or more components of the Bottom Spotting Model trigger buy signals.

The Zweig Breadth Thrust Indicator, which is reported with a delay, came within a hair of an oversold condition last week, and its real-time estimate did become oversold, though that does not count as an “official” oversold reading. In the past, the market has bottomed soon after similar episodes.

As well, one of the important indicators of equity risk appetite, which was bearish last week, is turning up. The relative performance of equal-weighted consumer discretionary may be bottoming, which is a constructive sign.

While these are not definitive market bottom signals, I interpret these as half-hearted buy signals that indicate low downside risk.

Key risk

Even though I believe any pullback should be shallow, the key risk to my bullish outlook is the reaction of the bond market. Last week’s blizzard of Treasury supply was not well received and caused some indigestion among buyers.

Notwithstanding the softer-than-expected core PCE report that depressed bond yields, auction supply is expected to rise and peak in June. This will put additional pressure on yields in the new month and present a key test for risk appetite. {Corrected chart below)

In conclusion, I believe the bullish implication of Triple 70 Breadth Thrust triggered on May 6 is still alive. The U.S. equity market has just hit a temporary air pocket and should experience a shallow pullback. The key risk is how the bond market reacts to a continuing flood of issuance in June, which could put upward pressure on yields and downward pressure on risk appetite.

Transitory disinflation in 2025?

Posted by Cam Hui - June 1, 2024

The closely watched April PCE moderated as expected. Headline PCE came in 0.3%, in line with expectations, while core PCE was 0.2% (blue bars), which was softer than expectations. Supercore PCE, or services ex-energy and housing, also decelerated (red bars). This latest print represents useful progress, but won’t significantly move the needle on Fed policy.

The worrisome development is the global trend of transitory disinflation. The Citi Inflation Surprise Index, which measures whether incoming inflation data is beating or missing expectations, is bottoming in most countries and rising again. If this continues, any expectations of ongoing rate cuts are likely to be pulled back.

Now that 2024 is nearly half over, it’s time to peer into 2025 to see the upside and downside factors that are expected to affect inflation and the Fed’s interest rate trajectory. The three main factors to consider are changes in immigration policy and how they affect employment; the evolution in productivity; and the possible political effects of the election on inflation.

Immigration and labour supply

Immigration has become an increasingly touchy subject in the 2024 election. What’s surprising is the degree of agreement about not only restricting illegal immigration, but also the willingness to shrink the pool of unauthorized workers.

The Fed has weighed in on this touchy topic. When asked about the labour market, Fed Chair Jerome Powell said during the December post-FOMC press conference that, “The labor force participation rate has moved up since last year, particularly for individuals aged 25 to 54 years, and immigration has returned to pre-pandemic levels. Nominal wage growth appears to be easing, and job vacancies have declined.”

In particular, the prime age (25–54) labour force participation rate (red line, right scale) has recovered quicker post-pandemic than the overall participation rate (blue line, left scale). Powell hinted that immigration may serve some role in supplying more workers and curbing wage growth. “Does labor force participation have much more to run? It might. Immigration could help, but it may be that, at some point—at some point, you will run out of supply-side help, and then it gets down to demand, and it gets harder.”

So what happens if there is a border bill that either restricts unauthorized immigration or implements a mass deportation of illegal workers? I looked at the data to test the hypothesis that unauthorized immigration is expanding the labour supply more than normal.

Unauthorized workers mostly toil in low-skilled and low-wage jobs. From a policy standpoint, few are worried about the Canadian who sneaks across the U.S.-Canada border to work at a six-figure job as a project manager at GE. The Atlanta Feds’ Wage Growth Tracker shows that workers with high school education (green line) has usually lagged overall wage growth (blue line), but the rate of wage increase has exceeded the median in the post-pandemic era. If there is an excess supply of unauthorized workers during that period, they should be depressing wage growth, which is not evident in the data.

Here’s another way of analyzing wage growth in greater detail. The accompanying chart shows the average hourly earnings of production and non-supervisory workers (black line), of retail trade workers (red line) and of leisure and hospitality workers (blue line), all normalized to 100 in January 2019, which is about a year before the onset of the pandemic.

While low-wage workers are concentrated in retail and leisure and hospitality, retail employment tends to require a higher skill level and have a language requirement for client-facing positions compared to leisure and hospitality workers. As the chart shows, average hourly earnings for retail workers have lagged the overall average in the post-pandemic era, while leisure and hospitality average hourly earnings have been stronger. As unauthorized workers tend to cluster more among leisure and hospitality, excess supply in this group should show up as depressed wages not higher ones.

Now imagine that in the 2025 post-election world the White House and Congress come to an agreement on an immigration bill. Regardless of whether the bill just restricts the supply of illegal immigrants or takes active steps to deport them, it will worsen labour supply at the low-wage end of the market, tighten the jobs market and create upward pressures on inflation.

The market is currently discounting one rate cut in 2024, which is expected to occur at the September FOMC meeting. All else being equal, any immigration bill to restrict labour supply in an already tight jobs market may resolve itself in no rate cuts and possibly rate hikes in 2025.

The productivity wildcard

Productivity is the cure for inflation. Better productivity is an offset to higher growth and wages. Analysis from the non-partisan Congressional Budget Office (top left chart) dramatically shows how productivity matters and how it affects not only inflation, but also the degree of fiscal room the government will have in the future.

The question of how productivity evolves has been a puzzle for Fed policy makers as productivity gains have been noisy. Powell discussed this policy dilemma at the May post-FOMC press conference: “We saw a year of very high productivity growth in 2023, and we saw a year of, I think, negative productivity growth in 2022. So I think it’s hard to draw from the data.”

As the accompanying chart shows, changes in productivity (blue line) are very noisy. It’s not unusual to see a leap in productivity when the economy revives from a recession. Economic output rebounds, but the number of workers is still low, which shows up as higher output per worker, or a productivity improvement. Productivity fell and went negative after the initial leap in the post-pandemic era, and it has risen again. What’s different this time is the prime age participation rate is also rising, indicating that productivity gains are not the result of fewer workers, which is a constructive development.

There are several schools of thought on productivity. The conventional view is that changes in productivity are noisy and Fed policy makers can’t reliably depend on productivity gains to moderate inflationary pressures.

A more constructive view is that the adoption of AI will drive powerful productivity gains in the coming years. There are numerous anecdotes of productivity gains through AI. One example can be found in this paper from the world of investing that found “machine learning models not only generate significantly more accurate and informative out-of-sample forecasts than the state-of-the-art models in the literature but also perform better compared to analysts’ consensus forecasts”.

On the other hand, the excitement over AI and large language models sounds remarkably like the hype over self-driving cars about 10 years ago. AI can get you 90–95% of the way, but the last 5% or 10% represents a last-mile problem that’s very difficult to solve. The St. Louis Fed published a paper that projected the pace of AI adoption to be similar to that of PC adoption, which is a cycle with an elongated pace of productivity gains.A more nuanced view is that PPP and inflation-adjusted productivity have been gaining steadily on a global basis, aside from Japan and Italy. The only difference is the strength of the USD.

Election effects

While it’s always difficult to predict electoral outcomes and it could be argued that polls aren’t very meaningful until the campaign begins in earnest in September, current market expectations of aggregated betting odds has Trump leading Biden despite his felony convictions last week.

With that in mind, Bloomberg reported that Deutsche Bank economists project that Trump’s proposed tariffs are expected to raise headline PCE by 1.2% and core PCE by 1.4%. This will force the Fed’s hand to pivot to raising rates.

In addition, investors will have to be prepared for the second-order effects of trade policy and Fed policy. If Trump, who is a self-professed “debt and low interest rate” guy, tries to politicize or change either the Fed Chair or the make-up of the Fed Board of Governors in order to force lower rates, expect USD weakness, accelerating inflation and possibly stagflationary growth.

