The market leaders hiding in plain sight

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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 mystery chart

As investors search for evidence of market leadership, here is a mystery chart of constructive patterns of a closely related group. The chart shows patterns of either upside breakouts or pending breakouts out of long multi-year bases.

 

 

 

Can you guess what they are?
 

 

Faltering U.S. leadership

U.S. equities have been the market leaders since the GFC, but that may be changing. The S&P 500 appears to be undergoing a topping pattern after violating a relative uptrend. The topping patterns are more evident in the relative performance of the NASDAQ 100 and the small-cap Russell 2000. The NASDAQ 100 topped out earlier on a relative basis and the Russell 2000 is flat to down when compared to MSCI All-Country World Index (ACWI).
 

 

I have repeatedly pointed out the premium forward P/E valuation of U.S. equities. Where can investors find better value and momentum in other parts of the world?
 

 

 

Hello Europe!

Back to our mystery chart. It’s the relative performance of MSCI Eurozone and selected major core and peripheral countries in the eurozone. With the exception of Germany, all countries have staged upside relative breakouts from long bases, indicating strong upside potential.

 

 

What about the U.K., which is the cheapest major region by forward P/E. While U.K. equities are exhibiting a similar multi-year relative base and breakout pattern to other eurozone markets, some caution is warranted.
 

 

While the technical pattern of the relative returns of large-cap U.K. stocks (dark solid line) appears to be constructive, history shows that their relative performance have been closely correlated to energy stocks (red dotted line). Here’s where trouble begins. Large-cap U.K. stocks are negatively diverging from the energy sector, indicating a country-level drag. Moreover, the relative performance of small-cap U.K. equities, which are more sensitive to the British economy, are lagging large caps.

 

 

Avoid.
 

 

Unexciting Asia

As we move across time zones, the relative performance of Asian markets can best be described as unexciting. Asian markets are flat to down compared to ACWI. The charitable characterization is that they will need more time to base before they can break out.
 

 

In the short run, Asian equities may see a boost from Chinese stimulus. Total Social Financing in China has been elevated in the last three months, indicating efforts by Beijing to boost the economy. Keep an eye on the relative performance of China and Hong Kong. Can they stage relative breakouts?
 

 

 

The week ahead

The market action of the S&P 500 last week showed the jittery and headline sensitive nature of market sentiment. The market was flat and marked time on Monday and Tuesday in wait of the closely watched CPI report. When CPI came in slightly softer than expected, prices rallied but retreated later on disappointment over the release of the FOMC minutes. The market then rallied Thursday when PPI came in lower than expected.

 

In the short run, liquidity conditions are stabilizing, but keep an eye on the debt ceiling impasse in Washington. The U.S. Treasury has been drawing down the TGA of funds held at the Fed as part of its extraordinary measures to keep the government running, which injects liquidity into the banking system. A resolution of the debt ceiling impasse will see an accumulation in TGA and more bond and bill sales, which reduces system liquidity.
 

 

 

That said, hedges are in a crowded short in S&P 500 futures, which will provide buying support and a floor on stock prices in the event of bad news. In the best case, it could spark a FOMO buying panic in the event of good news.

 

 

The S&P 500 is testing overhead resistance while exhibiting negative divergences in the 5-day RSI and the NYSE McClellan Oscillator, which are both overbought. Until we see a definitive breakout, the base case remains a choppy range-bound market.

 

 

 

In conclusion, the long-term structure of global markets is seeing a loss of leadership by U.S. equities and emerging new leadership in Europe. The short-run outlook will depend on the results of earnings season, but my base case remains a choppy and range-bound market.

 

How to position for the coming growth slowdown

Posted by Cam Hui -
The International Monetary Fund published its latest World Economic Outlook. It cut its global GDP growth estimate by 0.1% from 2.9% in January to 2.8%. More ominously, it issued a warning about a growing risk of recession in the advanced economies from financial instability risk from bank failures: “A hard landing — particularly for advanced economies — has become a much larger risk”
 

 

 

 

In light of the risks of a substantial slowdown, how should investors position themselves?
 

 

 

Signs of a U.S. Slowdown

In the U.S., signs of a slowdown are appearing everywhere. The March CPI report came in a little on the soft side, but decelerating inflation is a two-edged sword. The New York Fed’s Underlying Inflation Gauge shows slowing inflation, but sharp declines are consistent with a recession or economic slowdown.
 

 

Even though the Fed’s official position is a soft landing, the New York Fed’s yield curve-based recession probability estimate has spiked substantially.

 

 

The NFIB monthly survey of small business sentiment is revealing, though the readings have to be interpreted carefully as small business owners tend to be small-c conservatives whose sentiment rise when a Republican is in the White House and falls when a Democrat occupies the Oval Office. Nevertheless, the survey is useful as small businesses lack bargaining power and they are therefore sensitive barometers of economic conditions.
 

 

The latest sentiment figures show optimism has fallen substantially to COVID Crash levels.

 

 

Even before the onset of the banking crisis, small businesses reported tightening credit conditions. 

 

 

Moreover, hiring plans are softening. 

 

 

As we approach Q1 earnings season, FactSet reported an elevated level of negative earnings guidance…

 

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…and a depressed level of positive guidance.

 

 

Putting it all together, this spells an economic slowdown ahead.

 

Real-time Market Warnings

In addition, I am seeing real-time signs of a slowdown from market data.

 

Gold acts as a risk-off asset and performs well when stress levels are high. By contrast, the copper/gold ratio is a cyclically sensitive indicator and rises when market expectations of economic growth rise. The accompanying chart depicts past periods when the copper/gold is rising, which coincided with a falling gold/CRB Index ratio. @here are we today? Gold is rising relative to the CRB, indicating a risk-off environment, and the copper/gold is flat to down, indicating a period of softness in the economy.

 

 

During periods of economic stress, investors favour high-quality stocks at the expense of high-flying unprofitable companies. We measure the quality factor in several ways. One way is profitability. Standard & Poors has a higher profitability inclusion criterion for its indices than the FTSE/Russell indices. Therefore, the return spread between similar S&P and Russell indices could be a measure of profitability quality. 

 

As the accompanying chart shows, investors have been accumulating both large- and small-cap quality stocks, which is a signal of a risk-off condition for the economy and stock market.
 

 

 

 

 

Investment Implications

We began this publication with the rhetorical question of how investors should position themselves in light of the risks of a substantial economic slowdown. The coming environment is ideal for a 60/40-style balanced portfolio of equities and fixed income instruments.

 

Last year was difficult for the traditional 60/40 portfolio as both stock and bond prices fell together, but the relationship and correlation between the two asset classes have begun to normalize in 2023 (bottom panel). The accompanying chart shows the stock/bond correlation in the bottom panel and the shaded areas represent past major bear markets. It was only the double-dip recession of 1980–1982 during the tight Volcker money era that stocks and bonds exhibited positive correlation. Much like the Volcker era, the correlation is falling and the historical diversification effects of the two asset classes are re-asserting themselves.
 

 

 

 

While reasonable people can debate about the near-term trajectory of Federal Reserve monetary policy, there is little doubt that global central bankers are nearing the end of their tightening cycle. Historically, peaks in the 30-year Treasury yield have either been coincident or led peaks in the Fed Funds rate – and falling bond yields are bullish for bond prices. By contrast, peaks in the 30-year Treasury yield have shown a spotty record of calling equity market tops or bottoms.

 

 

 

The 30-year yield appears to have already peaked, which should be bullish for the bond price outlook. If history is any guide, the outlook for stocks is less certain.
In conclusion, the risk of a substantial economic slowdown is rising based on our review of macro, fundamental, and real-time market factors. Investors should position themselves by holding a diversified portfolio of stocks and bonds to protect themselves from possible future asset price volatility.

 

Does inflation matter to stocks anymore?

Posted by Cam Hui -
Mid-week market update: The S&P 500 roared out of the gate this morning on a slightly softer than expected CPI print. Robin Brooks observed that super-core CPI (core services  ex-housing and healthcare, light blue bars) have been decelerating.

 

 

Unfortunately for equity bulls, the gains faded over the course of the day.

 

Callie Cox pointed out that stock market volatility has been falling on CPI days when compared to FOMC and NFP days.

 

 

Does inflation matter to stocks anymore?

 

 

Differing technical patterns

What would prefer to hold in the current environment? The 7-10 year Treasury ETF (IEF), which is their upside breakout?

 

 

Or would you prefer the S&P 500, which unsuccessfully test a overhead resistance level while exhibiting a negative RSI divergence and overbought on the % of stocks above their 20 dma?
 

 

A review of market breadth, as measured by capitalization bands, tells a story of narrow leadership by the large-cap S&P 500. While the S&P 500 is range-bound, market strength deteriorates as you go down market capitalization groupings, starting with the equal-weighted S&P 500, which reduces the dominance of the megacaps, to the mid-cap S&P 400, and finally the small=cap Russell 2000.

 

 

A review of the relative returns of the top five sectors of the S&P 500, which comprise over 70% of index weight, shows few signs of sustained leadership. Technology relative strength is rolling over. The defensively oriented healthcare sector is starting to turn up. Financial and industrial stocks may be trying to bottom, and consumer discretionary is flat against the index.

 

 

None of this means that it’s time to be outright bearish, but disappointing performance in the face of good news is a cautionary flag. I reiterate my belief that the stock market is in a choppy range-bound pattern. Investors should wait for either a bullish or bearish catalyst before taking a directional view on stock prices.

 

Why I am fading the breadth thrust

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.

 

 

About that breadth thrust

I have had several discussions with investors over the meaning of the recent Zweig Breadth Thrust (see Interpreting the Zweig Breadth Thrust Buy Signal). A ZBT is a rare condition that occurs when the market moves from an oversold to an overbought condition within 10 trading days. There have been seven out-of-sample signals since Marty Zweig wrote his book, Winning on Wall Street. The stock market was higher a year later in every instance, though it did pause and pull back on two occasions, which occurred against Fed tightening cycles. I think that the latest signal will resolve in a pullback.

