We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Poised for a rebound
Numerous historical studies of volatility spikes have concluded that such episodes are good buying opportunities for stocks.
The accompanying chart shows just one example of what happens when the VIX Index surges above 45 and recycles below 30. The market has been higher every single time. The only question is whether the market re-tests its old lows.
If stock prices are poised for a rebound, the next question is the nature of the leadership of the ensuing rally.
The crowded trade reset
Let’s first begin with a review of the market backdrop.
Admittedly, psychology had become a little too giddy and was due for a reset. The Euphoriameter from Callum Thomas of Topdown Charts shows that sentiment had become a little too frothy and the recent market setback can be considered to be an opportunity for a welcome reset.
Longer term, growth stocks have been on a tear against value stocks since the GFC. The trend may have become excessive. The divergence between U.S. growth and value and EAFE growth and value became evident with the onset of AI investing mania in early 2023.
The recent risk-off episode may be the signal of a reset of the growth and value relationship.
The rotation continues
The accompanying chart shows the relative performance of the value and cyclical sectors of the S&P 500. All turned up when the S&P 500 topped out in early July.
By contrast, here is the relative performance of growth sectors. Only Communication Services have been flat against the S&P 500 in the past year. Technology and Consumer Discretionary, which are dominated by heavyweights Amazon and Tesla, turned down when the market topped in July.
In particular, the absolute and relative performance of technology stocks has been weak, and so is their relative breadth indicators (bottom two panels).
Growth stocks, as represented by the NASDAQ 100, aren’t sufficiently washed out to form a relative bottom (black line).
By contrast, a bottom-up review of deep value stocks is presenting greater buying opportunities. My Leveraged Buyout screen of non-financial stocks in the S&P 1500 (see How to buy a company with no money) revealed 38 candidates that pass the screen of buying the company with no more than 30% of the stock price and borrowing the rest, compared to 25 candidates at the end of July and 25 at the end of June.
The biggest surprise on the LBO list was the Tech Bubble favourite Cisco Systems, which is trading at a forward P/E of 12.7.
Small-cap stocks also look intriguing. If we use the relative performance of high yield (junk) bonds to their duration-equivalent Treasuries (black line) as a proxy for risk appetite, the small-cap/large-cap ratio (red line) began to diverge from high yield in early 2019 and recently fell to 20-year lows.
Tactically, small-cap indices have retreated back to their absolute and relative trading ranges after failed upside breakouts. Upside breakouts would be confirmations of renewed leadership by these stocks. I remain constructive.
Welcome signs of normalization
Since the recent volatility storm originated in the derivatives market, I am seeing welcome signs of normalization in the option market that lays the foundation for a stock market rebound in the week ahead.
The VVIX, which is the volatility of the VIX, has begun falling in line with the decline in the VIX. I interpret this as falling expectations of higher future volatility.
In conjunction with a falling VVIX, the term structure of the VIX has also normalized from inversion, indicating receding fear levels.
The SKEW Index, which measures the relative cost of tail hedges, rose above its 200 dma even as stock prices rebounded. Rising cost of downside protection in the face of market strength is a useful contrarian signal.
As always, there are no guarantees in trading, but these are constructive signs that the bulls are taking control of the tape. Look for an O’Neil Follow Through Day in the coming week for bullish confirmation. A follow through day can occur as soon as day 4 (last Friday) of a rally. It’s defined as the index rising 1% or more on higher volume than the previous day. The most powerful follow through days occur between day 4 and day 7 of the rebound.
In conclusion, the market is poised for renewed strength. A review of market leadership shows weakness by technology and other large-cap growth stocks. I believe the rotation from growth to value and from large caps to small caps will continue and these stocks will be the new leadership in the next leg up.
My inner trader continues to hold a long position in small caps. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
After strengthening rapidly, the Japanese Yen (bottom panel) has stabilized has stabilized in the 140-150 range. The 10-year Treasury-JGB spread also stabilized and found support. So did the Nikkei Average after suffering the greatest one-day decline since the Crash of 1987. The Bank of Japan sounded a dovish tone when deputy governor Shinichi Uchida said that the Bank would “refrain from hiking interest rates when the markets are unstable”. In addition, Bloomberg reported that “JPMorgan says three quarters of global carry trades now unwound”.
Is it all over? It’s time to assess the damage from the latest fright by diagnosing what sparked the sell-off.
Even though many market observers focused on the currency carry trade as the source of the mini-panic, I argue that the carry trade unwind was only a symptom of what’s plaguing the markets.
A complacency unwind
Joe Wiesenthal and Tracy Alloway at Bloomberg conducted a series of podcasts that explain the roots of the latest panic. It wasn’t just the unwind of the leveraged Yen carry trade, it was an unwind of a series of trades based on the complacency that the markets were going to stay in a low-volatility stable environment.
Here is a recent interview with Charlie McElligott, cross-asset macro strategist at Nomura, who pointed out that complacency manifested itself in the form of investors piling into a series of volatility selling products to enhance income. Things weren’t going to end well, it was just a question of when.
A different interview in January 2024 with Kris Sidial, Co-CIO of Ambrus Group, about the return of the short volatility trade and how investors forgot the lessons of Volmageddon told a similar story of complacency.
A separate interview in June 2024 with Michael Purves, CEO and founder of Tallbacken Capital Advisors, and Josh Silva, managing partner and CIO at Passaic Partners, on how the dispersion trade is another manifestation of complacency. The dispersion trade consists of investors using equity options to bet on the relative volatility between single stocks and stock indexes. For example, someone might buy volatility in a basket of individual stocks using single stock options while simultaneously shorting volatility in an index like S&P 500 is going to stay relatively low. This works if individual stock volatility is high while index volatility stays low and boring, which it was, until it wasn’t.
All of these derivative trades, including the carry trade, depend on a low volatility market environment. These trades saw a violent reversal when the market consensus suddenly shifted from a U.S. soft landing to pricing in the possibility of a hard landing.
In the space of a few days, initial jobless claims unexpectedly rose to a one-year high. A weaker-than-expected July Payroll report pushed the unemployment rate from 4.1% to 4.3%, which triggers the Sahm Rule as a recession indicator. Moreover, the Bank of Japan took a hawkish pivot by raising rates and tapering its quantitative tightening program. As Joe Wiesenthal put it:
In that moment that the “things are calm and will stay that way” bets get into trouble. So you have the collapsing yen carry trades. And you have the exploding VIX demolishing the short-volatility trades. And you have rising correlations busting dispersion trades. And of course any kind of long stock bets are implicitly short volatility trades, and you get this plunge in the hottest names in the market (like Nvidia and other MAG 7 companies).
In other words, it wasn’t just the carry trade that caused the panic.
Volatility spike = Panic bottom
Here is the good news. The accompanying chart shows the hourly swings in the S&P 500 since 2002. Episodes of hourly swings of +/- 2.5% coincided with market bottoms. The only question is timing and whether the stock market sees a short-term bottom or continues to fall after the initial volatility spike.
There appears to be two categories of bottoms. Sudden panics, usually from unexpected reversals of crowded positions, reverse themselves quickly. Longer term declines occur when the roots of the decline are macro or fundamentally driven, such as the GFC in 2008, the eurozone crisis of 2011, and the COVID Crash of 2020. In all cases, stock prices were higher a year later.
The latest panic appears to be in the first category. Stock prices are poised for a recovery.
Three of the five components of my Bottom Spotting Model flashed buy signals in the last week. The VIX Index spiked above its upper Bollinger Band, which is an oversold signal; the term structure of the VIX inverted, indicating fear; and the NYSE McClellan Oscillator fell to an oversold condition. In the past, the market has bottomed whenever two or more components triggered buy signals.
IPO stocks are turning up on a relative basis, which is a sign of the revival of the market’s animal spirits.
In addition, forward 12-month EPS estimates are still rising. This is a sign of positive fundamental momentum that’s supportive of higher stock prices. Hard landings don’t look like this.
Key risk
For traders, the key risk to the benign V-shaped recovery scenario is a Long-Term Capital Management (LTCM) style hedge fund blowup that threatens the stability of the financial systems. Even if the latest volatility spike caused a hedge fund to unravel, rest assured that central bankers have a well-worn playbook for dealing with financial crises. Flood the system with liquidity, and find one or more partners. Under such a scenario, expect a rally off the initial low, and a re-test of the old low about a month later.
Here is what I am watching. If stresses are appearing in the financial system, it should show up in credit yield spreads. So far, credit spreads have widened, but they haven’t spiked. The financial system doesn’t appear to be in crisis.
Market psychology is jittery, which is a recipe for higher volatility. As an illustration, the 2.3% rally of the S&P 500 in response to a noisy high frequency data release such as initial jobless claims shows the jittery nature of market psychology. While the initial claims report was modestly constructive, continuing claims show a gentle upward path. How will the market react next week if it encounters a disappointing economic report, or if Iran retaliates against Israel?
