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Green shoots, rotten roots?

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.

Green shoots, rotten roots?

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.
 

Are the green shoots turning brown?

Just when you think the global economy is starting to spring green shoots, the skies have darkened and some of those shoots may be turning brown. In the US, ISM Manufacturing fell and missed expectations. And that’s not all. Analysis from Nordea Markets concluded that the internals are pointing to further weakness.
 

Green shoots, rotten roots?

In China, both the official PMI, which is tilted towards larger SOEs, and the Caixin PMI, which measures SMEs, fell and missed expectations. These readings have cast doubt on the longevity of Beijing’s stimulus driven rebound.
 

Green shoots, rotten roots?

On the other hand, the Non-Farm Payroll report came in ahead of expectations. In Europe, the PMIs for peripheral countries like Italy and Greece are outperforming Germany. In addition, exports from Korea and Taiwan, which are highly globally sensitive, have rebounded indicating recovery.
 

Green shoots, rotten roots?

What’s going on? How do we interpret these cross-currents?

I agree with Rob Hanna’s insightful comment that “Tops Wobble Before Falling Over”. My review of the market’s technical conditions reveals the market is not wobbling yet. Any market wobble would be seen in NASDAQ and semiconductor stocks. Until Technology and NASDAQ leadership starts to falter, and if their leadership is not replaced by the reflation-sensitive cyclical groups, we remain bullish on equities.
 

Look for the market to wobble first

It can be useful during these periods of macro and fundamental uncertainty to turn to technical analysis. The market’s technical signals represent messages of how expectations are evolving, which investors should heed.

As stock prices have been on a tear since the Christmas Eve lows, there is some natural nervousness that the market has risen too far too fast. Rob Hanna at Quantifiable Edges made an insightful comment that “Tops Wobble Before Falling Over”, which he wrote on Thursday just after the post-FOMC market downdraft:

I’ve shown numerous studies in the past that suggest uptrends often become choppy before they ultimately end. It is highly unusual for an uptrend that is showing strong persistence to abruptly top out. The study below demonstrates this concept. The persistent uptrend of late has kept SPX above its short-term moving averages for an extended period. Tuesday, after 22 consecutive closes above the 10ma, SPX dipped down and closed below it. The study below looks at performance following other instances where SPX closed below its 10ma for the first time over 15 days.

Green shoots, rotten roots?

Hanna continued:

The strong upslope serves as some confirmation of the bullish edge. As my friend and colleague, Tom McClellan says, “A spinning top does not just stop spinning and fall over. It wobbles first.” I saw a few bullish studies along these lines last night. Odds seem to suggest a good chance of a bounce arriving in the next few days.

My own review of sector leadership confirms that, so far, the market is not wobbling yet.
 

The message from sector analysis

A review of sector leadership came to the following conclusions:

  • FAANG stocks are still dominant
  • Cyclical stocks are showing signs of emerging leadership
  • Defensive sectors are lagging

Barring any “wobbles” from these themes, the strength of high beta, glamour, and cyclical sectors lead to the conclusion that the path of least resistance for stock prices is still up.

The primary tool for a sector review is the Relative Rotation Graphs. RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The RRG analysis of US large cap sectors shows the dominance of FAANG stocks. Technology stocks are in the top right quadrant, indicating strength. Other strong sectors include Consumer Discretionary (AMZN), and Communication Services (FB, GOOG, GOOGL). By contrast, defensive sectors such as Utilities, Real Estate, and Consumer Staples are all in the bottom half of the chart, which indicate weakness. While Healthcare stocks are often classified as defensive, their recent weakness are attributable to market jitters over a Democrat victory in 2020, and the negative implications of a Medicare for All program.
 

Green shoots, rotten roots?

I have written about this before, but FAANG leadership is especially evident in the strong relative strength of NASDAQ 100 stocks, both on a capitalization weighted basis (middle panel), and on an equal-weighted basis (bottom panel).

An RRG analysis of small cap sectors reveals some common themes and notable differences. Tech stocks are still the market leaders, and defensive sectors are still the laggards. However, Consumer Discretionary stocks have moved from the top half of the chart to the bottom half, as small caps does not have AMZN to play a leadership role. I therefore interpret this sector as weaker than it actually is on the large cap chart.
 

