A key test: The Zero Hedge bottom?

Posted by Cam Hui -

The website Zero Hedge has built a successful franchise on the internet highlighting bearish and market crash narratives with a series of half-truths, misinformation, and conspiracy theories. A recent screenshot of Zero Hedge headlines gives you an idea of their editorial bias.
 

 

In other words, it occupies the supermarket tabloid niche of financial news.

A recent Buzzfeed story revealed that Zero Hedge, which had 670,000 followers, was permanently banned from Twitter for violating its platform manipulation policy. In one article, Zero Hedge accused a Chinese scientist of releasing the coronavirus from a bioweapons lab, released the scientist’s email and phone number, and invited readers to “pay the scientist a visit”.

Notwithstanding the controversy over Twitter’s actions, could this incident may be a sign of the Zero Hedge market bottom, marked by peak hysteria over the coronavirus threat.

Here are the bull and bear cases.
 

Peak bearishness?

Some anecdotal signs are emerging that sentiment is becoming panicky. John Authers at Bloomberg laid out on January 26, 2020 the signposts of peak panic, based on the magazine cover indicator.

While the sample size is extremely small (N=2), here is the cover of The Economist at the height of the SARS panic.
 

 

Here is the magazine cover at the height of the Ebola panic.
 

 

Here is the latest cover of The Economist.
 

 

Still not convinced. Callum Thomas has been conducting an (unscientific) Twitter sentiment poll every weekend since 2016. Sentiment has fallen to the second most bearish reading since the poll began.
 

 

Policy support

The Chinese stock market opened after a one-week Lunar Near Year holiday, and the Shanghai Composite was down -7.7%, which parallels the movement in H shares in Hong Kong, which did trade last week. However, many of the issues went limit down by the maximum -10%, which means that the index could not have fallen much further.

On the other hand, Hong Kong’s Hang Seng Index, which had traded last week, manage to steady itself with a 0.17% gain.
 

 

The USDCNH offshore yuan rate weakened past the 7 to 1 level.
 

 

Policy makers have promised massive market support. Major investors are banned from selling their stock holdings. The PBOC unexpected cut the reverse repo rate by 10 bp, and injected a total of 1.2 trillion yuan (US$173 billion) into money markets to stabilize the markets.

Could the worse be over? Watch for massive “whatever it takes” stimulus in the coming days.
 

A “false rally”?

I have made the case that the actual reason for the correction is mainly attributable to excessive bullish sentiment and overly bullish positioning by the fast money traders. The coronavirus panic was just the excuse for the sell-off (see Trading the coronavirus panic). If Chinese policy support were to put a floor on stock prices, and the stock market rises to test or exceed its old high, it would set up a situation where the excessive bullish positioning is not unwound. As a reminder, a rally would worsen the tensions from the Rule of 20 Indicator. At the current estimate of 20.7, this indicator is already flashing a valuation warning sign for stock prices.
 

 

Under such a “false rally” scenario, I would watch for a rally, marked by a negative NYSE Summation Index (NYSI) divergence, which are conditions that were seen in the last two major market tops.
 

 

This “false rally” is consistent with the observation that the Citigroup Panic/Euphoria Model remained in euphoric territory as of last Friday.
 

 

As well, it is consistent with the inability of the Fear and Greed Index to decline into the oversold target zone of 20 or less, which are readings consistent with durable market bottoms.
 

 

Seriously, can the market make a bottom without a “Markets in Turmoil” program from CNBC?
 

 

A key test of psychology

The market action in the next few days will be revealing of the psychology. Traders will start to focus on the Iowa Caucus tomorrow, and the New Hampshire primary next week. Bernie Sanders is currently the frontrunner to win the Democrat’s nomination for President. How will the market react a Bernie win in Iowa?

In the meantime, Bernie Sanders’ odds of winning the nomination has been soaring in the betting markets.
 

 

A more detailed bottom-up aggregation of PredictIt odds by Millenarian at the state level shows that Sanders has the edge.
 

 

If the coronavirus news was the actual reason for the market sell-off, then expect short-term stabilization and revival in stock prices, followed by a decline later. On the other hand, if it was just the excuse for an overvalued, overowned, and overbought market to go down, then a Bernie Sanders win could provide the next catalyst for further market weakness.

Stay tuned. My inner trader is maintaining his short position for now.

Disclosure: Long SPXU

 

Whistling past the graveyard (doji)

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Neutral (downgrade)
  • Trading model: Bearish

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.
 

A disappointing January

The month of January turned out to be a disappointing. Stock prices roared ahead out of the gate and pushed major market indices to fresh all-time highs. By the end of the month, the market had retreated to end the month slightly in the red. More importantly, the monthly chart printed a graveyard doji, which is often interpreted as a sign of trend reversal.
 

 

Steve Deppe studied past instances when the market rose 3% or more, set a fresh new all-time high, but finished in the red for the month. While the sample size is not high (N=10), the historical results reveal a heightened probability of large drawdowns in February.
 

 

The melt-up hangover may just be beginning.
 

Bearish trend reversals

Signs of bearish reversals are found everywhere. The UK officially exited the European Union on Friday. The FTSE 100 managed to fall below both its 50 and 200 day moving averages (dma) last week. More importantly, the small cap to large cap ratio flattened out and it has been range-bound since December, indicating lessening enthusiasm over the prospect of a booming local British economy.
 

 

Over on this side of the Atlantic, credit market risk appetite has plunged and flashed a negative divergence warning for the stock market.
 

 

The USD Index rallied through a bull flag formation last week. USD strength is a bearish sign for EM assets, because some fragile EM economies have excessive USD debt, and a rising greenback hampers their ability to repay.
 

 

Both the copper/gold and platinum/gold ratios, which are key cyclical and risk appetite indicators, are breaking down.
 

 

Friday’s stock market action was also disappointing. The index violated the lows of the week, indicating the bears had taken control of the tape.
 

 

As a consequence, the signal of the Trend Asset Allocation Model has been downgraded from bullish to neutral.
 

Silver linings

Nevertheless, the bulls can find some silver linings in a dark cloud. Both fundamental and macro momentum remains positive and constructive.

The latest Q4 earnings season update from FactSet revealed both good news and bad news. The bad news was, despite selected strong headline beats by large cap stocks like AAPL and MSFT, both the EPS and sales beat rates fell from last week, and they are now below their 5-year historical averages. The good news is forward looking indicators, namely the forward 12-month EPS estimate, rose strongly last week.
 

 

The bulls may find some solace in the ISM Manufacturing print to be scheduled for Monday morning. Aneta Markowska of Cornerstone Macro found that all five Fed regional manufacturing surveys improved in January, which suggests an upside ISM surprise.
 

 

The 3m10y yield curve has inverted, which has caused some consternation among investors. Similarly, the 2s10s has been flattening rather rapidly, which is another sign of slowing growth expectations. However, the 10s30s spread at the long end of the yield curve has steepened, even as the 30-year yield fell below 2%. The long end of the curve is not confirming the flattening and slowing growth thesis.
 