In conclusion, the recent disorderly risk-off episode can be attributed to the unwind of a series of trades that depend on a low-volatility and complacent environment. Historically, such unwinds have resolved in volatility spikes and higher equity returns soon afterwards. The current environment is supportive of a quick market recovery, though the risk of a LTCM-style blowup could see a longer and more complex market bottom.
Mid-week market update: Is the worst of the Japanese risk-off episode over? The Nikkei formed a bullish harami pattern when it recovered on Tuesday, but the recovery candle formed an “inside day” compared to Monday’s massive downdraft. As well, BOJ deputy governor Governor Shinichi Uchida calmed markets and struck a dovish tone when he said that the Bank would “refrain from hiking interest rates when the markets are unstable”.
While I am hopeful that the worse of the panic is over, I have some nagging doubts. Here’s why.
Insufficient fear
While most historical studies of sudden volatility spikes from an unexpected reversal of crowded positions have resolved in higher stock prices over time horizons of one month or more, I am seeing possible signs of insufficient panic that may resolve in further near-term weakness.
The accompanying chart shows the evolution of the VIX Index (bottom panel) and SKEW (middle panel), which measures the cost of downside tail-risk protection. Even though SKEW has risen, it is only in the middle of its recent historical range. Where’s the fear?
Here is the same chart in 2015 at the time of the surprise Chinese yuan devaluation. The S&P 500 skidded in response to the news and VIX spiked. SKEW was low at the time of the even, and took 2-3 weeks to rise the reflect increased downside protection costs. Stock prices weakened to retest its lows about a month after the initial low.
Here is the Volmageddon downdraft of 2018, which was caused by excessive crowding into short volatility products. VIX surged. SKEW also rose dramatically afterwards from historically low levels. Even though the S&P 500 pulled back about three weeks later, the sudden and dramatic increase in SKEW may have mitigated some of the downside equity price risk on the pullback, though the market did weaken to test its lows about two months later.
Fast forward to 2024, this hourly chart of the VIX Index and VVIX, which is the volatility of the VIX, shows that while VIX has declined, VVIX remains elevated, indicating residual anxiety in option volatility pricing.
Admittedly, this historical study has a very small sample size (n=2). Other volatility spikes, such as the one in 2008 (GFC) and in 2020 (COVID Crash) were macro driven and had longer lasting effects on the economy, which is not likely in the current circumstances. Nevertheless, the lack of strength in SKEW is worrisome.
Downside catalyst
One source of possible downside volatility is the looming threat of an enlarged Middle East conflict. News sources report that U.S. intelligence believe that an Iranian attack on Israel could come as early as late this week or the coming weekend.
There was also this report that Egypt had advised its airlines to avoid Iranian airspace overnight Thursday.
While I have no idea of the timing of an Iranian attack against Israel, even the threat of an attack will unsettle markets and trading desks won’t want to be long risk over the weekend. Don’t be surprised if the stock market sees a setback on Thursday and Friday.
In conclusion, how traders position themselves in the wake of the latest volatility storm is a matter of risk and time horizon. It’s likely that stock prices will be higher 1-3 months from now, but how the market gets to those higher prices is an open question. My inner trader continues to hold a long position in small caps. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Over the weekend, I wrote that risk appetite is at the mercy of the carry trade (see The carry trade as risk driver). I did not expect that the Yen would continue to skid badly and the Nikkei would crater by -12.4%, which is its worse one-day decline since the Crash of 1987. While correlation isn’t causation, and the price scales are different, the Nikkei has shown a close correlation to the NASDAQ 100 in the last year.
The carnage in Japan was so bad that it prompted some people in my social media feed to distastefully quip about seppeku, or Japanese ritual suicide. While it’s impossible to know in real-time when the panic ends, here are some clues on how to navigate the Seppeku Panic of 2024.
A leveraged position unwind
The VIX Index spike above 65 overnight before retreating, which is a level last seen in 2008 at the height of the GFC, and 2020 during the COVID Crisis. Both episodes had legitimate reasons for fear to soar. 2008 saw the global financial system close to the brink, and 2020 saw the global economy come to a sudden stop. What happened this time? The near-term catalyst is a position unwind of a leveraged carry trade that poses minimal systemic risk. The VIX closed the day at 38.56. As a frame of reference, a VIX of 40 implies an average daily swing of about 2.5%, which isn’t sustainable.
As a reminder, a carry trade is when a trader shorts a low-yielding currency and buys a high-yielding one. Nautilus Research identified one popular pair, long Australian Dollar/short Japanese Yen, and found that dislocations in AUDJPY tended to resolve in risk-on rebounds soon afterwards.
Nevertheless, the panic has overwhelmingly shifted the market consensus to a 50 basis point cut in the Fed Funds rate in September, with some observers calling for an intra-meeting rate cut. This is what panic looks like. An emergency rate cut would exacerbate the sell-off, as it would narrow the USD-JPY yield spread and push JPY even higher.
Spotting the panic crescendo
The only question is timing. How do we identify the crescendo of the panic?
One indicator to monitor is the shape of the VIX curve. The 3-month/1-month VIX has inverted, which is a sign of severe panic. The 1-month/9-day VIX has already been inverted for over a week. This is an indication of extreme fear.
Another is to watch for divergences between the VIX and VVIX, or the volatility of the VIX. If the VIX keeps rising but VVIX doesn’t respond, that may be a sign of panic exhaustion. However, the elevated VVIX reading may point to a higher for longer volatility regime.
Similarly, the failure of S&P 500 and other U.S. equity indices to hold its intra-day rally is disturbing. Brace for more aftershocks.
My inner trader is maintaining his long position in small caps. He is waiting for signs of stability in the coming days to add to his position. 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.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Watch the Yen
Even as equity markets turn risk-off, the real driver of risk appetite may be coming from cross-asset considerations and determined by hedge fund risk management policy. The combination of a hawkish shift in BOJ monetary policy and an easier tone to Fed policy has forced an unwind of the Yen carry trade. For the uninitiated, carry trades are where a investor borrows in a low yielding currency such as the Japanese Yen and invests the proceeds in a high yielding one. Since the yields spreads are relatively small, hedge funds take on carry trades with leverage, and lots of it.
A carry trade unwind forces carry traders to flatten their positions. As the positions are taken on with leverage, a rush for the exits by leveraged traders is exporting cross-asset volatility to the rest of the hedge fund’s book, which forces a de-risking and deleverage of other asset classes. That’s how disorderly panic sell-offs happen.
Is the panic over? From a technical perspective, both the 10-year Treasury-JGB yield spread and the Japanese Yen are testing the support zones, which may serve to stabilize asset prices as the USDJPY consolidates in the support zone.
What’s the downside risk?
Turning to the U.S. equity market, here are bull and bear cases as the S&P 500 violated its 50 dma.
The bulls will argue that downside risk is limited at these levels, barring some unexpected exogenous event. The index tested its 50% retracement level at 5300. The stochastic has recycled from oversold to neutral, which is a tactical buy signal, and the 5-day RSI is exhibiting a positive divergence.
The bears argue that the index exhibited an island reversal pattern with a measured target of 5100.
Nearing a bottom
Notwithstanding these the carry trade crosscurrents, conventional technical analysis that strictly focuses on the U.S. equity market leads us to believe that a bottom is near and near-term downside is limited.
Two of the five components of my Bottom Spotting Models have flashed buy signals again. The VIX Index has spiked above its upper Bollinger Gand, indicating an oversold condition, and the term structure of the VIX is inverted, indicating fear.
Goldman’s U.S. Panic Index, which is composed of a rolling percentile of four equity volatility indicators, has spiked to levels consistent with past short-term bottoms.
As we proceed through Q2 earnings season, the good news is forward 12-month EPS estimates are rising, which is an indication of fundamental momentum. The bad news is the sales beat rates are well below historical norms.
A question of leadership
If the market is bottoming, the bigger question is, what leads the market upward in its anticipated rebound? I am inclined to be cautious about the old AI-driven leadership. In particular, the semiconductor stocks, which have been the poster child of the AI investment theme, and have been unable to overcome overhead resistance after violating a rising trend line in June. The relative performance chart (bottom panel) especially highlights the weakness of this group as it tests its 2024 relative lows.
I would look for leadership in small cap and value stocks. Even as the S&P 500 violated its 50 dma, small caps holding above their 50 dmas.
The superior relative performance of value over growth is evident across all market cap bands and internationally.
There is a distinct difference in breadth between NYSE issues, which tend to tilt towards value, and NASDAQ, which are growth oriented.
These trend changes have been abrupt, but they look sustainable.