In conclusion, I peered into 2025 to see how U.S. inflation may evolve with specific focus on changes in immigration policy and how they affect employment, the evolution in productivity and the possible political effects of the election on inflation. Upward pressures on inflation will come from changes in immigration policy and a Trump win. Productivity gains are uncertain and AI-driven gains are likely to take a long time to be realized.

Such an environment is typical of a mid- or late-cycle expansion. It is bond price unfriendly, and neutral or positive for stock prices, depending how the nominal growth outlook evolves.

A modest correction ahead?

Posted by Cam Hui - May 29, 2024

Mid-week market update: I pointed out on the weekend that it’s not unusual for the S&P 500 to consolidate sideways after reaching its upper Bollinger Band before the market makes its next major directional move. There have been five other similar instances in the last six months. What’s a little unusual about the current episode is the length of the consolidation.

Even though the S&P 500 remains in its narrow consolidation range, the odds point to a shallow correction, as the daily stochastic has recycled from overbought to neutral, which is a sell signal. Initial SPY support can be found at 520-525, and secondary support at 505-510, based on volume by price analysis.

Narrowing leadership

Here’s what is bothering me. Even as the S&P 500 advanced, leadership was narrowing and it wasn’t broadening out.

Market leadership had become AI and NVIDIA and virtually nothing else. The technical condition of the Semiconductor Index as a proxy for AI plays appears precarious. On an absolute basis (top panel), the index staged an upside breakout and it’s pulling back to test its breakout turned support level. On a relative basis (bottom panel), it was rejected at an intersection of relative resistance levels, which is concerning.

I am also seeing a number of bearish cross-asset signals. Yesterday’s poor Treasury auction didn’t help risk appetite. The 7-10 year Treasury ETF (IEF) broke a key support level today. The USD is strengthening and testing a key resistance level, and oil prices are rallying. These are all signs that point to a risk-off environment.

A crowded long

In addition, analysis from the Leuthold Group showed that “commercial hedgers” in the S&P 500 e-minis, who are generally regarded as the “smart money”, have a short position similar to levels before the last major correction in early 2022. An interpretation of flip side of this coin is a crowded long by the “dumb money”, which would be contrarian bearish.

A modest correction

SentimenTrader is calling for a modest correction after last week’s downside break, which was the day my inner trader took profits in his long S&P 500 positions.

I agree with the modest correction call. Two of the five bottom spotting indicators in my Bottom Spotting Model are close to a buy signal. It wouldn’t take much of a market downdraft for the VIX Index to spike above its upper Bollinger Band, and the NYSE McClellan Oscillator (NYMO) is very close to an oversold reading.

Perhaps the PCE report could provide a catalyst on direction. Either way, don’t panic and get ready to buy the dip.

How to spot a market top

Posted by Cam Hui - May 26, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)

Subscribers can access the latest signal in real time here.

Bearish Capitulation

Morgan Stanley’s strategist Mike Wilson has been one of the more prominent bears left standing and he capitulated last week. Now that Wilson has reluctantly turned bullish, is it time to turn contrarian bearish on stocks?

I can think of two scenarios for the U.S. equity market. The bulls will argue that the market structure of the S&P 500 shows the index has outrun the bullish channel, as defined by the solid lines, and ascended to a steeper channel, as defined by the dotted lines. The advance has been characterized by a series of “good overbought” RSI signals. The bullish scenario opens up a short-term objective of 5500 before the rally is done.

The bears will argue that the combination of the “buy the rumour, sell the news” market reaction to the strong NVIDIA report and the negative divergence on the 5-week RSI is a signal of an exhaustive advance.

Bull or bear? Here are the signposts to an intermediate-term market top.

What could derail the bull?

I’ve made the point before that the U.S. economy is undergoing a mid-cycle expansion (see Relax, It’s Just A Mid-Cycle Expansion). In order for the equity bull to continue, it needs stable interest rates, continued economic growth and rising earnings.

Let’s begin with the issue of interest rates. The market took a risk-off tone after the release of the FOMC minutes, which had a hawkish tone and put the possibility of rate hikes on the table. Expectations shifted from two rate cuts this year to just one, and the timing of the first cut was pushed out from September to November. Despite all the hand wringing, the expected direction of interest rates is down.

The path of interest rates depends on inflation. Keep in mind that the world is undergoing a disinflationary cycle. The only debate is how quickly inflation is decelerating. Joe Wiesenthal highlighted how CPI has been trending down around the world.

Moreover, much of U.S. inflation is attributable to shelter. Harmonized core CPI from BLS and harmonized core PCE, as estimated by Moody’s, which exclude the shelter component of inflation, is already at the Fed’s 2% target.

In other words, equity bulls shouldn’t overly worry about the interest rate threat to stock prices.

Turning to the growth question, one of the best real-time signals of global growth are commodity prices. And they are not signaling a growth slowdown. Instead, they are trending up. The cyclically sensitive copper/gold ratio has become extended and it’s pulling back. The more broadly based base metals/gold ratio is flat to up.

Q1 earnings season is mostly over. The EPS beat rate was slightly above the historical average while the sales beat rate was below. The more important development is the continued strength in forward EPS estimates, which is a bottom-up sign of fundamental momentum.

An intermediate-term market top will not be in sight until the fundamentals shift that derail any of those factors, either in the form of rising rates or a downward shift in growth expectations.

Tactically cautious

That said, some tactical caution may be warranted in the short run.

Sentiment, as measured by the pub/call ratio, reached the froth zone. In the past, such conditions have made the market vulnerable to pullbacks. There were 17 other similar signals in the last 10 years. The market fell in 11 instances and six were resolved in a benign manner.

Equally concerning for the bull case is the inability of consumer discretionary stocks to outperform, which is a warning of falling risk appetite.

As well, the usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) flashed a sell signal when the 14-day RSI of ITBM recycled from overbought to neutral. The recent trend in breadth deterioration, as evidenced by the poor S&P 500 and Russell 2000 reaction to the blockbuster NVIDIA earnings blowout, is both a disturbing exhibition of market psychology and contributed to the decline in RSI.

On the other hand, traders are advised to be cautious about shorting this market as the NYSE McClellan Oscillator has already reached an oversold level. Even though the market is vulnerable to a setback, downside risk could be limited at these levels.

In conclusion, I am not overly concerned about the capitulation of a prominent bear on an intermediate-term basis. Stock prices are advancing on stable interest rates and continued economic and earnings growth. However, the stock market is showing some signs of bullishness exhaustion and it’s vulnerable to a short-term pullback.

How to buy a company with no money

Posted by Cam Hui - May 25, 2024

Perhaps you remember the late-night television commercials selling tapes and courses on how to buy real estate with no money down. One memorable character from the early 1990s ran infomercials featuring him on a yacht surrounded by bikini-clad women to emphasize how he, a Vietnamese refugee, had made a fortune from nothing. You could do the same thing if you bought his course.

The Wall Street equivalent of buying a company with no money down is the leveraged buyout, or LBO. The LBO was made possible by the popularization of junk bond, or high yield bond, financings, which was a financial innovation from the 1980s.

Even though the LBO has gone mostly out of usage, it may be time to revisit LBO targets now that high yield spreads are narrowing. I screened non-financial stocks in the S&P 1500 for LBO candidates and came up with a number of interesting insights.

It turns out that LBO candidates are relatively rare. They may be the modern deep value equivalent of Ben Graham’s formulation of stocks trading below net-net working capital or current assets minus all debt.

Introducing the LBO model

How do you identify an LBO candidate?

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.

How do you do that? Here is the formula I used to identify LBO candidates?

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

Given the current high yield spread against Treasuries, the financing rate is about 8%.

Model characteristics

Before diving into the companies identified by the LBO model, it’s worthwhile considering the factor characteristics of the model.

