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An unusual sweet spot for equities

Summary:
Preface: Explaining our market timing modelsWe 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 Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?” My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model

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

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

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

An unusual sweet spot for equities

The latest signals of each model are as follows:

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

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

Opportunities from uncertainty

Now that stock prices have recovered to within 2% of their all-time highs, what’s next for the stock market? To be sure, stock prices are no longer cheap. FactSet reports that the market is trading at a forward P/E ratio of 16.7, which is just above its 5-year average of 16.3 and well above its 10-year average of 14.7.

An unusual sweet spot for equities

Should investors throw in the towel? Not yet. While valuations are not compelling, equities remain in a sweet spot as cautious long-term sentiment readings can drive prices higher.

Strategas published a terrific analysis showing how forward US equity returns have historically been higher when global policy uncertainty is high. While the sample size for this study is small, it is consistent with the contrarian principle of buying when blood is running in the streets.

An unusual sweet spot for equities

Indeed, the latest reading of global policy uncertainty shows that it remains at an elevated level.
 

An unusual sweet spot for equities

Despite the elevated valuation, equities find themselves in an unexpected sweet spot. There is still room for stock prices to rise as tensions and risk levels fade.
 

The Mexico border climb-down

The good news is, risk levels are fading. President Trump threatened to immediately close the border with Mexico if the Mexican government didn’t act, or if Congress didn’t act to control illegal border crossings. This week, he climbed down from his threat to close the border right away by giving Mexico a year to mitigate border crossings, or he would either close the border or put tariffs on autos crossing the border.
 

An unusual sweet spot for equities

Fed nomination controversies

At the same time, Trump had been pressuring the Fed to pursue an easier monetary policy and cut rates.
 

An unusual sweet spot for equities

That tweet was followed by a CNBC interview with economic advisor Larry Kudlow, who called for the Fed to immediately cut by 50bp.

Top White House economic advisor Larry Kudlow wants the Federal Reserve to “immediately” cut interest rates by 50 basis points.

“I am echoing the president’s view — he’s not been bashful about that view — he would also like the Fed to cease shrinking its balance sheet. And I concur with that view,” Kudlow told CNBC on Friday.

“Looking at some of the indicators — I mean the economy looks fundamentally quite healthy, we just don’t want that threat,” he added. “There’s no inflation out there, so I think the Fed’s actions were probably overdone.”

After Friday’s better than expected March Jobs Report, Trump repeated his call for the Fed to cut interest rates. He went further and said the Fed should stop its quantitative tightening program and begin quantitative easing.

Trump nominated Stephen Moore and Herman Cain to fill the two open seats on the Board of Governors of the Federal Reserve. The only common element between the two candidates is they have been strong supporters of Trump policies in the past, as well as past hard money advocates.

Moore penned a recent WSJ Op-Ed entitled “The Fed Is a Threat to Growth”, subtitled “The real economy is ready to reignite, but Powell’s tight-money policy is acting like a wet blanket”, which summarizes his views well, However, his views on low interest rates appears to be a function of what year it is (and presumably the party in control of the White House at the time).

From the New York Sun, April 24, 2016: “A second reason for the business investment slump is monetary policy. While this may not be the right time for rate hikes, ultra-low interest rates have led to financial engineering rather than the deployment of excess corporate cash for productivity enhancing investments.”

From an interview with Brian Lehrer, April 3, 2019: “On balance I think low interest rates are a good thing. They mean that businesses can invest and borrow at low prices. It means that if you want to buy a home – I always tell people my gosh this is the golden age to buy a home, Brian…So I don’t have a problem with low interest rates”.

Establishment economists have been aghast at Moore’s nomination. He was not trained as an economist, Instead, he spent most of his professional life as an economic commentator on tax policy.  Even Greg Mankiw, who was Bush 43’s CEA chair, took the unusual position of publicly opposing Moore’s confirmation due to his lack of qualification and partisanship.

A couple of weeks ago, I gave a talk at the Federal Reserve Bank of Dallas. I said that, although I am not a fan of President Trump, I have to give him credit for making good appointments to the Fed. I was thinking about people like Jay Powell, Rich Clarida, and Randy Quarles.

Then today the president nominates Stephen Moore to be a Fed governor. Steve is a perfectly amiable guy, but he does not have the intellectual gravitas for this important job. If you doubt it, read his latest book Trumponomics (or my review of it).

