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Bearish warnings, but no trigger

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 Asset Allocation 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

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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 Asset Allocation 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.
 

Bearish warnings, but no trigger

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

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.

Subscribers can access the latest signal in real-time here.
 

Island reversal signal intact

A little over a week ago, the market traced out a bearish island reversal formation after violating a rising trend line. While the bullish island reversal signal in April saw the market advance immediately afterwards, the aftermath of the most recent signal resolved itself in a sideways consolidation, indicating that the bulls still had some life left in them, and they were struggling to maintain control of the tape.
 

Bearish warnings, but no trigger

Nevertheless, market internals revealed a number of bearish setups, with no obvious trigger. As an example, there is a divergence between the VIX Index and VVIX, which is the volatility of the VIX. I interpret this to mean that VVIX is not buying the recent fall in the VIX, and it is discounting an increase in volatility, which tends to be inversely correlated with stock prices.
 

Bearish setups

I can cite a number of other bearish setups, or divergences. The advance off the March bottom had been led by cyclical stocks. Indeed the relative performance of cyclical to defensive stocks had been rising steadily. The cyclical to defensive ratio rolled over even as the market tried to rally and trade sideways last week, which is a negative divergence.
 

Bearish warnings, but no trigger

A similar relationship can be seen in the ratio of equal-weighted consumer discretionary stocks, which I use to minimize the sizable weight of Amazon in the cap weighted consumer discretionary sector, to equal-weight consumer staples stocks. This ratio has long been used as a risk appetite indicator. The equal-weighted discretionary to staples ratio rolled over and continued to fall even as stocks consolidated sideways last week, which is another negative divergence.

There have been a number of warnings sounded about the extended nature of the put/call ratio, indicating crowded long positioning. These words of caution from SentimenTrader is just one of several examples.
 

Bearish warnings, but no trigger

There is also an ominous divergence between the equity-only put/call ratio (CPCE) and the index put/call ratio (CPCI). It is commonly believed that CPCE measures retail sentiment, as retail traders focus mainly on options on individual stocks, while CPCI measures dealers and institutions sentiment because they use those instruments for hedging purposes. The CPCE-CPCI spread has reached an extreme, and, if history is any guide, such episodes tend to resolve themselves bearishly.
 

Bearish warnings, but no trigger

That said, these divergences can only be regarded as bearish setups. Last week’s sideways market action was a signal that the bulls were not fully defeated. The bears need a trigger before they can seize control of the tape.
 

Don’t blame the Fed

So what might be a bearish trigger? First, I would not look to the Fed for a durable excuse for the stock market to rise or fall.

Consider the market reaction on June 11, 2020, the day after the FOMC meeting. The financial press reported that market skidded -6% because the Fed’s economic outlook was insufficiently upbeat. On the other hand, Jerome Powell made it clear in the post meeting press conference that the Fed was not concerned about the level of stock prices, and it was focused primarily on reviving the job market [emphasis added].

MICHAEL MCKEE. Mr. Chairman, Michael McKee with Bloomberg Television and Radio. I came across a statistic the other day that amazed me. Since your March 23rd emergency announcement, every single stock in the S and P 500 has delivered positive returns. I’m wondering, given the levels of the market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop and setback the recovery significantly, or that we might see capital misallocation that will leave us worse off when this is over?

CHAIR POWELL. What we’ve targeted is broader financial conditions. If you go back to the end of February and early March, you had basically the world markets realized at just about the same time, I remember that Monday, that there was going to be a global pandemic and that this possibility that it would be contained in one province in China, for all practical purposes, was not going to happen. It all — it was — you know, it was Iran, Italy, Korea, and then it became clear in markets. From that point forward investors everywhere in the world for a period of weeks wanted to sell everything that wasn’t cash or a — a short term treasury instrument. They didn’t want to have any risk at all. And so, what happened is markets stopped working. They stopped working and companies couldn’t — couldn’t borrow, they couldn’t roll over their debt. People couldn’t borrow. So, that’s — that’s the kind of situation that can be fair — financial turbulence and malfunction. A financial system that’s not working can greatly amplify the negative effects of what was clearly going to be a major economic shock. So, what our tools were — were put to work to do was to restore the markets to function. And I think, you know, some of that has really happened, as I — as I mentioned in my opening remarks, and that’s a good thing. So, we — we’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk, like markets are supposed to do. Borrowers are borrowing, lenders are lending. We want the markets to be working. And again, we’re not looking to — to a particular level. I think our — our principal focus though is on the — on the state of the economy and on the labor market and on inflation. Now inflation, of course, is — is low, and we think it’s very likely to remain low for some time below our target. So, really, it’s about getting the labor market back and getting it in shape, that’s — that’s been our major focus. 

It’s difficult to see how much more dovish Powell could have been, but the market cratered on Thursday/

By contrast, the market rallied on Monday when the Fed announced that, in addition to buying corporate bond ETFs, it planned to create an index of corporate bonds and buy the individual issues. Stock prices rallied on the announcement, even though the Fed had already announced that it would buy individual bonds several weeks ago.

Did any of that market reaction make sense? Be wary of attributing market moves to the Fed.

That said, the Fed is scheduled to publish the results of bank stress tests next week. The NY Times reported that while it will publish a system-wide report card under different stress scenarios, individual bank results will not be part of the disclosure.

