Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
- Ultimate market timing model: Sell equities
- Trend Model signal: Bearish
- Trading model: Bullish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
What is the market discounting?
The velocity and ferociousness of the recent US equity market weakness caught even bears like me by surprise. My social media feed has been filled with extreme bearishness. Opinions are now becoming bifurcated. Either the decline is the signal of something big, or the fall in stock prices represent a buying opportunity for fundamentally oriented investors.
It is impossible to make a buy, hold, or sell decision without some understanding of what the market is discounting. In other words, what bet are you making if you decide to buy or sell stocks here?
Further analysis reveals that investors are discounting only a mild US slowdown in 1H 2019, but no recession. From a technical perspective, both the US and global markets have violated well-defined uptrend lines, just as they did in 2015 and 2007. It remains an open question as to whether the trend line breakdowns will result in just a mild pullback, or a deeper bear market. (Please note that the curves and arrows drawn on the charts are only stylized, and do not represent technical projections or targets).
A slowdown ahead
There are plenty of signs that growth is decelerating, which both Ed Yardeni and Urban Carmel were prescient enough to warn about. My set of long leading indicators, which are designed to spot recessions a year in advance, began to deteriorate last summer and now stands at a near-recession reading. The deteriorating is becoming evident in growth expectations, as GDP growth is expected to slow from the torrid 3-4% annualized rate to about a 2% pace in 2019.
The transportation sector is a highly cyclical sector and represents a short leading indicator of economic growth. The recent FedEx (FDX) earnings report was disturbing, as the company stated “global growth has slowed but we are very surprised by the magnitude of the headwind, which is what might be seen in a severe recession”. The price performance of FDX and the DJ Transports has historically led GDP growth by roughly six months, and they are pointing to a sharp deceleration in economic growth. However, I would not characterize the decline to be severe enough to declare a recession (yet).
In addition, the latest update from FactSet shows forward EPS estimate revisions have been flattening, which is another indication of diminished growth expectations from Wall Street.
No recession expected
How has the market responded to these signals? The latest BAML Fund Manager Survey was highly revealing. Institutional managers overwhelming rejected the idea of a global recession in 2019 (top panel), but expected growth to decelerate (bottom panel). In other words, they only expect a slowdown.
What are they doing with their equity allocation? Last week, I highlighted analysis from Kevin Muir of The Macro Tourist, who believed that managers were in a crowded long in USD assets, including equities. As US growth slows in early 2019, managers will begin to normalize their overweight position in US equities. That is precisely what is the Fund Manager Survey is telling us. Instead, managers are re-allocating their weights to the high beta EM equities, which is consistent with the view that the world would avoid a 2019 recession.
The relative performance of US, EAFE, or developed non-US markets, and EM equities relative to the MSCI All-Country World Index (ACWI) tells the same story. US stocks have been range bound on a relative basis since August and they have begun to break down only recently. Instead, EM equities are gaining relative strength.
In other words, both the survey data and real-time performance data reflect the view that the market expects a US growth deceleration, but no global recession. Otherwise investors would not be buying the high-beta and high risk EM sectors, no matter how beaten up and cheap they seem.
The financial cycle vs. business cycle
One key risk to the outlook comes from a deteriorating financial cycle. A recent BIS paper, “The Financial Cycle and Recession Risk”, made a distinction between the business cycle, whose analysis is well captured using my long leading indicators, and the financial cycle.
Financial cycle booms can end in crises and, even if they do not, they tend to weaken growth. Given their slow build-up, do they convey information about recession risk? We compare the predictive performance of different financial cycle proxies with that of the term spread – a popular recession indicator. In contrast to much of the literature, our analysis covers a large sample of advanced and emerging market economies. We find that, in general, financial cycle measures provide valuable information and tend to outperform the term spread.
One of the best real-time indicators of the financial cycle is the relative market performance of bank stocks. Past technical breakdowns of bank stocks have signaled periods of financial stress, and the relative performance of regional banks (bottom panel) have shown to be an even more sensitive barometer. Bank stocks recently violated a key relative support line, which is an indication that the financial cycle is turning down.