From a fundamental perspective, Magnificent Seven earnings growth is expected to decelerate, while earnings growth for the rest of the S&P 500 is expected to rise. This is supportive of my rotation from growth to value investment theme.
In conclusion, risk appetite is undergoing a cross-asset carry trade-driven panic and a bottom is near. The equity market is sufficiently oversold and poised for a relief rally. Barring some unexpected exogenous event, downside risk is limited at these levels. Expect a short-term relief equity rally into August, led by small caps and value stocks.
My inner trader remains long small caps. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
The U.S. economy is showing signs of weakness. The Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has been trending down. In addition, Chair Powell has more or less made it clear that a September rate cut is in the works, as long as the inflation data stays low. The Fed doesn’t need any further softening in the labour market to reduce interest rates. He laid out the Fed’s reaction function this way at the post-FOMC press conference:
If we were to see…inflation moving down quickly, or more or less in line with expectations, growth remains let’s say reasonably strong and the labour market remains consistent with its current condition, then I would think that a rate cut could be on the table at the September meeting. If inflation were to prove sticky and we were to see higher readings from inflation, disappointing readings, we would weigh that along with the other things.
Moreover, the jobs market doesn’t need to cool any further for the Fed to cut:
I don’t now think of the labour market in its current state as a likely source of significant inflationary pressures. So, I would not like to see material further cooling in the labour market.
Financial markets have been rattled by the prospect of weaker growth. The key questions for investors are:
Is a rate cut too little, too late to stave off a downturn?
Has market psychology turned and bad news is now bad news?
What’s bothering markets?
Two data points rattled the markets. First, initial jobless claims unexpectedly rose to a one-year high. Continuing claims also showed signs of strength, indicating a weakening labour market.
Moreover, the weaker-than-expected July Payroll report pushed the unemployment rate from 4.1% to 4.3%, which triggers the Sahm Rule as a recession indicator. In the wake of the soft jobs report, the market consensus suddenly shifted from a quarter-point to a half-point cut in September.
The markets were also unsettled by unexpected weakness in the ISM Manufacturing PMI and continued a trend of disappointing ISM readings.
Too little, too late?
Is a rate cut a case of too little, too late?
Let’s begin with the reasoning behind a rate cut. The Fed Funds rate (blue line) has held steady while core PCE inflation (red line) has been falling. This raises the real Fed Funds rate and it is a de facto tightening of monetary policy. It’s time to cut. The only question is timing.
The economy is softening, both at the high end and the low end. The CFO of luxury goods maker LVMH recently observed in an earnings call that there is a “severe demand issue in champagne”, explaining that “champagne is quite linked with celebration, happiness, et cetera. Maybe the current global situation, be it geopolitical or macroeconomic doesn’t lead people to cheer up and to open bottles of champagne.” By contrast, French fry supplier Lamb Weston said: “the operating environment has changed rapidly during fiscal 2024 as global restaurant traffic and frozen potato demand softened. In fact, the downward traffic trends accelerated during the back half of the year and into early fiscal 2025”.
Leading indicators of the jobs market are also signaling weakness. Both temporary employment and the quits to layoffs ratio have been trending down, which are indications of a cooling labour market.
This doesn’t mean, however, that economic conditions are recessionary. Claudia Sahm, the former Fed economist who coined the Sahm Rule to spot recessions, said in a Fox Business interview that a recession is not imminent, even though the Sham Rule was (then) close to triggering.
She pointed out a key anomaly in the current circumstances. What’s really unusual is new job entrants to the labour force aren’t losing their jobs compared to last Sahm Rule recessionary triggers. Sahm attributed this to the effects of immigration: “Increased labour supply from immigrants pushing up unemployment and not a sign of weakening demand as is typical in a recession.”
Despite all the hand wringing over the Sahm Rule trigger, the prime age employment to population ratio and participation rates rose to multi-decade highs. These are the signs of a strong economy and not one that’s falling into recession.
A soft landing
Putting it all together, I believe the U.S. economy is undergoing a Goldilocks, not too hot and not too cold, economic soft landing. The monthly NFIB Optimism Index is a good indicator of the economy for two reasons. First, small businesses have little bargaining power and they are good barometers of the growth outlook. In addition, small business owners tend to be small-c conservative and lean Republican, which is an important indicator during an election year.
The NFIB divides its Optimism Index into hard data and soft data expectations. To no one’s surprise, there is a wide gulf between hard and soft data when a Democrat is in the White House. However, hard data optimism has been trending down, while soft data optimism has been trending up. Moreover, the latest readings show that both components have ticked up, indicating greater optimism and reduced recession risk.
The trend in real GDP growth and real final sales are strong. Even though growth rates may decelerate, recessions don’t look like this.
New Deal democrat, who monitors the economy based on a set of coincident, short-leading, and long-leading indicators, observed improvements in his short-leading and coincident indicators:
With the flattening of the 2 vs. 10 year Treasury yield, that spread becomes neutral. Additionally, real money supply continues to get “less bad.” On the other hand, mortgage applications. The remaining indicators have slowly changed back to either neutral or positive.
Both the short leading indicators and the coincident indicators have generally been improving over the past few months, albeit with some noise. The decline in the price of gas has been, as usual, well received. The coincident indicators, driven by strong consumer spending and more time inflation, are very positive.
In addition, productivity gains are strong, which sets the stage for non-inflationary growth.
For equity investors, whether the economy is recessionary or pre-recessionary matters. Analysis from Goldman Sachs shows that the stock market has continued to rise in past rate cuts if the economy continues to grow, but fallen if the economy is in recession.
Mid-week market update: This week has been full of major market moving events. The BOJ raised rates and announced it would half its bond buying program. The announcement spiked the JPY and set off a scramble to unwind the carry trade. The Fed kept rates unchanged today, but hinted strongly at a September rate cut. Hamas leader Ismail Haniyeh was assassinated in Iran, which raised the risk of a regional war and rising oil prices. We will also get the BOE decision tomorrow (Thursday). On top of that, investors will see several major megacap technology stocks report this week, starting with Microsoft, which disappointed, followed by META after the close Wednesday, and Amazon and Apple Thursday.
In the face of multiple major news events and sources of volatility, I am sticking to technical analysis to interpret the markets. Sometimes it’s more useful to analyze the market reaction than to try and analyze the event itself. This is one of those times.
Let’s start with the good news. The S&P 500 remains in an uptrend, though it is testing the bottom of a rising channel that began in October 2023.
Mag 7 weakness
The bad news is the weakness in the former leaders, the Magnificent 7. Despite today’s Magnificent 7 strength, the Magnificent 7 is lagging the S&P 500. The accompanying chart shows that while the S&P 500 filled its price gap from July 24, 2024, the Magnificent 7 ETF (MAGS) remains below the gap. By contrast, the small cap S&P 600 has staged an upside breakout.
Analysis from BoA shows that active funds are in a crowded long position in the price momentum factor (read: Magnificent 7), which postulates that market leaders will continue to lead the market.
On the other hand, the momentum factor, however it’s measured, is rolling over.
The pain trade is now a momentum unwind and a carry trade unwind that is likely to force hedge funds to reduce leverage and forecast risk profiles.
Broad market strength
Even though the megacap growth stocks, which comprise a significant weight in the S&P 500, are likely to be a drag on the upward progress of the index, the S&P 500 is enjoying broad market strength. Net 52-week highs-lows are positive, which is supportive of higher prices.
The Advance-Decline Lines are all holding above their upside breakout levels, with the sole exception of the midcap S&P 400.
Market breadth continues to broaden out.
From a fundamental perspective, we are also seeing evidence of strong positive breadth in earnings estimate revisions. Bear markets simply don’t act this way.
In conclusion, my base case calls for the U.S. equity prices to continue to rise, albeit in an uneven manner. The leadership has rotated to value and small cap stocks. My inner trader remains long small caps. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Farrell’s Rule 2 in action
The recent action in the financial markets appears to be a case of Bob Farrell’s Rule 2 in action: “Excess moves in one direction will lead to an excess move in the opposite direction”.
U.S. equity investors saw a sudden and violent rotation from growth to value stocks and from large caps to small caps. But that’s not the entire story.
The risk unwind is also evident in the currency markets. The Japanese Yen strengthened against the USD, which is a sign of a carry trade unwind. The bottom panel shows the long Mexican Peso/short Japanese Yen carry trade of buying a high yielding currency while shorting the low yielding currency, which also reversed itself. What’s remarkable is the correlation the currency markets have shown to U.S. equity prices (top panel) and the equity factor of long NASDAQ and short small caps (bottom panel).
The sudden nature and magnitude of these market moves is a sign of the crowding and leverage in hedge fund positioning. When it unwinds, volatility rises and VaR, or risk model Value at Risk, falls, which forces traders to reduce their positions.
What happens next?
