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 chart below.
Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.
Hitting the Exacta
Regular readers know that I have been bullish on stocks for a couple of months now. While I had expected a seasonal Santa Claus rally, Santa hasn’t been around and stock prices have been weakening. In one way, Old St. Nick may have left a present for the bulls under the tree as the recent sell-off has left the market oversold. As a result, two of my Trifecta Bottom Model indicators have flashed a buy signal. I call this hitting the Exacta.
My Trifecta Bottom Model (which was described in a past post Sell Rosh Hashanah?) consists of the following three conditions, which must occur closely (within a week) of each other:
- VIX term structure (VIX/VXV ratio) inversion
- NYSE TRIN more than 2
- My favorite intermediate term overbought-oversold model, which is the ratio of % of SPX stocks over their 50 day moving average (dma) / % of SPX stocks over their 150 dma less than 0.5
|Trifecta Bottom Model|
Last week, the market hit the Exacta again as the VIX term structure inverted and TRIN spike to over 2 within a week of each other. The question is whether this is August 2015 all over again, or a run-of-the mill instance of a short-term bottom.
No recession on the horizon
To answer that question, let`s consider the macro and fundamental backdrop to measure the risk of a major leg down in stock prices. First and foremost, is there is any significant risk of a US recession? Recessions are triggers for major bear markets.
I use a framework used by New Deal democrat to spot recessions a year in advance. He utilizes seven long leading indicators, which you can keep track of at my Recession Monitor. Currently, I would classify the indicator this way (links are to FRED graphs and comments from New Deal democrat are shown in parenthesis):
Positive, indicating little or no recession risk:
- Housing starts (Housing starts peaked at least one year before the next recession)
- Money supply growth (In addition to the 1981 “double dip,” on only 2 other occasions have these failed to turn negative at least 1 year before a recession)
- Residential real private investment (Aside from the 1981 “double-dip,” and 1948, it has always peaked at least one year before the next recession)
- Real retail sales (It has peaked 1 year or more before the next recession about half of the time)
Cautionary: Corporate profits have peaked and proprietors income have flattened. Call this a slight negative.
- Corporate profits and Proprietors` income, which can be a more timely proxy for corporate profits (Corporate profits have peaked at least one year before the next recession 8 of the last 11 times, one of the misses being the 1981 “double-dip.”)
Negative, but this indicator is somewhat unreliable as corporate bond yields have made lows as much as four years before a recession.
- Corporate bond yields (Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession)
Not relevant in the current environment
- Yield curve (The yield curve inverted more than one year before the next recession about half the time)
Forward EPS growth still positive
Insiders are buying
What are the “smart money” insiders doing? The latest report from Barron’s indicate that insiders are still buying heavily:
To summarize, there are no macro or fundamental reasons for a major bear market to be starting here. Risk levels are relatively low.
Will the USD give bulls a second wind?
I wrote last week that the US Dollar is the key to providing the bulls a second wind to the bull market (see The only market indicator that matters in 2016). So far, the jury is out and we are still waiting for the verdict in the form of an upside or downside breakout from a trading range.
Here is what I am watching. Should the USD weaken, then it provide a boost to the earnings of US companies operating overseas – hence the second wind for the bulls. So far, that hasn’t happened yet. One other benefit of a weaker USD would be stronger commodity prices, as the two are inversely correlated with each other. The top panel of the chart below shows that the greenback has strengthened a little but it has been volatile in the post-FOMC decision period, but remains in a sideways consolidation phase. The next two panels show the relative performance of energy and materials stocks against the market. While energy remains in a relative downtrend, materials stocks have been consolidating sideways on a relative basis.
One bright spot for commodity bulls comes from the strengthening AUDCAD currency cross rate. This cross rate is important as both Australia and Canada are major commodity exporters, but Australia is more exposed to China while Canada is more exposed to the US economy. Another key difference is Australian commodity exports are tilted towards bulk commodities like iron ore, while Canadian exports are higher weighted in energy. As the bottom panel of the chart above shows, AUDCAD has been rallying, which is a possible indication of renewed Chinese growth. The AUDCAD rally cannot be explained by the bulk vs. energy differential as the solid line showing the the relative performance between mining stocks and energy stocks is weakening.
I continue to believe that the USD is poised to weaken and the implications of that reversal will be bullish for stocks and commodity prices.
