What the Market Cycle Clock is telling us

Welcome to Beyond the Benchmark, the EFG podcast

Moz Afzal:
With Moz Afzal. Hi everyone. Today I have Jeff deGraaf a regular on the pod. Jeff, welcome.

Jeff deGraaf:
Thanks for having me.

Moz Afzal:
Of course, Jeff, he is the main principle at RenMac and obviously chief technician. So Jeff, one of the innovations you put out there a few years ago, which I think distinguishes you from other technicians in the market is your market cycle clock. So maybe give us a bit of a view on what your market cycle clock's telling us about the state of the markets at the moment.

Jeff deGraaf:
Sure, Moz, I'm happy to do that. So let me just explain what that it is real quickly. It's really understanding the relationship that inflation and growth have on equities and what we've seen is a lot of people, a lot of economists in particular use that to kind of get an idea as to what's going to happen to policy, what's going to happen to GDP, but not very many people use it to look at what's going to happen to the S&P and whether there's some predictability there. Now we use proprietary inputs for growth and inflation so they're not just off the shelf inputs, but they're not overly complicated. I don't think that's the magic in the sauce necessarily. It's that difference between the independent and dependent variable, if you will, and where we are right now, and for the last, I'd say six, maybe nine months now, we've seen seen a backup in the cycle clock.

And what I mean by that is growth has been below average, but inflation has actually ticked up and ticked higher. And when we go back and look at that historically, it's relatively unusual. It usually happens around supply shocks and I think that makes a lot of sense today because of the threats of tariffs and really the unknown of what was going to happen here, at least in the US but I know abroad obviously too and what the impact of that would be. And so that backup historically ends up being a modest negative for equities. That hasn't been the case necessarily, but what I'm most encouraged by is the direction. What tends to happen when we're in the zone, we move down. In other words, inflation tends to move down. Growth remains relatively subdued or subdued versus the average, and that's actually a healthy environment for equities.

So if you think about where the puck is going, not necessarily where the puck is, I think that's good news. It should be good news for cyclicality. And one of the things that's important around this market cycle clock that we do is we know the history of what should work. We know what type of styles do well, and so we're always pinging that if you will, against the market to see if the sectors, if the styles are really reacting consistently to where that market cycle clock is. And I think that's the good news.

One of the things, in fact, in our asset allocation model, we reallocated about a 25% cash position. This was back in around July, in the longer end of the curve, and people were kind of squawking about what the heck are we doing there? The whole idea is that when we're in this zone historically it's the point where the Fed starts to cut rates and obviously they've done that, so growth slows and you just get a very, very good kick from the long end of those yields coming in. So you get the appreciation plus obviously you get that yield play and that actually ends up being pretty bullish. So we know where we are today that yields historically tend to come down. And we also know that historically cyclicals tend to do very, very well versus defensive names. And if I were really to pinpoint this for you, I think what's interesting and we'll see, I mean there is evidence of it though, it's not overwhelming, but this is really the zone where discretionary names start to take off.

And I know that's going to feel maybe counterintuitive to some of your listeners when you look at the data and you say, well, growth is slowing and the Fed's worried about this and unemployment seems to be going up. Discretionary is amazing in how contrarian it is, if you look at the headlines going back historically and then look at the performance, they will do you no favours in being an investor. So again, we're not seeing it wholesale in discretionary yet, but I think there are some bright spots, broadly retail and autos have started to move. We won't get into specific stocks obviously, but kind of thinking about it from bigger ticket purchases, those look more interesting than some of the deterioration that we've seen in say restaurants. So we'll see what happens there, but clearly when we look at it versus say staples, we're still in a very, very good spot and very consistent with that market cycle clock.

Moz Afzal:
That's interesting. So what about what I love about the cycle clock and then looking at the sectors and their relative performance, you always can pick out the anomalies, so utilities definitely seem to be the anomaly in your work at the, you're kind of think historically they should not be doing that well, but actually doing pretty well. But you can then pick up the nuance, presumably this is about the AI play and energy usage and infrastructure.

Jeff deGraaf:
I would totally agree with that. And we're not seeing it in energy broadly, so we're seeing it particularly in electricity if you will. We're not seeing it in oil, we're not seeing it in gas, we're seeing it in electricity, and that's a global phenomenon, which is usually one of the things that we would like to look at is, are we seeing a consistent theme playing out globally? If it's going to work in Europe, it should be working in the US, it should be working in the far east. If it's isolated, then obviously that story becomes a little different and we have to go searching for the clues and the causes and then the durability of that narrative. But this is one that has been persistent really throughout much of the world.

