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Priced for perfection

Summary:
I have been in the habit of writing a weekend publication consisting of a relatively long research piece combined with a tactical trading commentary, which has at times been very long. As an experiment, I am splitting the two up. Please let me know if you prefer the format of two shorter posts, or a combined longer publication. As the market advanced to another fresh high, the forward P/E rose to 18.4, which roughly matches the level last seen at the melt-up high of early 2018.  From a pure valuation perspective, stock prices have risen too far, too fast. Oliver Renick, writing in Forbes, justified the elevated valuations this way: Actually, if there’s anyone for the bears to blame, it’s themselves. Economic data in the U.S., China and Eurozone are beating expectations by the

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I have been in the habit of writing a weekend publication consisting of a relatively long research piece combined with a tactical trading commentary, which has at times been very long. As an experiment, I am splitting the two up. Please let me know if you prefer the format of two shorter posts, or a combined longer publication.

As the market advanced to another fresh high, the forward P/E rose to 18.4, which roughly matches the level last seen at the melt-up high of early 2018.
 

Priced for perfection

From a pure valuation perspective, stock prices have risen too far, too fast. Oliver Renick, writing in Forbes, justified the elevated valuations this way:

Actually, if there’s anyone for the bears to blame, it’s themselves.

Economic data in the U.S., China and Eurozone are beating expectations by the biggest gap since early 2018 and on the longest win-streak since mid-2017, according to the sum of Citi’s economic surprise indices I compiled using Bloomberg. Geopolitical risk between the U.S. and China is fading, Brexit is on some path toward completion, a dropping dollar is providing relief to emerging economies, and the global banking system is still intact despite an unnerving foray into the land of negative interest rates. So stocks are rallying as things improve. It’s as simple as that.

Macro concerns have been resolved bullishly, one by one. The reduction of macro risk has compressed risk premiums, and conversely, boosted P/E ratios.

In other words, the market is being priced for perfection.
 

Market potholes ahead?

Here are some possible potholes that investors should be concerned about. A Chinese delegation is expected to arrive in Washington next week January 13-15 to ink a Phase One trade agreement. Could any last minute details hold up the signatures?
 

Caixin reported that China will not raise its annual low-tariff grain import quotas, which could be an impediment to its commitment to purchase more American goods as part of the Phase One deal. To be sure, there are some ways that it could fudge imports, such as diverting current indirect Hong Kong imports from the US to direct imports. Nevertheless, this development could become a last minute roadblock to a deal.
 

Fathom’s China Exposure Index (CEI), which measures the performance of US-listed firms that do business in China against their domestic peers, is already at highly elevated levels. What could possibly go wrong?
 

Priced for perfection

Even if the Phase One deal is concluded on time without any hitches, American trade negotiators are expected to turn their sights on the EU, which Trump has called “worse than China” on trade. EU trade negotiator Phil Hogan is scheduled to be in Washington next week for what could prove to be the start of contentious trans-Atlantic trade negotiations.

In addition, Friday’s weakish Jobs Report highlights the market vulnerability to weakening employment. Initial jobless claims has been inversely correlated to the SPX during this expansion cycle, but initial claims (blue line, inverted scale) are rolling over while stock prices (red line) continue to rise. How long can this negative divergence last?
 

Priced for perfection

New Deal democrat, who has done a stellar job of monitoring high frequency economic indicators, believes the jobs market is telling the story of a slowdown, but no recession.

This remains consistent with a significant slowdown. But there have been similar readings in 1967, 1985-6, 3 times in the 1990s, and briefly in 2003 and 2005, all without a recession following. So the threshold for continuing claims being a negative (vs. neutral) has not been met.

Giddy sentiment

Even as macro risks lurk, the sentiment backdrop tells the story of a market that is excessively bullish and vulnerable to a shock. Three of my real-time sentiment indicators are in the red. Each of these indicator capture a different dimension of investor and trader sentiment, but they are all flashing warning signs.

  • VIX Bollinger Band width narrowing, indicating volatility compression.
  • 10-day moving average of equity-only put/call ratio at historical lows, indicating bullish complacency.
  • 10-day moving average of TRIN at historical lows, indicating persistent buying pressure.
Priced for perfection

For the ultimate sign of giddiness, here is a tweet by Helene Meisler, market commentator and contributor at Real Money.
 

Priced for perfection

Joe Kennedy reportedly sold all of his stocks before the 1929 Crash when his shoeshine boy started giving him stock tips. Is this the modern day shoeshine boy moment?
 

Negative divergences everywhere

At the same time, the market is flashing negative technical divergences even as the index pushed to fresh all-time highs. The 5 and 14 day RSI, NYSE Advance-Decline Line, and % above the 50-day moving averages all failed the confirm the new highs.
 

Priced for perfection

This is a market that is increasingly vulnerable to a setback. Valuations are stretched, the market is priced for perfection, sentiment is positively giddy, and market internals are bearish. We just need a bearish catalyst. While price momentum remains dominant in the current environment, and the major market indices could rally further, risk/reward is unfavorable,

That said, I believe that investors and traders should react to these conditions differently. For some context, the trader at Macro Charts recently warned about how “extreme and historic complacency [is] building in markets”. He concluded:

If history is a guide, the risk-reward over the next 1-2 months is moving towards “extremely poor”, and we shouldn’t rule out a compressed (front-loaded) decline either. All that’s needed is a “catalyst”, as always just a narrative/excuse to trigger deleveraging.

Sounds dire, right? However, he examined past episode during the 2001-2005 and 2009-2020 periods when he spotted similar conditions. Maximum peak-to-trough drawdowns ranged from -4% to -17%, with an average of -8.7% and a median of -7.5%. In many of the cases, the market edged higher by about 1% before falling, so downside risk was slightly smaller than those statistics. In effect, average downside risk is in the 5-10% range.

Should investors be worried about a pullback of that magnitude? Doesn’t that just represent normal risk of holding equities? We therefore believe that investment oriented accounts are advised to remain invested but to wait to deploy new cash. The risk of a prolonged bear market is low, and downside risk is limited to a 5-10% correction and valuation reset. My inner investor is therefore still bullishly positioned.
 

Lines in the sand

On the other hand, traders should exercise caution, and take steps to either de-risk their portfolios, or set up risk management triggers to de-risk or possibly go short.

Subscribers received an email alert on Thursday indicating that I had taken profits in all of my long positions and I was in 100% in my trading account. Here are two lines in the sand that I am watching to become more aggressive and go short. The first is an SPX close below its 10 dma.
 

Priced for perfection

The second is a bond market rally. Either the 30-year yield or TLT has to break through the pictured trend lines. Since bond prices are roughly inversely correlated to stock prices, an upside TLT breakout is a signal that stocks may be in trouble.
 

Priced for perfection

My inner trader plans to take partial short positions in equities should either of these events occur. If both occur, he will take a full short position. Since both of these signals are a function of closing prices, I may not have sufficient time to alert subscribers with an email alert before the market close.

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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