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Why The Market Looks Ready To Rise (And Commodities Rally)

Published 11/23/2015, 05:58 AM
Updated 07/09/2023, 06:31 AM

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 S&P 500 chart below.

SPX Monthly with Trend Signals 2011-2015

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

The market can grind-up

For the last few weeks, my theme for the US equity market is a bullish outlook, combined with a setup for a rally of commodity and capital goods sectors. With respect to the first theme, 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) (the annotations in red are mine):

SPX: 100 Days From Major Troughs

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):

Average S&P 500 Movement in November, since 1950

Sentimental support

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

NAAIM Number 2014-2015


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.

Fund Manager Asset Allocation: US Equities 2005-2015

I am also encouraged by the latest readings fo insider activity, from Barron`s. We have seen two weeks of heavy insider buying as the stock market has pulled back and consolidated its gains.

Insider Transactions Ratio

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 continues 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.

Most Crowded Trades


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

Global FMS as of November 15, 2015


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

Global Economic Expectations 1994-2015


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

China Growth and Economic Expectations


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).

Copper Price 2006-2015 vs 10 Day Rate of Change

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

Cyclical vs Defensive Stocks 2014-2015

Don`t worry about rates and the 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).

Change in Forward 12-M EPS vs 10-Y Price Change


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.

US Stock Reaction to Fast vs Slow Rate Hikes


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 make 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

USD Overview with Rate Hikes 1980-2005


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

CRB Index after first rate hike

CRB Index with Rate Hikes 1980-2005


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:

USD Monthly 1995-2015

The week ahead

Looking to the coming 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).

SPX Daily with A-D Line and RSI(5)


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

SPX Performance Surrounding Thanksgiving 1950-2011


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.

S&P 500 Returns, Final 30 Trading Days


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

SPX vs % Stocks with 5-D RSI Above 70


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

S&P 500 vs Stocks at 20-D Highs Minus Lows


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

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (""Qwest""). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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