Green shoots, rotten roots?

Sometimes, a cross-border analysis can be revealing, as factor and sector returns are often correlated across different global regions. An RRG analysis of European sectors tells a similar story. Technology stocks are also the market leaders, and defensive sectors are mainly the laggards. One key difference is the cyclical sectors are more advanced in their leadership development than the US.
 

Green shoots, rotten roots?

The following table of US large cap, small cap and European sector leadership summarizes the important leadership themes. Technology is consistently in the leading quadrant across all three groupings, and defensive sectors are laggards. In the US, late cyclicals such as Energy and Materials are starting to show some life,
 

Green shoots, rotten roots?

Limitations of RRG analysis

I would, however, like to highlight some of the limitations of RRG analysis. One problem with this technique arises because of the quirks of the arbitrary boundaries of RRG charting. American large and small cap Financial stocks are in the bottom left “lagging” sector, but on the verge of rising into the top left “improving” quadrant, while European Financials have already risen to “improving”. The relative performance of US and European Financials are roughly the same. The chart below depicts the market relative returns of US Financials (black line) and European Financials (green line). In the past, the relative strength of this sector has been highly correlated to the shape of the yield curve, and the current steepening trend should be supportive of this sector.
 

Green shoots, rotten roots?

The other sectors that may be doubtful as emerging US market leaders are the deep cyclical resource extraction sectors of Energy and Materials. The relative performance of these sectors is highly sensitive to the USD, and the recent strength of the greenback will be headwinds for these sectors.
 

Green shoots, rotten roots?

By contrast, the relative performance of other cyclical sectors and groups seems more constructive.
 

Green shoots, rotten roots?

Investment implications

It is not enough for a market analyst to analyze the market from a purely technical perspective, and then come to a conclusion based purely on the charts. Risk and return exist in many dimensions, and my review would be incomplete without a review of the macro backdrop.

To recap, our review of sector leadership came to the following conclusions:

  • FAANG stocks are still dominant
  • Cyclical stocks are showing signs of emerging leadership
  • Defensive sectors are lagging

Let’s start with the cyclical stocks. The roots of the cyclical upturn comes from China. It was evident last year that the Chinese economy was slowing. In response, the authorities abandoned their previously stated objective of deleveraging, and rebalancing growth, to a highly targeted program of credit driven stimulus, as well as fiscal stimulus in the form of tax cuts. Evidence of a turnaround was shown in Q1, which provided the impetus for renewed optimism for global growth.

The latest round of economic statistics from Asia suggest that the recovery may be stalling. To be sure, a nascent export recovery is taking hold in highly China sensitive economies such as Korea and Taiwan. Based on these readings, I do not expect China to save the world with another stimulus growth leg, but Beijing has managed to stabilize Asian economies. Everything else being equal, the recovery is starting to look L-shaped.

That said, the Chinese leadership will not allow the economy to tank ahead of the October celebration of the founding of the PRC. Undoubtedly, they are counting on a US-China trade deal to provide the next round of stimulus for the economy. US Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin went to in Beijing last week for a round of talks which were described as “productive”. Vice Premier Liu He is expected to lead a delegation of Chinese officials to Washington in the coming week for further discussions. It is evident that both sides want an agreement, and official sources of hinted that we could see the outline of a deal by this coming Friday. The market has anticipated the prospect of a trade agreement before, and successive cries of “wolf” are being increasingly discounted or ignored. Nevertheless, press reports indicate that both sides appear to have given ground on substantive issues, and a positive announcement may be at hand. Should the discussions fall apart, I would expect the Chinese authorities would resort to Plan B, which is another round of stimulus so that growth holds up until Q4.

A Xi Put is firmly in the market. Expect the cyclical and reflation trade to keep working, at least until later this year.

In the US, the Powell Fed adjusted market expectations of a rate cut this year by stating that it doesn’t know whether the next move will be up or down. “Patience” has changed to “transitory”:

We expect that some transitory factors may be at work. Thus, our baseline view remains that with a strong job market and continued growth, inflation will return to 2 percent over time, and then be roughly symmetric around our long-term objective.

In a November 28, 2018 speech, Jerome Powell made it clear that one key focus of the Powell Fed is to avoid ad hoc responses to financial crises, and to develop a more systematic approach to ensure financial stability:

Outside of these crisis responses, however, systemic issues were not a central focus of policy.