One of the key questions is what EBITDA measure do you plug into the model? I tried three: The last reported EBITDA, a normalized EBITDA based on the median EBITDA margin as applied to last reported sales; and a forward 12-month EBITDA derived from Wall Street’s consensus forward 12-month EPS estimates.

The results were surprising. When measured by the ratio of LBO/Stock Price, a scatter plot of the results of LBO/Price from the last reported EBITDA and LBO/Price from normalized EBITDA were highly correlated.

As it doesn’t make a lot of investment sense to focus on last reported EBITDA as an input to a model because it represents stale data, I compared LBO to price for normalized EBITDA to forward 12-month EBITDA. The results were still highly correlated but not as correlated as the previous analysis (more on this later).

You would think that the LBO model would be correlated to the EV/EBITDA ratio. While there is tight dispersion to the scatter plot, the correlation was relatively low. This can be explained by the single dimensional characteristic of the EBITDA/EV ratio against the multi-dimensional nature of the LBO model, which incorporates margin variability and balance sheet cash in its analysis. In other words, EV/EBITDA is not a shorthand for LBO analysis.

In the end, I decided to employ both normalized EBITDA and forward 12-month EBITDA as inputs to the LBO model as a way to identify a range of possible LBO target values. I found that stocks which trade at LBO value are rare, but there were sufficiently interesting investment candidates if the LBO/Price criteria is relaxed to 0.7, or buying a company with 30% down or less.

I found additional insights from a scatter plot of stocks with LBO/Price of 0.7 on either the normalized EBITDA or forward 12-month EBITDA models. There were a considerable number of companies that scored well on normalized EBITDA, but didn’t score well on forward 12-month EBITDA. That’s because the forward outlook is weaker than the company’s history. These are the deep value recovery candidates.

With that preface, let’s look at a few LBO candidates identified by the LBO screen of LBO/Price of 0.7 or more.

LBO candidate examples

Tapestry, the luxury goods producer retailing under the Coach, Kate Spade and Stuart Weitzman brands is an example of a partial LBO. The company raised cash to finance a takeover of its rival luxury group Capri Holdings but was rebuffed by regulators. Now it has a $32/share cash hoard burning a hole in its pocket.

What will happen next? In theory, a corporate raider could swoop in and attempt an LBO. Instead, management could pay out a $32 special dividend. How do you feel about a $41 stock with a possible $32 dividend trading at a forward P/E of 9.4?

Asking for a (deep value investor) friend.

Speaking of deep value, here is a recovery candidate in a hated industry. Peabody Energy is a coal stock with a wide LBO target range. With the stock at about $24, the LBO target based on forward 12-month EBITDA is only $13, using a conservative allowable interest coverage ratio of 6. By contrast, the LBO target using normalized EBITDA is $23, which is very close to the current stock price.

Peabody Energy is an example of a deep value recovery candidate. If margins were to revert to its historical median level, the cash generative power of the company is strong, even though it is operating in an industry in decline.

In total, my LBO screen identified 22 LBO candidates with an LBO/Price ratio of 0.7 or more. The low number of stocks that fit this criteria may be reflective of an elevated stock market valuation. I will be monitoring the number of stocks that pass this screen in the future and report on the results on a regular basis. For the full list of stocks that pass my LBO screen, please contact Ed Pennock at ed@pennockideahub.com or +1 647 287-6800. This is a specialized institutional level report with institutional pricing of USD 1,000 for a single one-time report, or USD 6,000 annually for monthly reports.

In conclusion, I built an LBO model to identify possible LBO candidates among the S&P 1500. I found that stocks which qualify under an LBO criteria are relatively rare. This may be a modern day deep value equivalent of the Ben Graham net-net working capital model, whose candidates are usually micro-caps and not very invetable. Despite the LBO moniker, the model is a deep value one that spots companies with clean balance sheets with earnings above the of their debt capital and thematically similar to the Economic Value Added concept pioneered by Stern Stuart.

Many of the stocks identified by the LBO screen are blemished, each in a different way. A deep value screen like the LBO screen 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 that will be difficult to diversify away.

This was a summary of some specialized research that I undertook that I would normally not publish in these pages. We return to our regular programming tomorrow.

Drifting and waiting for the NVIDIA report

Posted by Cam Hui - May 22, 2024

Mid-week market update: After the market reaches its upper Bollinger Band, it isn’t unusual at all for it to consolidate sideways and drift for a few days before making the next move. As the chart below shows, this has happened four other times (grey shaded boxes) in the last six months. The latest episode is the fifth.

The market rose in two of the four episodes and fell in the other two, so there are no apparent clues to future short-term market direction. That said, I have heard concerns about the VIX Index declining below the 12 level, which is historically low. But the VIX did not fall below its lower Bollinger Band, which would be an overbought signal for the market.

The most important difference between now and past instances is the pending earnings report from AI bellwether NVIDIA. As a reminder, the last time NVIDIA reported earnings, not only did the stock pop, the upside gap took the S&P 500 with it and the market didn’t look back for weeks.

A sideways consolidation

Not only is the S&P 500 trading sideways, factor returns are also exhibiting a consolidation pattern. While breadth has been positive during this latest advance to all-time highs in the S&P 500 and other major indices, breadth hasn’t broadened out. Neither large-caps nor small-caps have been able to gain a decisive upper hand in leadership.

The sideways drift can also be seen in style returns. U.S. value and growth have traded leadership since February, and international value and growth have trade sideways for the last month.

So where does that leave us? Waiting for a catalyst like NVIDIA.

Bullish anticipation

Going into the earnings report, bullish anticipation is building. The Semiconductor Index rose above absolute and relative resistance. The upside breakout is impressive in the context of its violating of a rising trend line in early April and subsequent sideways consolidation and correction.

As it turns out, NVIDIA’s earnings beat Street expectations. As I write this, the stock is up about 2% in after hours trading. As the option market was pricing in a 6% move in either direction, this represents vastly diminished volatility. compared to expectations.

For what it’s worth, investors will see the minutes of the FOMC meeting tomorrow (Thursday). Jeffrey Hirsch at Trader’s Almanac observed that the Thursday is the most bullish day before the Memorial Day long weekend.

Both my inner investor and inner trader are bullishly positioned. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

A Trend Asset Allocation Model review

Posted by Cam Hui - May 19, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 10-May-2024)

Subscribers can access the latest signal in real time here.

A Trend Model review

Over the course of several discussions with readers, it was apparent that some didn’t understand the Trend Asset Allocation Model, otherwise known as the Trend Model. This is a model that applies trend-following principles to a variety of global markets and commodities to form a composite signal.

While a history of out-of-sample weekly signals are available dating back to 2013, there is no actual portfolio return track record. However, a simulated strategy of using the out-of-sample signals to either overweight or underweight the S&P 500 by 20% around a 60% S&P 500 ETF (SPY) and 40% 7-10 year Treasury ETF (IEF) would have yielded significantly better returns with 60/40 like risk.

This week I review the model’s internals to reveal why I am bullish on equities.

A trip around the world

The Trend Model uses a variety of global equities as its input. So let’s take a quick trip around the world.
Starting with the U.S., the Dow, S&P 500 and NASDAQ Composite achieved all-time highs last week, which trend-following models interpret as a bullish signal.

Across the Atlantic, both the Euro STOXX 50 and FTSE 100 have reached all-time highs, which is another bullish trend-following signal.

The Asian markets present a mixed picture. China and Hong Kong are recovering from recent lows. Beijing’s latest initiatives to rescue its troubled property market should put a bid under Chinese and Hong Kong equities. Japan made a new recovery all-time high in local currency terms, but the Yen has been weak and its market is still relatively weak for foreign investors. Taiwan has been strong, thanks to its exposure to the semiconductor industry, but Korea and Australia have mostly traded sideways for the past few months.

