The 2016 macro surprise that no one talks about

In Free by Cam Hui

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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.

 

The boy who cried wolf

We all remember the story of the boy who cried wolf. The villagers got one false alarm after another, which made them increasingly annoyed. When the wolf finally came, his warnings were ignored and he suffered the consequence.

I want to tell a more modern story of the boy who cried wolf. In this case, the wolf is inflation. In the wake of the Great Financial Crisis (GFC), there was a cacophony of voices (myself included) who warned that all the QE and money printing would eventually result in runaway inflation and USD devaluation. Even Warren Buffett was caught up in that frenzy when he penned his “unchecked greenback emission” NY Times Op-Ed in 2009:

Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Despite these dire forecasts of doom,  the USD has rallied in the wake of the GFC and gold prices are roughly flat from that period. That thesis of secular runaway inflation turned out to be wrong.

Today, a different kind of inflationary wolf pack stalks the landscape. Instead of the specter of secular runaway inflation, the cyclical inflationary wolves are gathering. When they descend on the flock in 2016, it will be the macro surprise that almost no one is talking about.

Jim Paulsen and the Phillips Curve

Jim Paulsen, who had been very good in calling the turn in the spring of 2015, is out with another piece of analysis that investors should pay attention to. The title says it all: Full Employment Typically Brings a Sector Rotation.

Underlying the macro assumption of Paulsen`s analysis is the Phillips Curve, which postulates a short-term policy tradeoff between inflation and unemployment. Today, the effects of the Phillips Curve are seemingly global. Not only are wage pressures rising in the US, CNN Money reported that a Korn Ferry Hay Group survey concluded that Chinese and Indian workers are expected to get 8% and 10% raises respectively in 2016. So much for the benefits of offshoring.

Paulsen went back to all the way back 1948 and observed that once the headline unemployment rate falls below 5%, which is the latest reading for US unemployment, the equity market undergoes a significant change in leadership.

For completeness, here are the sector definitions from his study:

The above performance chart shows the results of Paulsen’s study. First of all, I would point out that there is no need for panic. An annualized market return of 7.39% is still quite respectable. Paulsen found that market leadership shifts to late-cycle sectors where inflationary pressures start to rise as capacity utilization hits its limits. Therefore the best performing sectors are clustered in energy (note mining is not really mentioned in the sector definitions) and capital goods sectors like business equipment and manufacturing.

I was unable to reproduce Paulsen`s study going back to 1948, but I was able to find data that went back to 1970. The chart below shows the relationship between the unemployment rate (dotted black line) and the returns of energy stocks relative to the market (blue line). There were six episodes when unemployment fell to 5% or below during this study period. In all occasion except for one, energy stocks began a period of better market performance, which is reflective of the increased inflationary pressures. The sole exception occurred during the Tech Bubble of the late 1990s when market participants went overboard for internet related stocks to the exclusion of everything else in the market.

As the headline unemployment rate falls to 5% today, the stock market is poised for the appearance of rising inflationary pressures. As I pointed out last week (see Do you believe in Santa Claus?), the latest BoAML Fund Manager Survey shows a crowded macro trade of long USD, short resource stocks and short emerging market equities. When inflationary pressures start to tick up in 2016, it will be the macro surprise that will catch the market off guard, much like the metaphorical wolf who attacked the flock in the story of the boy who cried wolf.

However, it is probably tactically early for traders (though not investors) to buy into that trade. A glance at the breadth indicators of the energy ETF (XLE) shows a bearish pattern of lower lows and lower highs.

By contrast, the breadth indicators of materials stocks (XLB) is a bit more constructive as it is displaying an uptrend in % bullish indicator, though the advance-decline line is roughly neutral.

My inner investor is accumulating positions in energy and materials, while my inner trader is waiting for better internals or some signs of an upside breakout before committing to the long side on this macro trade.

Market outlook remains bullish

In the meantime, the stock market outlook remains tilted bullishly. The latest update from John Butters of Factset shows that the Street continues to revise forward EPS upwards, which is supportive of high stock prices.

The latest update from Barron’s show that the “smart money” insiders are still buying:

I want to address the concerns over the poor performance of US high yield, or junk, bonds (HY). The chart below shows the Chicago Fed’s National Conditions Financials Index and the St Louis Fed’s Financial Stress Index. Even though stress levels are ticking up, they are anywhere near danger levels.

Another way of measuring the level of anxiety in the HY market is to compare its yield spread to Treasuries vs. emerging market (EM) bond spreads. Such a comparison is especially useful as the latest round of concerns over default risk is coming from resource extraction industries like energy and mining – and EM economies tend to be more commodity sensitive. As the chart below shows, EM spreads suffered in the wake of the “taper tantrum” of 2013, when then Fed Chair Ben Bernanke floated a trial balloon that the Fed might start to taper down its QE purchases. As a result, EM bonds suffered disproportionately, though US HY did not get hurt as badly. Today, the spreads between US HY and EM bonds is just going through a normalization process where the spreads are returning to a more normal range.

I would be more concerned if EM spreads against Treasuries are blowing out, but that market remains fairly calm at the moment.

The week ahead: Another Zweig Breadth Thrust buy signal?

As I look forward to the volume light week ahead, two opposing forces are playing out in the US stock market. On one hand, we are entering a period of positive seasonality. This analysis from Ryan Detrick showed that the last week of December tends to be bullish.

Detrick also tweeted the following on December 24, indicating that the Santa Rally tends to last until January 5:

More importantly, the stock market may be on the verge of another Zweig Breadth Thrust (for full details and implications of the ZBT see A possible, but rare bull market signal and Bingo! We have a buy signal!).  As the chart below indicates, the Zweig Breadth Thrust Indicator (bottom panel) has two more days (until Tuesday) to rally and move above 0.615. Should that occur, it would trigger another rare buy signal for stocks that foreshadows further significant gains.

Can the market achieve another ZBT during this seasonally positive period? I have an open mind but I am not counting on it, largely because ZBTs are extremely rarely buy signals that have occurred only 15 times since 1945. In addition, breadth indicators from IndexIndicators show that the market is either overbought or near overbought and vulnerable to a pullback.

Overbought markets can get more overbought. Compare current readings of net 20-day highs-lows compared to the readings at the last ZBT, which occurred in early October:

My inner investor remains long equities with a tilt towards resource sectors. My inner trader is giving the bull case the benefit of the doubt and he is long large and small cap equities in anticipation of a continuation of the Santa Claus rally.

What happens next? Stay tuned.

Disclosure: Long SPXL,TNA

The philosophy of this site can be summarized by a variation of an old adage:

Give a man a fish, he’ll eat for a day.
Teach a man how to fish…he’ll want to get a boat.

I am not here to just give my readers a fish for the day, I would rather help them build their own boat.

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