 

Rob Hanna at Quantifiable Edges pointed out his Capitulative Breadth Indicator (CBI) had rose to 9 just before Friday’s market close.
 

 

In the past, he had used a CBI reading of 10 or more as a buy signal. However, he conducted a study based on a CBI reading of 9 or more, and the market closed at a 20-day low, and the results were encouraging.
 

 

The market may be oversold enough to stage a relief rally next week.
 

Resolving the bull and bear cases

Here is how I resolve the short-term bull and bear cases. The sell-off can mainly be attributed to excessive bullish positioning, and the news of the coronavirus was only a convenient trigger. The market will not make a durable bottom until sentiment gets washed-out.

We are not there yet. We have not seen the classic signs of capitulation. The Citigroup Panic/Euphoria Model (via Barron’s) remains in euphoria territory.
 

 

The Fear and Greed Index closed Friday at 44, which is constructive but the reading is still neutral, and it has not reached the sub-20 levels normally seen at market bottoms.
 

 

In the short run, much depends on positioning, and how momentum players react to events. Macro Charts recently highlighted the estimated dealer positioning based on gamma hedging (see Kevin Muir’s post as a primer on gamma. To make a long story short, dealers who are short gamma need to sell to hedge, which can create a cascade). Gamma turns negative at about SPX 3250. With the market closing 3225, gamma is modestly negative. but we will need further market weakness of 1-2% to spark a rush for the exits.
 

 

Analysis from Callum Thomas of Topdown Charts shows that the reflation and high beta trade is vulnerable to more de-risking. We have not seen the “margin clerk” price insensitive liquidation phase of the market yet.
 

 

An alternative scenario under consideration is a short-term bounce to test the old highs, accompanied by a negative NYSI divergence. The past two major tops have been characterized by such negative divergences.
 

 

If I had to guess, I would assign a 20-30% probability to such an outcome. Mark Hulbert, who also characterized the spark for the current weakness as a retreat in excess bullishness, tried to estimate the size of the correction this way:

Contrarians’ answer is that it depends on how traders react. It would be a good sign if they rush to the sidelines and then quickly jump onto the bearish bandwagon. In contrast, it would be a bad sign if they stubbornly hold onto their bullishness in the wake of the decline. In that case, contrarians would expect that an even deeper correction would be necessary to rebuild the Wall of Worry that would support a new leg upwards.

A short-term rally to test the old highs is paradoxically bad news for the bulls, and would likely resolve in a deeper correction. This “retest the old highs” scenario could very much be in play, and it has the potential to fake out a lot of traders. The market is testing trend line support, and it is just above its 50 dma.
 

 

As well, the market is oversold for a bounce, but it does not appear to be oversold enough for a durable bottom.
 

 

My inner investor is bullishly positioned, but he will sell any rallies to re-balance his portfolio to an allocation that is closer to his long-term asset mix allocations. My inner trader is short the market, and he plans to short into any rallies next week.

Disclosure: Long SPXU

 

Trading the coronavirus panic

Posted by Cam Hui -

Mark Hulbert made a terrific point last week. The coronavirus was not the real reason for the market sell-off. The real reason was excessively bullish sentiment. The coronavirus news was just the excuse.

That real culprit is market sentiment: Short-term stock market timers, on balance, have been extraordinarily bullish for a couple of months now. Even a few days of such excessive bullishness would normally lead to market weakness, much less a few months of such exuberance. So conditions were ripe for a pullback.

If it weren’t the coronavirus, in other words, something else would have been the straw breaking the camel’s back.

 

I had made a similar point in the past. Fast money positioning had become too extreme. Readings were at a crowded long, and portfolio leverage was highly elevated. The market was just ripe for a bearish catalyst.

In that case, how should you react to the coronavirus pullback?
 

Short and long-term outlooks

The answer depends on your time horizon. While I am not blind to the human effects of a possible pandemic outbreak, the purpose of this publication is to analyze the investment impact of such events. Ray Dalio of Bridgewater Associates recently outlined the issues well in a recent essay.

As for the spreading of this virus, as with any sort of unknown, there are 1) actual events and 2) the expectations of events that get reflected in market pricing. Generally speaking these once-in-a-lifetime big bad things initially are under-worried about and continue to progress until they become over-worried about, until the fundamentals for the reversal happen (e.g., the virus switches from accelerating to diminishing). So we want to pay attention to what’s actually happening, what people believe is happening that is reflected in pricing (relative to what’s likely), and what indicators that will indicate the reversal.

In other words, what are the risks? In the short run, here are the questions that investors need to answer:

  • Economic slowdown: Market base case is the SARS outbreak. Will the actual be better or worse?
  • Trade tensions: How will the coronavirus outbreak affect China’s ability to make the purchase committed to under the Phase One trade deal, and how will the US respond?
  • Other excuses: If the market was just overbought, are there other excuses for it to go down?

In the longer term, how does the coronavirus outbreak affect the global growth outlook?
 

Short-term threats

Since we are mostly in uncharted waters, a first order approximation of the effects to GDP growth is the SARS outbreak, whose effects were felt most acutely in Hong Kong, and the nearby Chinese province of Kwangtung.
 

 

However, there are a number of key differences between the SARS episode of 2003 and the Wuhan coronavirus epidemic of 2020.

China is a much bigger part of the world economy today. Disruptions in China today has a much bigger disruptive effect on the global economy because of its participation in global supply chains, as evidenced by the numerous announcements of overseas companies either curtailing or shutting down their operations in China. A partial list include household names like Starbucks, General Motors, Ford, Nissan, Apple, Honeywell, and Ikea.
 

 

As well, the government’s lockdown of activity during the Lunar New Year has cratered Chinese consumption, which is a much bigger portion of the Chinese economy today compared to 2003. As an illustration, box office receipts have cratered to zero during this period.
 

 

Another key difference between 2003 and 2020 is the increased level of debt in China, which makes that economy more fragile and vulnerable to unexpected shocks.
 

 

Comparing SARS and the Wuhan coronavirus can be problematical in other ways. There is some good news and bad news here. The bad news is the coronavirus infection rate is much higher than SARS.
 

 

The good news is the fatality rate is much lower. The SARS fatality rate was about 10%. Initial estimates of the Wuhan coronavirus fatality rate was 2-3%, but it is likely to fall further because of the higher reported infection rate.

Even then, the combination of high infection and low fatality rates have caused concerns at the WHO. The mildness of the virus could help it spread undetected until it reaches a highly vulnerable population. This may be the kind of virus that makes people sick enough so that it spreads, but not so sick that the infected are noticed by health authorities. So far, most of the infected countries are classified as either “most prepared”, or “more prepared”. What happens if the virus migrates to a country that is least able to deal with such outbreaks?
 