The mixed picture in Asia can be better seen on a relative return basis. When compared to the MSCI All-Country World Index (ACWI), China and Hong Kong are just starting to recover from relative downtrends. Japan is weak in USD terms, and the other Asian markets are trading sideways on a relative basis.

Commodity strength = Economic expansion

In addition to monitoring global equity markets, the Trend Model also uses commodity price signals as a signal of trends in the global economy.

A quick overview of the commodity markets show that commodities are showing moderate strength and they are trading above key moving averages. The cyclically sensitive copper/gold ratio has surged because of a squeeze in the copper price, but the more diversified base metals/gold ratio has been trading sideways.

A global economy in expansion

In summary, we have:

New all-time highs in U.S. equities;
New all-time highs in European equities;
A mixed picture in Asia; and
Moderate strength in commodity prices.

Putting it all together, this is a picture of an expanding global economy, which should be bullish for risk appetite.

Moreover, sentiment indicators are turning bullish, but readings are not excessive. As an examples, the latest BoA Global Fund Manager Survey shows that the equity weights of global institutions are rising, but conditions cannot be described as a crowded long, which would be contrarian bearish.

As well, the relative performance of IPOs shows a definite lack of investor enthusiasm for risk, which is contrarian bullish. The market’s animal spirits are still dormant.

That’s why the Trend Model is bullish on equities.

The week ahead

Looking to the week ahead, the major sources of possible volatility is the NVIDIA earnings report on Wednesday and the FOMC minutes on Thursday.

The NVIDIA report will undoubtedly have a major say in how the semiconductor stocks and the S&P 500 trades. The Semiconductor Index is at a crossroad as it tests overhead absolute and relative resistance.

My inner trader is staying with the bullish momentum trend and he is long the market. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

New highs can beget more new highs

Posted by Cam Hui - May 18, 2024

The Dow, S&P 500 and NASDAQ Composite all achieved new all-time highs last week. It is said that there is nothing more bullish than a stock making a new high. This is not a time for caution. Higher stock prices are ahead.

Here are the reasons why I am bullish.

Bullish Technicals

Let’s begin with a technical assessment of the stock market. The market printed a “triple 70 breadth thrust” during the May 2–6 time frame, in which the percentage of NYSE advancing stocks exceeded 70% for three consecutive days. The advance sparked a likely “good overbought” condition on RSI, which is a signal of a sustained rally.

Rob Hanna at Quantifiable Edges studied the effects of triple 70 breadth thrusts and found that the price momentum effects tended to be long lasting.

The upside breakout to all-time highs was accompanied by strong breadth. The S&P 500, NYSE and S&P 400 Advance-Decline Lines also showed all-time highs, which confirms the strength of the rally. The only exception was the small-cap S&P 600 Advance-Decline Line that was just short of a new high.

Progress on disinflation

From a top-down macro perspective, the market received some welcome news on inflation last week. April CPI came in slightly weaker than expected. Core CPI (blue bars) softened and so did services ex-shelter (red bars). Owners’ Equivalent Rent (green bars) also continued their expected pace of deceleration.

From a bottom-up perspective, FactSet report that citations of “inflation” have plunged.

The tame CPI report sparked a bond market rally and cemented market expectations of two rate cuts this year, with the first to occur in September. Even before the CPI report, dovish comments from Fed officials that took a rate hike off the table was helpful to risk appetite.

Valuation Tailwinds

The CPI report inspired bond market rally created some tailwinds on equity valuation. The forward S&P 500 forward P/E has been elevated at 20.7, which ahead of its 5-year average of 19.1 and 10-year average of 17.8.

While the longer term trend of valuation divergence between P/E and yields that began in 2022 is concern, in the short-term, falling yields have given some room for P/E expansion, which is a positive.

In addition, forward EPS estimates have been rising strongly in the wake of Q1 earnings season, which is nearly complete. This development lends support to high stock prices in the form of positive fundamental momentum.

Moreover, company guidance has been dramatically improving compared to late 2023 and early 2024.

A welcome growth revival

Lastly, strategist Jim Paulsen made the point that monetary velocity is a form of monetary productivity. In that sense, the U.S. is undergoing a major revivals in monetary productivity, which is helpful for growth and stock prices.

In conclusion, stock prices have achieved fresh all-time highs and they are rising for the following reasons, which indicate sustainable progress on disinflation and economic growth:

Strong technical picture;
Progress on disinflation and dovish comments from Fed officials; and
Continuing signs of growth.

All these factors are combining to be supportive of high stock prices ahead. While I have no specific target in mind, the measured upside objective from a point and figure analysis of the S&P 500 is an astounding 7469. As is the case with point and figure charting, the time frame for achieving such an objective is unknown.

How frothy is the stock market?

Posted by Cam Hui - May 15, 2024

Mid-week market update: Now that the Dow, S&P 500, and NASDAQ Composite have risen to an all-time high on the back of a slightly softer than expected CPI report, and Keith Gill, otherwise known as Roaring Kitty, and the meme stock brigade is back, how frothy is this stock market? Just look at the surge in the meme stock favourite, GameStop (GME).

This time is different

I would argue that sentiment is not extended and indicative of a short or medium-term top. Let’s address the meme stock mania first. Recall that the prices of these stocks were driven up by concerted call option buying which forced option market makers to buy the underlying stock and drive up the price. If the raid is well-engineered, the meme stock brigade could create a price spike using only a small amount of capital, as call option prices are low compared to the underlying stock.

If that’s the case, why haven’t we seen a move in either the CBOE put/call ratio or the equity-only put/call ratio? The accompanying chart shows the 10 dma of both ratios and the pink shaded lines indicate episodes of excessive bullishness, which is not what we see today.

As well, Bespoke Investment Group pointed out that it wasn’t just GameStop that led the rally yesterday (Tuesday), but the most heavily shorted stocks. I interpret this as a broader factor-based rally rather than just meme stocks.

In the meantime, the S&P 500 has reached a new all-time high while exhibiting strong breadth (bottom two panels). As I’ve pointed out before, the market is undergoing an advance characterized by a series of “good overbought” RSI readings. Stock prices can rise further.

What is extended

Here’s a corner of the market that is extended and due for a breather. Regular readers know that I have been long-term bullish on gold. Gold has staged an strong upside breakout through resistance. More importantly, the bottom panel of the accompanying chart shows that the gold/S&P 500 ratio is making a multi-year saucer-shaped bottom, indicating strong relative performance potential in the coming months and years.

Tactically, however, gold miners look extended and due for a correction or consolidation. GDX is exhibiting a negative RSI divergence, which has resolved in price weakness in the past, and the percentage bullish on P&F recently reached the overbought zone. While I am long-term bullish, my inner investor recently took profits in his GDX position and he is waiting for a pullback to re-enter his long position.

Both my inner investor and inner trader are bullishly positioned in equities. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

5 reasons you may have not have thought of to be bullish

Posted by Cam Hui - May 12, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 10-May-2024)

Subscribers can access the latest signal in real time here.

A good overbought advance

The S&P 500 violated a rising trend line in early April and corrected. It appears to have formed a V-shaped bottom and it is resuming its advance by clearing a resistance and volume congestion zone. It’s also exhibiting a series of “good overbought” conditions on the 5-day RSI. The “good overbought” rally will be confirmed if and when the 14-day RSI becomes overbought and stays overbought.

Market internals are pointing to another sustained upleg in stock prices. Here are four other reasons why.

A Triple 70 breadth thrust

The market printed a Triple 70 breadth thrust last week, defined as three consecutive days of NYSE advancing issues of 70% or more. Historically, such events tend to be signals of strong price momentum that are long lasting.

A case of good breadth

The advance has been accompanied by renewed strong breadth. Net highs-lows have turned positive for both NYSE and NASDAQ stocks, which is a sign of underlying strength.