The central bank’s vice chair for supervision, Randal K. Quarles, said the Fed would determine capital requirements — essentially the financial cushions that banks must keep to withstand losses — based on economic scenarios developed before the pandemic took hold. While the Fed is testing the strength of banks against multiple dire scenarios that reflect how the virus might play out, the central bank will not publish bank-specific results.

“We don’t know about the pace of reopening, how consumers will behave or the prospects for a new round of containment,” Mr. Quarles said. “There’s probably never been more uncertainty about the economic outlook.”

Powell has warned about what delayed bankruptcies could mean for bank balance sheets. The Fed’s lack of transparency on individual bank stress tests may mean there are hidden fault lines in the system. In the past, breaches of relative support of bank and regional bank stocks have signaled market dislocations. How bad will things be this time, and why is the Fed not telling us?
 

Bearish warnings, but no trigger

A second wave

The market has shown itself to still be sensitive to COVID-19 news. As an example, stock prices gapped up at the open on Friday by about 1%, but it sold off dramatically when Apple announced it was closing selected stores in Arizona, Florida, and the Carolinas over COVID-19 concerns.
 

Bearish warnings, but no trigger

Confirmed new case counts are spiking again, especially in the south and southwest. In particular, new case counts reached all-time highs in Arizona, California, Florida, and North and South Carolina.
 

Bearish warnings, but no trigger

The relative performance of healthcare stocks have begun to perk up again, possibly in response to heightened COVID-19 concerns. After lagging the market for several weeks, these stocks have begun to revive and lead the market again. The only laggard in the sector are healthcare providers, which probably reflects investor concerns about hospital profitability during the pandemic.
 

Bearish warnings, but no trigger

Q2 earnings season surprise?

Another possible negative trigger may come from reports from Q2 earnings season. FactSet reported that earnings estimates are rising again, even though prices and estimates had diverged in a major way since the crisis began.
 

Bearish warnings, but no trigger

The latest weekly update showed some an unusual estimate revision pattern. Analysts are becoming more optimistic this year, while less optimistic next year. The chart below shows the current level of quarterly estimates, plus the weekly revisions for each quarter. The Street has revised near-term estimates upwards, especially for Q2 and Q3, while longer term estimates in 2021 are flat to down.
 

Bearish warnings, but no trigger

The revival of near-term optimism is setting up the potential for disappointment. As the economy begins to reopen again, corporate guidance may turn to the increased cost structure that companies have to face in the new environment. As an example, Bloomberg reported that a Deloitte Consulting study concluded that the money banks will have to spend as much as 50% more for each employee to work in their office towers in the post covid-era.

As well, CNBC reported that retailers will have to compete with the liquidation sales of competitors.

Going-out-of-business sales are getting ready to be, well, basically everywhere this summer.

Retailers that have been forced shut for weeks because of the coronavirus pandemic are beginning to reopen their doors as cities such as New York reopen. That means liquidation sales that had been upended by the pandemic are starting again, or just getting ready to kick off. And that will be added to the usual seasonal sales by retailers looking to get rid of old inventory.

“I have never seen so many [liquidations] happening at the same time, ever,” said Scott Carpenter, president of retail solutions in B. Riley Financial’s Great American Group. “It’s one after another, after another, after another. And there’s more to come.”

Lastly, Biden has been steadily gaining on Trump, both in the polls and the betting markets.
 

Bearish warnings, but no trigger

Biden has promised to reverse the Trump 2017 corporate tax cuts, which would subtract about $10 from 2021 S&P 500 earnings. The strategy team at Goldman Sachs estimates an additional negative secondary order effect of $10, which reduces earnings by a total $20. To be sure, I made the point that there will be offsetting positive earnings effects as Biden’s anti-inequality proposals broaden out consumer spending (see What will a Biden Presidency look like?), but the market is likely to shoot first and ask questions later by focusing on the negatives.

The market’s P/E ratio based on 2021 earnings is already very elevated. How would it react if it begins to discount a Biden victory?
 

Bearish warnings, but no trigger

Waiting for the downside break

Looking to the week ahead, the market is in wait-and-see mode. Short-term breadth has recovered from a deeply oversold reading, and it could go either one of two ways. The pattern is reminiscent of the pattern in March when the market staged a brief relief rally before plunging further, or it could resolve with a sideways consolidation as it did last August.
 

Bearish warnings, but no trigger

The Fed’s balance sheet surprisingly shrank last week, and the shrinkage was attributable to reduced swap lines with other central banks, and lower liquidity demand for repos from the banking system. The Fed’s QE asset purchase program remains intact.
 

Bearish warnings, but no trigger

While the reduction in dollar swap lines is an indication of falling offshore dollar funding stress, the USD Index did catch a bid last week, and EM currencies weakened. Further greenback strength and conversely EM weakness could be the proverbial canaries in the coalmine that puts downward pressure on risk appetite.
 

Bearish warnings, but no trigger

However, the S&P 500 remains in a rising channel, and until we see a breakdown, it would be premature to be wildly bearish. My inner investor is neutrally positioned at roughly the levels specified by his investment policy statement. My inner trader is short, but positioning is light.
 

Disclosure: Long SPXU

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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