It is time for Senators to do their job. Mr. Moore should not be confirmed.

In an interview with Bloomberg TV, Moore was asked about his view on the correct size of the Fed’s balance sheet (starts at about 11:00). Moore replied, “To be honest, I’m going to have to study up on this one”. In reality, he had authored a 2014 Heritage Foundation paper, Quantitative Easing, The Fed’s Balance Sheet, and Central Bank Insolvency addressing this very issue.

Another common element between Moore and Cain is both are hard money advocates. In September 2015, Moore voiced his support for getting rid of the Federal Reserve and returning to a gold standard (click this link if the video is not visible).
 

Herman Moore’s credentials are a little bit more mainstream. He was on the board of directors of the Kansas City Fed from 1992 to 1996, eventually becoming the chair, though his role had little to do with monetary policy. Like Moore, Cain is a strong Trump supporter. He co-founded the America Fighting Back PAC. The home page tells the story of the PAC’s political leanings.
 

An unusual sweet spot for equities

It is puzzling that Trump would choose to nominate Herman Cain to be a Fed governor, because the entire history of Cain’s approach is contrary to Trump’s favor of low interest rates. Cain has always been a hard money advocate, and he has strongly believed in a gold standard. He penned a WSJ Op-Ed in 2012 calling for its adoption:

Article I, Section 8 of the Constitution grants power to Congress “to coin Money, [and] regulate the Value thereof.” But for the last 40 years in Washington, regulate has meant manipulate, with the Federal Reserve raising and lowering interest rates and buying and selling assets at its own discretion. All of this manipulates the value of the dollar. We regulate time by making sure an hour is always a fixed quantity of minutes and a foot is always a fixed quantity of inches. The more complex a society, the more it depends on fixed and rigorously reliable standards. A dollar should be defined—as it was prior to 1971 under the postwar Bretton Woods system—as a fixed quantity of gold.

Paul Krugman cited just one recent example of the dire effects of a gold standard straitjacket.
 

An unusual sweet spot for equities

To be sure, Herman Cain was never the sort of “low interest guy” that Trump favors. In a recent editorial, while Cain was supportive of Trump’s policies, he also justified rising rates that accompanies higher economic growth as “a good thing”.

The main thing to understand is that economic activity is picking up, and that’s what’s driving the rise in interest rates. Retail activity has turned out much stronger this holiday season than economists were predicting. Jobless claims are down. Business investment is up. And a tax cut is coming within days.

The first year of the Trump Administration has not produced everything we wanted, but the overall economic performance has been triumphant, and we’re just getting started. That’s why interest rates are rising, and that’s why you should understand it’s very good news.

While many market participants may find Trump’s attempt to politicize the Fed to be disturbing, the purpose of these pages is not to discuss what should happen, but the market implications of likely events and policies. While Trump may believe that Moore and Cain could act as counterweights to Powell’s hawkishness, Moore will likely become a conditional dove (when a Republican occupies the White House) and Cain is an uber-hawk and anti-inflation fighter. If both are confirmed, their views will offset each other.
 

Reflationary surprise ahead?

In the meantime, global central bankers have all gone on pause as the risk of a global slowdown is rising. The Fed has turn to “patience” as a mantra, citing the combination of slower growth and uncertainties from abroad. The NDR Global Recession Model shows a high likelihood of recession, which is defined as sub-3% growth, and not the same way as US recessions.
 

An unusual sweet spot for equities

However, the world may be in for a rebound. The better than expected PMI from China, upbeat ISM, and better than expected March Employment Report, which I forecasted (see A March Jobs Report preview) are foreshadowing a possible global reflationary surprise.
 

An unusual sweet spot for equities

The behavior of global stock prices is supportive of the global reflationary thesis. Callum Thomas recently observed that the incidence of “golden crosses”, a condition where the 50 dma rises above the 200 dma as signals of improving stock indices trends, is rising all around the world.
 

An unusual sweet spot for equities

As well, analysis from Yardeni Research indicates that forward 12-month estimates have bottomed and they are rising across all market cap bands, indicating positive fundamental momentum.
 

An unusual sweet spot for equities

Even the Atlanta Fed’s GDPNow nowcast of Q1 GDP growth has recovered to 2.1% from a near zero reading in March.

An unusual sweet spot for equities

The ECRI’s Weekly Leading Index is also turning up, though readings remain in negative territory.
 