In addition, the Advance-Decline Line is also showing signs of good breadth. Even though the S&P 500 is below its all-time high, most versions of the A-D Line have reached their previous highs, with the exception of the small-cap S&P 600 A-D Line.

Falling USD and yields

One of the headwinds posed by stock prices has been rising yields and USD strength, as the USD has been inversely correlated to stock prices. Yields have been retreating across the entire yield curve but remain above their upside breakout levels. The USD Index is similarly weakening and nearing a key resistance turned support level. Stock prices have the potential to undergo a parabolic advance should Treasury yields and the USD break support.

Supportive sentiment

Sentiment, as measured by the Fear & Greed Index, is supportive of a further advance. Readings are only starting to rise from a mild fearful condition and they are nowhere near greed levels, which indicate a frothy market.

From a sentiment modeling perspective, the relative performance of equal-weighted consumer discretionary stocks, which takes out the effects of heavyweights like Amazon and Tesla, has been a terrific contrarian indicator. Relative weakness in this sector has been strong S&P 500 buy signals, and they are now testing a key relative support zone.

In support of this contrarian bullish thesis, references to the “low end consumer” have surged in earnings calls..

Key risks

The bull case isn’t without risks. A review of the relative performance of defensive sectors shows that three of the four have rallied out of relative downtrends and they are either consolidating or starting to rise (Utilities). Leadership by defensive sectors would be an unwelcome development for the bulls.

One key market-moving event that could be a source of volatility is the CPI report on Wednesday. The Cleveland Fed nowcast calls for a headline CPI reading of 0.4% and a core reading of 0.3%. Anything can happen.

In conclusion, a review of technical and sentiment conditions shows that stock prices are setting up for a sustained advance. The combination of strong momentum, good breadth and skeptical sentiment points to higher stock prices. Key risks are evidence of a disturbing relative strength by defensive sectors and an upcoming CPI report that could upend the bullish narrative.

My inner investor is bullishly positioned in accordance with the Trend Asset Allocation Model. Subscribers received an email alert that my inner trader re-entered the market on the long side on Friday. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Beware of the AI hangover

Posted by Cam Hui - May 11, 2024

Artificial Intelligence (AI) related stocks have been on an absolute tear. The Magnificent Seven, which is one proxy for AI plays, has beaten the S&P 500 for six consecutive quarters. But the degree of outperformance is decelerating. This looks like the early stages of an AI hangover.

I believe AI stocks are overhyped short term but underhyped long term. Here’s why.

AI doubts emerge

The exuberance over AI can be exemplified by the market reaction to the earnings of two AI ecosystem stocks, Palantir (PLTR) and Cloudflare (NET), both of which reported double beats on earnings and revenue. Reports of segmented results were strong. In Palantir’s case, the company even raised guidance, but the stock fell because guidance failed to exceed the whisper numbers. In Cloudflare’s case, the market sold off because the company failed to raise guidance.

From a fundamental perspective, signs are appearing that the narrative is turning from the upside to the downside of AI adoption. The CNBC article, “AI engineers report burnout and rushed rollouts as ‘rat race’ to stay competitive hits tech industry”, tells the story of AI development for the sake of appeasing investors instead of actual productive development. The key points are:

Artificial intelligence engineers at top tech companies told CNBC that the pressure to roll out AI tools at breakneck speed has come to define their jobs.
They say that much of their work is assigned to appease investors rather than to solve problems for end users, and that they are often chasing OpenAI.
Burnout is an increasingly common theme as AI workers say their employers are pursuing projects without regard for the technology’s effect on climate change, surveillance and other potential real-world harms.

At the Berkshire Hathaway annual general meeting, Warren Buffett was asked about AI, his response focused mainly on the downside of AI:

Journalist Izabella Kaminska recently raised an important question of the usefulness of future Large Language Models. Current LLMs are trained on “mainly established authors who have a substantial body of pre-published work that can provide enough learning material to ensure it emulates their intelligence faithfully”, but what happens when LLMs begin to proliferate and try to train themselves on LLM output?

Technical warnings

From a technical perspective, momentum in AI stocks is flagging. I identified 29 stocks exhibiting strong price momentum in January (see At Least 29 Reasons to be Bullish), most of which were technology stocks. Most, like this chart of NVIDIA, are either consolidating sideways or pulled back like Palantir and Cloudflare.

By contrast, market leadership has shifted to cyclical names, like Costco, which broke out of a multi-year base and rallied to fresh highs.

The homebuilding stocks are exhibiting a similar pattern of market strength.

GE, which is an important cyclically sensitive industrial stock, has been on an absolute tear.

In other words, leadership has shifted from AI-related technology to value and cyclical stocks. But from a long-term perspective, the AI bull isn’t over. Here is the percentage of NASDAQ 100 stocks bullish on point and figure, which recently bottomed out at below 25% and rebounded. In the last 10 years, such episodes have always seen the NASDAQ 100 stage a relief rally. However, the initial rally was often fleeting and followed by a lower low.

Another source of warning of near-term NASDAQ weakness can be found in the relative volume of NASDAQ/NYSE volume, which is weakening.

Be patient

Even though AI stocks appear to be overhyped in the short run and prone to a hangover, investors are advised to be patient on the long-term potential of AI. A St. Louis Fed study compared the pace of AI adoption to other technologies. It concluded that “early evidence on the diffusion of AI seems to suggest a pattern similar to those of personal computers and cloud computing”. In other words, it will be a long cycle. Investors need to be patient about the pace of AI benefits.

In conclusion, I believe AI is overhyped in the short run and underhyped in the long run. Recent instances of earnings report reactions of stocks in the AI ecosystem indicate excessive frothiness and even AI bellwethers like NVDIA have begun to consolidate sideways. A St. Louis Fed study of the pace of technology adoption suggests that AI adoption will undergo a long cycle like the PC, so investors need to be patient.

Investors who want to monitor the turn may want to keep an eye on the semiconductor stocks as AI proxies. These stocks are correcting and consolidating sideways after breaching a rising trend line. Upside absolute and relative breakouts of resistance will define the re-emergence of the AI bull.

A new breadth thrust buy signal?

Posted by Cam Hui - May 8, 2024

Mid-week market update: Bulls were disappointed when the Zweig Breadth Thrust buy signal didn’t achieve its objective when the ZBT Indicator failed to rise from oversold to overbought in 10 trading days. But they received a consolation when it reached a late overbought reading on Monday, which was two days late.

Do the two extra days matter? Is this a sort or, kind of, breadth thrust buy signal?

An alternative breadth thrust

Jason Goepfert studied the history of ZBT buy signals within a 13-day window instead of the usual 10-day window, and the results were reasonably good.

Rob Hanna at Quantifiable Edges pointed that we saw a Triple 70 Breadth Thrust, defined as three consecutive days of NYSE up issues of 70% or more.

This is starting to look like an alternative breadth thrust buy signal. The good news with breadth thrust buy signals is the market tends to consolidate or pull back for about three or four days after the initial signal, which would have been on Monday. Is this an opportunity to buy?

Key risks

Before you go all-in on the long side, here are some risks to consider.

Yesterday’s release of the Senior Loan Officers Opinion Survey on bank practices (SLOOS) presented investors with some sobering news. After significantly loosening lending standards, banks marginally tightened them.

Tatiana Darie at Bloomberg observed, “A simple regression analysis based on SLOOS and high-yield bond defaults tracked by Moody’s suggests spreads should be widening based on these weakening fundamentals.”

This matters because the relative performance of junk bonds is correlated to equity prices because junk bond performance is an indicator of risk appetite. Right now, junk bond relative performance (green line) is exhibiting a minor positive divergence against the S&P 500. The risk is the spread widens and junk bond relative performance tanks and sparks a risk-off stampede.