 

As an example of the effects of different levels of preparedness, a recent WSJ article documented the differences in response between two Canadian cities, Vancouver and Toronto, to the SARS outbreak.

In Vancouver, by contrast, “a robust worker safety and infection control culture” enabled the hospital to contain the virus, the report found. The Vancouver man with SARS felt ill after a trip to Asia and went to the hospital. Because of his symptoms, the staff whisked him out of the crowded ER within five minutes. Caregivers wore tight, moisture-proof masks and disposable gowns to protect themselves.

The same evening, the Toronto man, whose mother had come from Hong Kong two weeks earlier, went to the hospital with feverish symptoms. For 16 hours he was kept in a packed emergency department. His virus infected the man in the adjacent bed, who had come to the ER with heart problems, and another man three beds away with shortness of breath. Those two other men went home within hours but were later rushed back to the hospital, where they spread the virus to paramedics, ER staff, other ER visitors, a housekeeper working in the ER, a physician, two hospital technologists and, later, staff and patients in the critical-care units.

Poor adherence to infection-control protocols was to blame. Staff failed to wear masks and disposable gowns and didn’t wear face shields while inserting breathing tubes down patients’ airways. After the initial Toronto patient was finally admitted to a hospital room, it took five more hours for him to be isolated.

American hospitals, which are ranked as “most prepared”, have their shortcomings:

A June 2017 literature review of shortcomings in U.S. emergency rooms found a lack of adequate distance between patients, use of contaminated equipment, failure to use shields to protect health-care workers who are intubating patients, and failure to ask coughing patients to wear masks…

The CDC conducted “mystery patient” drills at ERs in 49 New York City hospitals, sending in 95 patients pretending to have symptoms of measles and Middle East respiratory syndrome. In 78% of cases, the ER staff gave these patients masks and isolated them quickly. Even so, only 36% of health-care staff washed their hands. The CDC found “suboptimal adherence to key infection control practices.”

The nightmare scenario is the Spanish Flu of 1918, which killed millions. The effects of the Spanish Flu was exacerbated by poor sanitation and containment protocols. Already, the virus was identified in India, which could be an at-risk country because of its vast population and uneven healthcare standards. What if it shows up in the countries marked as “least prepared”?

So far, the Chinese government has gone all-in with relatively draconian quarantine measures to combat the spread of the virus. This is in stark contrast to the initial response of denial during the SARS outbreak. While policy response and transparency is positive, which the market values, perceptions could easily turn negative at any time. (Recall Ray Dalio’s comment about “what people believe is happening that is reflected in pricing”). However, the government’s public response could turn defensive if unflattering questions and news articles start to emerge. Consider as an example this New York Times opinion piece which concluded that the government cannot be trusted:

Behind all this lies the feeling that most other people in the party can’t quite be trusted. This has been reinforced over the past few days by reports that at least eight people who were detained in Wuhan in early January on charges of spreading rumors are in fact medical doctors, not fear-mongering ne’er-do-wells. This startling fact is now leaking out in online reports that are sometimes, but not always, being blocked. At some point, the government will have to admit to a partial cover-up.

Considering the underlying distrust, it’s hard for the government to say what many epidemiologists are saying: This outbreak is serious but not catastrophic. Because if the state leveled with the people, it would also have to admit that there is no need for this degree of social control. Fewer than 200 people were reported to have died as of Thursday evening, in a country of nearly 1.4 billion, and there is no indication that we are at the start of a Hollywood disaster-style movie.

The government’s inability to formulate a measured response will turn this outbreak into a direct successor of the SARS epidemic. That hardly was a huge public health disaster — fewer than 800 deaths — yet it has taken on a legendary reputation as a catastrophe of unimaginable proportions, one that should never be allowed to recur.

Anything that threatens the authority of the Party is a threat, and the standard Chinese response would be censorship, which would rattle the markets as they hate uncertainty. Imagine the following scenarios (and to be clear, they are made-up and speculative) where questions are asked:

  • Stories circulate of drug-like deal behavior for surgical masks and other medical supplies that the authorities either turn a blind eye to, or unable to control.
  • Embarasing questions about the government’s response to a coronavirus outbreak in Xijiang, and the uneven healthcare provided the Uighur population, compared to the majority Han Chinese.

We would go into the second phase of the fight against the virus, where a veil of censorship goes up, and the world becomes unsure of China’s ability to control the outbreak.

For now, the base case adopted by most analysts is one quarter of very soft or negative GDP growth, followed by a rebound as the virus scare burns itself out. At this point, these are only guesstimates, and investors should monitor how the consensus shifts in the future.
 

 

Political and electoral considerations

Another key question is how the US will react to a Chinese slowdown. The Phase One targets of Chinese imports of American goods were already very ambitious. Any soft patch in Chinese growth, even if it’s confined to just one calendar quarter, will make them impossible to meet. How will Trump react, especially in an election year when he is politically pressed to show progress in a trade war? Will trade tensions rise again?
 

 

As well, I began this report with the thesis that the market was ready to fall, and the coronavirus news was just an excuse. Supposing that news begins to emerge that the outbreak is becoming well contained, could the market still go down?

The answer is yes. There are other threats that could rattle the markets. The Iowa caucus is coming up next week, to be followed by the New Hampshire primary the following week. The latest PredictIt odds now show Bernie Sanders in the lead to win the Democrat’s nomination for President.
 

 

Would that be enough to spook Wall Street? You bet!
 

The long-term outlook

Looking out longer term, the outlook is much brighter. There are numerous indications that the global cyclical rebound scenario that I outlined is still valid (see How far can stock prices rise?). The market should be able to look through the valley of a one quarter hiccup to Chinese and world growth under the base case coronavirus scenario.

Consider, for example, this Gavyn Davies FT article, “Signs of a global recovery in manufacturing are starting to show”. Davies referred to the Fulcrum nowcast, which has unambiguously turned up. He did, however, add the caveat of an assumption that “there will be no meaningful impact on GDP from the coronavirus”.
 

 

There are also other numerous signs that the cyclical revival is still alive and kicking last week (see How my Sorcerer’s Apprentice trade got out of hand), so I will not repeat myself here.

In the absence of definitive recessionary signs, these indications of a cyclical rebound are bullish for the long-term equity outlook. In the short run, however, prices may have gotten ahead of themselves and the US market is overvalued.

How overvalued? The Rule of 20 provides some guidance. Recall that the Rule of 20 flashes a warning sign whenever the sum of the market’s forward P/E and the CPI inflation rate exceeds 20.
 

 

At a minimum, how far does the market need to correct for the Rule of 20 indicator to fall to 19.9? Based on today’s headline CPI inflation rate of 2.3%, and my forward 12-month EPS estimate of 178.71, the S&P 500 would have to correct to at least 3145 before the Rule of 20 sound the all-clear signal. This represents a peak-to-trough correction of about -5.5%. However, the historical evidence shows that the Rule of 20 indicator has fallen much further in the past before bottoming. In other words, pencil in a 5-10% peak-to-trough correction.

