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Assessing the damage

Summary:
Stock markets were recently sideswiped by the dual threat of a new Omicron strain of COVID-19 and Jerome Powell’s hawkish pivot. Global markets adopted a risk-on tone and the S&P 500 pulled back to test its 50-day moving average.  This week, I assess the damage that these developments have done to the investment climate from several perspectives: Fundamental and macro; Omicron and Federal Reserve monetary policy; and Technical analysis. Fundamental momentum still positive Let’s start with the good news. Recessions are bull market killers and there is no recession in sight. New Deal democrat maintains a dashboard of coincident, short-leading, and long-leading indicators. His latest update concluded that the “underlying indicators for the economy in all timeframes remain

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Stock markets were recently sideswiped by the dual threat of a new Omicron strain of COVID-19 and Jerome Powell’s hawkish pivot. Global markets adopted a risk-on tone and the S&P 500 pulled back to test its 50-day moving average.
 

This week, I assess the damage that these developments have done to the investment climate from several perspectives:
  • Fundamental and macro;
  • Omicron and Federal Reserve monetary policy; and
  • Technical analysis.

Fundamental momentum still positive

Let’s start with the good news. Recessions are bull market killers and there is no recession in sight. New Deal democrat maintains a dashboard of coincident, short-leading, and long-leading indicators. His latest update concluded that the “underlying indicators for the economy in all timeframes remain generally positive”.
Fundamental momentum is still strong. Forward 12-month EPS estimates for both large and small-cap stocks are still rising.
CEO confidence is on fire. So is the employment and capital spending outlook.

Omicron and the Fed

There is much we don’t know about the Omicron variant of the virus. Some very preliminary data indicate that it is spreading more quickly than previous variants. The data from South Africa’s Gauteng province, which includes Johannesburg, indicates that Omicron related caseloads are rising faster than Delta. Early anecdotal evidence also suggests that infections are mild as hospitalization rates are similar or lower than other waves. On the other hand, early reports indicate that the current generation of vaccines are not as protective against Omicron infection, though they are still effective against serious illness.
There are two ways of interpreting this preliminary data. A benign scenario of a fast spreading but less deadly virus is equity bullish. Lockdowns measures would be minimal and there would be few supply chain disruptions. As well, a lower mortality wave would have the additional benefit of endowing the infected with some natural immunity. Such an outcome would be bullish for the cyclical and value stocks and beneficial to high-beta small-caps.
The cautious view came from the Fed’s Jerome Powell, whose testimony to Congress was initially interpreted by the markets as dovish but turned out to be hawkish [emphasis added]:
The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.
Here is the reasoning behind’s Powell’s phrase, “time to retire the word transitory”.  The Fed recently rolled out its Flexible Average Inflation Targeting framework (FAIT) as a way of addressing criticism that it was chronically undershooting its inflation target. FAIT also served as a way of allowing the Fed to pay more attention to its full employment mandate. 
The Fed’s response to the pandemic was a test of FAIT. The downturn in 2020 was highly unusual inasmuch as demand for goods rose while demand for services fell. At the same time, the global economy shut down in response to the pandemic and sparked a supply shock in goods production. As a consequence, durable goods PCE shot up while services PCE was relatively tame. Over time, supply chain bottlenecks should ease and inflation should fall, which was the reasoning behind the “transitory” narrative.
The emergence of Omicron poses “increased uncertainty for inflation”. Further COVID-19 disruptions to the supply chain mean that the inflation spike is more enduring and less transitory. In effect, the Fed risks being caught behind the inflation-fighting curve by allowing inflation expectations to rise and become unanchored. In other words, the Fed’s nightmare scenario is stagflation caused by slow growth from COVID-19 induced bottlenecks and rising inflation expectations. 

Stalling price momentum

Even though fundamental momentum remains positive, the combination of the Omicron news and the Fed’s hawkish pivot has turned price momentum negative. The S&P 500 had been held up during most of 2021 by the presence of positive price momentum, but momentum has turned. My momentum indicator, defined as the percentage of S&P 500 stocks above their 50 dma to percentage above 150 dma, rose above 1 and recycled below 0.9. Historically, this has been an intermediate-term cautionary signal to de-risk equity portfolios.
A longer time horizon price momentum model focuses on the percentage of stocks above their 200 dma. In the last 20 years, there has only been five episodes when this indicator reached 90% and stayed there, indicating a “good overbought” market advance (grey shaded periods). This indicator has also stalled and recycled downwards. Even though macro indicators, such as the copper/gold ratio and the equal-weighted consumer discretionary/staples ratios, appear benign, past stalls have not ended until the percentage of stocks above their 50 dma has reached the oversold levels of 20.

Investment implications

What does this mean for the stock market? The intermediate-term outlook depends on the path of the Omicron wave and the Fed’s reaction function. Ned Davis Research found that stock prices especially struggle if the Fed undergoes a fast tightening cycle. 
What will the Fed do? Powell testified the FOMC will consider speeding up the taper of its QE program at the December meeting, but nothing is set in stone. Expect the Fed to pivot to the narrative that “tapering does not mean rate hike”. The Fed will remain data-dependent and its reaction function will depend on progress towards economic recovery and the wildcard posed by the Omicron variant.

It is appropriate, I think, for us to discuss at our next meeting, which is in a couple of weeks, whether it will be appropriate to wrap up our purchases a few months earlier. In those two weeks we are going to get more data and learn more about the new variant.

Investor reaction function will also be dependent on time horizon. I have been calling for a sloppy range-bound market in H1 2022 (see How small caps are foreshadowing the 2022 market and Time for a mid-cycle swoon?). The latest risk-off episode is probably just a shot off the bow of equity investors.
 

Under these conditions, investment-oriented accounts should practice some scenario planning and risk mitigation. In the coming months, gradually de-risk portfolios by reducing equity risk and raising fixed-income allocations. My Trend Asset Allocation Model remains at a risk-on signal. The model is based on trend following principles and it will not buy in at the bottom and sell at the top. While I am not inclined to front-run model readings, I expect the Trend Model signal will be downgraded from risk-on to neutral in the next few weeks.
 

I would favor a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation and scenario analysis. If the Fed’s stagflation fears were to materialize, high-quality FANG+ stocks will outperform in a growth-scarce world. Make sure to focus on quality growth names with strong cash flows and competitive positions. Speculative growth stocks, such as meme stocks and unprofitable but promising growth companies such as the ones held by ARKK, are underperforming.
 

On the other hand, if the benign scenario of the Omicron wave is correct, high-beta and cyclically sensitive small-cap value stocks would have the greatest leverage to a recovery.
 

Positioning for short-term traders is a different matter. The market is wildly oversold and there are numerous short-term studies that call for a relief rally. Instead of de-risking, traders should be buying the dip.
 

As one of many examples, 95% of S&P 500 stocks closed down on November 30, 2021. There were 19 similar episodes in the last 10 years and the S&P 500 was higher within 20 trading days every time.
 

In conclusion, I have been calling for a transition from an early cycle market to a mid-cycle market marked by more choppiness. The recent air pocket encountered by global stock markets may just be the prelude to such a scenario. Investment-oriented accounts should gradually de-risk portfolios by reducing equity weights and adding fixed income positions. Focus on a barbell portfolio of FANG+ growth and small-cap value stocks as a way of risk mitigation.
 

Traders, on the other hand, are faced with a market that is extremely oversold. The short-term risk/reward is tilted to the upside. Buy the dip in anticipation of gains over the next few weeks.
 

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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