The currency market unwind
The accompanying chart shows the 10-year JGB yield, the spread between 10-year Treasuries and JGBs, and the Yen exchange rate. Yen weakness for much of 2024 has been mainly attributable to the relative dovishness of the BoJ and relative hawkishness of the Federal Reserve.
Fast forward to July, Yen weakness has pushed up Japanese inflation and it’s putting pressure on the BoJ to raise rates when it meets next week. In the U.S., the market is expecting the first Fed rate cut to occur at the September FOMC meeting. Moreover, market pricing of a half-point cut in September is 12.7%, though that is not the consensus.
The best sign of the shift in market consensus in rate cuts is the Bloomberg OpEd by former New York Fed President Bill Dudley: “I’ve long been in the ‘higher for longer’ camp…The facts have changed, so I’ve changed my mind. The Fed should cut, preferably at next week’s policy-making meeting.”
The signals from the BoJ and the Fed in the coming week could prove pivotal to the outlook of the risk unwind.
Stocks are oversold
Over in the U.S. stock market, two of the five components of my Bottom Spotting Model are oversold and flashed buy signals. The VIX Index spiked above its upper Bollinger Band, and the term structure of the VIX has inverted, indicating fear. Historically, the market has bounced whenever two or more components triggered buy signals.
These conditions should be setting up for a near-term price bounce into August, though the magnitude and the leadership of the bounce is less certain.
Buy small caps for the bounce
Here’s an educated guess. S&P 500 price gains were about half driven by EPS gains and half by P/E expansion. By contrast, the small-cap recovery in the S&P 600 was driven almost entirely by a rising P/E ratio.
On the other hand, the large-cap S&P 500 trades at a significant premium to small- and mid-cap stocks. The unwind could be explained by a valuation reset.
So we return to Bob Farrell’s Rule 2 in action: “Excess moves in one direction will lead to an excess move in the opposite direction”.
I reiterate my analysis from earlier in the week on small cap momentum (see Hey, hey, LBJ, how many kids have you killed today?). I went back to 1994 and studied the strong rally in the small-cap S&P 600. There were only 11 non-overlapping instances when its 5-day return exceeded 10% and found a strong and long-lasting price momentum effect. After pulling back for about a week, the S&P 600 went on to record strong median returns going out 60 trading days, or three months.
Small-cap stocks are breaking out, both on an absolute basis (top two panels) and a relative basis (bottom two panels).
By contrast, the large-cap S&P 500 is testing support at its 50 dma and gap support at 5400. Secondary support can be found at 5300.
Semiconductor stocks, which were the market leaders, have decisively violated absolute and relative support.
The NASDAQ 100, which is just starting to weaken, isn’t oversold yet (black line).
The relative weakness in growth stocks is evident by the rotation from growth to value across all market cap bands and internationally.
Key risk
In conclusion, my base-case scenario calls for a short-term relief equity rally into August, led by small caps and value stocks.
The key risk to this forecast is a further disorderly unwind in risk. Sentiment hasn’t fully reset. The Fear & Greed Index is only in neutral and showing no signs of fear.
The CBOE put/call sentiment is still a little frothy, which is a sign to be cautious.
The Citi Panic/Euphoria Model is still firmly euphoric.
Subscribers received an alert last Thursday that my inner trader had initiated a long position in small cap stocks. 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.
It’s becoming harder and harder to avoid the cold hard facts. China is slowing. The PBOC unexpectedly cut interest rates last week. The central bank began by cutting the benchmark lending rate on overnight, 7-day and 1-month standing lending facility (SLF). The move was followed by another surprising 0.20% cut in its 1-year policy rate, which is more than its usual move of 0.10% cuts.
The Citi China Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, peaked in Q1 and it has been falling ever since. The market had hoped for some signs of new direction or signals of stimulus from the Third Plenum, but the communiqué was uninspiring.
As China’s economy slows, there are signs that it’s starting to take a toll on global risk appetite.
Market-based signals
It is well-known that official Chinese economic statistics can be manipulated. That’s why I use real-time market data to measure the state of the Chinese economy. The news isn’t good.
Starting with commodities, as China has been a voracious consumer of commodities, commodity prices are weak. Moreover, the cyclically sensitive copper/gold and base metal/gold ratios fell to fresh lows (bottom panel).
Stock prices are also signaling weakness. The relative performance of MSCI China to the MSCI All-Country World Index (ACWI) and Hong Kong are testing multi-year lows. In addition, the relative performance of the higher beta Chinese small caps has fallen sharply.
Inadequate rebalancing
The initiatives announced from the Third Plenum were disappointing to the markets. The WSJ article headline, “China’s Leaders Point to Economic Threats but Show No Sign of Changing Tack”, tells much of the story. In the face of a weak real estate market and growing local government debt burdens, Beijing chose few course corrections, and an inadequate level of urgency to rebalance growth to the household sector from infrastructure and manufacturing.
As the accompanying charts show, exports, as measured by industrial production, spiked to an elevated level in the wake of the COVID Crisis, but growth in the domestic economy, as measured by retail sales, remained below trend.
In spite of a widespread view that globalization is in retreat, Brad Setser found that China is still highly dependent on exports as its primary growth driver.
A recent study by Rhodium Group projects that Chinese real domestic consumption growth to be 3–4% over the next 5–10 years. Michael Pettis observed that a 3–4% real growth rate is slightly below the pre-COVID trend rate, which wouldn’t be enough to rebalance the economy. If China were to rebalance its economy by reducing the investment and infrastructure share of GDP growth by 10% over the same period, that amounts to an average growth rate of 1.1–2.1%, which is positively recessionary by Chinese standards.
Investment implications
Here’s why the deceleration in China growth matters for global investors. China heads one of the three major trade blocs of Asia, Europe and the U.S. Already, the Chinese slowdown is showing up in Europe and European equities.
My analysis of global equity returns found that the relative returns of U.S. stocks are negatively correlated to Chinese stocks, but relative returns in Europe and EM ex-China are positively correlated. When China sneezes, non-U.S. economies catch colds.
As a consequence of the slowdown in the Chinese growth outlook and no fixes in sight, I am downgrading my Trend Asset Allocation from bullish to neutral. Investors should regard this shift not as a sell signal, but a take profit signal from a buy signal that went overweight equities in July 2023. We’ve had a good run, it’s time to take some chips off the table.
As a reminder, a model portfolio of over or underweighting the S&P 500 using out-of-sample Trend Model signals from 2013 would have seen strong returns with a 60/40 balanced fund-like risk profile.
In conclusion, the slowdown in China has become unmistakable. The initiative announced in the wake of the Third Plenum has done little to address the problems of a weak real estate market and high local government debt. The effects of the Chinese slowdown are being felt mostly in non-U.S. equity markets. I am therefore downgrading my Trend Asset Allocation Model from bullish to neutral.
Mid-week market update: Today’s market action looks rather ugly today, but I believe that stock prices are poised for a short-term bottom as the S&P 500 tests a key rising trend line on the weekly chart.
Here’s why.
A market bottom signal
Two of the components of my market bottom model have flashed buy signals. The VIX has spiked above its upper Bollinger Band, and the term structure of the VIX has inverted. Historically, two or more buy signals have been good indicators of short-term bottoms.
Breadth also appears to be constructive. Despite the large -2.3% decline in the S&P 500, net NYSE and NASDAQ 52-week highs-lows remain positive.
Trust the Great Rotation
The market is rotating away from growth to value, from large caps to small caps. That rotation is continuing. A rotation from growth to value is apparent across all market cap bands.
Both the Russell 2000 and S&P 600 are holding up well above their breakout levels. Moreover, both indices are on the verge of upside relative breakouts (bottom two panels).
In conclusion, today’s market panic may mark either a short-term bottom, or the stock market is very close to a tradable bottom. My inner trader was waiting for today’s market close to confirm the buy signals before acting. He will be entering the market on the long side tomorrow.
Look for better performance from value and small cap stocks in the near future. As a reminder, I highlighted the price momentum effects of small caps stocks in a post published Monday (see Hey, hey, LBJ, how many kids have you killed today?).
Well, well, the Biden decision to withdraw from the presidential race certainly put a new spin on stock market behaviour. According to Ryan Detrick, stock prices don’t behave well during election years of lame duck presidents.
That said, “lame duck” years often refer to a second term president. The closest analogues to the current circumstances could be 1968. When LBJ, under severe pressure over the opposition to the Vietnam war, said on national television, “I will not seek, nor will I accept the nomination of my party”. Baby Boomers may remember the chant, “Hey, hey, LBJ, how many kids have you killed today?”
His successor, Hubert Humphrey, won a controversial nomination (remember the riots outside the convention in Chicago). A divided party lost the White House to Nixon. The market also topped out in 1968.