However, investors can find cheaper valuations outside the US. While the forward P/E of the US market is at nosebleed levels, developed market P/E ratios are more reasonable at about 14, and EM equities is trading at a forward P/E of 12.8. In the short-term, however, I would avoid EM because of their exposure to China and the uncertainties associated with the coronavirus.
 

 

While the above chart shows the valuation differential between US and non-US equities, the following chart illustrates the tactical price differential. US stocks have surged on a relative basis against MSCI All-Country World Index (ACWI), while non-US stocks have all tanked by comparison.
 

 

In conclusion, traders and investors need to consider their time horizons in order to navigate the latest coronavirus panic. In the short run, the market is falling because of excessive bullish positioning, and the risk-off unwind is not complete. There is more unfinished business to the downside for equity prices.

Longer term, I believe that the global growth outlook remains intact. Investors with longer time horizons should use any market weakness to add to their equity positions. In particular, they should focus on non-US markets, which are more reasonably valued.

In other words, buy the dip, but not yet.

Disclosure: Long SPXU

 

Time to sound the all-clear?

Posted by Cam Hui -

Mid-week market update: I am old enough to remember that one of the burning question for the January FOMC meeting was be whether the Fed would make a technical adjustment on Interest Paid on Excess Reserves (IOER) by 5 basis points. (They did).

Those were simpler times! The stock market rose relentlessly, day after day, and all was well in the land.

Now that stock prices have turned back up again as I had suggested (see Buy for the Turnaround Tuesday bounce), is it time to sound the all-clear and jump back into equities again?
 

 

Based on the historical experience, here are some questions that should be answered.
 

Down Friday/Down Monday

For some perspective on market history, Jeff Hirsch at Almanac Trader found an important historical pattern on what he called “Down Friday/Down Monday”. Most of the time, this pattern proved to be ominous, except when it wasn’t:

Today’s retreat triggered the first DJIA Down Friday/Down Monday of 2020. The combination of a DJIA Down Friday* followed by a Down Monday** has been a rather consistently ominous warning, but they have also occurred at significant market inflection points (interim tops and bottoms). The last occurrence was in August of last year. That declined proved to be a good entry point for new long positions as the market enjoyed a solid rally through the end of the year.

How can you tell the difference? According to Hirsch, here is the key “tell”:

if DJIA recovers its recent losses within about 4-7 trading days, then the DF/DM that just occurred was likely the majority of the decline. However, if DJIA is at about the same level or lower than now, additional losses are more likely sometime during the next 90 calendar days.

In other words, price momentum will tell the story. As guidelines, the DJIA has to recover back to 29167 and SPX has to recover to 3326 by next week. Otherwise the odds favor another leg downwards.

 

Remember sentiment?

Another key question for investors and traders is the evolution of sentiment, particular fast money sentiment and positioning. I wrote on the weekend (see A market stall?) that a market decline was more or less inevitable due to excessive hedge fund bullish positioning.

Risk-adjusted returns, as measured by 3-month equity returns divided by standard deviation has one of the best readings dating all the way back to 1928. This is attributable to two factors. The stock market has been rising steadily, and the low realized volatility of the market, which has encouraged risk taking by hedge fund traders. Positioning is now at a crowded long, which makes the market vulnerable to a setback. Should prices start to recycle downwards, the potential for a disorderly unwind of long positions is high.

 

 

Now that the risk unwind appears to have begun, how has sentiment evolved? While it’s difficult to get any real-time estimates of hedge fund positioning, there are some updates of sentiment that may be useful. The latest update of II sentiment shows some retreat in bullishness, but readings are still elevated.
 

 

Callum Thomas has conducted an (unscientific) weekend Twitter poll since mid-2016, and the survey provided a snapshot of sentiment on the weekend when the anxiety over coronavirus infection was at its height. The survey showed equity bullishness plunged to near all-time lows. However, it would be highly unusual for the market to turn up based on a one-week precipitous decline in bullishness. Wait for the 4-week average to catch up to lower levels of bullishness.
 

 

That said, cratering bullishness has historically been associated with VIX readings of over 20, which has not occurred yet.
 

 

The bulls have not suffered enough pain yet. We need more for capitulation to occur.
 

Market internals

A review of the relative strength of the top five sectors reveals a weakish picture. As a reminder, the top five sectors comprise nearly 70% of index weight, and it would be difficult for the market to make a major move without the participation of a majority of these sectors. Of the five sectors, only one (Technology) is unambiguously bullish, one (Communication Services) is neutral, and the other three are bearish. This gives the market a slight bearish tilt, though the market is volatile, and leadership shifts can happen at any time.
 

 

Looking beneath the surface, even the strength of Technology stocks is problematical. An analysis of the equal vs. cap weighted performance of technology stocks shows that the equal-weighted to cap weighted ratio within the sector is tanking. This is a sign of narrowing leadership by large cap FAANG stocks.
 

 

Further breadth analysis of the top five sectors also reveals how market breadth has deteriorated. Net highs-lows are all falling, and one sector (Communication Services) is showing negative net highs-lows. Can the market rally to new highs with internals like this, or are these signs of an oversold bottom?
 

 

In conclusion, the weight of the evidence indicates that the market has unfinished business left to the downside. My inner trader took partial profits on his short positions on Monday (see Buy for the Turnaround Tuesday bounce), but he remains short the market.

Disclosure: Long SPXU
 

Buy for the Turnaround Tuesday bounce?

Posted by Cam Hui -

I just wanted to put out a quick note this morning. The markets are obviously very chaotic this morning and they have taken on a risk-off tone. The VIX Index has spiked above its upper BB, and its term structure has inverted. Both are indications of high fear.     Should traders step in and […]

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A market stall?

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Bearish

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.
 

A market stall?

For the last two weeks, I have been warning about the extended nature of the stock market (see Priced for perfection and Froth everywhere!). Now that the advance is pausing over concerns the Wuhan coronavirus, is this the start of a market stall?

It’s starting to look that way. The SPX violated its 5 and 10 day moving averages, and printed an outside reversal day. These are all indications of a possible change in trend.
 

 

Here are bull and bear cases.
 

The bear case

Let’s start with the bear case, which is more obvious from a tactical perspective. First, equity risk appetite as measured by the ratio of high beta to low volatility stocks has rolled over. This has been a reliable trading signal in the past of market weakness.
 

 

The signal from credit market risk appetite is similarly worrisome. Both high yield and emerging market bonds are underperforming their duration-equivalent Treasuries. While these indicators are tracing negative divergences to equity prices, their readings have tended to be volatile.
 

 

The price of the long Treasury ETF has staged an upside breakout from a falling trend line. Rising Treasury prices are an indication of diminished risk appetite, which is equity bearish.
 

