SHOULD YOU BUY THE S&P 500 BREAKOUT?€¦ · supportive of an eventual advance, as the put/call...

Cam Hui, CFA | [email protected]

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Quantitative & Strategy

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SHOULD YOU BUY THE S&P 500 BREAKOUT?

September 9, 2019

EXECUTIVE SUMMARY

About a month ago, we suggested that the market was in need of a valuation reset, and

outlined a price and forward P/E range for the market (see Powell's Dilemma (and Why It

Matters)). Since then, the index has weakened into the top of my projected range, followed

by an upside breakout from a month-long trading range.

Is it time to buy the breakout?

We believe the decision to chase the S&P 500 upside breakout is dependent on investor

time horizon. The combination of crowded short sentiment levels and positive price

momentum can lead to powerful price surges. Traders can therefore take advantage of these

conditions to ride the rally. The S&P 500 could rise to test, and possibly exceed, the

previous all-time highs in the coming weeks.

However, the longer-term viewpoint is less bullish. Investment-oriented accounts should

take advantage of the market strength to fade the rally if they are overweight equities and

rebalance to either a neutral or an underweight position. Valuations are stretched, the

earnings outlook is mixed and macro tail-risks remain unresolved.

Cam Hui, CFA [email protected]

Table of Contents

An Upside Breakout ............................... 2

A Sentiment Driven Rally ......................... 3

The 2011 Market Template ...................... 6

2011, Then and Now ................................ 9

mailto:[email protected]

https://humblestudentofthemarkets.com/wp-content/uploads/2019/08/20190805-Powells-dilemma.pdf




September 9, 2019


An Upside Breakout

About a month ago, we suggested that the market was in need of a valuation reset, and outlined

a price and forward P/E range for the market (see Powell's Dilemma (and Why It Matters)). Since

then, the index has weakened into the top of our projected range, followed by an upside

breakout from a month-long trading range.

Exhibit 1: The S&P 500 Breaks Out

Source: Stockcharts

Is it time to buy the breakout?




September 9, 2019


A Sentiment Driven Rally

The underpinnings of the market rally can be attributable to excessively bearish sentiment. The

advance began last Wednesday on the news that Hong Kong chief Carrie Lam had withdrawn

the controversial extradition bill, and the British parliament had passed measures that made a

no-deal Brexit more unlikely. Stock prices gained further the next day on the news that U.S.

and Chinese trade negotiators would be meeting in early October.

Marketwatch reported that BAML strategist Michael Harnett’s Bull and Bear Indicator had

flashed a contrarian buy signal, and the signal was based mainly on excessively bearish

sentiment:

B. of A.’s Bull & Bear Indicator, which tracks 18 measurements on asset flow, sentiment, and price,

is flashing a contrarian buy signal that hasn’t been seen since way back in January. The drop in the

reading was driven in large part by asset flows out of equity and emerging market debt, Harnett said.

The indicator has a solid track record of predicting what’s next. Since 2000, global stocks rose a

median 6.3% in the three months after such a buy signal was triggered, while 10-year Treasury yields

increased 50 basis points.

Exhibit 2: The Bull & Bear Indicator Flashes a Buy Signal

Source: Marketwatch, BAML Global Investment Research

Indeed, retail sentiment, as measured by the AAII bull-bear spread, had reached a crowded

short reading in late July, and it has been recovering ever since.


https://www.marketwatch.com/story/enjoy-2019-while-it-lasts-because-the-big-top-is-coming-b-of-a-strategist-warns-2019-09-04


September 9, 2019


Exhibit 3: AAII Bull – Bear Spread

Source: Stockcharts

Institutional sentiment has also been excessively bearish. The State Street North American

Investor Confidence index, which measures the actual positioning of portfolio managers, has

also reached levels consistent with contrarian buy signals.



September 9, 2019


Exhibit 4: State Street Investor Confidence Contrarian Bullish

Source: Datastream

Given the general tone of bearishness, it was therefore little surprise that good news on the

geopolitical, political and trade fronts sparked a risk-on stampede.