 

 

 

What’s a Breadth Thrust?

I have found that too many investors regard technical indicators and their buy and sell signals as black boxes. To address that issue, let’s consider the investment theme behind a breadth thrust. A breadth thrust involves the following conditions:

  • Usually an oversold market where sentiment becomes washed out.
  • A sudden violent market recovery and buying stampede with broad participation.
  • The momentum from the buying stampede eventually pushes prices higher and usually marks the start of a new bull phase.

Let’s apply those three criteria to the current ZBT buy signal. Arguably, the recent banking crisis jitters created an oversold and washed-out sentiment. But broad participation? The accompanying chart shows the relative performance of the five sectors in the S&P 500 by weight. The sectors comprise over 70% of index weight. Technology was the sole market leader. The other four were either flat or lagged the market. Broad participation doesn’t look like this.

 

 

I would also point out that the Fed tightening cycle isn’t complete. Cleveland Fed President Loretta Mester explained in greater detail why the Fed has much more work to do to tame inflation. She said that the Fed should raise the Fed Funds rate above 5% this year and hold it at restrictive levels, which she defined as the inflation rate, for some time to quell inflation. 

 

The market is discounting a rate plateau just below the 5% level specified by Mester and rate cuts that begin mid-year, which is contrary to the message from Mester and other Fed speakers. As a reminder, Fed Chair Jerome Powell stated during the last FOMC press conference that rate cuts in 2023 are not part of the Fed’s baseline.

 

 

If a breadth thrust is the signal of a new equity bull phase, valuation would be a concern. I pointed out last week that the current signal would be the highest forward P/E in the out-of-sample history of ZBT buy signals. It would also be the highest P/E compared to the 10-year Treasury yield, or equity risk premium, in the out-of-sample history. Investors who buy here wouldn’t be depending on valuation support, but betting on the start of a new investment bubble.

 

 

Breadth thrust signals aren’t perfect. Technical analyst Walter Deemer highlighted the simultaneous combination of a Whaley Breadth Thrust and Breakaway Momentum in mid-January. The buying stampede was sparked by the bullish prospect of China re-opening its economy after a reversal of its zero-COVID policy. While the S&P 500 did rally shortly after the two signals, it pulled back after investor disillusionment with the China re-opening trade. Similarly, the latest ZBT signal was sparked by a recovery off the banking crisis low, but the KBW Regional Banking Index has since retreated to test its previous lows, which is not a good sign.

 

 

Other analysts have analyzed breadth thrusts and arrived at similar conclusions. Tom McClellan analyzed the history of ZBT buy signals all the way back to 1928 and concluded that they only had about a 50-50 chance of success, though he defined failures as the market not immediately rising to new highs.
 

Brett Steenbarger quantified the short-term effects of breadth thrust and he was not impressed.

I went back to 2006 and identified all market occasions in which more than 90% of SPX stocks were above their 3, 5, and 10-day moving averages at the same time. Interestingly, out of well over 4,000 market days, this only occurred on 42 occasions.  Over the next five trading sessions, the market was down by an average of -.26%, compared with a gain of +.18% for the remainder of the sample.  No particular edge here, even going out 20 days.  Returns over a next 20-day period were volatile, with 17 of the 42 occasions rising or falling by over 5%.

 

 

Not Bearish

My skepticism of the effectiveness of the latest ZBT doesn’t mean that we are outright bearish on stock prices. Rob Anderson at Ned Davis Research pointed out that the Coppock Curve flashed a buy signal for the S&P 500 at the end of March by turning up.

 

 

While the Coppeck Curve is flashing a buy signal, other short-term factors are not as bullish. The Fed is draining liquidity (blue line) after stabilizing the banking system. Eagle eye readers will also have noticed that Bitcoin, which is a partial proxy for short-term system liquidity, went nowhere last week.

 

 

As the Fed drains liquidity from the banking system, regional bank stocks struggled to hold their long-term support. Coincidence?

 

 

Here’s the good news. The market structure of the S&P 500 indicates that it’s undergoing a bottoming process. The percentage of S&P 500 stocks above their 50 dma is moderating. My base case calls for breadth to recover in a choppy manner for the next few months.

 

 

In the short run, the market is range-bound. Wait for greater clarity for either an upside breakout or downside breakdown before taking a view on market direction.

 

 

A fire and ice challenge to risk assets

Posted by Cam Hui -
 In case you missed it, the 10-year Treasury yield fell and broke a technical support level even as the 3-month T-Bill yield rose. This left the 10-year to 3-month yield spread inverted further, which has historically been a strong recession signal.
 

 

 

The 10-year and 3-month Treasury yield spread has inverted before every recession. If history is any guide, a slowdown is just around the corner.

 

 

 

The stock market and other risk assets are facing a fire and ice challenge. Fire in the form of still overly hot inflation readings and ice in the form of a deteriorating economy.
 

 

 

The Fire Threat

The fire threat of too-hot inflation was outlined by Cleveland Fed President Loretta Mester, who explained in greater detail of why the Fed has much more work to do to tame inflation. She said that the Fed should raise the Fed Funds rate above 5% this year and hold it at restrictive levels, which she defined as the inflation rate, for some time to quell inflation. The Fed remains data-dependent and the path of monetary policy depends on how quickly price pressures ease.
 

 

 

 

The seriousness of the global inflation fight was reinforced when the Reserve Bank of New Zealand (RBNZ) unexpectedly raised rates by 50 basis points. Despite New Zealand’s small size, the RBNZ was a leader in the latest tightening cycle and the recent aggressive move could be interpreted as a signal that a pivot to an easier monetary policy may not be as close as the market thinks.
 

Mester’s remarks stand in stark contrast to the Fed Funds market expectations of a near-term plateau that peaks just below 5%, followed by a series of rate cuts that begin in mid-2023.

 

 

Former Fed economist Claudia Sahm explained the difference in the Fed’s and the market’s thinking this way. The Fed expects inflation to be sticky.

The Fed thinks that inflation, especially ‘super core,’ will be very persistent, and bringing it down will require high rates for some time. It also does not expect a recession.

On the other hand, the market expects a recession:

Markets also expect a recession, possibly a severe one. The thinking is that the Fed will not stand by and do nothing as the economy tanks. Inflation should soften in a recession, giving the Fed cover to cut some.

Sahm thinks that we will see a recession.

The Fed will not cut. And there will be a recession starting in the second half.

 

 

The Ice Threat

The ice threat can be neatly summarized by the U.S. Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. ESI recently peaked at a high level and began to roll over, indicating a loss of economic momentum. 

 

 

Looking ahead to Q1 earnings season, forward 12-month sales estimates have been flat to up while forward EPS has been falling in an uneven manner, indicating margin compression. This is not an environment that’s conducive to strong equity returns.

 

 

Q1 earnings season will kick off with reports from large banks. Even though financial stocks have stabilized after the banking crisis, their relative performance continues to struggle, and so has their relative breadth conditions (bottom two panels). How will the market react to the reports from the banks?

 

 

As well, market internals of the relative performance of cyclical industries are weakening. Even the semiconductors, which had been the last holdout among the leaders, recently violated a rising relative trend line, indicating a loss of cyclical momentum.
 

 

By contrast, defensive sectors are either staging relative breakouts or on the verge of relative breakouts, indicating that the bears are trying to seize control of the tape.

 

 

In the current environment, investors have been piling into large-cap quality as a refuge. We measure the quality factor in several ways. One way is profitability. Standard & Poors has a higher profitability inclusion criterion for its indices than the FTSE/Russell indices. Therefore, the return spread between similar S&P and Russell indices could be a measure of profitability quality. In addition, the dotted line (middle panel) shows the relative performance of a quality ETF against the S&P 500. As the accompanying chart shows, investors panicked into large-cap quality in March, but the return to small-cap quality was flat during the same period.

 

 

 

Remember China Re-opening?

One of the last hopes for the cyclical bull case was the China re-opening narrative. The market greeted the prospect of China re-opening its economy after abandoning its zero-COVID policy with great fanfare in January. Since then, the China re-opening trade has gone nowhere. The relative performance of China and the stock markets of its major Asian trading partners have either gone sideways or down.

 

 

What about China’s domestic economy? The accompanying chart shows the relative performance of selected cyclical sectors compared to MSCI China. Here are my main takeaways:

  • Material stocks, which are sensitive to commodity demand, mainly from infrastructure spending, are lagging after showing a brief burst of strength.
  • Consumer sensitive sectors such as consumer discretionary and internet stocks, which contain heavyweight consumer spending sensitive Alibaba and Tencent, have gone nowhere on a relative basis since the re-opening announcement.
  • The real estate sector, which is the most vulnerable part of the Chinese economy because of the collapse in prices and major developers like China Evergrande, along with the financial sector, have been steady against MSCI China. This is an indication that the authorities have stabilized the property market and the tail-risk of a disorderly breakdown has been diminished.

 

 

 

The Bearish Tripwire

So far, these signals are only bearish warnings and not outright bearish signals. We would watch for a technical break in NASDAQ 100 leadership as a sign that the bulls have lost control of the tape to the bears. As well, keep an eye on the relative performance of European equities, which are still in a relative trading range. An upside relative breakout or downside breakdown out of the range could be a useful signal of how leadership could develop in the next market cycle.
 

 

 

A NFP preview

Posted by Cam Hui -
Mid-week market update:  I know that we mostly focus on the outlook for the stock market in these pages, but investors should cast their eyes on the bond market once in a while, as they might learn something. Bond prices staged an upside breakout, which is a signal of economic weakness.

 

 

As the next major economic data point is the March Employment Report due Friday morning, this is a good time to review the jobs market outlook, which is probably more important  to the bond market than the stock market.

