Market indicators flashing warning signals

Pre-extreme market polarisation, I had developed my own share market indicator for the ASX, and for a while it proved rather reliable and effective.

Its composition was extremely simple and straightforward too.

I would look up each of the four major banks and compare share prices with respective consensus price targets. If there was no more room to move, or share prices were already trading above targets, this was a strong signal that market sentiment was running a bit too hot, and a pull back, at the very least, would next ensue.

It seldom took long for that pull back to follow. Yes, those were the days. Economic cycles were text-book copies. Forecasting was a lot easier. And share markets moved en bloc, not segment per segment, or as has been the case in recent years, along extremely polarised demarcation lines.

The big four Australian majors are still important index weights, but in a polarised market they no longer represent a weather vane for market sentiment or share market direction in general, hence I have not written about my indicator for a long while.

Remember, the sector has been in a sustainable down-trend for more than five years (from the peak in April 2015) and only climbed out of its, partially self-induced, bear market cycle late last year.

In a market that is driven by Apple, Microsoft and Tesla in the US, and by CSL, Macquarie Group and Afterpay locally, trying to draw any conclusions from share prices from the big four local banks is a waste of everybody's time. But in 2021, the banks are back, and so are insurers, builders, contractors, and other cyclicals, so maybe this means my proprietary market indicator is making a come-back too?

Bad news.

Share prices for both ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) were trading slightly above consensus target last week, and have since retreated slightly. CommBank ((CBA)) usually trades at a premium and continues to do so, currently circa 7% above target. Westpac ((WBC)) shares are still trading more than -4% below target.

Throughout most of the past two decades, NAB has been the sector laggard, ever since that sorry FX trading scandal, so this is quite the familiar set-up with Westpac the new laggard and NAB back on par with ANZ Bank. What this means, all else remaining equal, is that the Value trade locally has had a big run, and banks have been at the forefront of it, but now, maybe, investors should be asking some questions about ongoing momentum and share price valuations.

Which is exactly the kind of chatter I have been picking up from corners of the local investment community here and there. It's not that there's no more room to improve for the banks, but for now, at the very least, a bit of a pause seems but appropriate.

The intriguing additional observation is that, on some momentum measurements, the correction in relative valuations between Value (the banks) and Quality & Growth (CSL and technology stocks) has reached its own extreme, placing the first group into a short-term Overbought position and Growth stocks generally in Oversold territory.

In line with market dynamics over the past five months, traders will be eyeing global bond yields to assess how long, how far, how deep, and exactly when.

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As it turns out, the reading of my personal banks-targets market indicator is not that dissimilar from Citi's Panic/Euphoria market sentiment gauge, which indicates investors have become too bullish and have priced assets accordingly. It is my understanding Citi's market strategists have had some deep discussions with clients over the past weeks about the exact implications of having the Panic/Euphoria reading at an all-time record high.

At face value, Citi's proprietary sentiment gauge is straightforward and pretty reliable too: when the indicator moves deeply into Panic territory there is a 96% chance for a positive return from equities over the subsequent twelve month period. When the indicator moves too far into a Euphoria reading, the odds change to a 75% chance of losing money over the year ahead.

I have been paying attention over the years because this market indicator has done a great job in picking turning points, in particular on the downside, when things look dire, but positive returns will follow (at some point) over the year ahead. Little surprise thus, the signal fell into 'Panic' early last year, and before that in late 2018. The most negative reading (deepest into Panic mode) occurred in early 2016, when the needle moved lower than in early 2009, believe it or not.

So conclusion number one is this indicator is much more reliable when pointing at too much pessimism being priced into markets and assets, as also indicated by the differences in success rates. At the top (deep into Euphoria) things have been less straightforward as also shown by the fact this indicator has been flashing warning signals, while moving ever deeper into Euphoria, since late last year. Back in the late 1990s, the reading was literally in Euphoria for multiple years, before ultimately collapsing into Panic territory as the Internet & Technology bubble burst.