An unusual sweet spot for equities

Investment implications

I have written before about the excessively defensive posture of institutional managers. State Street sentiment, which is derived from the actual holdings of US managers and what they do with their money, shows a high degree of cautiousness.
 

An unusual sweet spot for equities

The BAML Fund Manager Survey of global institutional managers also indicate a historically low weighting in equities.

An unusual sweet spot for equities

There are other indicators of sentiment, each measuring a different constituency. The Commitment of Traders measures futures traders and fast money hedge funds, NAAIM measures RIAs serving retail investors, and AAII weekly sentiment measures mostly individual day and swing traders. What matters the most to long-term sentiment is institutional investor positioning. While these behemoths move at a glacial pace, their big money flows, once started, can persist for months and quarters, and therefore they are best when forecasting the long-term outlook. Right now, institutions are very cautious. At a minimum, that should put a floor on any corrections as the breadth of any selling should be limited.

In short, the combination of overly defensive institutions in an environment that is coming out of a growth scare, and falling policy uncertainty puts equities in an unusual sweet spot. A turnaround after a period of excessive pessimism creates the conditions for a FOMO rally of risky assets. I expect equity prices will be considerably higher by year-end.
 

The week ahead: “Good overbought” advances

Looking to the week ahead, the stock market appears to be repeating the pattern of grinding up while flashing a series of “good overbought” readings on RSI-5, only to see the advance stall when RSI-14 reaches the overbought level of 70. The Index is now testing the upper end of a rising channel, while RSI-14 is overbought, indicating a high likelihood of a minor pullback early in the week.
 

An unusual sweet spot for equities

Breadth indicators are generally constructive for the bull case. The S&P 500 Advance-Decline Line made another all-time high Friday, which is a positive sign of bullish breadth. Two of the other three breadth indicators are bullish, with % bullish and % above the 200 dma advancing to fresh recovery highs as stock prices rallied. Only the % above the 50 dma flashed a negative divergence. I interpret these conditions as long-term bullish, but a pullback can happen at any time.

An unusual sweet spot for equities

The breadth indicators for the NASDAQ 100 are also exhibiting a similar constructive pattern. The NASDAQ 100 Advance-Decline Line made a fresh all-time high, and both the % bullish and % above the 200 dma rose to new highs as the index rose.
 

An unusual sweet spot for equities

An analysis of market cap leadership is also constructive for the bull case. The performance of both mid and small cap stocks made double bottoms relative to large caps (troops leading the generals). As well, NASDAQ 100 stocks remain in a constructive relative uptrend.
 

An unusual sweet spot for equities

Credit markets are also confirming the equity market advance. The price performance of high yield (junk), investment grade, and EM bonds relative to their duration-adjusted Treasury benchmarks are not diverging from stock prices.
 

An unusual sweet spot for equities

Although the weekend Barron’s cover did flash a “magazine cover” contrarian cautionary signal.
 

An unusual sweet spot for equities

However, SentimenTrader pointed out that Barron’s does not function well as a good contrarian magazine cover indicator.
 

An unusual sweet spot for equities

A survey of sentiment indicators are not at extreme levels, which gives room for the market to rise further. AAII weekly sentiment is neutral, despite the recent market rally.
 

An unusual sweet spot for equities

The NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investors’ funds, spiked last week. Readings are not yet at bullish extremes, and the spike could be indicative of a FOMO rally as advisors pile into stocks.
 

An unusual sweet spot for equities

Option market sentiment is not at a crowded long either. The term structure of the VIX Index (middle panel) is below average, but readings cannot be considered to be a crowded long. The VIX Index (bottom panel) has also not breached below its Bollinger Band, which is a signal of an overbought stock market.
 

An unusual sweet spot for equities

The 30 day moving average of the equity-only put/call ratio is in the middle of its 10-year historical range. Sentiment, as measured by the put/call ratio, can hardly be described as either panic or euphoria, but meh!
 

An unusual sweet spot for equities

Short-term breadth indicators are also showing the similar pattern of rising prices while flashing a series of “good overbought” signals. However, readings are overbought, indicating a high likelihood of a pause or pullback early in the week.
 

An unusual sweet spot for equities

My inner investor is bullishly positioned. He is slightly overweight equities compared to his target equity weights. My inner trader is also bullish and long the market. He is prepared to buy more should the market pull back next week.

Disclosure: Long SPXL
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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