The second closest analogue was 1980, when Jimmy Carter won a bitter fight for his party’s nomination over Ted Kennedy, Carter, who was also politically wounded over the nomination fight, lost to Reagan that year. The market also topped out in 1980.
Remember the Great Rotation?
Before you become too excited and turn overly bearish, do you want to make decisions based on historical studies of n=2?
Remember the Great Rotation? The Russell 2000 exhibited extreme positive momentum last week. Here is one historical study from Steve Strazza of subsequent returns after returns of 10% or more over a five-day period. Forward returns were strongly positive.
Here is another study from the Short Bear based on 10-day returns of 10% or more, which were also strongly bullish.
The Russell 2000 historical studies were based on data that began in 2000. I conducted a similar study using another small cap index, the S&P 600, that went back to 1994. Here are the median returns, based on non-overlapping signals (n=11 if you include the latest episode). Similar to Russell 2000 studies, returns tended to bottom out after 5 trading days and turned up afterwards.
By contrast, the % positive results showed that the short-term bottom was about two weeks, not one week.
As the sample size was small (n=11), here is the full study showing signals with overlapping periods (n=32). Returns started to dip after the first signal, instead of exhibiting further price momentum for an extra two days.
Here are the percentage positive results, which showed a bottom after five trading days.
Now ask yourself the following question: Do you want to rely on a study of n=2, or give greater confidence to studies of n=11, or an overlapping period study of n=32?
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Here comes the Great Rotation
The stock market recently underwent a Great Rotation. Leadership violently rotated from growth to value, and from NASDAQ stocks to small-cap stocks. The reversal was accompanied by a sudden downdraft in the S&P 500.
For investors, the burning question is whether the Great Rotation is a signal for a correction in stock prices.
A crowded long
Arguably, last week’s market action was just the start of a Great Rotation. The violent nature and the magnitude of the move are indicative of a price insensitive short covering. Hedge funds have been increasingly long NASDAQ and short value and Russell 2000 stocks. Fund flow analysis shows that investors have moved to an off-the-charts crowded long in technology. If the rotation were to continue, the unwind has the potential to go much further.
Q2 earnings season is just kicking off. Estimate revision analysis shows that earnings expectations for AI stocks are falling, which could put downward pressure on these stocks and exacerbate the effects of the Great Rotation.
The bull case
Having established a significant reversal is likely underway, the next question is, “What’s the outlook for the S&P 500?”
Here is the short-term bull case. The Great Rotation was accompanied by strong breadth, as evidenced by upside breakouts in different Advance-Decline Lines to all-time highs.
Similarly, the Great Rotation also saw an expansion in NYSE and NASDAQ 52-week highs-lows. Bear markets simply don’t act this way.
While the sample size is small (n=3), SentimenTrader pointed out that seismic shifts in small-cap to large-cap stocks were long lasting.
The bear case
Here is the short-term bear case.
The reversal out of large-cap technology has the potential to be a stampede. The top 10 stocks in the S&P 500, which is dominated by large-cap growth stocks, account for just under 30% of index weight. By contrast, the largest stock in the Russell 2000 has a weight of less than 0.5%. Selling pressure out of the large growth names has the potential to overwhelm the buying pressure from purchases.
The value component of the growth to value rotation consists mostly of cyclical stocks. The consumer discretionary to consumer staples ratio, which is an indicator of risk appetite, is showing few signs of strength, which is potentially a negative sign for equity risk appetite.
The relative performance of defensive sectors is edging up. While the moves aren’t definitive, this is a development to keep an eye on. Further relative strength by defensive sectors could be a warning for stock prices.
In addition, the NYSE McClellan Oscillator (NYMO) and NASDAQ McClellan Oscillator (NAMO) reached overbought conditions and recycled back to neutral, which are tactical sell signals.
The Citi Panic/Euphoria Model is highly euphoric.
Investment implications
So where does that leave us?
Even though breadth indicators are improving, which is bullish, we would not be so quick to buy any dip that appears. I observed last week that the second half of July tends to be seasonally weak. As well, the stock market tends to be volatile during earnings season as prices respond to the major earnings report headlines of the day, which are unpredictable.
The next week should offer better clarity on market direction. The S&P 500 has weakened to an area of support.
The value/growth ratios are at or near areas of relative resistance, and across all market cap bands.
Expect some near-term choppiness. Stay cautious short term, but be prepared to buy the dip should panic conditions appear, or if the Fed were to offer dovish guidance at the July FOMC meeting.
In the wake of Biden’s subpar debate performance and the assassination attempt on Trump, the prediction markets’ odds of a Trump victory in November have substantially risen. Equally important is Wall Street’s reaction, which has investors sitting up to take notice of the implications of a second Trump Administration in 2025.
Despite the real-time information from the betting markets, financial markets haven’t fully discounted the possibility of a Trump win. Here’s how you can take advantage of that arbitrage opportunity.
Trump 2.0 macro effects
Donald Trump sat down with Bloomberg Businessweek for a wide ranging interview. Here are the key points, covering the Fed, trade and tax policy.
Starting with the Fed, Trump said that he would allow Fed Chair Jerome Powell to serve out his term, which ends in May 2026, but “if I thought he was doing the right thing”. The Financial Times also reported that Trump warned the Fed to avoid cutting interest rates before the election. While the headline that he wouldn’t fire Powell was designed to calm markets, the qualification of “doing the right thing” and attempts to strong arm current monetary policy could create instability.
These comments puts the Fed in a difficult position. The markets is putting the odds of a September rate cut as a virtual certainty in the wake of softer-than-expected inflation data. The September cut would be followed by further cuts in November and December. Fed officials will need to push back against that dovish interpretation if they don’t want to surprise the markets.
On trade, Trump called for new China tariffs at a rate of between 60% and 100%, and would impose a 10% tariff on imports from other countries. A new economics paper modeled the effects of a 10% across the board tariffs on imports and 60% on China. It concluded “across-the-board tariffs do not protect manufacturing jobs because the cost of imported intermediate goods increases, raising costs in manufacturing production” and “the world economy can adjust to U.S. trade wars, diverting trade around the U.S.”
Goldman Sachs chief economist Jan Hatzius stated at the ECB’s Sintra conference that a 10% tariff could spark trade war retaliation which raises the U.S. inflation by 1.1% and forces the Fed to into five quarter-point rate hikes.
In addition, Trump’s threat to restrict immigration and deport undocumented workers will act as a supply shock to the labour market. This will put additional upward pressure on wages and push inflation upwards.
On taxes, Trump told Bloomberg that he aims to cut corporate taxes to 15%, though he admitted that objective may be overly challenging and he would accept a 20% rate “for its simplicity. He will also extend the 2017 Tax Cuts and Jobs Act.
On one hand, this should provide a fiscal boost to the economy. On the other hand, it will add to the fiscal deficit. A study of the effects of 2017 legislation found that the reduced corporate tax rates did increase domestic investment by 20% and investment by foreign firms substantially. However, the tax cuts did not pay for themselves and raised the deficit by an extra $100 billion per year.
In short, Trump’s plans are inflationary. A WSJ survey of economists found that 56% believed inflation would be higher under another Trump term than under a Biden term. In particular, any attempt to interfere with Federal Reserve independence could send financial shockwaves around the world in light of the reserve currency status of the USD.
On the other hand, Trump voiced his desire for a lower USD in the interview.
I think manufacturing is a big deal, and everybody that runs for office says you’ll never manufacture again. We have currency problems, as you know. Currency. When I was president, I fought very strongly and hard with President Xi and with Shinzo Abe… So we have a big currency problem because the depth of the currency now in terms of strong dollar/weak yen, weak yuan, is massive.
A government that strong arms the Fed to lower rates in the face of inflationary pressures would have the unwelcome effect of tanking the greenback as confidence on its status is eroded.
Discounting Trump 2.0
While the Bloomberg Businessweek interview and details from the Republican platform reveal the intentions of a Trump Administration, investors need to understand the new administration’s actual plan of action.
The easiest policy to implement would be the extension of the 2017 tax cuts. The BoA Global Fund Manager Survey found that the policy areas most affected by a Trump win would be trade, followed by immigration.
Global managers also believe that a sweep, which would likely be a Republican seep in light of the electoral outlook, would be inflationary that resolves in higher bond yields.
What about the stock market? Reasonable people can disagree on the growth outlook under Trump 2.0, but it is undeniable that investors face more challenging valuations today compared to Trump 1.0. When Trump first took office, the S&P 500 was trading at a forward P/E of 16, compared to over 21 today. Stock prices could face additional headwinds if bond yields were to rise, which would also put downward pressure on valuation.
How is the market reacting to all this?