As an aside, consistent with the analysis from the BIS paper, the bear market and recession that began in 2000 was not the result of financial stress, but a Tech Bubble that was not largely financed with debt. If punters had bought NASDAQ stocks on margin, the resulting downturn would have been far worse.
The usefulness of the relative performance of US bank stocks is their correlation of the relative performance of European banks. The relative performance effect appears to be global, with the exception of selected localized events such as the recent US tax cut effect on financials. This is an indication that bank stocks are capturing the global financial cycle.
Where are the stresses in the financial system? They don’t seem to be emanating from the US. Financial conditions have deteriorated, but they don’t appear to be out of control.
Yield spreads have widened, but readings are not levels seen before the last recessions.
In this cycle, the financial risk originate outside the US. For one, Europe never fixed its banking leverage problems from its last cycle.
John Authers at Bloomberg recently cited USD liquidity as a possible problem for eurozone banks:
Meanwhile, the agonies for banks in the euro zone grow ever worse. The new reason for their problems, which have happened even though the European Central Bank, unlike the Fed, is still engaged in QE, seems to be a shortage of dollars. This is partly because of the Fed, but also possibly in part because of another signature U.S. policy. The tax reform package passed a year ago provided for the repatriation of foreign U.S. corporate subsidiaries’ earnings. Previously, those earnings sat in the accounts of foreign banks, providing a supply of dollars. Now that the big and successful U.S. tech groups are no longer leaving large piles of cash in Europe, the problems for Europe’s over-bloated and inefficient banking system have grown much more acute
Indeed, offshore USD liquidity is tightening, and has the potential to put downward pressure on equity prices.
And who can forget the debt building in China.
The Chinese economy is already slowing. The SCMP reported that unemployment is rising as the trade war is starting to bite. This will handcuff China’s maneuvering room in its trade negotiations with the US as Beijing has historically put a heavy policy weight on employment and social stability.
Beijing is now officially worried about unemployment, as the US-China trade war continues to weigh on the world’s second largest economy.
On Wednesday, the State Council unveiled policies ranging from refunding unemployment insurance payments to companies that do not lay off staff to giving subsidies to jobless young people aged 16 to 24 rather than only to college graduates without jobs, according to a document on the government’s website.
The cabinet’s policy paper, which was drafted on November 16 but only made public this week, had already been passed down to local governments last month. The local governments were told to draft their own versions, taking account of local conditions, within 30 days.
Beijing has prioritised employment stability over other economic targets in various meetings, but the document offers the first sign of unease within the central government leadership over whether it can fight off unemployment pressure, as the trade war continues to reduce corporate hiring demand, particularly from export manufacturers.
Reuters report that China plans a stimulus package to support growth:
China will ratchet up support for the economy in 2019 by cutting taxes and keeping liquidity ample, the official Xinhua news agency said following an annual meeting of top leaders amid a trade dispute with the United States.
The government has launched a raft of measures, including reductions in reserve requirements for banks, tax cuts and more infrastructure spending, to ward off a sharp deceleration in the world’s second-largest economy. Further policy steps are expected.
Another round of stimulus is unlikely to have similar effects as past packages. If the stimulus is purely fiscal in nature, investors are likely to be disappointed with the magnitude of the effect. If the stimulus is credit driven, John Authers pointed out that credit impulses are growing less and less effective as a way to boost growth.
Then there is the trade war. The most benign outcome would see Trump extract minor concessions from Beijing and declare victory. Another possible bullish scenario would involve Trump, under pressure from declining stock prices, continue to negotiate but delay the implementation of the next round of tariffs.
Regardless of how the trade dispute will be resolved in the near-term, trade frictions are unlikely to go away. Leland Miller of China Beige Book recently made the point on CNBC that there is a bipartisan consensus in Washington that trade with China is a big problem. Miller expects trade tensions to ramp up in the runup to the 2020 election, as both sides will try to position themselves as being “tough on China”.
Assessing the bull and bear cases
How will these risks resolve themselves? Unfortunately, my time machine is in the shop getting fixed and I don’t have a definitive answer.