September 9, 2019


The 2011 Market Template

We have also suggested in these reports in the past that 2011 could serve as a useful

template for today’s market. The summer of 2011 was marked by high anxiety and

uncertainty over a budget impasse in Washington and a eurozone Greek Crisis. That period

was marked by endless European summits and meetings to talk about meetings. The crisis

was eventually resolved when the ECB stepped in with its LTRO program as a way of

buying time for member states to enact structural reforms.

Fast forward to 2019, the market is marked by anxiety over a global economic slowdown

and possible recession, a Sino-American trade war, Brexit fears and rising political tension

in Hong Kong.

From a technical perspective, the consolidation period in 2011 from August to mid-

October was constructive. Bearish momentum was fading, as the 5-day RSI flashed a series

of higher lows even as the index repeatedly tested support. Sentiment indicators were

supportive of an eventual advance, as the put/call ratio, VIX term structure and AAII

sentiment all saw fear fading. In addition, breadth was improving, as measured by an

uptrend in 52-week new highs.



September 9, 2019


Exhibit 5: The 2011 Market Template

Source: Stockcharts

However, the market did stage a false breakout after a month of consolidation in early

September. At that time, all of the momentum, sentiment and breadth indicators were also

helpfully bullish. Coincidentally, the BAML Bull and Bear Indicator also flashed a buy signal

just before the false breakout. This false breakout was one of the few historical failures of the

BAML Buy and Bear buy signal, though the indicator did later flash a useful buy signal in

December 2011.



September 9, 2019


Is today’s market surge a real upside breakout, or just a fake-out?

A comparison of today’s market technical conditions with those from 2011 is not helpful in

answering that question. Just like 2011, the momentum, sentiment and breadth indicators are

flashing bullish signals, and the BAML Bull and Bear Indicator is turned bullish.

Exhibit 6: Which Repeat of 2019?

Source: Stockcharts



September 9, 2019


2011, Then and Now

While the technical conditions are similar, there are a number of key differences. Let us start

with sentiment, which was the principal basis for this rally. The weekly AAII survey asks what

members think of the market, and since opinions can change quickly, survey readings can be

volatile. By contrast, the more important monthly AAII asset allocation survey asks what

members are actually doing with their money, and those readings tend to be more stable. The

AAII asset allocation survey shows that while equity bullishness has retreated, overall readings

are nowhere near the panic levels consistent with an intermediate-term bottom.

Exhibit 7: Where’s the Panic?

Source: American Association of Individual Investors

As well, valuations are far more demanding today compared to 2011. The forward P/E ratio

during the 2011 range-bound period was extremely low by historical standards. By comparison,

the market is trading at an elevated forward P/E of 16.8, which is above both its 5- and 10-year

averages, and just below its peak of 17.1 achieved in late July.



September 9, 2019


Exhibit 8: An Enormous Valuation Gulf Between 2011 and 2019

Source: FactSet Information Systems

Perhaps as a result of the very inexpensive valuations, the 2011 bottom saw a cluster of heavy

insider buying. On the other hand, there is no similar pattern of support from this group of

“smart investors” today.

Exhibit 9: Insiders Were Buying Heavily in 2011

Source: Open Insiders



September 9, 2019


The earnings outlook presents a mixed picture today. Analysis from Yardeni Research, Inc.

(YRI) shows that while forward 12-month margins and EPS revisions are flat to up for large-

cap stocks, they are deteriorating for mid and small caps (annotations are ours, while estimate

revision calculations are based on YRI data).

Exhibit 10: Large Cap EPS and Margins Steady, But Mid and Small Caps Deteriorating

Source: Yardeni Research, Inc.

From a top-down perspective, it is difficult to see much earnings growth visibility. The Atlanta

Fed’s Q3 nowcast of GDP growth is 1.5%, and the New York Fed’s nowcast is 1.6%. In all

likelihood, earnings growth is likely to decelerate as GDP growth slows from 3.1% in Q1, and

2.0% in Q2 to below 2% in Q3.