It’s been a bit of a mixed bag. The accompanying charts show the performance of different Trump market factors. Each of the charts is designed that a rising line denotes rising odds of a Trump win. The trade-related factors, such as the relative performance of companies with domestic revenue, and logistics shipping giants FedEx and UPS, show little reaction. By contrast, the yield curve and gold prices are signaling higher inflationary expectations.
The Republican platform has promised a policy of “drill, baby, drill” of energy independence, which should benefit energy stocks. The energy sector has lagged the market and it would be a prime beneficiary should Trump win the White House.
Another Trump trade that should perform well is financial stocks, which should benefit from deregulation and lower taxes. Watch for few barriers to consolidation in the banking sector, which should benefit regional banks. The sector recently staged a convincing upside breakout on an absolute basis, but remains range-bound relative to the S&P 500 (second panel), though relative breadth appears constructive (bottom two panels).
By contrast, the technology sector may be at risk under a Trump White House. Trump expressed his skepticism about defending Taiwan against China in the Bloomberg Businessweek interview: “I mean, how stupid are we? They took all of our chip business. They’re immensely wealthy. I don’t think we’re any different from an insurance policy. Why are we doing this?”
The shares of TSMC skidded -3.6% after those remarks. The Semiconductor Index, which has been an AI bellwether, is testing a key area of absolute support (top panel) and violated relative support (bottom panel).
In conclusion, the betting odds on a Trump victory in November have risen substantially, but the markets haven’t fully discounted such an outcome. Investors who want to position for Trump 2.0 should seek long inflation exposure (long gold/short bonds) and short globalization (long domestic producers/short transportation and logistics). Regardless of the growth outlook, equity returns may be more challenging as Trump 2.0 will see the S&P 500 at more lofty multiples than the P/E ratio of Trump 1.0. At a sector level, look for better performance in energy and financials, while technology may be under some pressure.
Mid-week market update: Small cap stocks, as measured by the Russell 2000 and S&P 600, staged convincing upside breakouts in the past week. Both small cap indices are now testing key relative resistance zones against the S&P 500.
Even though this seems to be counter-intuitive, such a development could be bearish for the S&P 500.
A breakout and breadth thrust
Let’s start with the bull case. The small cap upside breakout was impressive. A point and figure chart of IWM with a 1% box size shows a measured upside target of 280, which represents an upside potential of about 25%.
What’s more, the market triggered a Whaley Breadth Thrust yesterday. This has resolved bullishly in the past, if history is any guide.
Reasons for short-term caution
I should be wildly bullish here. So why am I cautious?
I am worried about the possibility of a disorderly position unwind. The accompanying of market neutral ETF BTAL is a proxy for the factor exposure of the hedge fund and fast money crowd. The steady march upwards of BTAL was accompanied by long growth/short value and long NASDAQ 100/short Russell 2000.
Now we’ve seen a violent reversal of those factor returns of historic proportions. Undoubtedly, hedge funds are feeling pain and risk managers are forcing traders to unwind their positions. The risk is a disorderly stampede for the exits that resolves in a Volmageddon outcome. When that happens, hedge funds become forced sellers of everything, which results in a volatility spike and correlations of all assets converge to 1.
To be sure, the Volamageddon scenario is only a scenario that may not play out. But the market is already overbought, as measured by the NYSE McClellan Oscillator (NYMO) and the NASDAQ McClellan Oscillator (NAMO). Bear in mind, however, that stock prices can continue to advance when the market was overbought in the past, but they have usually resolved in either short-term weakness or sideways consolidations.
As well, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) saw a take profits signal when its 14-day RSI became overbought yesterday. At the same time, the percentage of S&P 500 above their 20 dma also reached overbought territory. None of this means that stock prices have to fall, only that upside potential is diminishing and it may be time for the stock bull to pause.
It only took an unexpected catalyst to spark market weakness. Today’s selloff in tech was sparked by the massive selloff in ASML on the prospect of further restrictions on the exports of chip making equipment to China. That’s how volatility spikes happen.
This is also consistent with the seasonal record of some price sloppiness in the second half of July.
In conclusion, the upside breakouts of small caps should be interpreted bullishly on an intermediate term basis. However, a combination of the possibility of a violent hedge fund position unwind and severely overbought conditions argue that it’s time for bulls to take some short-term profits and prepare for near-term volatility.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Another upper BB ride
The S&P 500 went on an upper Bollinger Band ride and unusually pulled back on Thursday after the soft CPI report and closed below the upper BB on Friday. What’s unusual is the risk-on tone adopted by the rest of the stock market even as heavyweight technology stocks in the S&P 500 weakened. The small-cap Russell 2000 gapped up and staged an upside breakout through a key resistance level in response to the prospect of lower interest rates owing to the weak CPI print.
Historically, the S&P 500 has consolidated sideways for a few days after upper BB rides. Will this time be any different, or does small-cap strength foreshadow further price advances in the near future? What about the rest of 2024?
The bull case
Here is what’s different this time. As we approach Q2 earnings season, fundamental momentum as measured by forward 12-month EPS revisions have been strong.
Many of the laggards, such as the Russell 2000, small cap QQQ, and bank stocks, which are just reporting earnings, are staging upside breakouts.
A pause ahead?
Here is the case for near-term consolidation. The first reason is seasonality. Historically, the month of July has been seasonally strong for the S&P 500, but most of the gains have occurred in the first half of the month.
To be sure, seasonality can inform investors about the climate but also the specifics of the weather pattern ahead. The Zweig Breadth Thrust Indicator, which is an overbought/oversold indicator, is nearing an overbought condition that has signaled periods of sideways consolidation in the past year, which was a period when the market was on a bullish rampage.
On the other hand, indications of banking system liquidity have been turning down. Liquidity has shown a rough correlation to the S&P 500 in the past and falling liquidity could pose a headwind to stock price gains.
More ominously, Cross Border Capital warned that Chinese liquidity is falling rapidly, which is negative for global risk appetite.
The Citi Panic-Euphoria Model is wildly euphoric.
A rough roadmap
So where does that leave us? Here is my base-case scenario, which represents a rough roadmap for the rest of the year.
An analysis of election year seasonality calls for a pause for the remainder of July, followed by an August rally, possible weakness in October, and a rally into the election and year-end.
On the other hand, an analysis of VIX seasonality calls for implied volatility to bottom in late July and rise until an October top, followed by declines into year-end.
My base-case scenario is based on an analysis of current market conditions and seasonal patterns of a near-term top in July and sideways consolidation for the remainder of the month. Expect a rally in August, which could be consistent with an anticipation of a September rate cut in the wake of the July 31 FOMC meeting and Jackson Hole speeches. Volatility and risk should rise into the November election, followed by a post-electoral rally into year-end.
We’ve all seen the warning signs about narrow market concentration and deteriorating breadth. The S&P 500 is an accident waiting to happen.
On the other hand, strategist Ed Yardeni stated in a CNBC interview that he believed we are in a “slow motion melt-up”. I agree. While the excesses in the stock market are becoming more evident and risks are rising, the bull isn’t done just yet.
The accompanying chart from Jurrien Timmer at Fidelity illustrates my point. If this is a bubble in the making, it could run a lot further as valuation differences are nowhere near the height of the Nifty Fifty or Dot-Com Bubble eras.
Remember Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
The AI bull tires
The AI-driven bull market may be starting to tire as warnings are appearing. Goldman Sachs recently published a prominent research article, “Gen AI: Too Much Spend, Too Little Benefit?”. Goldman argued that the GDP growth benefits from AI implementation will be limited. AI-related capex is too high in light of the lack of a killer application. Moreover, looming power shortages will constrain AI growth.
Sequoia also issued a research report, “AI’s $600B Question”, which raised similar points. Bloomberg reported that Citi strategists recommended investors take profits in AI-related stocks. A CNBC interview with Roger McNamee highlighted the following issues with the current state of AI research and deployment:
The power usage of Generative AI is breaking the power grid;
Water usage will be another constraint. AI needs plenty of water for semiconductor fabrication, training data sets and cloud services.
Copyright and Privacy: Large Language Models (LLMs) were made possible by stealing a lot of copyrighted content and private data-like e-mails, word processing documents and spreadsheets stored in the cloud, and so on.
Security: What are the security vulnerabilities, especially national security, for anyone who uses Generative AI and LLMs?
How do you deal with toxic uses such as deliberate disinformation, deepfake porn or deepfake scams against the elderly and plagiarism?
Today, the hyperscalers (Amazon, Microsoft, Google, and META) dominate total capex, which creates significant risk if this bubble were to pop.
For the last word, a truly transformative leap in processing may be coming in the form of bioprocessors. See this news report about 16 lab-growth brains running a living computer as a proof of concept of bioprocessing has the promise of truly transforming AI-driven processing:
Swiss technology firm Final Spark has successfully launched Neuroplatform, the world’s first bioprocessing platform where human brain organoids (lab-grown miniaturized versions of organs) perform computational tasks instead of silicon chips.