 

 

Signs of weakness

There are many signs that the jobs market is weakening. The February JOLTS report showed a decline in job openings that was beyond market expectations.

 

 

Leading indicators, such as temp jobs (blue line) and the quits/layoffs ratio (red line), were not as calamitous. Nevertheless, the quits/layoffs ratio from the JOLTS report shows a noisy decline, indicating job market weakness.

 

 

Mike McDonough, the Chief Economist at Bloomberg Financial Products, observed that mentions of “job cuts” art now starting to exceed “job shortages” on company earnings calls, which are signs of labor market softness.

 

 

As well, ISM Manufacturing PMI fell and badly missed expectations. Moreover, ISM Manufacturing Employment showed similar signs of weakness.

 

 

 

Soft, but not that soft

While the jobs market is showing signs of softness, it’s not a disaster. ISM Non-Manufacturing Employment rose, though it missed expectations.

 

 

Initial jobless claims (blue line) have been remarkably resilient. For some context on the strength of the economy, initial claims normalized for population (red line) made an all-time line before the onset of the pandemic and readings remain low by historical standards. (The figures are shown in log scale in order to minimize the distortions caused by the pandemic jobless spike).

 

 

Here is a close-up of initial claims data, which is stable but exhibiting minor signs of weakness.

 

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In conclusion, the March Employment Report this Friday will probably elicit a market reaction, but unfortunately the markets won’t be open until Monday. Expect minor signs of weakness, but not that weak. If I am right, bond prices should rally, but what happens to stock prices will be an open question. The S&P 500 pulled back after testing resistance amidst an overbought condition. Likely support can be found at the 50 dma at about 4027.

 

 

Interpreting the Zweig Breadth Thrust buy signal

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Neutral*/li>

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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 ZBT buy signal

The market flashed an extremely rare Zweig Breadth Thrust buy signal late Friday. Without going into a lot of detail, the ZBT buy signal is triggered when the market surges from an oversold to an overbought reading within 10 trading days, which it managed to achieve on Friday.

 

 

 

How should investors interpret this buy signal? At first glance, it appears to be an excitingly bullish development, or a “what’s the credit limit on my VISA card” buy, but I have doubts.

 

 

Analyzing the ZBT

There have only been six out-of-sample ZBT buy signals since Marty Zweig wrote the book, Winning on Wall Street, that outlined the details of this technique in 1986. In all cases, the stock market
was higher a year later. In four of the six instances, the market kept rising after the signal and never looked back. The two “failure”, which saw the S&P 500 pull back after the buy signal. Will this market immediately launch itself to new highs or will the rally fizzle like it did in 2004 and in 2016?

 

 

What category does the current episode belong? I can observed that most ZBT buy signals were seen in V-shaped rebounds after the market tanked and sharply recovered, While there was a relief rally in the aftermath of the banking crisis, the current episode can hardly be described as a V-shaped recovery.

 

The unsuccessful buy signals occurred when the Fed was undergoing a tightening cycle. What’s different this time is we are near the end of the tightening cycle, which doesn’t quite fit the “fizzle” template. The market is discounting nearly a 50-50 chance of a quarter-point rate hike at the May FOMC meeting and rate cuts by mid-year. Is the Fed still tightening? The market is unsure on that score, but the latest Fed rhetoric is still of the “there is  more work to do” variety.

 

 

What about valuation? The accompanying chart shows the S&P 500 forward P/E at the time of the six out-of-sample ZBT buy signals, along with the 10-year Treasury yield as an indication of the relative attractiveness of stocks compared to bonds. I can make the following observations:

 

  • Most ZBT buy signals occurred when the forward P/E dropped suddenly and then recovered (a V-shaped rebound), which is not the case today,
  • The S&P 500 current forward P/E of 18.1 is higher than any of the other P/Es seen during past ZBT buy signals.
  • Past buy signals were triggered in environments of more
    attractive cheaper valuations of stocks compared to bonds. Even
    though forward P/E of the other ZBT buy signals were lower than what it
    is today, the other buy signals occurred in environments when the
    10-year Treasury was lower than it is today, with one exception.
  • In the one exception in 2004 when the 10-year Treasury yield was higher, the S&P 500 forward P/E was still lower than it is today. Even then, the 2004 buy signal fizzled by trading sideways for several months before rising to fresh highs. The price action can be seen as a P/E de-rating before rising again.

 

 

In short, the latest ZBT breadth thrust signal has been triggered when the stock market is the most expensive in history compared to other buy signals. The combination of a lack of valuation support and uncertainty over Fed policy leads me to believe that the immediate upside to the latest buy signal is likely to be limited. While the S&P 500 will probably be higher a year from now, the more likely path for stock prices is a pullback in a choppy setting before the market can reach fresh highs.

 

Technicians need to be prepared to be disappointed.

 

 

Home on the range

Despite the rally experienced by the U.S. equities and the ZBT buy signal, the S&P 500 remains in a trading range. Initial support can be found at the falling trend line at about 3800, with secondary support at the 200 wma at about 3750. Initial resistance is at about 4080, which the index broke through, and secondary resistance at 4150. With the market already overbought, as measured by the NYSE McClellan Oscillator, expect choppiness and turbulence until the index can break out, either to the upside or downside.

 

 

 

Uncertainty from bond and factor analysis

Other assets confirm the range-bound nature of this market. As an example, the bond market is unhelpful in determining the trend in risk appetite as bond prices are also range-bound. The 7-10 Year Treasury ETF (IEF) staged a failed upside breakout and retreated back into a range between 94.50 and 100. The International Sovereign Bond ETF (IGOV), which is priced in USD and has a similar duration, or interest rate sensitivity, as IEF, is lagging IEF. The poor relative performance of IGOV is surprising as the USD has been weak for most of March, which should provide a boost to IGOV returns.

 

 

The analysis of the commonly used four Fama-French equity return risk factors, which are price momentum, quality, size and value and growth, also offer few clues to market direction. One possible hint can be seen in the recent positive but choppy returns to quality, which is often a characteristic found during past equity bears.

 

 

The banking crisis also has both bullish and bearish implications. On one hand, it is constructive that regional banking stocks have stabilized. 

 

 

On the other hand, the emergency liquidity injections are starting to be drained from the banking system in the wake of the crisis, and lower liquidity tends to be bearish for risk assets.

 

 

Mixed Sector Internals

An analysis of the returns of style and sector internals also show a mixed picture. While it’s true that investors have gravitated toward large-cap growth during the recent banking crisis, most of the outperformance can be found in technology. The other two growth sectors show little signs of leadership.

 

 

By contrast, the relative performance of value sectors, which are cyclically sensitive, have been challenging.

 

 

If large-cap technology is leading the market and value is lagging during a period of financial stress, does this mean it’s time to turn bearish?
 

The answer is no. The relative performance of defensive sectors presents a mixed picture of market leadership. Of the four defensive sectors, one (consumer staples) is in relative uptrend, one (real estate) is in a relative downtrend and the other two are range-bound when compared to the S&P 500. These are not signs that the bears have seized control of the tape.
 

 

In conclusion, I believe that despite the potential excitement generated by the ZBT buy signal, the U.S. equity market remains in a holding pattern. Investors should wait for more definitive signs of market direction from either factor returns or market internals before turning overly bullish or bearish. Investors will see the March Jobs Report next week, followed by the start of Q1 earnings season, which may provide better guidance to near-term market direction.
 

 

What USD weakness may mean for asset returns

Posted by Cam Hui -
An unusual anomaly arose during the latest banking crisis when a long-standing historical relationship broke apart. When bank stocks skidded in response to the problems that first appeared at Silicon Valley Bank, the 2-year Treasury yield fell dramatically, indicating a rush for the safety of Treasury assets. What was unusual this time was the weakness in the USD. The greenback has rallied during past financial scares and crises as investors piled into the safety of the USD and Treasury paper. This time, Treasuries did reflect a flight to safety, but not the USD. As the USD has been inversely correlated to the S&P 500, and the dollar can’t advance even with the macro tailwind of a banking crisis, what does this mean for asset returns?

 

 

 

The long-term picture

Let’s start with the long-term view. The 20-year chart of the USD shows that it has retreated to test a support zone that stretches back to 2015. If it were to break support – the next support level can be found at just under 90 – it would spark a secular bear phase and the dollar could face considerable downside potential compared to current levels.

 

 

What would a break of support mean for asset prices in the next market cycle? While correlation isn’t causation, the relative performance of the S&P 500 against MSCI EAFE has been highly correlated to the USD Index. Will dollar weakness mean better relative returns for non-U.S. equities?   

 

 

To be sure, the relative forward P/E valuation of different regions argue against U.S. equities.

 

 

If the USD were to fall into a secular bear phase, one asset that is likely to benefit is gold, which has historically been inversely correlated to the dollar. Gold prices staged an upside breakout from a multi-year base in 2020. If the greenback were to weaken further here, it would represent further tailwinds for the yellow metal.

 

 

The measured upside on a monthly point and figure chart of gold is $2,779, though that represents a multi-year target and it’s unlikely to be reached in the immediate future.

 

 

 

A cyclical Warning

One word of warning. There is one negatively correlated asset to the USD that is flashing a cyclical warning. In addition to gold, commodity prices have also been historically inversely correlated to the dollar. But the two assets started to diverge in mid-2021.

 

 

 

I attribute this to a sign of global cyclical weakness. The decline in the cyclically sensitive copper/gold and base metals/gold ratios is a sign of economic weakness. Economic weakness is also foreshadowing a reduction in risk appetite, as measured by the stock/bond ratio.

 

 

A similar relationship can be found between the copper/gold ratio and the 10-year Treasury yield. Weakness in cyclical indicators like copper/gold point to lower bond yields and a probable recession ahead.

