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Market outlook

S&P 500 bulls may be running on borrowed time

Risk assets seems to be on a tear to the upside at this moment with the US S&P 500, considered as a global benchmark index for stocks and the Dow Jones Industrial Average both hit fresh all-time closing highs in the past week despite lingering growth and heightened inflationary concerns reinforced by the global supply chain crunch and energy supplies shortages as we head into the winter months for the northern hemisphere.

Let’s us now focus on the inflation equation side of the story as higher input prices are likely to squeeze profit margins of corporations due to higher operating costs and on the other side of the coin, lower purchasing power from consumers if growth in wages do not increase in line with inflation which in turn could lead to lesser demand for corporations’ goods and services. All in all, a big risk of adjustment to the current future rosy earnings forecasts by analysts in general that may get repriced or downgraded swiftly.

Inflationary expectations (forward looking) as implied by market expectations derived by the trading behaviour inferred from the US Treasuries market has risen significantly in the past one month. Both the 5-year breakeven inflation (a gauge of expected inflation in the next 5 years) and 10-year breakeven inflation rates have broken above their three-month ranges in place since July and now traded at 2.96% and 2.65% respectively as of 27 October. Interestingly, the 5-year breakeven has surged to a 16-year high and broke above the March 2005 peak of 2.92%. Inflationary expectations rise and fall almost in similar lock-steps with the movement of oil price; WTI crude as depicted in Chart 1 below since 2003. Therefore, higher oil prices tend to see higher inflationary expectations and vice versa.

Chart 1 – US Breakeven Inflation Rates

Source: TradingView (click to enlarge chart)


The next question is that oil prices which in turn can trigger a spill-over rise in the prices of other commodities ranging from agriculture to industrial metals and how such movements may impact the global stock market?

Chart 2

Source: Bloomberg (click to enlarge chart)

Chart 2 depicts the long-term price actions of the S&P 500 since the 1960s in comparison with the ratio of the S&P 500 plotted against the Bloomberg Commodity Index (the energy group has the highest weightage of close to 30%) at the bottom. The ratio of S&P 500 over the Bloomberg Commodity Index measures the relative strength of the stock market against commodities; an upward sloping ratio of the S&P 500 / Bloomberg Commodity Index indicates that the stock market is outperforming the commodities market which in turn intuitively could mean that the growth of corporates’ earnings is likely to be able to surpass inflationary pressures which may translate to a higher upside momentum seen in stock prices over commodities prices and vice versa if the ratio is sloping downwards.

An interesting observation between the ratio of the S&P 500 / Bloomberg Commodity Index and the movement of the S&P 500 is that the in every long-term secular bear market of the S&P 500 that recorded a -40% plus decline has been preceded by a negative (bearish) divergence seen the ratio of the S&P 500 / Bloomberg Commodity Index during the bear markets of December 1972 to August 1974, August 2000 to September 2002 and October 2007 to February 2009 based on closing prices.

A negative divergence occurs when the price movement of the S&P 500 is trending upwards, but the ratio of the S&P 500 / Bloomberg Commodity Index is moving in the opposition direction, trending downwards or flat over a similar period.

Chart 3

Source: Bloomberg (click to enlarge chart)

Once a negative divergence has been detected in the ratio of the S&P 500 / Bloomberg Commodity Index, it tends not to trigger an immediate significant correction on the S&P 500. As illustrated on Chart 3, there had been leading periods where the S&P 500 continued to trend upwards persistently after the first sign of negative divergence emerged before it formed a secular peak. The lead period for the December 1972/August 1974 bear market was 20 months, 14 months for the August 2000/September 2002 bear market and 9 months for the January 2007/October2007 bear market. Overall, an average and median period of 14 months.

Chart 4

Source: Bloomberg (click to enlarge chart)


In the on-going secular uptrend phase of the S&P 550 in place since March 2009 low, a first sign of negative divergence has been detected in the recent months during the period of November 2020 to March 2021 and the negative divergence has remained intact as of October 2021 as depicted in Chart 4.

Therefore, the current leading period of uptrend persistency seen in the S&P 500 is at around 7 months so far. Hence, based on the average and median period of 14 months lead period as observed in the past data, the current uptrend of the S&P 500 may have another 7 more months to run before a potential secular peak could occur in May/Q2 2022 that increases the odds of a likely -40% corrective decline to retrace the entire current secular bullish trend since March 2009 low.

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