The first such facility hosts the processing prowess of 16 brain organoids, which the company claims uses a million times less power than their silicon counterparts.
While bioprocessing is still in its early research stage and its actual use is probably a decade away, what happens to all those NVIDIA chips and AI-related capex if bioprocessing is deployed at scale?
Notwithstanding the AI-related mania, consensus analyst long-term EPS growth estimates can be useful as a sentiment indicator. The latest long-term growth estimates have spiked to levels near the NASDAQ top in 2000, which is concerning.
Too early to turn bearish
Despite the warnings, I believe the bull run isn’t over just for a number of macro, fundamental and technical reasons.
First, the trend of decelerating inflation readings is setting the course for the Fed to cut rates. Jason Furman observed that core CPI for the last three, six and 12 months 1.1%, 3.3% and 3.3%, respectively. However, the higher-than-expected PPI report could call into question whether Powell can convince the hawks on the FOMC at the September meeting is still an open question, but the Fed is on track to cut rates in the near future.
The higher-than-expected PPI report didn’t move the inflation needle very much either. Now that both CPI and PPI have reported, most of the components of PCE, the Fed’s preferred inflation metric are known. The Cleveland Fed’s core PCE nowcast for June is now flat, or more precisely -0.01%. It’s an open question whether Powell can convince the hawks on the FOMC at the September meeting is still an open question, but the Fed is on track to cut rates in the near future.
From a valuation perspective, while S&P 500 forward P/E appears excessive, the excesses are concentrated in the largest names. Marketwatch pointed out that while the S&P 500 forward P/E is 21.4, which is near the top of its historical range, its median forward P/E is 17.8, which is just below its 10-year average of 17.9.
As we approach Q2 earnings season, forward 12-month EPS is very strong, which is a sign of positive fundamental momentum.
Few major signs of distribution
From a technical perspective, there are few major signs of distribution. The accompanying breadth chart of the market in 1999 and 2000 illustrates this point. Percentage bullish topped out and began to decline in May 1999, which was well before the NASDAQ top of March 2000. The S&P 500 Advance-Decline Line started diverging from the S&P 500 in mid-1999. Investors saw a warning of a major top when the NASDAQ 52-week highs-lows turned negative mid-March 2000, which was about two weeks before the actual top and technical break.
Consider the breadth outlook today. Percentage bullish has been falling this year, but as the 1999–2000 episode shows, that indicator was very early to signal a top. The S&P 500 A-D Line is only exhibiting a minor breadth divergence; 52-week highs-lows (bottom two panels) are still healthy.
The frenzy in AI-related tech has largely been confined to large-cap stocks and there are few signs of excess in small-cap tech. An analysis of the relative performances of large-cap and small-cap tech shows that small-cap tech stocks have lagged the Russell 2000 for the past year. Moreover, the relative performance of small-cap to large-cap tech parallels the relative performance of the Russell 2000 to the S&P 500 (bottom panel).
In fact, the market may be undergoing a rotation from growth to value. Value started to outperform internally in early June, and it started to turn up recently in the U.S. across all market cap bands. This is what bulls like to see. When one sector falters, another takes up the leadership baton.
As Q2 earnings season proceeds, investors will be closely watching the reports from the megacap AI names. If there is an AI bubble, it is arguably not over. If history is any guide, the 12-month normalized NASDAQ 100 to S&P 500 ratio (black line) is not even in the overbought zone and could potentially surge further.
In conclusion, valuation and breadth indicators are flashing concerning signs of excesses. I believe this market bull has more room to run. Valuations are stretched but not bubbly. Price and fundamental momentum are strong, and I am not seeing signs of distribution.
Mid-week market update: The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscilator (ITBM) flashed a buy signal in the third week of June when its 14-day RSI recycled from oversold to neutral. The S&P 500 consolidated sideways for about a week and resumed it climb. This is the story of why I did not act on the buy signal and the lessons learned.
A frothy market
At the time, I was concerned about the stretched nature of market breadth and the signs of froth in sentiment readings. At the time, the put/call ratio had issued a cautionary signal, which was the sign of a tactical top. Even though the put/call ratio has backed off from a crowded long extreme, sentiment readings are still stretched.
I was also corresponding with a reader about the excessively high level of over 100 for the NAAIM Index, which measures the sentiment of RIAs who manage individual investor funds. Here is the full history of the NAAIM Index. Readings of over 100 have often marked a tactical top, but it can be a bit of a hit and miss as a trading signal. While you would have usually realized profits if you had shorted whenever NAAIM exceeded 100, you would also have experienced significant drawdowns in some instances.
There was also the continuing breadth divergence shown by the market, as documented by SentimenTrader.
Strong momentum
That’s the short of trading environment investors face today. Valuation and breadth are stretched, but price momentum is strong and positive. The S&P 500 made another all-time high while going on an upper Bollinger Band ride. In the past, breaks from upper BB rides have resolved in several days of sideways consolidation before stock prices break, either up or down.
While relative breadth, as measured by the strength of megacap leadership to the broad market, is weak, absolute breadth is behaving reasonably well. Net NYSE 52-week highs-lows is still positive, which is a constructive sign for risk appetite.
Market catalysts
Looking to the days and weeks ahead, investors can look forward to the U.S. CPI report tomorrow (Thursday) morning, followed by the PPI report Friday. Once the CPI and PPI are out, the market should have a fairly accurate estimate of PCE, which will be a key reading for Fed officials as they convene their July 31 FOMC meeting. Fed Chair Powell struck a more balanced tone in his Capitol Hill testimony this week as he characterized risks as more balanced between growth and inflation. The Street interpreted his remarks as dovish, but it remains to be seen whether he can convince the hawks on FOMC to cut rates by the September FOMC meeting, which is now the overwhelming market consensus.
Here is JPMorgan’s estimate of the market reaction function to core CPI. The Street is mostly expecting a soft CPI to fuel a greater risk-on reaction.
In addition, earnings season is kicking off and anything can happen.
My inner trader decided to override the ITBM buy signal as he was concerned about the elevated levels of risk. He missed the buy signal, and it’s too late to be buying now. Even though the trade worked out, he would have done the same thing all over again for risk control reasons.
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
Trading model: Neutral (Last changed from “bullish” on 23-May-2024)
Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
Subscribers can access the latest signal in real time here.
Warnings everywhere
Even as the S&P 500 reached another all-time high, numerous warnings about a market top have been appearing in my social media feed and elsewhere, starting with the elevated level of the forward P/E ratio. The S&P 500 forward P/E now stands at 21.2, which is above its 5-year average of 19.3 and 10-year average of 17.9.
This will not end well
Most of the warnings fall into the “this will not end well” category, which are condition indicators and not necessarily actionable trading signals.
One example is the warning about an extreme in market concentration. The weight of the top 10 stocks in the S&P 500 has spiked to 34%, which is the highest in its history.
Topdown Charts warned about an extreme in speculative sentiment, as measured by the assets of leveraged long and leveraged short ETFs.
Another possible contrarian data point is the departure of uber bearish strategist Marko Kolanovic from JPMorgan. Kolanovic turned disastrously bearish at the market bottom in 2022 and his target for the S&P 500 was 4200. JPMorgan announced that Kolanovic is “exploring other opportunities”.
From a technical perspective, different variations of the Advance-Decline Lines are forming negative divergences as they haven’t confirmed the new all-time high in the S&P 500.
While these conditions are concerning, where’s the actionable trading signal?
Too early for risk off
For traders, it’s too early to turn bearish. I see no signs of a bearish trigger. Instead, conditions appear bullish from a tactical perspective.
Let’s start with the relative performance of the defensive sectors, which are all flat to down compared to the S&P 500.
While concerns about market concentration and narrow leadership are very real, there are no signs of price momentum breaks in large-cap growth stocks. Even though you may be cautious or even bearish, you don’t want to stand in front of this runaway freight train.
Similarly, the NASDAQ 100 achieved a relative breakout against the S&P 500. Relative breadth indicators (bottom two panels) have also been steadily improving.
As well, Q2 earnings season is coming up. Forward 12-month EPS estimate revisions are rising strongly, indicating positive fundamental momentum.
Bull or bear?
We arrive at the question, should you be bullish or bearish under these conditions?
Investors and traders should be reminded of the technical adage, “Tops are processes, but bottoms are events”. To explain, market bottoms tend to be emotional episodes marked by panics, which tends to be a sudden event. By contrast, market tops are marked by distribution, which can be a long drawn-out process.
Technical analyst Walter Deemer once quoted veteran floor trader Edwin Stern to make my point: “When everybody is bearish, everybody is apt be wrong. When everybody is bullish, everyone may be right now and then.”
Here is an example. The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investor funds, has provided strong buy signals whenever it fell below its lower 26-week Bollinger Band. On the other hand, excessively high readings have not useful sell signals.