 

 

In conclusion, the USD Index is on the verge of breaking long-term support. If it does, it would have multiple implications for asset class returns:

  • Bullish: Non-U.S. compared to U.S. equities.
  • Bullish: Gold.
  • Bearish: Near-term economic outlook. Commodity prices are sounding a warning that a recession is likely ahead, which would be bullish for Treasuries and bearish for cyclically sensitive assets like commodities.

 

How greedy should you be during this rally?

Posted by Cam Hui -
Mid-week market update: There is an adage on Wall Street, “Bulls, make money, bears make money, hogs just get slaughtered.” I issued a tactical buy signal to subscribers on the weekend based on my usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM). ITBM flashed a buy signal as of the close on Friday when its 14-day RSI recycled from oversold to neutral.

 

 

 

Now that the stock market is rallying, how greedy should you be? One guideline to consider is, after an ITBM buy signal, the percentage of S&P 500 above their 20 dma generally reaches at least 60%, if not more, before the rally peters out. (Note one-day data delay on % above 20 dma).

 

 

Still range-bound

This will be a relatively brief note as the technical structure of the stock market is mainly unchanged since my last update on the weekend. The S&P 500 is still range-bound. Support can be found at the falling trend line at about 3800. Initial upside resistance is at about 4080, with secondary resistance at about 4150. 

 

 

Before you get too bullish, let’s takeone step at a time. The daily chart of the S&P 500 shows that the index is just testing its 50 dma level, and there is a resistance zone just above the 50 dma. Net NYSE highs-lows have barely turned positive. While that is constructive, it’s no reason to throw caution to the wind and get all bulled up. Tactically, long exit triggers to consider are 1) percentage of S&P 500 above their 20 dma above 60% (almost), or 2) the VIX Index reaches to bottom ot its Bollinger Band (not yet).

 

 

 

Inflation will set the tone

Keep in mind that we will see the report of February PCE, which is the Fed’s preferred inflation metric, Friday morning and the report will be a potential source of volatility and it will set the tone for the market next week. 

 

The Cleveland Fed’s Inflation Nowcast tool is in line with consensus cover PCE expectations of 0.4% month/month and 4.7% year/year.

 

 

S&P Global (formerly IHS Markit) reported that G4 goods inflation has been falling, but services inflation, which is a metric that the Fed is watching closely, was stubbornly strong in March.

 

 

My inner trader remains tactically long the S&P 500, but he is inclined to either reduce or exit his position tomorrow (Thursday) ahead of the PCE report, especially if the market exhibits any bullish follow-through. 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 SPXL

 

A Fed Put of a different kind

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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: Sell equities [downgrade]
  • Trend Model signal: Neutral [downgrade]
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Market stabilization

Last week, I suggested that one of the key conditions for a sustainable rally is for the KBW Regional Banking Index (KRX) to hold long-term support despite Friday’s market jitters over the stability of Deutsche Bank. While KRX has held support, it disappointed the bulls by refusing to rally off the bottom.  We interpret this to mean that market sentiment over the banking crisis has stabilized.

 

 

The Fed Put has been activated, but it’s a put of a different kind. Investors can return to more mundane matters such as technical and fundamental analysis.
 

 

Wobbly signs of cyclical strength

As a framework of analysis, you need to understand that investors rushed into large-cap growth stocks as safe havens during the banking crisis. Since large-cap growth comprise about 40% of S&P 500 weight, any relative performance analysis using the S&P 500 is distorted by the significant weight of growth stocks.

 

 

Before the banking crisis, cyclical industries had been in relative uptrends. The same relative performance analysis of the cyclicals reveals a series of broken relative uptrends, with the single exception of semiconductors.
 

 

 

The relative performance analysis of the same cyclical industries against the equal-weighted S&P 500, which reduces the outsized weights of large-cap growth stocks, shows a series of similar patterns of weakness.

 

 

The wobbly message from the relative performance of cyclicals is confirmed by a cautionary signal from the softening commodity prices, which should be performing well in light of USD weakness, and weakness in the cyclically sensitive base metal/gold and copper/gold ratios.

 

 

 

Macro and fundamental headwinds

In effect, market conditions have deteriorated since the banking crisis. Not only are cyclical stocks losing momentum, but macro and fundamental analysis called for caution.
 

 

The most significant macro headwind was presented by Fed Chair Jerome Powell during the latest post-FOMC press conference. Even though the latest quarter-point hike was interpreted as a dovish hike by the markets, Powell pushed back against market expectations that the Fed would cut rates in 2023 as it was not in the Fed’s baseline. Nevertheless, Fed Funds futures are pricing in a series of rate cuts starting mid-year.
 

 

Do you really want to fight the Fed?
 

In addition, equity valuations is still challenging. The S&P 500 is trading at a forward P/E of 17.2. The last time the 10-year yield was at these levels, the forward  P/E was considerably lower, though they were at similar levels in 2003.

 

 

When you consider that Street analysts have been downgrading earnings estimates, the forward P/E ratio could be higher even if pries were unchanged. This makes valuation even more challenging for investors.
 

Equally disturbing is the stock market’s poor breadth. Even as the S&P 500 struggles at its 50 and 200 dma, different versions of Advance-Decline Lines are testing support and not showing any signs of strength.

 

 

 

What kind of Fed Put?

I interpret current conditions as Powell Fed has conveyed that there is a limited Fed Put in the market. The Fed will act to support the banking system, or a Bank Put, but it will do little to support the overall stock market, or a Market Put.

 

Here’s what the Fed Put looks like. The chart of the financial sector looks ugly, but a bottom may be near. It’s exhibiting a positive 5-day RSI divergence and relative breadth indicators are improving (bottom two panels).

 

 

As long as market concerns over the banking system are in place, expect a range-bound choppy market, bounded by about 3800-3830 on the downside and about 4080 to the upside. If 3800-3830 support breaks, the next major support can be found at the 200 wma at about 3740.

 

 

As a consequence of these conditions, the Trend Asset Allocation Model reading has been downgraded from bullish to neutral. The Ultimate Market Timing Model is also downgraded to sell as there is a possible recession on the horizon, and recessions are bad news for stocks.My inner investor will start to de-risk and realign his portfolio from an equity overweight to a neutral weight consistent with long-term investment policy weights.

 

 

The week ahead

Tactically, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator flashed a buy signal Friday when its 14-day RSI recycled from oversold to neutral on Friday. In the past three years, this model has had 26 buy signals. Of the 26, 22 of them resolved bullishly and four resolved bearishly. My inner trader plans on entering a small long position on Monday/ However, I wouldn’t characterize it as a high confidence trading call in light of the volatile and choppy backdrop.

 

 

Helene Meisler’s weekly sentiment poll readings were cautiously bullish. Respondents have been mostly right about short-term market direction, which makes my inner trader  somewhat optimistic.

 

 

 

 

My inner trader plans on entering a long position on Monday. The usual disclaims 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.

 

Why the dot-plot doesn’t matter

Posted by Cam Hui -
It was a closely watched FOMC meeting. The Fed raised rates by a quarter-point, which was widely anticipated, and signaled that it would likely raise another quarter-point before it’s done. It was interpreted as a dovish hike. The Fed also  published a Summary of Economic Projections (SEP), also known as the “dot plot”. In the end, the “dot plot” wasn’t very relevant for two reasons. It was stale by the time it was published, and there was a high degree of uncertainty around the projections.

 

 

During these times of uncertainty, what matters more is the Fed’s reaction function to financial crises. To address that issue, I have conducted an event study of how the Fed has reacted to shocks and crises in the past in order to estimate the Powell Fed’s reaction function.

 

 

1987 Crash

Starting with the Crash of 1987, the accompanying chart shows the S&P 500 as a measure of risk appetite, the yield on 2-year and 3-month Treasury paper as measures of market expectations of changes in policy, the Fed Funds rate, and the 3-month growth in M2 money supply indications of changes in monetary policy.
 

In response to the greatest market crash since 1929, the Fed embarked on a course of monetary easing as Treasury yields and the Fed Funds rate fell and bottomed within and bottomed within a month of the crash. M2 growth similarly surged and stabilized at about the same pace as the other indicators.
 

 

 

LTCM implosion, 1998

Policy response to the Asian Crisis of 1997 was more complicated and matters didn’t come to a head until the Russia Crisis and the failure of Long-Term Capital Management (LTCM) in 1998. After Russia defaulted in August 1998, Treasury yields fell first and policy action, as measured by the Fed Funds rate and M2 growth, followed about a month later. LTCM, which was a secretive hedge fund founded in 1994 by Joh Meriwether, the former head of bond trading as Salomon Brothers, and included Nobel laureates Myron Scholes and Bob Merton, had initially been initially been very successful with strong returns by identifying small pricing differences and exploiting with high degrees of leverage. The fund began to suffer difficult drawdowns in 1998, starting with -7% in May, -10% in June, and –18% in July. The Russia default and subsequent financial crisis widened the pricing differences LTCM expected to converge and the fund was down -44% in August. The fund collapsed -83% in September as excessive financial leverage magnified the losses to a total of $4.5 billion, which threatened the financial system’s stability. The Fed engineered a recapitalization of LTCM on 23 September 1998 by a Consortium of 14 financial institutions after the fund collapsed and declared bankruptcy.
 

Treasury yields, which are a proxy for market expectations, bottomed in October, about a month after the LTCM bankruptcy. As measured by the Fed Funds rate, policy rates bottomed in December, and M2 growth, as a measure of monetary stimulus, peaked in late November.
 

 

 

9/11, 2001

The 9/11 attack on the Twin Towers in New York was an exogenous geopolitical event. and not a crisis rooted in the financial system. The stock market had been in a bear market for over a year when the dot-com bubble burst in March 2000. Interest rates had already been declining, but the Fed reacted to 0/11 by boosting liquidity into the banking system, as evidenced by the surge in M2 growth. As the financial effects of the shock wore off, monetary stimulus was withdrawn and normalized by December. Stock prices rebounded, but topped out in early January and resumed their bear trend, which ended in late 2002.