Conventional macro business cycle models indicate that while recession risks are rising, but readings are not high enough to make a recession call for late 2019 or early 2020. I can therefore make the case that the American economy slows in 2019, but avoids a recession. In that case, the current market carnage represents a buying opportunity. New Deal democrat‘s long leading indicators have been bouncing around but readings are neutral, indicating no recession ahead. He warned against projecting the deterioration of model readings into the future to make a recession call:
The long leading indicators remained neutral again this week. The nowcast remained positive. The short-term forecast a weaker positive, Although there were no rating changes, stocks, commodities, the regional Fed new orders indexes, and the US dollar all turned less positive or more negative.
I want to add a note this week that I think people are getting ahead of themselves, projecting weak trends to weaken even further, and assuming that means recession. It has struck me this week how in many ways the current situation reminds me of year-end 1994. Alan Greenspan was aggressively raising rates in the face of non-existent inflation. Sentiment turned awful, and portions of the yield curve briefly inverted. And then … it didn’t happen. There was a big slowdown in 1995 followed by a big rebound. I’m not on recession watch now, and I won’t go on recession watch unless and until the broad range of data justifies it.
Indeed, the latest update from Open Insider shows that this group of “smart investors” are buying the dip.
On the other hand, global recession risks are rising. While correlation is not causation, but German manufacturing and Chinese industrial activity. Further Chinese weakness could see financial contagion effects leak into the European banking system.
From a technical perspective, I would look for conditions when the market stops responding to bad news. One example can be found during the eurozone and Greek Crisis of 2011. During the summer of 2011, the eurozone was at risk of breaking apart, and European leaders were having almost weekly summits on how to solve the problem. At times, it seemed that Europe was leaderless, and no one was in charge. The crisis lifted after the ECB unveiled its LTRO program to backstop the banking system in order to buy time for member states to engage in structural reform. Some time during that process, the market stopped falling on bad news.
We have not arrived at that point yet. The market response to the FOMC decision shows that the market had unrealistically high expectations for Fed policy.
In addition, % Bears from the Investors Intelligence survey (blue line) edged up last week but remains stubbornly low. The latest survey was done early in the week, when the market was already tanking. Ideally, I would like to see % Bears exceed % Bulls as the sign of capitulation. The lack of a spike in II Bears is an indication that long-term sentiment is insufficiently washed-out for a long-term bottom.
My recommendation is to monitor the evolution of financial risk, as well as the evolution of investor psychology in order to determine the timing of a market bottom. My inner fundamental and macro analyst is keeping an open mind as to the possible outcomes. My inner technician believes that this is the first leg down of a deeper bear market.
The short-term outlook
Looking ahead to the next few week, to say that the market is oversold is an understatement as readings are now at off-the-charts levels. The CBOE put/call ratio (CPC) reached 1.82 last Thursday, which is the highest level in its history since 1995. A historical study shows past SPY returns when CPC 5 dma crosses above 1.24 for 1st time in a month, n=13 since 1995. 92% closed higher within 5 days with average return of 2.5%.
The Zweig Breadth Thrust Indicator is also oversold, and readings are comparable to levels seen at the panic selloffs in 2008 and 2011.
The NYSE McClellan Summation Index (NYSI) has reached the oversold levels seen at previous major bear markets. The good news is the positive divergence on stochastics (bottom panel).
The % Bullish indicator is also in blind panic territory.
One reader likened the panic as “hanging on a horse running in a burning barn”. The following observation from SentimenTrader is just one of many examples of this panic.
Conditions are more than ripe for a relief rally. That said, some caution is warranted. Urban Carmel pointed out that while the market has historically seen a bounce under similar conditions, but the market has re-tested the lows soon afterwards (see red arrows).
My inner investor interprets these conditions as the signs of an intermediate term bear market. He de-risked his portfolio in September and he is glad he missed the carnage.
My inner trader was caught long, and he is hanging on to play the bounce. When the rally comes, he is watching short-term breadth for an overbought condition to short into for the likely re-test of the previous lows. Volatility will be treacherous. Adjust your position sizes in accordance to your risk tolerance.
I have received a number of words of encouragement on the record of the trading model this year. The latest drawdown is a shock and disappointment. I will write a full analysis of the trading model in the near future.
Seasons Greetings and happy holidays to all.
Disclosure: Long SPXL