Offsetting these observations are the facts this indicator flashed warning signals in early 2020 as well as in 2018, and on both occasions markets turned south pretty quickly, and violently too. Given we are as deep into Euphoria as ever recorded in the history of this indicator, with data going back to the late 1980s, strategists at Citi have made the audacious prediction that US equities are now cum a 100% historical probability of a negative return on a twelve month horizon.

For good measure, Citi's proprietary tool is not good for timing but it has historically proven a reliable indicator at both extremes of human sentiment, with a twelve month horizon. I think we can all imagine the conversations with clients that have been taking place. Despite all the push-back received, Citi strategists remain undeterred: the indicator will prove correct. History says so.

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The obvious question that arises, both from my own market indicator as with Citi's sentiment reading, as with just about every market gauge these days, is whether we are measuring a particular, popular part of the market, or the market in general.

The difference is, of course, the first scenario involves a turning point that indicates momentum will revert back from Winners into Laggards, i.e. from CBA and Fortescue Metals into ResMed and Afterpay, rather than broad-based weakness for the share market in general.

This is the mistake many investors made in mid-2018 when calls were made of too expensive share prices for companies like CSL, REA Group, Appen, and Altium, but soon after those share prices started correcting in September, the cheaper parts of the share market that had not participated in that year's rally started selling off too, until the Federal Reserve got the message and reversed policy.

This time around Citi strategists do not think share market weakness will be concentrated in banks and resources stocks only. They do think these stocks will become an integral part of the "problem" as investors are likely to push the economic recovery narrative too far, but we are probably not yet at that point.

To justify higher share prices, investors have to rely on ever more robust profit growth forecasts, and there is an obvious risk attached to that. Citi thinks herein lays the core problem. Ever more robust growth forecasts carry more risk for disappointment. The other potential risk factor is that what has been feeding this year's momentum switch into banks and resources and other cyclicals; rising bond yields.

At some point, rising bond yields, if ongoing, will cause a correction in the share market. Citi thinks the answer might be found in 'real' rates, i.e. adjusted for inflation. Global bond yields might be rising this year, they are still negative when corrected for inflation. Were 'real' rates to move closer to zero, Citi believes markets will become increasingly uncomfortable.

The same goes for central bankers who do not want normalising bond yields to undo their strategy for accommodating economies back into sustainable health. Real rates above zero equals financial tightening, hence the Federal Reserve and other central banks will be poised to increase market interventions to keep financial conditions loose and supportive.

On the other end of central bank yield controlling policies sits the US government, which is projected to borrow huge sums over the years ahead, which might require higher costs (yields).

The one factor that potentially can disrupt all good intentions is consumer price inflation. The likes of Morgan Stanley believe colleagues, peers, financial markets and central bankers are underestimating how much inflation will be generated as economies recover and gather steam in 2021.

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When it comes to earnings forecasts, Citi recently positioned itself above market consensus for the year ahead, but the strategists note the share market is pricing in an additional 5% in growth. On this basis, the strategists suspect US ten-year treasuries at 1.75%-2% could become problematic. On Monday, the ten year yield rose to 1.71%.

When adjusted for inflation, US bond yields are approaching the zero mark, even accounting for higher CPI readings in the months ahead. The most recent CPI reading placed headline inflation at 1.7%.

In terms of the US share market, Citi strategists believe the S&P500 is operating within a trading range of 3600-4000. On Friday, the index closed at 3943. Based upon the Panic/Euphoria indicator reading, and the context above, Citi strategists see it as their duty to warn of rising risk as the index approaches the top end of the range.

In terms of share market correction, the same team at Citi also runs a Bear Market Checklist that has been indicating some fluffy behaviour in parts of financial markets, but nothing as serious as had been observed in late 2007 or in 2000.

Citi strategists are therefore referring to history which has shown the typical decline after market sentiment runs up too high into Euphoria is between -9-10%.

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