 

 

 

 

GFC, 2008

The crash that marked the Global Financial Crisis (GFC) of 2008 was a slow and draw-out affair. The S&P 500 topped out in 2007. Bear Stearns failed in March 2008, but the markets shrugged off the event as it didn’t pose any systemic risk. It wasn’t until the Lehman Brothers collapse in September that it sparked an institutional bank run and a crisis of confidence among broker-dealers. That’s when the Fed swung into action. Treasury yields fell and the Fed Funds eased to the zero-bound. M2 growth surged.  Stimulus measures peaked in December. Even though the three-month rate of m2 growth peaked at that time, the 12-month growth rate continued to rise until February 2009.
 

 

 

COVID Crash, 2020

The COVID Crash was another event whose roots were not in the financial system, but whose effects had real-world economic implications. After the COVID-19 pandemic began to spread, China responded by shutting down its economy to combat the virus. The Chinese shutdown, along with outbreaks in the rest of the world, threatened the global economy with a slowdown of Great Depression proportions. Fiscal and moneary authorities around the world responded with unprecedented levels of stimulus. Interest rates dropped to near zero, and M2 growth surged over a three-month time span

 

 

 

What’s next?

Fast forward to 2023, what can investors expect?

 

It is said that history doesn’t repeat itself but rhymes. This was a limited event study that focused on the reaction of the Fed to financial crises and other shocks. In all cases, the Fed took action to stabilize the system once it became apparent that a failure threatened financial stability. Once stability returned, the Fed withdrew stimulus measures 2-3 months after the event. If history is any guide, the Fed should normalize and withdraw liquidity enhancing measures by about May or June.

 

If that’s the template, here are some real-time indicators to watch. First, anxiety over the banking system needs to stabilize. The KBW Regional Banking Index is testing a key support zone. A violation would signal further bank system jitters and invite further policy support.

 

 

Watch for signs that the Fed is withdrawing liquidity support, which would be bearish for equities. Fed liquidity can be measured by changes in its balance sheet  – changes in the Treasury General Account – changes in Reverse Repo Purchase agreements.

 

 

While the Fed liquidity indicator is reported weekly, the price of Bitcoin and other crypto-currencies can be used as a quick approximation of system liquidity.

 

 

 

Also don’t forget the USD. The USD is a risk-off asset and it’s inversely correlated to the S&P 500. The USD will eventually break out of its trading range, but in which direction?

 

 

Once policy support is withdrawn, equity investors will have to focus on such mundane matters as interest rates and the earnings outlook. While most of the instances in the five historical studies saw stock prices roar to new highs, this time may be different. Fed Chair Jerome Powell pushed back at his press conference twice against the notion that the Fed will cut rates in 2023 as it’s not in the Fed’s baseline. Nevertheless, market expectations are calling for a series of cuts that begin mid-year. Either the market or the Fed is very wrong, and it’s usually not wise to fight the Fed.

 

 

In addition, the yield curve is starting to steepen after becoming deeply inverted. A steepening yield curve after an inversion usually foreshadows recession, and recessions are not negative for stock prices.

 

 

Putting it all together, the banking crisis pattern of 2023 more resembles the 9/11 shock. The stock market was already in a bear market, and interest rates rose after the effects of the shock wore off. Expect a similar pattern of a short-term stock market recovery, followed by further weakness as market fundamentals reassert themselves. This is consistent with my “party now, pay later” theme of a near-term rally, follow by weakness later this year

 

Is the Fed’s glass half full, or half empty?

Posted by Cam Hui -
Mid-week market update: Investors and traders have been waiting for the moment of the FOMC announcement and subsequent press conference. How does the Fed respond to the twin challenges of a banking  

John Authers highlighted analysis from Bespoke indicating the market was entering a period of extreme volatility in Fed Funds futures.

 

The fluctuation of fed funds futures has been so extreme that, since their inception in 1994, the only other months to see such volatility were: January 2001 (when the Fed started to hike); September 2001, month of the 9/11 terrorist attacks; January and October in the crisis year of 2008; and March 2020, when Covid-19 arrived. This is according to an analysis by Bespoke Investment Group. In contrast to the Fed’s current tightening regime, all those months saw the central bank cutting rather than hiking in response to clear crisis conditions. Over the last month, the gap between the highest and lowest fed funds rates that have been predicted stands at 77.5 basis points:

 

 

The Fed has spoken, It raised rates by a quarter-point and the statement changed from it expects “ongoing increases” to “some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time”,
 
The Summary of Economic Projections (SEP) showed a Fed that expects slower growth but stronger inflationary pressures compared to the December SEP.
  • Lower GDP growth in 2023, but
  • A hotter economy, in the form of lower unemployment rate and higher PCE inflation rates,
  • The same terminal rate of 5.1% for 2023 and a higher rate in 2024 compared to December.
 
 

 

During the press conference, Powell pushed back against market expectations of rate cuts: “Rate cuts in 2023 ‘Not our baseline expectation’”,

 

 

He further hedged his past expectations of a soft landing as it’s too early to know if recent events change the odds of a soft landing. A pathway to a soft landing still exists and we are trying to find it. His remarks are in direct contradiction to the New York Fed’s yield curve based recession model showing surging recession risk.
 

 

 

The banking crisis and aftermath

As a reminder, this is what a banking crisis looks like. The KBW Regional Banking Index skidded with almost no warning to test its long-term support. After UBS agreed to buy Credit Suisse, regional bank shares stabilized and rebounded.

 

 

That said, the stock market reaction to the FOMC statement was initially bullish, but turned negative when Powell said that rate cuts were not their base case.  I remain constructive on this market.The banking panic had pushed the stock market to an oversold extreme. The NYSE McClellan Oscillator had fallen to -100, which historically had been a signal to buy for a bounce.

 

 

I expect that the market will chop around for the next few weeks but grind higher as it works off its oversold condition. Subscribers received an email alert that my inner trader had exited his long S&P 500 position when the VIX Index reached the midpoint of its Bollinger Band and the S&P 500 tested its 50% retracement level. The index is probably on its way to re-test the 200 dma, which should hold as support, and eventually work its way higher.

 

 

Assessing the technical damage

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Dodged a bullet
The S&P 500 dodged a technical bullet last week when it successfully tested falling trend line support. Had the trend line been violated, the next major support would have been the 200 wma at about 3730.

 

 

Even as the bulls breath sighs of relief, they shouldn’t expect a rally to challenge the old highs just yet. The stock market has sustained considerable technical damage. Textbook technical analysis calls for a period of basing before stock prices can rise in a sustainable way.

 

 

Technical damage

Here’s what technical damage looks like. The equal-weighted S&P 500, mid=cap S&P 400, and small-cap Russell 2000 all violated downtrend channels and testing support.

 

 

 

The relative performance of cyclical industries had recently a bright spot for this market, but they’ve all turned down during the latest risk-off episode, with the exception of semiconductors. This is another sign that the bulls have lost control of the tape.
 

 

 

Conversely, the relative performance of defensive sectors are making a comeback, except for real estate.

 

 

 

Silver linings

Even though technical conditions look dire, some silver linings can be found in a dark cloud. First and foremost, insiders are buying the dip. The accompanying chart shows that insider buying activity (blue line) has exceeded insider sales (red line). The history of these “smart investors” since the onset of the COVID Crash shows that they were quite prescient in the purchases. 

 

 

 

The Citi Panic/Euphoria Model is now below the October level, which was when the market reached its 12-month low, and it’s in panic territory.
 

 

 

The flood of short-term liquidity unleashed by the Fed should be supportive of stock prices.

 

 

Even though large-cap cyclical industries have rolled over on a relative basis, small-cap cyclical sectors have held up well compared to the Russell 2000, which are positive breadth divergences.

 

 

The S&P 500 is exhibiting a series of useful positive divergences in the form of the 5-day RSI and the percentage of S&P 500 stocks above their 20 dma. In the past six months, there have been two other similar occurrences, with the basing episodes lasting about 2-3 weeks.  If the past is any guide, the bulls will have to wait another 1-2 weeks before the market can break to the upside.

 

 

 

What to watch

Looking to the week ahead, the key even is the FOMC decision on Wednesday. For traders, there are two key indicators to watch.
 

 

The first is the price action of the regional banks, which has become an open wound for investors. The KBW Regional Bank Index needs to hold long-term support as a pre-condition for the stock market to sustainably rally.
 

 

 

Nick Timiraos of the WSJ pointed out that the latest update from the Fed suggests that most of the liquidity provided to the banking system went to Silicon Valley Bank (San Francisco Fed) and Signature Bank (NY Fed). There was little demand for funds from the other Fed districts.  Despite the market’s fears of contagion, the crisis appears to be contained for now.

 

 

The second is the USD Index. The USD has been inversely correlated to the S&P 500. Despite the financial turmoil, the USD hasn’t staged an upside breakout, which is constructive development for risk assets. In the short run, the direction of the greenback will depend on the market perception of Federal Reserve actions.

 

 

By the book, the recent risk-off episode would result in a mechanical downgrade of the Trend Asset Allocation Model from bullish to neutral. But the markets have been extremely volatile. The MOVE Index, which measures the volatility of the bond market, has spiked to GFC levels. I am therefore waiting another week for the market to react and digest the FOMC decision to before changing the model reading to avoid any possible whipsaws.

 

 

In other words, it’s all about the Fed next week.

 

 

Disclosure: Long SPXL

 

Between the Scylla of inflation and Charybdis of financial instability

Posted by Cam Hui -

In response to the recent financial turmoil, Fed Funds futures is discounting a 25 bps hike at next week’s FOMC meeting, followed by a brief peak and rapid rate cuts for the rest of the year.
 

 

Are those market expectations realistic? How will the Fed navigate between the Scylla of inflation and Charybdis of financial stability and recession?