Moz Afzal:
Yeah, no, it's very interesting. Again, what I love about the work that you do, you're able to pick out not just the things that you expect to happen, but also the things you don't. It's just something new, which obviously you want to investigate and figure out why this is happening.

Jeff deGraaf:
You're so right. And that's the fun part of the business. I mean I would always say what we're looking for is we're looking for about 70 to 75% alignment. We want kind of what should be happening to happen and there will always be some anomalies and some outliers for whatever reason. But those are the fun ones when you can say, hey, why is this different? And then really try to be at the cutting edge of finding out that difference and then exploring it and understanding that narrative going forward. That's a lot of fun in this business frankly.

Moz Afzal:
Absolutely. I just want to just touch on financials again, another global phenomenon and we've seen financials outperform pretty much in all locations there, be it the US Europe and even Asia. What's your kind of view from here around that financials relative to the market cycle clock?

Jeff deGraaf:
I think, well financials look better than what we would expect. That's not to say that they should be bearish, but they're always an odd group in that sometimes they flourish during these periods and sometimes they struggle during these periods. I think what we've seen, and we've done a lot of work here recently, is more of a normalisation of the yield curve. I think we went from what was deemed by the press financial repression. I think that's right, where central banks were kinking curves and they were suppressing rates and doing things that were unnatural from a market perspective in terms of market pricing. And that lasted for roughly 15 years. And so we've seen a pretty big shift in the dynamic of certain sectors and certain industry groups back to a pre-2008 or what we call the GFC, obviously the great financial crisis where industries and are starting to react more like they did pre GFC to how they were post GFC.

And so you have to be careful there because the last thing, and I don't want to get this too technical here, but the last thing you want to see when you're doing work, particularly work that's quantitatively based, is a sign flip. In other words, if I had an association or a relationship that was positive, if I went up, you went up. If I went down, you went down. And if that flips somehow, if I go up and you go down and you go up and I go down, all of a sudden what are we supposed to do? Because that relationship has now twisted and a lot of those relationships are going back to where they were pre GFC. So I think it's the normalisation of the curve. I think a little bit of the inflation, and I know you can take some heat for this, I think that's actually a good thing because it gets people thinking a little differently and more consistently with how the world has worked historically

Moz Afzal:
So moving then on to looking at some of the trends in the S&P, the Russell, Nasdaq, Mag-7 continues to be powering ahead, it just doesn't seem to be letting up at all. Thoughts on directionality here for the next say six months?

Jeff deGraaf:
Look, I think we're still in a good spot. I mean, we are seeing some momentum softness, and what that means is that we don't have to chase strength. We think things will pause and consolidate and it's probably more on a individual and industry basis than it is for the market. But it's the same thing. I mean, one of the go-tos for us is looking at the percentage of issues that are trading above their 20 day moving average. And so if you're making a new high in the equities and that number's below half, so below 50%, it just tells you that it's just a few names driving the market. Again, I think people make a much bigger deal about that type of breadth being some overhang negative for stocks. A lot of it tends to be relative performance based, and so that's not something that you really want to stand in the way of, it's just kind of rotational and that's not an issue.

I actually think the breakout and the Russell 2000 is really important because that is a foil to those breadth bears that are out there. You've got 2000 names that are collectively making new highs. And for those that might be squawking, that's happening on an equal weight basis too. So that takes care of that problem that you have just the mega cap names within small cap, which is a little ironic making new highs, it's happening across the board. So I don't see a breadth problem in the market. Certainly you've got rotation, certainly you have a concentration effect, but that tends to happen. I get most worried when our momentum signals are in the top 90th percentile. In other words, when momentum is working as the exclusion of almost everything else, it just says that the FOMO crowd is kind of dominant and they're probably overextended and we're not seeing that now our momentum measure, our momentum percentile.

In other words, performance is right about 50%. So it's got a ways to go before that gets to a point that makes us uncomfortable. I think some of the sentiment measures have deteriorated, but again, not enough to be for one focused enough or concentrated enough to be an issue. And then the other part is that just not enough of them are triggering, right? We have a few episodic ones here and there. Some of the option work shows some frenzy, but again, that's more in line with the consolidation than it is some structural problem for equities.