The trade war is indeed cutting GDP growth. A newly published Fed study tried to quantify

these effects. The researchers did a textual analysis of major newspapers by “searching for terms

related to uncertainty — such as risk, threat, uncertainty, and others — that appear in the same

article as a term related to trade policy — such as tariff, import duty, import barrier and anti-

dumping”. They then correlated the frequency of these trade policy uncertainties (TPU) with

variables of economic output. The Fed researchers concluded that uncertainty had knocked

about 1.0% from GDP growth:

We find that the rise in TPU in the first half of 2018 accounts for a decline in the level of global

GDP of about 0.8 percent by the first half of 2019. Had trade tensions not escalated again in May

and June 2019, the drag on GDP would have subsequently started to ease. However, renewed

uncertainty since May of 2019 points to additional knock-on effects that may push down GDP further

in the second half of 2019 and in 2020.


https://www.frbatlanta.org/cqer/research/gdpnow.aspx?panel=1

https://www.frbatlanta.org/cqer/research/gdpnow.aspx?panel=1

https://www.newyorkfed.org/research/policy/nowcast.html

https://www.federalreserve.gov/econres/notes/feds-notes/does-trade-policy-uncertainty-affect-global-economic-activity-20190904.htm


September 9, 2019


Exhibit 11: Uncertainty Reduces GDP Growth by 1%

Source: Federal Reserve, Wall Street Journal

Even though market risk appetite was buoyed by the news that American and Chinese

negotiators are scheduled to meet again, the reality is that there is enormous daylight between

the positions of both sides. Xi Jinping mentioned the word “struggle” 60 times in a speech

published last week in official media, which is a signal that China is digging for a protracted

trade war. The U.S. economy appears to be sidestepping a recession, and as long as the

economic pain is manageable ahead of the 2020 election, Trump is unlikely to offer significant

concessions.

Last Friday’s Jobs Report offers an example of a slowing, but non-recessionary, economy. The

headline Non-Farm Payroll growth missed expectations at 130K, compared to an expected

160K. But internals reveal a picture of still robust employment. Both the prime age participation

rate (LFPR) and the employment-population rate spiked, and prime age EPOP reached a new

cycle high. These are not recessionary conditions.



September 9, 2019


Exhibit 12: Prime Age EPOP and Participation Rates Are Not Recessionary

Source: FRED, Federal Reserve Bank of St. Louis

Average hourly earnings grew at an above expected rate of 3.2%, and average weekly hours

edged up back to 34.4 from a weaker than expected 34.3 the previous month. Our income

proxy, which is a multiple of average hourly earnings, hours worked, and people employed,

shows no recessionary signs. In short, the economy is slowing, but the pain is tolerable, and it

is difficult to see how Tariff Man will give much ground.

Exhibit 13: No Signs of a Recession from Our Income Proxy

Source: FRED, Federal Reserve Bank of St. Louis

Ultimately, stock prices depend on earnings and valuation. If earnings momentum is mixed and

valuations are demanding, where’s the upside? The final 2011 upside breakout was sparked by

ECB action, which took tail-risk off the table. Today, considerable tail-risk remains. American

and Chinese negotiation positions are miles apart, and the risk of a new European front in the



September 9, 2019


trade war is very real; Hong Kong protesters do not appear to be backing down from their

demands; and the Brexit drama has not been fully resolved.

In conclusion, the decision on whether to chase the S&P 500 upside breakout is dependent on

investor time horizon. The combination of crowded short sentiment levels and positive price

momentum can lead to powerful price surges. Traders can therefore take advantage of these

conditions to ride the rally. The S&P 500 could rise to test, and possibly exceed, the previous

all-time highs in the coming weeks.

However, the longer-term viewpoint is less bullish. Investment-oriented accounts should take

advantage of the market strength to fade the rally if they are overweight equities and rebalance

to either a neutral or an underweight position. Valuations are stretched, the earnings outlook is

mixed and macro tail-risks remain unresolved.



September 9, 2019


Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub


SHOULD YOU BUY THE S&P 500 BREAKOUT?€¦ · supportive of an eventual advance, as the put/call...

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