 

 

Anatomy of a banking crisis

The responses to the collapses of Silicon Valley Bank and Signature Bank were swift and clear. The response has three legs, as outlined by this joint press release from the Fed, Treasury, and FDIC.

 

First, the FDIC invoked the systemic risk exception  to protect all deposits of the troubled banks. On the other hand, shareholders and bond holders had to take their lumps. This allows the deposit insurance fund to cover any gap between the funds obtained from the problem bank’s assets.The deposit insurance fund was refilled with a bank levy and therefore there is no cost to taxpayers.

 

As well, the Fed reduced haircuts on collateral offered at the discount window, making it an easier way for  banks to obtain funding from the Fed in the event of deposit withdrawals. More importantly, the Fed and the Treasury used their 13-3 emergency authority to create a new bank funding facility called  Bank Term Funding Program (BTFP). The BTFP allows the Fed to lends against Treasuries and Agencies for a year, a longer term than the discount window, at par, which is a generous term as the market usually prices such securities at a discount to par.

 

Just when the authorities thought banking jitters were over, the Saudi National Bank, which is the largest shareholder of the too-big-to-fail Credit Suisse, announced that it would not inject any more capital into the troubled Swiss institution. The announcement sparked another risk-off stampede in European banks. At the height of the panic, the one-year CDS of Credit Suisse was trading at levels last seen in Greek banks at the height of the Greek Crisis. The crisis stabilized when the Swiss National Bank, Switzerland’s central bank, said that it would step in and provide support to Credit Suisse “if necessary”. Finma, the Swiss financial regulator, also issued a statement certifying that Credit Suisse “meets the higher capital and liquidity requirements applicable to systemically important banks”.

Still, the financial contagion wasn’t over. In the US, First Republic Bank fell victim to deposit flight. The panic briefly paused when a consortium of 11 banks agreed to deposit $30 billion for First Republic for at least 120 days.

 

The worst of the storm may have passed. From a technical perspective, the KBW Regional Banking Index found some footing at a long-term support zone).

 

 

 

The inflation problem

That’s not the whole story. The fragility of the banking system makes the Fed’s price stability mandate far more complicated. Inflation is still too high and the Fed needs to bring it back down to its 2% target.

 

The latest CPI report presented a good news, bad news story on inflation. Core CPI came in ahead of expectations. As the accompanying chart shows, goods inflation has been decelerating sharply but most of the strength has been in services (blue bars).

 

 

New Deal democrat argued that “Properly measured, consumer prices have been in deflation since last June “. He highlighted the lagging nature of Owners’ Equivalent Rent (OER), the major component of shelter CPI, as house prices tend to lead OER by 12 months or more. After making all the adjustments, NDD concluded:

If we substitute the FHFA house price index for OER, headline CPI would have been down -1.4% as of December (since that is when the reported FHFA data ends).

 

 

That’s the good news. The bad news is goods disinflation is abating. Excessive inventory has been worked off. Inventory/sales ratios have normalized after the COVID Crash and retailers are not as compelled to offer large discounts to sell their goods. As well, used auto prices, as measured by the Manheim Used Vehicle Index, has risen for three consecutive months. 

 

 

Even more problematic is the tight labor market. The Atlanta Fed’s wage growth tracker shows a welcome deceleration in wage growth, but readings are still too high at 6.1%.

 

 

Further analysis beneath the hood shows signs of a tight labor market. Job switcher salary increases are strongly outpacing the raises of job stayers, indicating strong worker bargaining power.

 

 

The Fed’s reaction function

The key question for investors is, “What will the Fed’s reaction function be under the current conditions?”

 

Notwithstanding the fed’s dual mandate of price stability and full employment, the main reason that central banks were created was to ensure financial stability. It rose to the task admirably in this instance. The price was a dramatic pivot in market expectations of monetary easing. Market expectations of a series of rate cuts this year is simply unrealistic in the face of elevated and persistent inflationary pressures.

 

On the other hand, the latest Philadelphia Fed survey is pointing to a slowing economy. The Fed may be tightening into a recession. The average workweek plunged in March.

 

 

 

The new orders component of the survey also skidded to recessionary levels.

 

The ECB, which is only tasked with only fighting inflation, responded last week with a dovish rate hike. Its benchmark rate rose the widely expected 50 bps, but it withdrew forward guidance on the future trajectory of interest rates.  Its statement walked a tightrope between price stability and financial stability.

Inflation is projected to remain too high for too long…The Governing Council is monitoring current market tensions closely and stands ready to respond as necessary…The new ECB staff macroeconomic projections were finalised in early March before the recent emergence of financial market tensions

Will the Fed follow a similar path? The Fed hates to surprise markets, and, if I had to guess, it would raise rates by the expected 25 bps. But that leaves a lot of wiggle room for other actions to address the problems of price stability and financial stability. My base case scenario calls for the Fed to:

 

  • Repeat the mantra that inflation is too high and the Fed is committed to its 2% target.
  • Correct market expectations of rapid rate cuts in 2023 with a higher for longer message. All eyes will be on the Summary of Economic Projections (SEP), or “dot plot”, for the likely trajectory of interest rates. Also  keep an eye on changes in projected GDP growth as a signal of whether the Fed expects a recession.
  • A possible temporary suspension of the shrinkage of its balance sheet, or quantitative tightening,
    as a way of ensuring there is plentiful liquidity for the banking
    system and underline that it stands ready to provide additional support as needed.

 

How will the market react? Will it focus on the higher for longer message, which is equity bearish, or the Fed’s readiness to provide ample liquidity to the market as evidence of a Powell Put? Moreover, does the Fed revise its GDP growth projections in the face of the signs of a slowdown?

 

Stay tuned.

 

Banking panic: Another GFC or buying opportunity?

Posted by Cam Hui -
Mid-week market update: Just when you thought the Treasury Department, FDIC, and the Fed had the SVB debacle fixed, the market plunged today on the news that the largest shareholder of Credit Suisse had declined to inject further equity into the troubled bank. This is what a bank panic looks like. Financial stocks in the US and Europe are cratering, though they remain stable in China.

 

 

Is this another GFC, or a buying opportunity?

 

 

What a financial panic looks like

Central bankers and banking regulators have a well-known playbook for dealing with banking crises. If a troubled bank has a solvency problem (its asset book was good but depositors wanted their money), the central bank could provide liquidity. If the bank is insolvent, the banking regulator would take over, oust management, and try to merge the bank with a larger and well-capitalized buyer. The shareholders of the problem bank would take the first hit, followed by the bondholders.

 

During the GFC, when Bear Stearns failed, followed by Lehman Brothers, the Fed’s hands were tied because broker-dealers were beyond the Fed’s regulatory reach. The same problem was evident during the Russia Crisis that sank Long Term Capital Management (LTCM). LTCM was a hedge fund that was beyond the Fed’s reach. Fast forward to 2023, the problem first appeared at Silicon Valley Bank, and now the crisis of confidence has migrated to Credit Suisse.

 

Credit Suisse senior CDS recently traded at 1000 bps,which is an almost unheard of level, as explained by this Bloomberg article:
In the credit market, spreads of more than 1,000 basis points in one-year senior bank CDS are extremely rare. Major Greek banks traded at similar levels during the country’s debt crisis and economic slump. The level recorded on Tuesday is about 18 times the contract for rival Swiss bank UBS Group AG, and about nine times the equivalent for Deutsche Bank AG.
 

The CDS curve is also deeply inverted for the bank, meaning that it costs more to protect against an immediate failure, instead of a default further down the line. The lender’s CDS curve had a normal upward slope as recently as Friday. Traders typically ascribe a higher cost of protection over longer, more uncertain periods.

 

 

The panic can be seen in a lack of liquidity in equity and bond markets. Liquidity in the S&P 500 e-mini futures has plunged.

 

 

A similar situation has developed in the Treasury market as bid-ask spreads have widened.

 

 

 

Rays of hope

Amid the panic, here are some rays of hope. Insider buys (blue line) are exceeding sales (red line). They have been fairly good at spotting recent market bottoms.

 

 

Here is the pattern of insider trading during the Greek Crisis of 2011.

 

 

To be sure, insiders aren’t perfect. They were buying all the way down during the GFC, though their decisions turned out reasonably well based on a one-year time horizon.
 

 

 

From a technical perspective, the Zweig Breadth Thrust Indicator is at oversold levels that was only exceeded by the COVID Crash.
 

 

Current conditions indicate that risk/reward is tilted to the upside. at least in the short-term. Oversold markets can become oversold, but you would have to be betting on a catastrophic collapse if you are bearish. I believe that possibility is unlikely as the Central Banker Put is coming into play. The regulatory authorities have the situation under control and  they are prepared to act.Longer term, however, much will depend on the path of monetary policy. The upcoming ECB and FOMC decisions will yield more clues to the future.
 

 

Disclosure: Long SPXL
 

Trading the SVB panic

Posted by Cam Hui -
I know that financial stocks are more than just banks, they include financial conglomerates like American Express, broker-dealers, life and property and casualty insurers, and so on. But mark this day. This will be a financial panic to tell your grandchildren about. As the chart shows, the technical damage to the sector is considerable.

 

 

 

Contagion effects

The contagion effect can also be seen in small caps, which dropped along with large cap financials.

 

 

European financial stocks also skidded in sympathy. The good news is China is marching to its own drumbeat.

 

 

 

The dog that did not bark

Financial panics follow a well-known script. A crisis erupts. Investors rush for safe havens. Fiscal and monetary authorities step in to stabilize the situation.

 

Here’s what’s the same. Investors did rush for the safety of Treasury assets. The 2-year Treasury yield fell to 4.02% from over 5% last week. The Fed and Treasury Department played their part. It was fortunate that the crisis occurred within the banking system, which is within the Fed’s purview (unlike the Lehman Crisis which occurred within broker-dealers that the Fed couldn’t rescue). A solution was found and the Fed flooded the system with liquidity, as evidenced by the rally in crypto-currency prices.