Moz Afzal:
So a bit of consolidation here and then maybe a move back later towards the end seasonality November, December, and obviously Q1 is usually pretty solid seems. Is that fair?

Jeff deGraaf:
And I think short rates coming in is also very helpful. I mean, we're seeing, look, the short rates have been in a downtrend for probably 18 months now, right? The two-year yield. So it was a little more dicey or edgy on the tens, and that seems to now be rolling over a bit. It's even more dicey on the 30, but that's giving you a steeper in the curve, which is good. So I think these short rates are okay and are certainly helpful and we will see what it does to inflation. I'm not as bearish on inflation as some of my counterparts are, but we'll see. The market cycle clock is telling us that historically inflation should cool. I don't know that it's going to two or below, but I think directionally it's probably going in the right direction

Moz Afzal:
And certainly that gives you ammunition for those cyclicals to continue to perform. So one of the areas you've been puzzled with is how strong high beta has been versus momentum as a factor and it's stayed strong. Maybe last week was a bit of a dip, but what's your sense there and how surprised have you been?

Jeff deGraaf:
I'll give you a little background here. During the tariff meltdown, if you will, beta performance was in the zeroth percentile, the worst we'd ever seen. In other words, if you owned high beta versus low beta, you'd never seen worst performance on a 65 day rolling basis than you did at the first part of April. We were actually telling clients to buy beta at that time because of that exact same thing where beta was just so wiped out that we said, look, people don't have enough beta in the portfolios. And then it came screaming back obviously, and then we got into July and usually it's about a three month to four month window. It took us through July and we just said, hey, this beta trade has probably got some danger to it because of this extremism.

And it was a hundred percent that we'd never seen beta do as well as it had in the middle of July. So our whole point was at this time when we go back and look, historically beta will seed ground to momentum. In other words, it doesn't have to be a disastrous factor, it just doesn't tend to dominate like it has and momentum starts to pick up. And that hasn't happened nearly as robustly as we would've hoped. Momentum has gotten better, but not really at the expense of beta yet. So it's a trickier spot. I'm still comfortable with it because of that relationship. Historically, I think the harder part is if you have high beta and you have high momentum, I actually think those names are okay if you have high beta in mediocre to low momentum, I think those are really dangerous names. So that's how we look at it. And that's a little nuanced, but if we look at the consistency of either one of those factors through time, you'd much rather be long the momentum factor because it does have this persistence to it, and then use the beta factor more as a tactical kind of risk on risk off, if you will. And so right now I think we're in about the 92nd percentile, so it's come down, but that just means that the rate of return isn't as torrid as it was back two months ago or so.

Moz Afzal:
Yeah. Good. So Jeff, you were one of the very first to call out China, and obviously it I guess is one of those trades that did very well and very concentrated I guess this time last year and September, October did very, very well. I kind of did nothing and then suddenly just shoots up again. Is that frustrating trade where all the returns are in a very concentrated space of time, seems to be more persistent now, I would argue certainly from August, September, October and coming into October. What's your viewpoint? I know you slightly more nuanced now than you were before.

Jeff deGraaf:
Yeah, look, we still like China a lot. I think it's a big bottom. They went through a bear market in terms of duration, really similar to things that we did back in 2008 and 2009. I know there's a lot of concern about the reporting and financials and the health of that market, but as a pure observer is one that just doesn't get too involved in that and believes in the messaging of the market, I think it's still very, very bullish. Now, you are seeing some deterioration in financials there here more recently. So the good news is they're oversold here, so I would expect that they'll find some footing and be able to rally if they somehow stumble and start to relatively underperform, that will require us to kind of reevaluate what's going on. But I would say, and I certainly am hopeful who the winner is here, but I don't think the AI race has been won.

I think they're right in it, and it's probably neck and neck and you see it in their names and particularly the tech space. But those are good charts, and you look at almost any of them that the old days, the ones that we in the west can pronounce relatively easily, those are good looking names and I think there's something to that, that it's not just episodic or it's not just a sliver of industry, but it's broad based. So we've got roughly a 32% return by this time next year for the major indices in China. That'd be the Shanghai 300. And when we go out and look at single stocks, there's plenty of them that look like doubles to us. So these are big bases, these are names that really haven't done anything for three years.