In addition, cross-asset analysis shows that the bond market and the USD are driving stock market performance. Bond prices rallied out of their narrow range, but pulled back in the wake of a weak 10-year Treasury auction today. The USD fell out of its range, but strengthened recently back into the narrow trading range. I interpret this as a non-confirmation of the breadth thrust signal and these cross-asset relationships need to be watched carefully.

In conclusion, the breadth thrust signals are constructive but need to be treated with some caution. Cross-asset analysis reveals a number of risks that could threaten risk appetite. If you want to trade the breadth thrust signal, trade it with a trailing stop loss discipline.

My inner investor remains bullishly positioned. My inner trader took profits in his S&P 500 long position on Monday and he is staying on the sidelines for now.

What’s driving stock prices right now?

Posted by Cam Hui - May 5, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 16-Apr-2024)

Subscribers can access the latest signal in real time here.

Key drivers

What are the key drivers of stock prices? There are some factors to keep an eye on:

Interest rates;
Geopolitical risk; and
The earnings outlook.

The accompanying chart shows the market progress of the first two factors. The 7-10 year Treasury ETF (IEF) is staged an upside breakout of a narrow range that began in mid-February. The USD, which is tied to interest rate differentials in the short run, has also break down out of a similar trading range. These are constructive signs that the interest rate environment is benign. Geopolitical risk indicators like oil and gold prices are in retreat, which are signals of a narrowing risk premium on the market.

As for the earnings outlook, Q1 earnings season has progressed in a constructive manner, which is bullish for risk assets.

Fed policy not hawkish

The good news is the Fed hasn’t taken a hawkish pivot. At the May post-FOMC press conference, Jerome Powell pushed back against the odds of a rate hike:

For a different perspective, a review of the Taylor Rule rate (blue line) shows that the targeted rate is slightly below the actual Fed Funds rate (red line), indicating that there’s little need to raise rates.

The market remains on edge because of an acceleration in wage rates. The Employment Cost Index (ECI), which measures both wages and benefits, came in at 1.2% for Q1, which was higher than the expected 1.0%. Q1 unit labour costs also came in at a hot 4.7%, ahead of an expected 3.6%. The April Jobs Report shows a welcome cooling in the labour market. The headline employment was softer than expected at 175,000 and, more importantly, average hourly earnings also missed Street expectations.

The JOLTS report also came in on the tame side. Job openings, hires and quits were all sliding. BCA Research argues that investors shouldn’t be overly worried about rising wages. The JOLTS data is a leading indicator of ECI, and they’re all pointing down.

In addition, the New York Fed’s Multivariate Core Trend Inflation, which is an indicator of inflation persistence, fell to 2.6% in March.

In reaction to the softer than expected April Jobs Report, the market is discounting two rate cuts in 2024, with the first occurring at the September FOMC meeting.

Constructive earnings outlook

With Q1 earnings season in full swing, earnings reports have generally been better than expected. The EPS beat rate is 77%, which is equal to the 5-year average of 77% and ahead of the 10-year average of 74%. More importantly, forward 12-month EPS estimates are rising.

This means that the recent market downdraft was driven by P/E compression and not earnings fundamentals, which have been improving. As the forward-looking inflation outlook seems to be decelerating and the Fed is not hawkish, this should lead to a stabilization in P/E ratios and possible P/E expansion, which would be positive for stock prices.

There is even more bullish macro news. Recession Alert found that the net percentage of 39 OECD countries with rising leading economic indices (LEIs) and the net percentage of 39 central banks that are easing rates are powerful leading indicators of U.S. stock prices with a 7-10 month lead at an r-squared of 0.57.

Signs of healing

In the short run, the technical structure of the market is pointing to healing, which is a signal that the correction may be coming to an end.

Breadth indicators are off their worse levels and improving. Both NYSE and NASDAQ net highs-lows are have risen from negative to positive.

Risk appetite indicators present a mixed but slightly bullish picture. The ratio of high beta to low volatility stocks is tracking the S&P 500, but high yield bond relative performance has been flashing a minor positive divergence.

Lastly, investors shouldn’t be overly worried about the negative seasonality effects of “sell in May and go away”. Callum Thomas at Topdown Charts found a distinct difference between May–October seasonality during bull and bear markets. Notwithstanding the bullish reasons that I have already cited for higher stock prices, as long as the S&P 500 stays above its 200 dma, you can consider this to be a bull market.

The one short-term blemish to the bullish outlook is a continued deterioration in banking system liquidity, which could put a lid on any stock price rally and possibly even spark a re-test of the recent lows.

The S&P 500 faces an important short-term test in the coming week. The index rallied to test its 50 dma resistance and it’s in a heavy resistance zone. The bulls need to see some upside follow through. Stay tuned.

In conclusion, a review of the main short-term drivers of stock prices, namely interest rates, geopolitical risk and the earnings outlook, are all pointing to higher stock prices. As well, short-term technical indicators such as breadth and momentum are also bullish. The key risk to this bullish outlook is a continued deterioration in banking system liquidity that could pose headwinds to stock prices.

Both my inner investor and inner trader are bullishly positioned. The usual disclaimer apply to my trading positions

Disclosure: Long SPXL

Value or growth? Here’s an analytical framework for decision making

Posted by Cam Hui - May 4, 2024

Should you be a value or growth investor?

The accompanying chart shows the historical record. In the last 20 years, growth has handily beaten value. The U.S. value/growth track record closely tracked the international developed value/growth record until 2023, when AI-related plays in the U.S. went on a tear. Such stocks weren’t readily available in non-U.S. markets.

Does that mean you should continue to bet on growth investing or are value stocks about to have their day? Here an analytical framework to think about the value/growth paradigm.

The DA in EBITDA

Michael Mauboussin recently published an article that’s a master class on valuation techniques, focusing mainly on the P/E and EV/EBITDA multiples. One of the key points that he made is that not all EV/EBITDA multiples are the same. Investors need to distinguish between the EBIT and the DA in EBITDA. That’s because the DA in EBITDA is a proxy for the maintenance capital needed to maintain a company’s business. All else being equal, you should prefer a lower DA because it offers a higher free cash flow to investors.

The accompanying chart plots the EBITDA depreciation factor, or the DA in EBITDA, against the return on invested capital (ROIC) – weighted average cost of capital (WACC), which amounts to a first-order approximation of economic value-added, or the EVA concept originally promoted by Stern Stewart. As the chart shows, companies with higher DA tend to have lower EVA.

In plain English, these results mean that, all else being equal, asset-light companies with lower DA should trade at a higher multiple than asset-heavy companies. It just happens that in the last 20 years, the asset-light companies have been the growth stocks. They tended to be platform companies that engage in little or no manufacturing and rely mainly on intellectual capital to generate cash flow.

That’s been the secret of growth investing success.

This chart from Goldman Sachs documents how non-capital-intensive stocks have skyrocketed against their capital-intensive counterparts. That’s another way of distinguishing between growth and value stocks.

Mauboussin advised investors to focus on the DA in EBITDA in order to maximize the FCF available to investors. There is an additional detail in analyzing EBIT. Ian Hartnett of Absolute Strategy Research pointed out that EBIT margins tend to be higher in large-cap companies.

Putting it all together, the secret of past investing success has been an exposure to large-cap growth for its innovation and intellectual property, as well as its strong margins because of scale.

It would be difficult to suggest that investors should avoid these engines of innovation, but contrarians may find opportunities among asset-heavy stocks after a prolonged period of underperformance.

The cyclical opportunity

In the short run, however, value has outperformed growth across all market cap bands and internationally. That’s because the market consensus has pivoted from a soft landing to a no landing scenario of continued economic growth, even as inflation stays elevated and the Fed maintains its higher-for-longer interest rate policy.

Investment implications

Under the current circumstances, what should the equity investor do?