 

The bull case

While bearish red flags are beginning to be raised, there are a number of neutral to bullish indicators to consider. The USD Index has staged an upside breakout out of a multi-year base, and it is tracing out a bull flag formation. Should the USD break out of the bull flag, it would be bearish for emerging market assets, and therefore negative for risk appetite. Keep an close eye on the greenback. The jury is still out on that question.
 

 

The latest BAML Global Fund Manager Survey shows that EM is the largest equity overweight position among managers. A USD rally and EM retreat has the potential to cause the maximum amount of pain, and a disorderly unwind and risk-off stampede.
 

 

The latest update from Q4 earnings season remains upbeat. EPS and sales beat rates are neutral to positive relative to history. More importantly, forward 12-month earnings estimates are rising, indicating positive fundamental momentum. However, the magnitude of the EPS beats was slightly disappointing. They came in at a rate of 3.2% above expectations, which is below the 1-year average of 4.5% and 5-year average of 4.9%.
 

 

Just as importantly, the market is behaving as expected by rewarding EPS beats and punishing misses.
 

 

Breadth and momentum indicators are still strong. The % of stocks above their 50 day moving average is not behaving in a way similar to past major market plunges. Arguably it is still early and this indicator could fall dramatically in the near future.
 

 

As well, NYSI has barely begun to roll over. Past major market tops have been characterized by negative divergences in NYSI, which is not evident this time. In the past, rollovers by the high beta to low volatility ratio have been followed by 5-10% corrections, but this time could be different. The possibility exists that, in the absence of a NYSI negative divergence, any pullback could be shallow in the order of -2%. This would be followed by a market rally and negative NYSI divergence that marks the final top.
 

 

The verdict

After considering the bull and bear cases, what’s the verdict?

The recent market melt-up was characterized by excessively bullish sentiment and a bullish stampede by traders. This chart from SentimenTrader (via Andrew Thrasher) makes a great point. Risk-adjusted returns, as measured by 3-month equity returns divided by standard deviation has one of the best readings dating all the way back to 1928. This is attributable to two factors. The stock market has been rising steadily, and the low realized volatility of the market, which has encouraged risk taking by hedge fund traders. Positioning is now at a crowded long, which makes the market vulnerable to a setback. Should prices start to recycle downwards, the potential for a disorderly unwind of long positions is high.
 

 

For a longer term perspective, consider the evolution of long bond yields. The 30-year Treasury yield has staged a recent tactical retreat, but the level of macro concerns outside of the Wuhan coronavirus is relatively low compared to past episodes of falling bond yields. Indeed, the St. Louis Fed Financial Stress Index hit an all-time low, and the Chicago Fed National Conditions Index isn’t that far behind.
 

 

This is compressing real bond yields, which is bullish for gold, and the reflation trade. My interpretation is that while the market is at risk of a short-term pullback because of excessive risk positioning, investors should consider market weakness to be an opportunity to buy the reflation trade.
 

 

In the short run, we may not be at a tipping point in the market just yet. In the past, significant market downdrafts have not occurred without the Fear and Greed Index recycling from above 60 to below the 60 mark. While we are close, that bearish tripwire has not been triggered yet.
 

 

While I am leaning towards a bearish resolution, the signals of a major downdraft are not yet in place. Traders could dip their toes in the bearish pond, and await further developments. My inner trader had already initiated a short position, and he raised his shorts when the market violated its 5 dma on Friday.

While my inner trader is tactically bearish in his trading account, the week ahead may not be as easy as anyone thinks. Earnings season is in full swing, and a host of macro releases could have market moving consequences. The Fed and the BoE meet next week. We will also see the US and the eurozone report initial estimates of Q4 GDP, and China will report its official PMI.

Consequently, the week ahead could be very volatile and difficult to navigate from a trader’s perspective. Monday could see further downside as the weekend news is filled with stories of the seriousness of the Wuhan coronavirus. The market is already mildly oversold as of Friday’s close, and could see a Tuesday turnaround after more weakness on Monday.
 

 

Keep an open mind, and adjust the size of your trading positions to the expected heightened volatility.

Disclosure: Long SPXU
 

How my Sorcerer’s Apprentice trade got out of hand

Posted by Cam Hui -

Remember the story of the Sorcerer’s Apprentice from Fantasia (click link for YouTube video)? Mickey Mouse played the role of a sorcerer’s apprentice tasked to carry buckets of water. Instead of doing it himself, he stole the sorcerer’s hat and animated a broomstick to carry the buckets for him. To speed up the work, he animated more and more broomsticks, until everything got out of hand.
 

 

While I don’t claim to be a prescient genius who can see the future of the market, I was fortunate to spot the beta chase early. Bloomberg reported on December 18 that Stanley Druckenmiller had turned bullish, and Druckenmiller would not have gone on television to proclaim his embrace of risk if he hadn’t fully entered into his entire position yet. As Kevin Muir at The Macro Tourist pointed out, “It is also probably safe to say that Druckenmiller, on the whole, is way ahead of most investors.” In other words, the fast money crowd was stampeding into the reflation and cyclical recovery trade.

Nevertheless, the subsequent melt-up does feel a bit like a “sorcerer’s apprentice” rally that got out of hand. Now the equity risk appetite seems to rolling over, and the steady advance seems to pausing on the news of the Wuhan coronavirus, what’s next?
 

 

A melt-up recap

To recap the events of the last few months, let’s go back to last August. The 2s10s yield curve had inverted, and there was widespread concern about a recession. While I was skeptical about the recession narrative, I did expect a deeper valuation reset that did not materialize.
 

 

The market eventually recovered and broke out to all-time highs in late October. On November 10 (see How far can stock prices rise), I speculated about the possibility of a market melt-up. The Street had become overly defensive in its positioning, and evidence of a global cyclical recovery was emerging, which would lead to a beta chase stampede to buy stocks.

A more reasonable scenario is a bubbly market melt-up, followed by a downdraft, all in a 2-3 year time frame.

On December 1, I confirmed the melt-up scenario (see Buy signal confirmed: It’s a global bull):

The SPX may be undergoing a melt-up in the manner of late 2017. It is unusual to see the index remain above its weekly BB for more than a week, which it did two weeks ago. The melt-up of late 2017 also saw similar episodes of upper weekly BB rides, punctuated by brief pauses marked by “good overbought” conditions on the weekly stochastic. The technical conditions appear similar today, and I am therefore giving the intermediate term bull case the benefit of the doubt.

Even though the bullish stampede was in my forecast, its sheer breadth was astonishing. In particular, the fast money crowd had gone all-in, both on risk and leverage. The degree of leverage undertaken by hedge funds was exacerbated by a compression in realized volatility, which was the result of HF steady buying. The compression in implied and realized volatility served as an input to trading desk risk models, which encouraged even more leverage to fund long positions. In other words, the sorcerer’s apprentice was animating more and more broomsticks.
 