Your decision to be bullish or bearish will depend on your time horizon and risk tolerance. Investment-oriented accounts can consider reducing risk in their portfolios today. Traders, on the other hand, should take advantage of continuing positive momentum and stay bullish equities.
My own preference is to take a modeled approach and allow my Trend Asset Allocation Model to determine risk levels. The Trend Model remains bullish as the S&P 500 staged another upside breakout to an all-time high. Enjoy the ride, as least for now.
Recent U.S. economic data has generally been weakening, as evidenced by the decline in the Citigroup Economic Surprise Index (ESI, gold line), which measures whether economic data is beating or missing expectations. As ESI has been roughly correlated to bond yields, this should put downward pressure on rates and expectations of rate cuts in the near future.
Not so fast! Fed policy has become increasingly constrained by politics, both on a short- and long-term basis. Here’s why.
Reasons to cut rates
Here are the reasons to cut rates. The market has seen a series of tamer inflation readings, as measured by core CPI (blue bars) and core PCE (red bars). CNBC reported that Fed Chair Powell sounded dovish during a European Central Bank forum in Sintra, Portugal, though he refused to commit to a September rate cut.
“We’ve made quite a bit of progress and in bringing inflation back down to our target,” Powell said at a central banking forum in Sintra, Portugal.
“The last [inflation] reading and the one before it to a lesser extent, suggest that we are getting back on the disinflationary path. We want to be more confident that inflation is moving sustainably down toward 2% before we start the process of reducing or loosening policy,” he added.
As a reminder, Powell had set out the tripwires to rate cuts at the last FOMC press conference, namely better inflation readings or a cooling employment market. Headline June Nonfarm Payroll came in slightly ahead of expectations, but the April and May figures were revised down. More importantly, leading indicators of employment, such as temp jobs and the quits to layoffs rate, are weakening.
In addition, a mechanical application of the Taylor Rule based on a 2% inflation target and 2% real rate, shows that the Taylor Rule rate (blue line) is below the actual Fed Funds rate (red line), indicating an excessively tight monetary policy.
As a consequence, the market is now expecting two rate cuts in 2024, with the first at the September FOMC meeting, followed by a second in December.
A higher bar
While the data is pointing to a rate cut in the near future, the political cycle is constraining the Fed’s actions in the short run. Ahead of the election in November, Powell needs a unanimous decision if the Fed is to cut rates in order to avoid the appearance of boosting in order to help Biden regain the White House. He can’t afford any dissents in a rate decision vote. As I pointed out before, there is a significant hawkish group of FOMC voting members (Bowman, Waller, Barkin, and Bostic) who are resisting rate cuts (see The Market Gods Present Patient Investors With Three Gifts).
The minutes of the June FOMC meeting reflect that divide within the FOMC. Fed officials “noted that the uncertainty associated with the economic outlook and with how long it would be appropriate to maintain a restrictive policy stance”. In particular, “some participants emphasized the need for patience in allowing the Committee’s restrictive policy stance to restrain aggregate demand and further moderate inflation pressures. Several participants observed that, were inflation to persist at an elevated level or to increase further, the target range for the federal funds rate might need to be raised.”Even though Fed officials have said that they don’t concern themselves with politics, the Fed intensely monitors market conditions, and the market is starting to discount the odds of a Trump win in November. Companies with domestic revenue are leading the S&P 500, which is an indication that the market is discounting higher tariffs in the future. The yield curve is steepening, inflationary expectations are rising, and gold has staged a triangle breakout, which is consistent with a Trump win (see Why the November Election Matters to Gold).
For what it’s worth, Goldman Sachs concluded that the effects of Trump’s proposed tariffs would boost short rates by 1.3%, or about five rate hikes.
The market should gain more clarity about the Fed’s likely interest path well before the September FOMC meeting. This Fed hates to surprise markets, and if a cut is likely at the September meeting, Fed speakers will begin a campaign to correct expectations of a cut just after the July 31 FOMC meeting. At a minimum, I would like to see greater transparency about its decision making framework after the July meeting.
New York Fed President John Williams said in a speech Friday that it’s not ready to cut just yet: “Inflation is now around 2-1/2 percent, so we have seen significant progress in bringing it down. But we still have a way to go to reach our 2 percent target on a sustained basis. We are committed to getting the job done.” If the Fed intends to signal that a September cut is not in the works, expect further messaging like this to continue.
Stay in your (narrower) lane
The short-term challenge for the Fed is its rate decision process. Here are the long-term challenges. Bloomberg reported that Powell is trying very hard to “stay in his lane” ahead of the November election:
“We’ve been given this great responsibility and great powers and it’s really important that we get it right,” he observed. “We’ve been told to ‘stay out of politics and do your job.’”
The problem, as all of them know, is that political decisions, from tariffs to energy policy, all have some impact on the economy.
The same goes for public finances. Powell restated that fiscal policy is a political matter, “so we don’t comment on it — and particularly in advance of a presidential election.” But he then acknowledged the challenges.
“You can’t run these kinds of deficits in good economic times for very long,” he said. “We’ll have to do something sooner or later, and sooner will be better than later.”
A little-known U.S. Supreme Court decision in finance circles may constrain monetary policy in the longer term. The Supreme Court reversed a long-standing precedent in the Chevron case, which limits the power of federal agencies to interpret ambiguous statutes. It was a resounding victory for conservatives in government deregulation. The NY Times described the implications of the decision this way:
The Supreme Court on Friday reduced the power of executive agencies by sweeping aside a longstanding legal precedent, endangering countless regulations and transferring power from the executive branch to Congress and the courts.
The precedent, Chevron v. Natural Resources Defense Council, one of the most cited in American law, requires courts to defer to agencies’ reasonable interpretations of ambiguous statutes. There have been 70 Supreme Court decisions relying on Chevron, along with 17,000 in the lower courts.
The decision is all but certain to prompt challenges to the actions of an array of federal agencies, including those regulating the environment, health care and consumer safety.
In the past, the Fed has used its “emergency authority” to buy assets, increase its balance sheet, and “abundant reserves” in response to the COVID Crash and the GFC. In light of the reversal of Chevron, the key question for the Fed is what Act of Congress allows the Fed to manage monetary policy like this?
The Fed’s has a dual mandate from Congress, namely “full employment” and “price stability”. Under the legal standard laid out by the previous Chevron decision, the Fed used “legal authority” granted by Congress to address “short-term liquidity needs”. Under the new Supreme Court’s interpretation of Chevron, does the Fed have that level of authority to interpret the law to define an “emergency”?
Imagine some time in the near future when the federal budget becomes increasingly constrained by fiscal dominance and net interest outlays exceed the primary deficit. One solution is a financial repression through yield curve control by the Fed by keeping long rates down through open market intervention. Will someone in the near future gain the legal standing to challenge the Fed’s decision-making authority under the new legal standard?
What happens in the next financial crisis? Supposing that a major financial earthquake occurs outside the U.S. In the past, the Fed would have opened up USD swap lines to maintain global financial stability. Will it have the same level of authority under the new standard? The Fed’s mandate is “full employment” and “price stability”. Financial stability is not part of its mandate. We have seen how the lack of a dual mandate affected the conduct of the European Central Bank, which has tended to err on the side of fighting inflation.
These are all valid questions. No one has the definitive answer at this point. What it does raise is a greater risk of global financial instability in the long run.
In conclusion, recent economic data is signaling a trend of growth deceleration, which raises the odds of a September rate cut. However, political considerations may derail a decision to ease in September as Powell may not achieve a unanimous vote, which would open the Fed to charges of interference in the electoral process. In addition, the Supreme Court’s recent repudiation of the Chevron decision opens the door to constraining future Fed policy to take extraordinary measures to stabilize the financial system in the event of a crisis.
Mid-week market update: The S&P 500 followed the typical pattern of consolidating sideways for about a week after an upper Bollinger Band ride before breakout out to a fresh all-time high. As recent history shows, it’s impossible to know which way stock prices will break after the consolidation.
In many ways, the upside breakout was not a big surprise.
Positive seasonality
One reason is positive seasonality. Ryan Detrick documented how stock market has enjoyed a seasonality tailwind during the first half of July.
Other bullish factors
I am also seeing other bullish factors at play. We are entering Q2 earnings season, and John Butters at FactSet pointed out that Street analysts have made smaller than average cuts in EPS estimates ahead of reporting season, indicating strong fundamental momentum.
From a technical perspective, the lagging relative performance of defensive sectors is a constructive sign for the bulls.
Longer term, the market’s narrow leadership continues to be worrisome. In the short run, however, large cap tech is enjoying strong relative momentum (bottom two panels).
Don’t fight the bull trend, at least for the first two weeks of July.
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