While growth stocks present long-term opportunities (see The Path to Magnificent Exuberance), the market is discounting an economic expansion with stubbornly higher than expected inflation, which will keep the Fed on hold. Given the higher duration, or interest rate sensitivity, of growth stocks, growth will face relative performance headwinds during this phase of the economic cycle. By contrast, the cyclically sensitive value stocks will enjoy relative performance tailwinds under these conditions.

I would advocate a strategy of holding an overweight position in cyclically sensitive value stocks, a market weight position in growth stocks, and an underweight in defensive sectors. Recession risk is relatively low during a mid-cycle expansion, and a commitment to defensive sectors is unnecessarily.

Callum Thomas pointed out that non-U.S. markets have a much higher cyclical exposure compared to the U.S., so it makes sense to raise non-U.S. exposure.

I prefer Europe and Japan, in that order, for cyclical exposure while avoiding emerging markets. European stocks have been in a choppy relative uptrend since last October, and should benefit from a global cyclical rebound. Japanese stocks recently achieved fresh all-time highs in local currency terms, but uncertainty over BOJ policy has weakened the Japanese Yen, which makes Japanese equity exposure problematic for unhedged foreign investors. The relative hawkishness of Fed policy is likely to put a bid on the USD, and USD strength presents significant risks to emerging market exposure, which I would avoid.

Timing the turn

While I am advocating a tactical overweight position in cyclicals and value stocks, how can investors time the turn back to growth?

Large-cap growth, as proxied by the NASDAQ 100, has been showing signs of relative weakness, but its relative performance is still in the middle of its historical normalized range. Should the NASDAQ 100 dip into the grey oversold zone, I would begin to raise the weight to growth.

More sophisticated investors with detailed quantitative tools can look for signs of changes in price and fundamental momentum, as measured by EPS estimate revision, to spot shifts in investment regime changes. If estimate revisions for value stocks begin to falter, and revisions for growth stocks are stock, that would be a signal to pivot from value to growth.

In conclusion, while growth has outperformed value for prolonged periods, I believe that cyclically sensitive value stocks present outperformance opportunities over the medium term. The U.S. economy is undergoing a mid-cycle expansion, which should benefit value over growth. By contrast, the high duration properties of growth stocks will present relative performance headwinds in a higher for longer interest rate environment. I recommend that investors maintain an overweight position in value, a market weight position in growth, and an underweight position in defensive sectors. In addition, aggressive investors may wish to consider overweighting small caps for their cyclical sensitive.

Macro events have been big nothingburgers

Posted by Cam Hui - May 1, 2024

Mid-week market update: The big macro events of this week hasn’t really moved the needle on risk appetite. The market didn’t react much to the Quarterly Refunding Announcement detailing the schedule of Treasury issuance. The JOLTS report showed slightly weaker than expected job openings, but quits and layoffs declined as well, indicating a general deceleration in the labour market.

The FOMC decision came in slightly more dovish than expected, as the Fed reduced the rate of quantitative tightening a little more than expected. This should reduce any headwind that equities may face from a reduction in banking system liquidity.

As a consequence, market expectations of the future direction of the Fed Funds rate made a slight dovish pivot. The market is still expecting just one rate cut in 2024 that begins in November, but the timing of the second rate cut has been pulled forward from March to January.

Market analysis

The rally in the S&P 500 stalled at its 50 dma, which appears ominous, but unsurprising as volume analysis shows considerable overhead resistance at those levels.

So what’s next? On one hand, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator flashed a buy signal when its 14-day RSI recycled from oversold to neutral. This is an indication of building price momentum that has usually resolved in a bullish manner.

In the short run, the price signals from cross-asset analysis tells a more uncertain story. Both bond prices and the US Dollar, which tends to move inversely to stocks, are in tight trading ranges. Bonds attempted to break upward out of its range in the wake of the FOMC meeting today, but failed. The USD weakened in response to the FOMC decision, but it’s still in its range. I am waiting for breakouts or breakdowns for clues to changes in risk appetite.

While the short-term outlook appears somewhat uncertain, the weight of the evidence indicates suggests that the path of least resistance for stock prices is up. My inner trader remains long the S&P 500. The usual disclaimers apply to my trading positions.

Disclosure: Long SPXL

Time to tiptoe back into Big Tech?

Posted by Cam Hui - April 28, 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: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Bullish (Last changed from “neutral” on 16-Apr-2024)

Subscribers can access the latest signal in real time here.

Washed out Big Tech?

In discussions with investors, I have been asked if Are Big Tech has formed a bottom. Big Tech had been the leadership in the U.S. equity market. It’s an important group as it forms roughly 40% of the weight of the S&P 500. The NYSE FANG Plus Index staged an upside breakout out of a cup and handle pattern with long-term bullish implications. The index then pulled back and it’s bouncing off a relative support zone (bottom panel).

Is it time to tiptoe back into these stocks? What are the implications for the overall market in light of the outsized weight of Big Tech in the S&P 500?

Don’t be overeager

The chart of QQQ, or the NASDAQ 100 ETF, tells a similar but more detailed story as the analysis of the NYSE FANG Plus Index. QQQ bounced off a relative support level. However, indicators of relative breadth (bottom two panels) haven’t decisively turned up just yet.

An analysis of the 12-month normalized relative performance of the NASDAQ 100 shows that it is nearing the oversold zone. I interpret to mean that investment-oriented accounts should be accumulating Big Tech, but there is more downside potential.

Relative volume of the NASDAQ to NYSE, which tends to be either coincident or lead the NASDAQ 100, is turning down, which is another warning that Big Tech may be in need of one final flush.

I conclude from this analysis that Big Tech is showing signs of healing but may be vulnerable to further downside, which may be relatively minimal.

Constructive signs

As for the rest of the stock market, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator (ITBM) is on the verge of a buy signal, which is triggered when its 14-day RSI recycles from oversold to neutral.

About half of the Regional Banking Index has reported earnings results, and the index is holding above relative support. This is another constructive sign that a potential trouble spot has dodged a bullet.

While these are constructive signs that the stock market may have limited downside risk, Ryan Detrick pointed out that the market has historically shown some choppiness after a five-month winning streak ends. With the caveat that the sample size in this study is small (n=7), this does suggest that a re-test of the recent lows may be ahead.

Growth or Value?

Notwithstanding the questions about market direction, one key question is, value or growth? Big Tech, or large-cap growth stocks, had been the market leadership for much of 2023 and early 2024. They have since stumbled but show possible bottoming behaviour. Value stocks have begun to turn up since February and the relative performance is evident across all U.S. market cap bands and internationally.

My inclination is to follow the adage, “The trend is your friend”. Overweight value, but take a partial position in growth as it’s showing signs of a potential relative bottom.

In addition, value sectors, which tend have greater cyclical exposure, are all behaving well relative to the S&P 500.

Zweig Breadth Thrust watch

We have seen from last week’s the market has responded strongly to single market events on a daily basis, such as the Tesla earnings announcement, the GDP and PCE reports, the Alphabet and Microsoft reports. The coming week will see the Quarterly Refunding Announcements (QRA) on April 29 and May 1, the FOMC meeting on May 1, and followed by the April Employment Report on May 3.

I am on Zweig Breadth Thrust watch. As a reminder, a ZBT buy signal is triggered when the ZBT Indicator surges from oversold to overbought within 10 trading days. The 10-day window ends on Thursday, which is the day after the FOMC meeting. Anything can happen.

Watch for rate-driven volatility from the QRA, which will disclose the U.S. Treasury’s plan of issuance of bill and bond supply, and the FOMC meeting. Treasury yields are rising. The 2-year yield has already reached 5%. While the Fed isn’t expected to cut rates at the May meeting, the it may disclose plans to reduce the pace of its balance sheet runoff, or quantitative tightening, which could be a bullish development.