 

The slower moving institutional investors were also buying into the cyclical recovery trade. The BAML Global Fund Manager Survey showed a spike in global expectations that began late last year.
 

 

Equity positioning, however, was not as extreme as hedge funds. Readings are only in neutral territory and nowhere near crowded long levels. By contrast, the 2017/18 melt-up episode began with global institutional equity positioning already bullish, and readings then surged to a crowded long.
 

 

Another difference between the current melt-up and the 2017/18 experience is the lack of participation by retail investors. The TD-Ameritrade Investor Movement Index, which tracks the custodial position of the firm’s clients, shows that while individual investors did buy into the rally, their level of exuberance was nothing compared to the last melt-up episode.
 

 

What next?

So where do we go from here?

The fast money crowd front ran the institutional cyclical recovery trade, and hedge funds are now in a crowded and leveraged long on risk. Market valuation became extended. The stock market is now trading at a forward P/E of 18.6. The Rule of 20, which flashes a warning whenever the sum of forward P/E and inflation rate exceeds 20, is warning of a market pullback.
 

 

The cyclical recovery narrative is also showing some cracks. In the US, the relative performance of cyclical groups are mixed. Semiconductor stocks are still on fire. Industrial stocks have been soft against the market, but much of the weakness is attributable to the well-publicized problems at heavyweight Boeing. An equal-weighted analysis, which reduces the effects of Boeing, shows that the sector is performing reasonably well. However, homebuilding stocks were underperforming during a period when the cyclical recovery theme was dominant, though they have since begun to rise again and remain in a relative uptrend. Transportation stocks, on the other hand, have done nothing except to lag the market during this entire period.
 

 

In Europe, the rally of cyclically sensitive have paused. Industrial stocks did stage an upside relative breakout, but they have paused and begun to move sideways. Similarly, the financial sector broke out of a relative downtrend, but they are also consolidating sideways. By contrast, a defensive sector like consumer goods are bottoming on a relative basis, and it is starting to show signs of life.
 

 

As the European markets have begun to take on a defensive tone, bond yields have fallen (and bond prices have risen). Falling bond yields are detrimental to European banking profitability, and it is therefore no surprise to see European banks start to underperform. The recent price recovery of the Austrian century bond is an example of the shift in risk appetite.
 

 

Normally, at this point I would turn to an analysis of China and Asia’s markets for completeness. However, the recent panic over the Wuhan coronavirus makes analysis difficult. It’s all noise until we get more clarity on the situation.
 

The cyclical trade still alive and kicking

In summary, the market is tactically poised for a pullback. Valuations are extended, and fast money positioning is too bullish. But that doesn’t mean the bull is dead, once we see a valuation reset. All fundamental and macro signs show that the cyclical recovery trade is still alive.

From a top-down perspective, the Citi US Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations, is rising and indicating that the cyclical recovery is showing strength.
 

 

G10 ESI is also showing a similar pattern of strength.
 

 

Calculated Risk reported that the Chemical Activity Barometer, which is a leading indicator of industrial production, is turning up.
 

 

Renaissance Macro Research also pointed out that the word count of “weak” and “slow” are falling in the latest Fed Beige Book survey, which is another sign of cyclical strength.
 

 

From a bottom-up perspective, consider the latest excerpted comments from The Transcript, which is a summary of company earnings calls:

Business sentiment is improving
“We see some resolution to those issues and that combined with continued consumer strides, leads us to expect to see businesses continue their solid activity and we’re hearing more optimism.” – Bank of America (BAC) CEO Brian Moynihan

“There’s no question in the fourth quarter the environment improved. Based on the data or information we can see across activity and dialogue with clients, I would say that it’s improved in the fourth quarter and the trends that we’re seeing early into 2020 are a little bit more positive.” – Goldman Sachs (GS) CEO David Solomon

” the fourth quarter definitely, I would say, stabilized. Things trade certainly stabilized. Things, broadly speaking, stopped getting worse and so, we saw sentiment improve a bit” – JPMorgan Chase (JPM) CFO Jennifer A. Piepszak

Manufacturing seems to be turning a corner
“last year we did see a little bit of weakness in manufacturing, but we’re starting to lap that and we’re starting to see some positive momentum coming out of that sector. So generally, we’re seeing some very good signs from our corporate.” – Delta Air Lines (DAL) President Glen Hauenstein

” For most of calendar year 2019, the weakness in global manufacturing was exacerbated by the inevitable inventory destocking that companies undertook in response to the weak demand conditions…As we enter 2020 however, we are seeing signs of an improvement.” – Schnitzer Steel Industries (SCHN) CEO Tamara Lundgren

Significantly, the US consumer is doing fine
“our results continue to reflect the strength of the U.S. consumer in the biggest economy in the world…We also continue to see healthy consumer trends in spending and asset quality. ” – Bank of America (BAC) CEO Brian Moynihan

“Our outlook heading into 2020 is constructive, underpinned by the strength of the U.S. Consumer.” – JPMorgan Chase (JPM) CFO Jennifer A. Piepszak

China headwinds are moderating
“In Europe, growth continues to remain relatively low given manufacturing weakness. However in China trade headwinds appear to have moderated with both monetary and fiscal stimulus supporting growth estimates of nearly 6%” – Goldman Sachs (GS) CEO David Solomon

Across the Atlantic, the latest flash PMI release shows signs of green shoots in manufacturing. Manufacturing PMI edged up, and the new orders/inventory ratio rose strongly, indicating that the inventory de-stocking cycle is over.
 

 

As well, the latest ZEW survey from Germany rose unexpectedly. While ZEW is a sentiment survey, it has historically led eurozone GDP growth by about 12 months.
 

 

In conclusion, the stock market is tactically poised for a pullback and valuation reset. However, fundamental and macro indicators all point to a continuation of the global cyclical recovery. I have pointed out before that the highly reliable long-term monthly MACD buy signal for US equities remain in play.
 

 

Similarly, the buy signal for non-US markets is also still valid.
 

 

Any market weakness should only a hiccup. Investors should be preparing to buy the dip, while traders should position themselves for a correction.

Disclosure: Long SPXU
 

Cruisin’ for a bruisin’

Posted by Cam Hui -

Mid-week market update: Bloomberg reported that BAML strategist Michael Harnett wrote a report back on December 12 forecasting a melt-up. He believed the market’s gains would be front loaded in 2020. and he projected an S&P 500 target of 3,333 by March 3. The index reached that level intra-day today, and it’s still January. Are the front-loaded gains over?

Sentiment is certainly extended. II %bulls rose to 59.4% this week, and the bull-bear spread has reached the highest level since October 2018.
 

 

SentimenTrader observed that Trump’s tweets about the stock market had reached a new record.
 