 

Here’s what’s different this time. The rush into Treasury assets was not accompanied by a stampede into the USD. In fact, the USD weakened. Moreover, jitters were felt in Europe, even though there was no clear evidence that any European banks were in trouble at all.

 

These are some “dog that did not bark” observations. Why did the USD weaken? If the European banking is under stress, why did EURUSD rally? 

 

Historically, the USD has been inversely correlated with the S&P 500. These conditions lead me to believe that the panic is only temporary and the authorities have the situation under control. Animal spirits overwhelm rationality and a positive divergence is occurring between stocks and the USD.

 

 

In conclusion, this is a classic bank panic. The authorities have done their part and the damage should be contained. All financial markets except for stocks have behaved according to script. The stock market should bottom and rally from these levels.

 

 

Disclosure: Long SPXL
 

Will the Fed crash the stock market?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

Breaks at key support

A week ago, I wrote that I was bullish on the equity outlook, but the S&P 500 appeared to be extended short-term and the Powell testimony and Jobs Report could be sources of volatility (see China: Global bullish catalyst?). I was right on the volatility as Powell sounded a hawkish tone and the SVB crisis didn’t help matters. The S&P 500 violated its key support levels at the 50 dma and 200 dma. In addition, the equal-weighted S&P 500, the mid-cap S&P 400, and the small-cap Russell 2000 all blew through the bottom of descending channels.

 

 

Is this the End? Here are the bull and bear cases.

 

 

Bull case

In response to Powell’s remarks, Fed Funds futures is now discounting a 50 basis point move at the March 20 FOMC meeting and a terminal rate of 550-575 basis points. The 2-year Treasury yield spike above 5%, which is a high for this cycle before pulling back. These conditions should be very challenging for stock prices, but the S&P 500 only fell -3.1% from Friday to Thursday, which is the day before the Jobs Report. Is that all the Fed can do to dent the stock market?

 

Meanwhile equity risk appetite indicators are exhibiting positive divergences.

 

 

From a long-term perspective, the analysis of the 50 and 200 dma of the equity call/put ratio shows that sentiment is recovering from an excessively condition. The crossover of the 50 and 200 dma is a constructive sign that signals the start of a new bull leg in stocks.

 

 

 

The bear case

Here is the bear case. The Fed’s hawkish tone put a bid under the USD, which has been inversely correlated to equity prices. The USD Index has been range bound but it may be about to stage a major technical breakout, which would be negative for risk appetite.

 

 

Stock prices may also be facing headwinds from liquidity conditions. Fed liquidity is showing a negative correlation to the S&P 500. The lack of liquidity is a potential a headwind for the bulls, though the sudden banking crisis could compel the Fed to inject funds into the banking system.

 

 

From a technical perspective, the NYSE McClellan Summation Index (NYSI) is recycling from an overbought condition, but the stochastic hasn’t reached an oversold reading yet, which suggests further downside potential in the next few weeks.     

 

 

As well, different versions of the Advance-Decline Line are breaking below support, which is an ominous near-term development. Market breadth has sustained considerable technical damage. Unless stock prices can immediately reverse those losses, they may need a period of basing before they can rally higher.

 

 

 

The verdict

What’s the verdict? The S&P 500 has been consolidating sideways since it staged an upside breakout through a falling trend line in January. The upside breakout was constructive for stock prices, but until the consolidation period resolves itself either to the upside or the downside, it’s difficult to be definitive about direction. While I am constructive on stock prices, some caution needs to be warranted here.

 

 

Tactically, the market is poised for a relief rally. Three of the four components of my Bottom Spotting Model have flashed buy signals. The VIX Index has spiked above its upper Bollinger Band, which is an oversold market reading, the NYSE McClellan Oscillator is oversold, and TRIN spiked above 2 on Thursday, indicating price-insensitive selling, which is a characteristic of a margin clerk driven liquidation. Only the term structure of the VIX Index hasn’t inverted on a closing basis, though it did invert several times during the day on Friday.

 

 

Subscribers received an alert Friday that my inner trader had initiated a long position in the S&P 500 and he had bought into the panic. 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.

 

The headline volatility event next week will be the CPI report. The FOMC meeting will be in the following week on March 20. Brace for further choppiness.

 

 

Disclosure: Long SPXL
 

Double-dip recession of 1980-82 = False dawn of 2023?

Posted by Cam Hui -
One of these cyclical indicators is not like the others. While many cyclical industries are in relative uptrends, which is a technical signal of economic expansion, the 2s10s yield curve is deeply inverted and shows few signs of steepening. This is one of those occasions when the stock market and bond markets disagree.

 

 

Which market is right? Maybe they both are.

 

 

What’s Fed thinking?

Let’s start with the economy and the Fed’s reaction function. Fed Chair Jerome Powell and other Fed officials have been repeating the mantra that the Fed will continue its inflation fight until the job is done and inflation is at 2%.

 

Here’s a quick snapshot of the economy. The Atlanta Fed’s GDPNow estimate of 2.6% is signaling a strong expansion.

 

 

In addition, the US Economic Surprise Index has been rising, indicating economic data is surprising to the upside.

 

 

As the Fed has indicated it’s focused on the jobs market and wage growth in its inflation fight, here are some metrics to consider. Initial jobless claims have been flattening out and show uneven signs of rising even after all the monetary tightening.

 

 

Average hourly earnings, unit labor costs, and the employment cost index are all decelerating, but readings remain elevated. While recent signs of disinflation are welcome, services inflation has been sticky on the way down and the journey from 4-5% to 2% inflation could be much harder than anyone thinks.

 

 

That’s because, in light of the Fed’s hyper focus on wage and services inflation, Steno Research argues that China’s credit impulse leads ISM services price. That makes China’s recent stimulative policies bad news for inflation in H2 2023.

 

 

As well, San Francisco Fed President Mary Daly warned that reshoring could raise the demand for labor and push up inflationary pressures:
 

If firms decide to reshore some or all of their foreign production facilities, costs and prices are likely to continue to rise. My conversations with business leaders suggest that some of this is already happening…a trend toward less global competition could mean more inflation in the goods sector and more pressure on overall inflation going forward.

Moreover, the combination of a decline in the labor force participation rate and low immigration is restricting labor supply and putting upward pressure on wages.
Another potential factor affecting future inflation is the ongoing domestic labor shortage. Labor force participation fell precipitously during the pandemic and has been slow to recover, especially among workers aged 55 years and older. These developments exacerbate the already significant downward drag on participation related to population aging. Absent a substantial pickup in the share of working-age adults looking to be employed or a large change in immigration flows, labor force participation will continue to decline and worker shortages will persist, pushing up wages and ultimately prices, at least in the near and medium term.
She concluded that “further policy tightening, maintained for a longer time, will likely be necessary”.

 

Even more worrisome is a Kansas City Fed study that linked tight labor markets to rent inflation. With the Fed focused on services inflation, rents have been a major component of CPI and especially services inflation.

 

 

The study found that tight labor markets affect rent inflation because of “greater demand for rental units afforded by job gains and wage growth”.
Rent inflation responds more to labor market conditions compared with other components of inflation. We attribute this link between labor market tightness and rent inflation to greater demand for rental units afforded by job gains and wage growth. Although online measures of asking rents currently suggest official measures of rent inflation will decline, we caution that rent inflation is likely to remain above pre-pandemic levels so long as the labor market remains tight.
As a consequence, Fed Chair Jerome Powell sounded a hawkish tone during his Congressional testimony and put a 50 bps rate hike on the table for the next FOMC meeting.

 

 

What’s bond market thinking?

Here’s one way of squaring the circle of disagreement between the stock and bond markets. The accompanying chart shows two cyclical indicators, the 2s10s yield curve and the copper/gold ratio. The historical evidence shows that the 2s10s yield curve normalizes about 1-3 before a recovery in the copper/gold ratio. 

 

Fast forward to 2023. As investors have already observed from stock market internals, cyclical industries are roaring ahead, just like the copper/gold ratio. This presents a problem for the Fed. How can it control inflation when readings at still elevated and, if current signs of an expansion are correct, it would lead to further inflationary pressures? The answer is more monetary tightening that’s beyond market expectations. Current conditions are reminiscent of the double-dip recession of 1980-1982, when the Fed reversed its accommodative policy and tightened to extremely painful levels. Instead of a double-dip, current recovery expectations are likely to be a false dawn.

 

Bond market expectations are already reflecting the false dawn scenario. The 2-year Treasury yield, which can be thought of as a proxy for market expectations of the terminal Fed Funds rate, is making a new high for the cycle. Historically, peaks in the 2-year rate have been either coincident or led peaks in the Fed Funds rate, though the signal has shown a hit-and-miss record on stock market timing. Bottom line, the peak in the 2-year rate is ahead of us, which raises the uncertainty of any Fed Funds forecast.

 

 

 

Will the Fed break something?

In the past, Fed tightening cycles always breaks something. Nothing has broken yet in the current cycle, but the behavior of bank stocks is concerning. Banks tend to borrow short and lend long, and therefore the shape of the yield curve affects profitability. It’s no surprise that the relative performance of banks is correlated to the yield curve, but the recent violation of relative support by bank stocks and the SVB Financial Group and Silvergate Capital debacles could be the signal of rising stress in the banking system.

 

 

These circumstances lead me to believe that the combination of a cyclical rebound and elevated inflation rates raises the odds of a double-dip recession. While history doesn’t repeat itself but rhymes, the 1980-1982 experience may be a useful template to think about the stock market. In that case, current market conditions puts is at about Q2 or Q3 1980. Brace for volatility.

 

 

In addition, the 2s10s yield curve is also pointing toward a false dawn recovery. In the past, yield curve normalization leads the copper/gold ratio, which is a key cyclical indicator, by 1-3 years. The 2s10s yield curve hasn’t even begun to normalize in any signification fashion yet but the copper/gold ratio has turned up. This “false dawn” pattern is highly reminiscent of the 1980-1982 experience.

