Sunday, November 22, 2015

How the market can rise (and commodities rally)

Trend Model signal summary
Trend Model signal: Neutral
Trading model: Bullish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

The market can grind-up
For the last few weeks, my themes for the US equity market is a bullish outlook, combined a setup for a rally of commodity and capital goods sectors. With respect to the first theme of the bullish equity outlook, I use the framework of the Zweig Breadth Thrust off the panic sell-off bottom of August and September (see Bingo! We have a buy signal!). Michael Batnick recently tweeted this chart from Credit Suisse (annotations in red are mine):

In the context of a strong momentum thrust from a market bottom, this chart is a good road map of what may happen next. We have gone through a brief period of consolidation and pullback. In general, the market tends to grind up from here.

Further, we are approaching a period of bullish seasonality. Stocks tend to have a positive bias Thanksgiving Week and analysis from Ryan Detrick showed that the rest of the year tends to be bullish as well (via Marketwatch):

Sentimental support
Sentiment models are also supportive of higher prices. The NAAIM survey of RIAs show that sentiment has recovered from bearish extremes and they are trending bullish. Risk appetite pulled back slightly last week, but they have further room to run and portfolios are not fully invested.

The BoAML Fund Manager Survey (FMS) shows that global managers remain underweight US equities, which indicates a potential for a bullish stampede as we enter a period of positive seasonality aided by the momentum tailwind of a Zweig Breadth Thrust.

I am also encouraged by the latest readings from Barron`s of insider activity. We have seen two weeks of heavy insider buying as the stock market has pulled back and consolidated its gains.
The combination of bullish momentum, positive seasonality and improving, but not overbought, sentiment readings point to a grind up into year-end.

A late-cycle market
I have also been advocating a rotation into late cycle commodity sensitive sectors (see Profiting from a late cycle market and Global reflation = Buy risk (and cyclicals)). That trade setup continue to develop. Technicians know that the an oversold and wash-out market combined with signs of reversal is a powerful buy signal. We are starting to see signs of that today in the late-cycle sectors.

The BoAML FMS is instructive on sentiment. The top three most crowded trades of long USD, short commodities and short EM equities are all correlated and amount to the same macro theme.

Fund managers' biggest over and underweight positions relative to their history reflect the unloved nature of these sectors.

However, we are starting to see signs of reversal as global growth expectations turn up:

The elephant in the room has been China, but managers believe that the China growth outlook is stabilizing and recovering.

I pointed out last week that Tom McClellan had identified a 10-month cycle in copper prices, which should be bottoming about now. McClellan also warned that he did not expect a durable bottom until we saw price capitulation, as measured by the 10-day rate of change. We may have seen that last week. In the past, copper prices have tended to rally whenever the 10-day ROC hit -10% (marked by the vertical blue lines).

Sober Look also highlighted analysis from JPM indicating that cyclical stocks are beating defensive stocks as a sign of reflation.

Don`t worry about rates and Dollar
The issue of Fed policy has come up numerous times in discussions with investors about my bullish outlook on equities and commodities. I have been repeatedly asked the question, "The Fed is likely to raise interest rates in December, wouldn't that be bearish for stocks, bullish for the USD and therefore bearish for commodities?"

Not necessarily. There are two parts to that question. Historically, the Fed has begun a rate hike cycle when it sees inflationary pressures start to tick up. Everything else being equal, higher interest rates would be negative for equity valuations because E/P, which is the inverse of the P/E ratio, would fall and therefore depress P/E multiples. But everything else isn't equal. Typically, the negative effects of a slight P/E contraction are offset by better earnings growth, or bigger E in the P/E ratio. Indeed, the latest figures from John Butters of Factset shows that forward EPS estimates are rising again, which is equity bullish (annotations in red are mine).

As well, the market discussion has moved on from the timing of the first rate hike to the pace of the rate hikes. Ned Davis Research showed that the stock market has historically reacted much better to a slow pace of rate increases than a fast pace. In the current circumstances, the Federal Reserve has made it very clear that the pace of tightening will be slow, measured and data dependent.

What about the US Dollar? Isn't a rate hike USD bullish and therefore commodity bearish because of their inverse correlation? Not necessarily. The upcoming rate increase must be the most telegraphed initial rate hike in Federal Reserve history. The market will undoubtedly shift its focus to the evolution of the dot plots to see how quickly the Fed is likely to raise rates. Assuming that the FOMC does raise rates in December, the USD may very well see a reflex rally evaporate should Yellen makes it clear, as she is likely to, that the trajectory of future rate hikes will be slow and shallow.

Indeed, Urban Carmel showed that the USD has often fallen after the first rate hike:

USD Index after first rate hike

...and commodity prices, as measured by the CRB Index, has tended to rise:

CRB Index after first rate hike

From a technical perspective, the USD Index is approaching a key long-term Fibonacci retracement level, which may be a signal for a pause and pullback:

The week ahead
Looking to the week ahead, I am unabashedly bullish. The SPX rallied last week and regained its 200 dma. Momentum is positive but not overbought on RSI5. My preferred breadth metrics remain neutral to positive (see my recent post Don't worry about bad breadth for a discussion on my interpretation of breadth).

We are also entering into a period of positive seasonality as Thanksgiving Week has generally been stock market friendly (via Urban Carmel):

Ryan Detrick showed that we have seen a 12 year streak of positive returns for the final 30 days of the year. 2015 is not likely to be the unlucky 13th year given the strong momentum backdrop this year.

IndexIndicators measures of breadth are not overbought either on a short-term (1-3 day) basis:

...or on a longer term (1-2 week) basis, but price momentum remains positive.

Bottom line: Stock prices are likely to move higher. Both my inner investor and inner trader are bullishly positioned, with exposure to the market and in the commodity sensitive sectors of the market.

Disclosure: Long SPXL, ERX, NUGT

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