 

As well, Macro Charts pointed out that further analysis from SentimenTrader showed that option buy-to-open volume reached a record high for a second week in a row.
 

 

It certainly seems that the stock market is “cruisin’ for a bruisin'”.
 

Stage set for a volatility spike

I have been warning about the possibility of a pullback for nearly two weeks (see Priced for perfection).  It isn’t just that the market is overbought and valuations stretched, fast money positioning is set up for a sharp response should any unexpected fears, such as a coronavirus induced economic slowdown, spook the market.

A week ago, Macro Charts reported that the market had gone 66 days without a 1% decline. The clock is still counting as both implied and realized volatility have compressed.
 

 

Callum Thomas at Topdown Charts also documented the case of suppressed FX volatility.
 

 

As overall asset volatility falls, the volatility, or risk, estimates that go into Value At Risk (VaR) models for trading desks also falls. This encourages traders to take more risk. Indeed, as volatility declined and the prices of risky assets rose, both systematic and discretionary hedge funds have piled into equities.
 

 

Moreover, they have also increased leverage in accordance to the reduce risk estimates from their VaR models.
 

 

We all know what happens next. Should volatility normalize, the level of risk and leverage allowable by VaR models declines. If such an event is accompanied by a risk-off episode, the potential for a disorderly sell-off is high. Credit Suisse documented what happened to the EURUSD exchange rate after past periods of suppressed FX volatility.
 

 

All the market needs is a trigger.
 

A coronavirus trigger?

Could the coronavirus news be the trigger, or the excuse, for a volatility spike? As a reminder, the SARS coronavirus infection of 2003 infected thousands, and killed hundred. It also cratered the Hong Kong economy, and sliced 1% off China’s GDP growth,
 

 

It is revealing that the editor of Global Times, which is part of the Chinese official media, would admit to the spread of the virus. The timing of the outbreak is unfortunate, as widespread travel during the Lunar New Year festivities is likely to encourage the spread of the infection.
 

 

Business Insider reported the scope of the infection is widening quickly, and nine fatalities have been confirmed so far. The virus has migrated to the US. The Center for Disease Control announced its first case of infection yesterday.
 

 

Equally worrisome is the news that Wang Guangfa, a respiratory expert of Peking University First Hospital, has been infected with the virus (story in Chinese here). He is reported to be in stable condition.

Bloomberg Asia Chief Economist Tom Orlik pointed out two sources of fragility that Chinese economy faces today as a result of the coronavirus infection. First, services suffered the most during the SARS epidemic. Services comprise a far larger part of the Chinese economy today, which makes it more sensitive to consumption shocks.
 

 

As well, the financial markets were far more orderly then subject to more government control. Today, the markets play a bigger role in the price discovery mechanism. Consequently, volatility risk is far higher today compared to 2003.
 

 

To be sure, the current outbreak is less virulent than SARS. The apparent infection rate is far lower than SARS, and the Chinese authorities have been more proactive in dealing with the problem compared to the 2003 episode.
 

 

On the other hand, even the Ebola outbreak of 2014, whose economic effects were regionally isolated, panicked the market and spiked the VIX Index from 11 to 31 in the space of about a month (see The Ebola correction? OH PUH-LEEZ!).
 

Trade war trigger?

If the coronavirus is not enough to rattle the markets, another bearish trigger might be the threat of a transatlantic trade war. The fur is flying in a trade spat at Davos. In an unplanned news conference, Trump characterized the EU as “worse than China” on trade. The dispute over the French tax on digital companies remains unresolved, and Trump has threatened to impose tariffs on European cars in retaliation. The UK managed to get into the act, too. The Chancellor of the Exchequer Sajid Javid vowed to impose their own digital tax in April.
 

 

Stayed tuned.
 

Bracing for volatility

Another source of volatility might be the Iowa caucus. The WSJ reported that implied volatility usually picks up around elections, and traders are buying volatility ahead of the Iowa caucus.

Options markets are bracing for big swings in stock prices around the U.S. presidential election.

Traders are picking up options that would pay out after the Iowa Democratic caucuses on Feb. 3, betting on volatility, according to Wells Fargo Securities. That’s based on options tied to the S&P 500 expiring on Feb. 5. Traders have also paid up for options on the Cboe Volatility Index, or VIX, expiring that month, which would profit if market turbulence jumped through February.

Ahead of the Iowa caucus on February 3, another source of volatility might occur the week before. The FOMC meeting is scheduled for Wednesday, January 29.
 

Technical warnings

From a technical perspective, I have been monitoring the high beta/low volatility factor pair (see Froth everywhere!). In the past, rollovers in this pair trade has led market declines. It just breached a rising relative trend line to confirm a shift in regime from risk-on to risk-off.
 

 

Equally worrisome is the behavior of the DJ Transportation Average. Even as the DJIA made new all-time highs, the Transports has been stubbornly weak, and it has been unable to rally to fresh highs as confirmation.
 

 

Econbrowser confirmed the softness of sector fundamentals by highlighting the weakness of the Cass Freight Index and BTS Freight Services Index.
 

 

My inner trader initiated a short position based on the rally of TLT, the long Treasury bond ETF, through a declining trend line. As rising Treasury prices tend to be risk-off signals, a bond market rally is bearish news for risk appetite. TLT fell below the trend line, but recovered Tuesday and strengthened Wednesday.
 

 

Having taken a partial short position, my inner trader is now waiting for the S&P 500 to decline through its 5 day moving average, as an additional bearish signal to increase his short position.
 

 

My inner trader is bearishly positioned. My inner investor remains bullish. While valuations are stretched, the longer term macro outlook remains bright, and downside risk is probably no more than 10%. If an investor is afraid of a 10% pullback, than he should re-think his commitment to equities.

Disclosure: Long SPXU

 

Froth everywhere!

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bearish*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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.
 

Will history repeat itself?

Looking to the week ahead, there is no doubt that the stock market is becoming more and more frothy. While I did alert readers to the potential for a melt-up in early December (see Buy signal confirmed: It’s a global bull), the magnitude of the price surge has caught me even by surprise.

I remain bullish on an intermediate term basis. The SPX may be undergoing a melt-up in the manner of late 2017. It is unusual to see the index remain above its weekly BB for more than a week, which it did two weeks ago. The melt-up of late 2017 also saw similar episodes of upper weekly BB rides, punctuated by brief pauses marked by “good overbought” conditions on the weekly stochastic. The technical conditions appear similar today, and I am therefore giving the intermediate term bull case the benefit of the doubt.

The melt-up of 2017/18 ended in late January, 2018. Will history repeat itself? As a reminder, here is the latest cover from Barron’s.
 

 

Today, market conditions are characterized by:

  • Excessively bullish sentiment: While crowded long sentiment readings are warnings of downside risk, they do not act well as timely trading indicators.
  • Waiting for a catalyst: While there has been plenty of good news, there has also been bad news lurking in the background. This brings investors and traders to ponder the question of, “Is the glass half full or half empty?”
  • Overbought markets: But overbought markets can indicate either “good overbought” markets dominated by price momentum, or overbought markets ripe for a reversal.