 

 

In conclusion, current equity market expectations of a cyclical recovery is simply unrealistic in light of the Fed’s focus on 2% inflation. Any signs of growth will be met with tighter monetary policy that will have the effect of pushing the economy into recession. While history doesn’t repeat itself but rhymes, the current situation is highly reminiscent of double-dip recession of 1980-1982. While the technical conditions are still constructive for stock prices, investors are advised to be prepared to revise their risk profile as conditions may change later this year.
 

China: Global bullish catalyst?

Posted by Cam Hui -

Preface: Explaining our market timing models 

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

 

The Trend Asset Allocation Model is an asset allocation model 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
  • Trend Model signal: Bullish
  • Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.
 

 

America the weak?

This chart of the Euro STOXX 50, MSCI China, and S&P 500 (all in USD) tells a story of differing relative strength. The Euro STOXX 50 has been flat since early February the best relative performer. MSCI China has been correcting, but turned up last week when Hong Kong announced that it was eliminating its COVID mask mandate. In addition, China’s PMI data came in better than expected, indicating expansion. The S&P 500 topped out mid-February and its bottom lagged both Europe and China.
 

 

Let’s briefly review the performance and backdrop of each region.

 

 

US: Fed-induced headwinds

Good news is bad news in America. January core durable goods rose 0.7% from -0.4% in December (consensus 0.1%). January pending home sales surged by 8.1% (1.0% expected). Q4 unit labor costs rose 3.7% (1.6% expected), which is a signal of wage pressures. However, the Institute of Supply Management (ISM) Manufacturing PMI rose slightly from 47.4 to 47.7 but missed expectations (vs. 48.0 consensus).

 

Fed Funds futures are discounting three consecutive quarter-point rate hikes, followed by a plateau until early 2024. Past expectations of any rate drops in late 2023 are gone. Powell’s Congressional testimony Tuesday and Wednesday should bring further clarity to Fed Funds expectations and be a source of potential market volatility.

 

 

From a bottom-up perspective, the results of Q4 earnings season landed with a thud. The Street is cutting forward 12-month EPS across all market cap bands.

 

 

It’s not a pretty picture.

 

 

Europe: Still the leader

On the other hand, a relative performance analysis shows that eurozone equities have been the leaders since the October bottom. Most notably, standouts were France and Greece (yes, that Greece).

 

 

Since the October bottom, industrial and financial stocks have shown the greatest relative strength in Europe, which are signals of cyclical strength. Bloomberg reported that the “EU Seeks Trade Deal With US to Unlock EV Benefits” and it’s seeking to clinch the outline of an accord that could allow US consumers get IRA tax credit for EU vehicles. Such news could provide a boost to the European auto sector and further improve sentiment for European equities.

 

 

 

China: From re-opening to recovery?

The bull case for China may be evolving from an re-opening story to a recovery story. A Bloomberg article indicated that China’s reopening trade may be unraveling: “Hedge funds who piled into the rally late last year are rapidly trimming risk. Key stock benchmarks in Hong Kong have fallen more than 10% from their January peaks. Bond outflows have resumed.” Alibaba, which is an approximate proxy for hedge fund exposure to China, recently became oversold based on its 14-day RSI. Oversold conditions in the last year have resolved in price rebounds.

 

 

 

A different Bloomberg article tells a story of renewed optimism: “China’s Upcoming Congress Spurs Optimism on Mainland Stocks” as “investors say NPC meeting to deliver bigger windfall onshore”. Hong Kong and Chinese equities surged last week when John Lee, the city’s the chief executive, announced eliminated mask mandates.

 

An analysis of my China re-opening indicators tells a mixed story. On one hand, the pullback in Chinese equities and the equity markets of China’s major Asian partners is very real. While the USD-denominated performance of the Japanese market has moved sideways against the MSCI All-Country World Index (ACWI), other Asian markets have violated either rising relative trend lines or relative support, indicating market expectations of weakness and underperformance.

 

 

On the other hand, a review of the relative performance of key sectors within the Chinese market leads to a more constructive conclusion. Material stocks are still turning up relative to MSCI China, which is a market signal of strong commodity and materials demand from Chinese infrastructure investment. As well, the real estate and financial sectors are also exhibiting signs of relative turnarounds, which are signals that Beijing’s policies to support the property market are having their effect. However, consumer discretionary and internet stocks, which are dominated by giants like Alibaba and Tencent, whose businesses are sensitive to consumer spending, are still lagging.

 

 

This update of the China market internals tells a mixed, but constructive picture. While the initial market enthusiasm over the re-opening story has faded, underlying indicators of a cyclical rebound from market and sentiment indicators are still positive. 

 

 

The geopolitical tail risk is a Chinese decision to supply arms to Russia. While it has sent non-lethal aid such as helmets and dual-use items such as aircraft parts in the past, sending weapons such as artillery shells to bolster Russia’s depleted stocks would be a game-changer in Sino-Western relations. It risks the imposition of sanctions and could crater the Chinese economy. Goodbye re-opening. Goodbye recovery.

 

However, if the current trend were to continue, the market should see more concrete signs of a cyclical rebound by Q2. The bull case for China appears to be evolving from a re-opening story, which became overbought and faded, to a longer-lived recovery story.

 

With Europe still the global leaders and China and Asia showing signs of a bullish turnaround, US equities are likely to be laggards for the remainder of this year.

 

 

The week ahead

Look into the week ahead, the S&P 500 regained its 50 dma but it looks extended on the hourly chart. The 5-hour RSI has exceeded 90, which is a level that has led to short-term pullbacks in the last three months. Before you jump on the bulls’ train, Powell’s Congressional testimony Tuesday and Wednesday and Friday’s Jobs Report could be sources of volatility.

 

 

My inner investor remains bullishly positioned. Subscribers received an email alert on Friday that my inner trader had taken profits on his long S&P 500 position. He is standing aside for better opportunities. In all likelihood, we will see some weakness in the coming week. Keep an eye on whether positive or negative divergences develop should the index retreat and re-test its early March lows.

 

Publication note:  I am scheduled for a cataract operation on my eye Monday. There will be no mid-week market update next week as I expect to be out for the week. I will try to publish at least an abbreviated note next weekend, but that will be dependent on the progress of my recovery.

 

A tale of two bubbles

Posted by Cam Hui -
It was the best of times. It was the worst of times. The S&P 500 (SPX) remains in a well-defined uptrend, but the NASDAQ 100 (NDX), which represents large-cap growth, violated an uptrend that stretches back to the GFC. The relative performance of the NASDAQ 100 to the S&P 500 shows a similar trend break that’s somewhat reminiscent of the Tech Bubble top of 2000. Moreover, the recent relative performance of speculative growth stocks, as measured by ARK Investment ETF (ARKK), is similar to the post-2000 Bubble bust.

 

 

 

Growth poised for a recovery?

Is this the bottom for growth stocks? The dark line in the lower panel depicts the relative performance of the NDX to the SPX, normalized to the price action in the last 12 months. The shaded regions show periods when the NDX has been oversold relative to SPX and reached an area of relative support. With the exception of the 2000-2002, relative oversold periods at relative support have been good times to buy NDX for superior relative performance.

 

 

NDX is now recycling off oversold. Does this mean that the worst is over for growth stocks?

 

 

This time is different

History doesn’t repeat itself but rhymes. Not all growth stock bubbles are the same. At the 2000 top, the NASDAQ 100 was full of companies with unprofitable companies with insane valuations. Fast forward to 2023, large-cap growth stocks are mostly profitable, cash generative, and have strong competitive positions. By contrast, the performance of speculative growth stocks as proxied by ARK Investment ETF (ARKK) far more resembles the behavior of growth stocks in the post-bubble bust of 2000-2002.

 

To be sure, large-cap growth is richly valued and have come to represent about 40% of S&P 500 weight. Consider, for example, that the S&P 500 trades at a forward P/E premium of 3-4 points compared to the mid-cap S&P 400 and small-cap S&P 600. Moreover, the history of forward P/E by market cap shows that the large-cap premium wasn’t evident until 2020, the onset of the pandemic.

 

 

 

A question of leadership

The dominance of FANG+ large-cap growth in the S&P 500 begs another question. US equities have been leading non-US since the GFC. Much of the outperformance is attributable to the superior fundamentals and earnings growth from FANG+ names. Now that the NASDAQ 100 has violated its uptrend, can US equities continue to lead?

 

US equities also trade at a considerable premium forward P/E to the rest of the world. Unlike the P/E history of US forward P/E by market cap, the US valuation premium had been relatively modest until about 2016, when it began to widen against the rest of the world.

 

The question of future market leadership can be distilled as, “Are the FANG+ stocks gone ex-growth in their earnings outlook?”
 

On one hand, the recent scramble over natural language AI is a sign that competitive barriers are crumbling, as evidenced by investor concerns over the AI threat to Google in search. Facebook’s uneven pivot to the Megaverse is another example that the growth trajectory for social media may be decelerating. Netflix’s initiatives to limit password sharing is another sign that the company is reaching the limits of subscriber growth. By contrast, Apple’s research initiatives for non-invasive blood glucose monitoring opens up an enormous medical device opportunity for the Apple Watch.

 

In all likelihood, faltering large-cap growth is putting US global equity leadership on borrowed time. Investors should keep an eye on the evolution of relative performance. Should the S&P 500 violated any relative uptrend compared to either EAFE or EM, it will be a definitive signal to decisively rotate into non-US equities for better performance in the next cycle.

 

 

 

Publication note: I am scheduled for a cataract operation on my eye Monday. There will be no mid-week market update as I expect to be out for the week. I will try to publish at least an abbreviated note next weekend, but that will be dependent on the progress of my recovery.