And I was on CNBC last week and had a conversation with Scott Wapner, and he's like, can they go higher from here? Because some of them have already doubled. And I would just say that that's one of the worst things you can look at in terms of, it's called reference bias or anchoring effect. Don't use that. The stock can't go up because it's already gone up. That just doesn't work. And you can test that and it becomes pretty clear pretty quickly that that's just not a good reference. So I think you've got names that yeah, they've done well, and I understand the reluctance to buy into those. But keep in mind, and I always say this when the people call it easy money, right? In the market, oh, that was the easy money. That might be easy money in hindsight, but in real time it's psychologically probably the hardest money that you can find.

And what that requires is this contrarian approach. You have to be willing to say, I don't care what the narrative is. I don't care what people are saying or what the stories are, but these stocks are going up, they're moving higher, or at best they're not going down with this terrible news. Something must be going on here. And again, psychologically, you're always being tested by the narrative, by the headlines, by pundits, et cetera, and yet the stocks or the markets are acting much, much better than what the expectations are. That's where the easy money is made.

Moz Afzal:
Yeah, no, exactly. It certainly does look very interesting moving to closer to the end. Now, there are two other areas I wanted to pick up on broader emerging markets. Are there any other countries? I was looking for example, China versus India, which tends to be pretty negatively correlated. India's chart looks like it's rolling over and doesn't look great, but China looks pretty good.

Jeff deGraaf:
I would say the frontier markets are pretty interesting now that gets very diverse, very quickly and very broad, and I don't even know what companies these are. So it's not just a, hey, the US looks good and it's kind of wagging the rest of the dogs here. These are good looking charts. So I think we have a global bull market that's taking place. I think that's underappreciated. I'm not going to try to speculate as to what the root cause is, but I think it is far more powerful than people are giving it credit for.

Moz Afzal:
Yeah, no, I would just certainly agree. So last point was obviously you are often great at looking at things in a very different lens compared to the consensus. Anything that we haven't covered that you think, what looks really interesting, no one's really talking about.

Jeff deGraaf:
Well, we haven't talked about gold, we haven't talked about precious metals. Clearly there's been a diversifier away from the US dollar. I think that continues. Does that put at risk the dominant trade of the US dollar as the reserve currency? I think that's premature, but certainly it's something that I think is at least worth discussing and on the table, and I would say you do have some of these, it tends to go in waves. I mean, we've all heard it through our careers of losing the bond market and deficit funding and everything else and the currencies and the implosions and all that. And I'm not hyper bearish on that stuff. That actually I think ends up being equity good. So that's the one thing that I think people miss is that's actually probably really equity good because you, you're getting productive assets.

Moz Afzal:
So best returns would be when inflation's been two and a half, 3% right in the US.

Jeff deGraaf:
Yep. Yep, a hundred percent. So look, I think that's something to keep in mind because we do have silver that's making a new high. We have gold that's making a new high platinum looks good, palladium looks good, they all look good, all the precious metals look good. Yeah, and I would say that probably one of our most frequently asked questions is around the dollar and it's weakness. As I said, I agree with you. I don't think it has much bearing on the equity market. We've had periods when equity markets have been absolutely fine with the dollar's been on a weaker trend, but certainly for international investors, one easy trade over the last 15 years was by US equities unhedged, right? In euros or sterling or yen for example. They've been great easy investments, and even when you've had corrections, the dollar has been negatively correlated to risk assets. So you've had that benefit from a sharp ratio perspective. But you certainly today, this year in particular, a lot of our European or Euro based clients are on Swiss Franc. Clients in fact are really struggling with the S&P 500 at these levels.

Jeff deGraaf:
Yeah, well look, I think that the trend of the dollar is lower, so I think you have to give that some consideration. So yeah, that was probably a luxury that is kind of slipped through the fingers here, at least in the intermediate term. So I would say us as a non-US investor, I would say US equity still look good, but there is some hedging that probably needs to be associated with that.

Moz Afzal:
Yeah, no, absolutely. Well, Jeff, again, thank you very much for your time. Always very much appreciated. Continue the great work and all the best to the gang. As I said, I think you guys have been fairly consistent over this last two or three years and long may it continue.

Jeff deGraaf:
Thank you so much for having me.

Moz Afzal:
Thank you. So that wraps us up for today and we look forward to speaking to you again very soon. Thank you very much.

 

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