In conclusion, Big Tech has been lagging the market since February and the relative performance reset is nearing an end. The overall stock market is undergoing a bottoming process. Investment-oriented accounts should be accumulating positions at these levels, but should be prepared for some near-term choppiness. Tactically, I am inclined to overweight value over growth stocks for short-term performance.

Both my inner investor and inner trader are bullishly positioned and my inner continues to hold a long position in the S&P 500. The usual disclaimers are applicable to my trading positions.

Disclosure: Long SPXL

Relax, it’s just a mid-cycle expansion

Posted by Cam Hui - April 27, 2024

The market adopted a risk-off tone when headline Q1 GDP came in lower than expected at 1.6%, compared to an expected 2.5%. More importantly, core PCE rose at an annualized rate of 3.4%, which was hotter than expectations and led to stagflation fears. Upon closer inspection, nominal GDP growth was dragged down by the combination of inventory adjustments and exports. Final sales, which is a better signal of economic growth, came in at 3.1%.

Greg Ip at the WSJ offered a constructive interpretation when he pointed out that the U.S. economy still accounts for 26.7% of global GDP, which is the highest level since 2006.

Investors should fade stagflation fears and embrace the “no landing” scenario. These conditions should be good news for risk assets. It’s what a mid-cycle expansion looks like.

A mid-cycle expansion

Instead of focusing on economic statistics, consider the message from the financial markets. Investors are seeing the combination of strong stock and commodity markets and a weak bond market.

This idealized depiction of a business cycle would classify the current phase as a “stage 4” market. I interpret this as a mid-cycle expansion when the economy is enjoying bullish fundamental and technical momentum.

Here is an example of fundamental momentum. The recent market correction on a peak-to-trough basis was -5.5% for the S&P 500. Investors should consider this episode as a buying opportunity as the price decline was attributed entirely to P/E contraction. Forward 12-month EPS estimates are continuing to rise.

The economy is healthy. One of the key earnings reports that I monitor is the VISA double beat on both sales and earnings as the company reported “resilient consumer spending”. Moreover, fundamental momentum is expected to broaden. Earnings growth for the non-megacap Big Tech companies are forecast to outpace Big Tech by year-end.

From a technical perspective, the positive readings from the monthly MACD histogram of the NYSE Composite underline the strength of the equity bull phase. Historically, positive MACD crossovers have signaled momentum-driven bull markets that have been long lasting.

Friday’s March PCE report didn’t really move the needle of expectations in the wake of Thursday’s GDP report. The market is now only discounting a single rate cut in 2024, which is expected to occur at the September FOMC meeting.

Putting all together, stock prices should continue to advance during a mid-cycle expansion, even in the absence of rate cuts. As long the economy remains resilient, earnings continue to rise, and we don’t get a significant acceleration in inflation, the bull market will continue.

Despite all the hand wringing over the last-mile inflation problem, my base case calls for continued progress toward the Fed’s 2% inflation objective. One of the most troublesome elements of inflation is shelter, and it is well known that Owners’ Equivalent Rent is a lagging indicator of shelter inflation. The Cleveland Fed’s New Tenant Repeat Rent Index (blue line) shows that rent growth has slowed to well below 2%.

Beware of accidents

That said, there is theory and there is practice. While the idealized version of the economic cycle is a useful analytical framework, the past history of 20 years shows that similar episodes of “strong stocks, strong commodities, and weak bonds” have resolved in mid-cycle accidents (red circles) whose causes were often independent of the economic cycle.

Tail risk: Asian competitive devaluation

The most obvious spark is the tail-risk of an Asian competitive devaluation. Starting in Japan, the USDJPY exchange rate has been weakening, which was exacerbated by last week’s lack of action by the BoJ. Yen weakness has occurred despite a rise in the 10-year JGB yield owing to a widening spread between the Treasury-JGB that’s attracting Japanese investors abroad.

The pressures that yen weakness is putting on China and the effects of PBOC intervention are becoming more evident. In the last month, the onshore yuan (white line) has been weakening while the offshore yuan (blue line) has been roughly flat, but in a choppy manner. This pattern may be a sign that the PBOC is leaning against the market to avoid yuan weakness. The risk is a sudden and wholesale devaluation of the Chinese yuan, which would reverberate all over Asia.

Brad Setser at the Council on Foreign Relations also found that the onshore yuan has been bumping against the lower end of its policy band, which is another sign of downward pressure.

Another sign of downward pressure on the Chinese yuan from capital flight is the stampede by Chinese investors into gold.

The risk, therefore, isn’t just Japanese yen weakness, but yen weakness that pressures China to devalue the Chinese yuan in one sudden stroke. Such a shock would trigger an emerging market stampede of competitive devaluation and spark a risk-off tone to financial markets.

As an aside, Callum Thomas of Topdown Charts offered the following analog of the gold price when compared to the Chinese stock bubble of 2014–2015. Gold prices could explode upward should China decide to suddenly devalue the yuan.

In conclusion, the U.S. economy is undergoing a mid-cycle expansion, which is characterized by a combination of fundamental and technical momentum. As long as the economy stays resilient, earnings estimates rise and inflation doesn’t accelerate, stock prices can advance without rate cuts. The risk of a cyclical bear that begins at these levels is minimal.

The key tail-risk to the benign scenario is a disorderly Asian competitive currency devaluation that sinks emerging markets and sparks a risk-off environment, which would be equity bearish.

A V-shaped rebound, or dead cat bounce?

Posted by Cam Hui - April 24, 2024

Mid-week market update: I presented this chart on the weekend and rhetorically asked if the inevitable market bounce would be durable. Since then, the S&P 500 rallied strongly off last Friday’s oversold condition. In addition, the stochastic recycled from oversold to neutral, which is a tactical buy signal.

Does this mean the relief rally isn’t a dead cat bounce, but a durable V-shaped rebound?

Not necessarily. The weekly S&P 500 chart shows the stochastic to be on a sell signal, which implies further downside potential.

Bull and bear clues

Here are some clues. The bears will argue that the bond market hasn’t rebounded and the USD Index, which tends to be inversely correlated to stock prices, is undergoing a high level consolidation. On the other hand, the bulls will argue that geopolitical risk is receding, as evidenced by weakness in oil and gold prices.

Risk appetite indicators are mixed. Credit market risk appetite, as measured by the duration-adjusted relative performance of junk bonds, is exhibiting a minor positive divergence. Equity risk appetite, as measured by the relative performance of high beta to low volatility stocks, is roughly tracking the S&P 500.

Breadth indicators are showing signs of healing. The 52-week high-low spreads are showing signs of recovery and readings are returning to positive, which is a constructive sign.

Faltering momentum

In the wake of last night’s strong bullish reaction to Tesla’s earnings results, I initially thought that the market had the makings of a three white soldiers bullish reversal. Instead, the third candle fizzled and we are left with only two white soldiers, which could be interpreted as a case of faltering price momentum.

I am also on Zweig Breadth Thrust buy signal watch. The market is on a ZBT buy signal setup, with last Friday as day 1. As a reminder, the ZBT Indicator has to surge from oversold (<0.40) to overbought (>0.615) within 10 trading days. While anything can happen, I am not holding my breath for the buy signal.

The verdict

I began by asking if the rebound is a dead cat bounce, or a V-shaped rebound. Honestly, I don’t know. In the end, how stock prices behave will depend on earnings and interest rates. Aggregate earnings revisions have been positive, though individual earnings reports can create volatility on a daily basis. As well, rate expectations will depend on inflation (see widely anticipated PCE report this Friday), and the upcoming FOMC decision next week.

My base case calls for a bull trend over the next few weeks, though investors will likely some interim choppiness. Regardless of the short-term trajectory of stock prices, investment oriented accounts should be accumulating positions at these levels. My inner trader continues to hold a long position in the S&P 500. The usual disclaimers are applicable to my trading positions.

Disclosure: Long SPXL

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