The Global Financial Crisis demonstrated, in the clearest way, the limits of this approach. Highly inventive and courageous improvisation amid scenes of great drama helped avoid another Great Depression, but failed to prevent the most severe recession in 75 years. The crisis made clear that there can be no macroeconomic stability without financial stability, and that systemic stability risks often take root and blossom in good times.3 Thus, as the emergency phase of the crisis subsided, Congress, the Fed, and the other financial regulators began developing a fundamentally different approach to financial stability. Instead of relying on improvised responses after crises strike, policymakers now constantly monitor vulnerabilities and require firms to plan in advance for financial distress, in a framework that lays out solutions in advance during good times.

Even though the Fed has signaled that it doesn’t know whether it will cut rates this year, the Powell Financial Stability Put remains in place. The lagging relative strength of defensive sectors is testament to the floor that the Fed is likely to put on stock prices.

At the same time, with the cyclical and reflation trade in doubt, the market has gravitated to the only source of consistent growth, which are the FAANG and Technology stocks.

Keep an eye on the semiconductor group, which has both Tech and cyclical qualities. The group was a strong market leader, but became over-extended and was rejected a relative resistance. Despite the pullback, the relative uptrend remains intact.
 

Green shoots, rotten roots?

Any market wobble would be seen in NASDAQ and semiconductor stocks. Until Technology, and NASDAQ leadership starts to falter, and if their leadership is not replaced by the reflation sensitive cyclical groups, I remain bullish on equities.
 

The week ahead

Looking to the week ahead, the stock market appears to be resuming its orderly advance after a brief post-FOMC downdraft. Subscribers received an alert early Thursday indicating that short-term indicators had flashed buy signals, based on the assumption that the market would continue its slow grind upwards. The SPX was testing its wedge support, the VIX Index had breached its upper Bollinger Band indicating a short-term overbought condition, and the 14-day RSI was near levels where it had bottomed in the past during this advance. I was fortunate in that call, when stock prices staged a strong turnaround on Friday after the April Jobs Report printed a positive surprise.
 

Green shoots, rotten roots?

Long-term sentiment is supportive of further market strength. Mark Hulbert highlighted an academic study by Malcolm Baker and Jeffrey Wurgler, Investor Sentiment and the Cross-Section of Stock Returns. The latest readings from the Baker-Wurgler model indicate no signs of market froth indicative of a major market top.
 

Green shoots, rotten roots?

The analysis of equity fund flows came to a similar conclusion. Enthusiasm for stocks is nothing compared to the 1999-2000 NASDAQ top, or the 2005-07 top (via Urban Carmel).
 

Green shoots, rotten roots?

As well, the Conference Board`s measure of long-term equity sentiment is neutral, and not excessively bullish.
 

Green shoots, rotten roots?

Intermediate-term sentiment models like the Fear and Greed Index reset and recycled after last week’s brief scare. The index closed at 60 on Friday, which is well below the 80-100 target zone where past rallies have topped out.
 

Green shoots, rotten roots?

At the same time, Q1 earnings season is providing positive fundamental momentum support for stock prices.  Both earnings and sales beat rates are above their historical averages, and forward 12-month EPS estimates continue their trend upwards. At the current rate of improvement, the market may be able to avoid the dreaded “earnings recession” of a YoY quarterly earnings decline that was feared by many investors several weeks ago.
 

Green shoots, rotten roots?

As well, FactSet reported that the rate of quarterly estimate cuts for Q2 is lower than the historical average, indicating a better than average fundamental outlook.
 

Green shoots, rotten roots?

From a technical perspective, NASDAQ 100 leadership remains intact.
 

Green shoots, rotten roots?

Another encouraging sign is the upside breakout by the small cap Russell 2000. While this index is still well below its all-time high, the breakout is likely to spark some animal spirits and increased risk appetite among traders.
 

Green shoots, rotten roots?

The combination of benign intermediate and long-term sentiment readings and positive price and fundamental momentum is bullish. My inner investor is overweight equities. My inner trader added to his long positions late last week, and he is strapping himself in for the ride to further highs.

Disclosure: Long TQQQ, 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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