The latest results from the BoAML Fund Manager Survey of global institutional managers is revealing. When asked what they though the most crowded trade was, institutional managers cited long USD, short commodity stocks and short emerging market (EM) equities – in that order. Since those three themes all correlated to each other, the top three most crowded trades is in effect the same macro trade (annotations in purple are mine):
When asked what their own portfolio position was, the answer was about the same. Global managers have a crowded long in the USD:
Yet, they thought that the USD is overvalued. So why are they in a crowded long USD macro trade?
When asked what phase they thought the global economy is in, the consensus seems to be shifting from mid-cycle to late-cycle, which is the phase when inflationary pressures start to manifest themselves and commodity prices rise.
Setting up for a late cycle market
In effect, the 1H 2016 market is setting up for a late cycle expansion, when inflationary pressures start to rise. Scott Grannis believes that the market is in for an upside surprise in inflation:
The collapse of crude oil prices since mid-2014 has not only devastated the oil industry, it has also sowed confusion over the issue of inflation. Since crude prices started falling in the summer of 2014, headline inflation fell from 2% to essentially zero for most of this year. Yet if we exclude energy from the calculation, inflation has been fairly steady at 2% for a long time. This bears repeating: if not for the big decline in oil prices in the past 18 months, the underlying trend of inflation at the consumer level would have been 2% for the past 13 years.
Energy prices are not going to fall forever; once they simply stabilize, then headline inflation should bounce back to 2% fairly quickly. The Fed understands this, but—arguably—markets do not, since key measures of inflation expectations over the next 10 years range from 1.25% to 1.8%, and those expectations assume that oil prices will decline substantially further in the next year or so.
The market expectations of forward inflation is 1.25%, which is in effect discounting further declines in energy prices:
The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market’s expectation for the annualized rate of CPI inflation over the next 5 years. Currently about 1.25%, it is significantly less than the prevailing rate of ex-energy CPI inflation. Either the market is correctly anticipating more and substantial declines in energy prices, or it is seriously underestimating future inflation.
The Fed understands these dynamics, and that was made evident in a recent speech by Janet Yellen:
Regarding U.S. inflation, I anticipate that the drag from the large declines in prices for crude oil and imports over the past year and a half will diminish next year. With less downward pressure on inflation from these factors and some upward pressure from a further tightening in U.S. labor and product markets, I expect inflation to move up to the FOMC’s 2 percent objective over the next few years.
On the other hand, I would not be overly concerned about an overly aggressive Fed in 2016. In the latest round of post-meeting Fedspeak, Reuters reported that San Francisco Fed president John Williams indicated that the Fed plans on running a higher pressure economy for a while (translation: tolerant of higher inflation):
Though much more optimistic about the economy than in prior years, Williams said that at the end of this week’s meeting, there was no round of high-fives among the 17 policymakers at the table.
“We are not done: we still have inflation unquestionably running stubbornly low due to mostly, I think, global factors,” he said.
To keep job creation strong, rates will need to stay low, rising only modestly next year, he said, adding: “We are going to run a higher-pressure economy for a while.”
The scenario that I envisage for 2016 involves a transition to a late cycle market. Inflationary pressures rise, the USD falls and interest rates rise. For the stock market, this translates to a topping process with the following characteristics:
- A change in leadership to late cycle resource and capital goods plays
- A short-term boost to earnings and therefore stock prices because of the falling Dollar
- Followed by a faster than expected pace of Fed tightening, which will eventually unsettle markets (as per Grannis)
Readers might gasp at my use of the term “topping process”, as I have been relatively bullish recently. I would qualify that term by stating that it would be overly premature to be selling out now, as investors will miss the last boost to the market from the tailwind of the effects a falling USD in boosting EPS growth. The key is to watch for downside risk by monitoring signs of impending recession with my Recession Monitor.
Even the recent carnage in the US junk bond market is nothing to freak out about. It is a source of concern, not a cause for alarm. While I am well aware of the bearish conclusions drawn by other analysts from the sell-off seen in junk bonds, there hasn`t been an adequate explanation as to why EM bonds are outperforming US junk. The chart below shows the relative price performance of US junk to their duration equivalent Treasuries (UST) compared to the relative price performance of EM bonds to their duration equivalent UST paper. If the stress in US junk market is so high, shouldn’t they be even be higher in emerging markets?
The week ahead: Waiting for Santa Claus
In addition, analysis of Twitter breadth activity from TradeFollowers is also supportive of the bull case. Even as the market declined, bullish Twitter breadth remained strong while bearish Twitter breadth weakened, which is indicative of bullish market internals (purple annotations are mine):