 

Too bullish?

\
Signs of excessive bullishness are everywhere you care to look. The Fear and Greed Index has been stretched, but readings have been at nosebleed levels for over a month. While these conditions warn of contrarian bearishness, sentiment models are much better at spotting bottoms than tops. They are simply not actionable as sell signals for trading accounts.
 

 

Macro Charts pointed out that the Daily Sentiment Indicator (DSI) for VIX, which tends to be inversely correlated with stock prices, printed at 9% bulls for three times last week. The historical record for such episodes have been bearish for stock prices. On the other hand, Macro Charts had been cautious since this run-up began in December. That said, DSI for both the SPX and NDX have been over 90, which are warning signs.
 

 

Callie Cox observed that the market is undergoing a period of prolonged equity volatility compression.
 

 

As a reminder, the last two episodes were resolved in a bearish way.
 

 

Callum Thomas at Topdown Charts also pointed out that volatility compression has not been restricted to equity volatility. FX volatility has also been suppressed, which tends to end with a volatility explosion.
 

 

File these indicators under “this will not end well”, but the market is unlikely to fall without a bearish catalyst.
 

Glass half full, or half empty?

A lot of important market moving news had hit the tape in the past week. While the market has reacted mostly positively to news, we have also seen bad news that have lurked under the surface. This is setting up a dilemma for investors and traders when interpreting news.

Is the glass half full, or half empty?

Consider the Phase One deal signed by Donald Trump and Liu He last Wednesday. While our trade war factor, which measures the relative performance of domestically oriented companies, is flashing a huge sigh of relief. On the other hand, soybean prices are retreating they are testing a major support level. Is the glass half full, or half empty?
 

 

In addition, the Senate is about to pass legislation to ratify USMCA, or NAFTA 2.0. At the same time, EU chief trade negotiator Phil Hogan called out Trump for being obsessed with the trade deficit. Treasury Secretary Mnuchin is scheduled to meet with French finance minister Le Maire at the sidelines of the Davos World Economic Forum next week. They have set a deadline of next Wednesday to settle the dispute of the French digital tax, which Trump has threatened to retaliate by imposing 100% tariffs on French wines and other imports. We could see a new transatlantic trade war break out by next weekend.

Is the trade tension glass half full, or half empty?

From a valuation perspective, the market is now trading at a nosebleed forward P/E multiple of 18.6. However, the 10-year yield at the January 2018 peak was 2.6%, compared to 1.8% today, indicating that the market may not have reached a similar level of peak valuation because the discount rate on earnings is lower.
 

 

Here is another perspective on the valuation question. According to Morningstar, the market is roughly 7% overvalued. This degree of overvaluation is high relative to its history, and the only episode that eclipsed the current period was the melt-up of 2017/18.
 

 

The very early results from Q4 earnings season have been neutral to positive. The EPS beat rate is in line with historical averages, while the sales beat rate is above average. Moreover, forward 12-month EPS is being revised upward, indicating positive fundamental momentum.
 

 

Is the valuation glass half full, or half empty?

The message from the credit markets is similarly ambiguous. On one hand, the performance of both investment grade (IG) and high yield (HY) relative to their duration-adjusted Treasuries have roughly matched the stock market in the past year, indicating a confirmation of the new highs. On the other hand, both the relative performance of IG and HY have been flat since mid-December while stock prices have soared, which is a negative divergence.
 

 

Is the credit market risk appetite glass half full, or half empty?

From a technical point of view, the analysis of the relative performance of the top five sectors of the market is revealing. Since these sectors comprise nearly 70% of the weight of the index, the market cannot make a major move without signs of either bullish or bearish leadership from these sectors. Of the five sectors, one (technology) is in a bullish relative uptrend, two (heathcare and communications services) are range bound, and two (financials and consumer discretionary) are weak. The net weight of strong sectors compared to weak sectors is roughly zero. In short, the internals from sector leadership is not as positive as the progress of the major market averages.
 

 

Is the technical analysis glass half full, or half empty?
 

An overbought market

Breadth indicators from Index Indicators show that the market is simultaneously recycling from an overbought condition on different time horizons, which is unusual.

On a short (1-2 day) basis, the market is turning down from an overbought condition based on % of stocks above their 5-day moving average (dma).
 

 

On a 2-5 day horizon, the market is also recycling from overbought condition based on % of stocks above their 10 dma.
 

 

Similarly, readings are the same based on the net 20-day highs-lows, which is an indicator with a 1-2 week horizon.
 

 

Are these “good overbought” signals exhibited by a steady price momentum based market advance, or the signs of an imminent market stall?
 

On the edge of a precipice

The market’s prevailing thinking at this time is a glass half full, but even a minor change in psychology could turn the paradigm to a glass half empty. Tactically, the market environment is highly risky, and prices could turn down with little or no warning at any time.

My inner trader initiated a short position last week when long Treasury prices rallied above a falling trend line. Since Treasuries represent the safety trade, UST strength would be bearish for risk appetite and therefore bearish for stock prices. Unfortunately, bond prices reverted below the trend line on Friday.
 

 

However, I am not ready to close out the short position just yet. The market has begun to recycle from an overbought position. More importantly, equity risk appetite, as measured by the ratio of high beta to low volatility stocks, is testing a rising trend line and may be rolling over. In the past, such rollovers have preceded bearish episodes.
 

 

Traders should monitor how these indicators develop over the next few days. This may be the start of an inflection point for stock prices.

Disclosure: Long SPXU

 

Energy: Value opportunity, or value trap?

Posted by Cam Hui -

Callum Thomas recently highlighted an observation from BAML that the market cap of Apple (AAPL) is now larger than the entire energy sector.

AAPL is now the largest stock in the index, but its weight at 4.5% is not especially extreme in the context of the historical experience. The fact that AAPL’s market cap has eclipsed the aggregate weight of the energy sector is telling.

Is this an inflection point for the energy sector? Do energy stocks represent a value opportunity that should be bought, or a value trap to be avoided?

I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

The Sun is about to undergo a period of low sunspot activity, which has shown to have a cooling effect on the Earth’s climate. The climate data that emerges over the next decade should show that the effects of human-induced warming to be partially or fully offset by the effects of the solar cycle. Public concerns about climate change, and policy surrounding a global climate emergency, are likely to abate, but that process will take time.

I conclude that while the sector is acquiring a value characteristic, sentiment is not yet a wash-out and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade set-up. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.

The new tobacco?

In this era of hyper-sensitivity about climate change, energy stocks are being shunned in a way that they are becoming the new tobacco stocks. The topic has grabbed the attention of top policy makers and major investors. Canada’s Financial Post reported that BoE Governor Mark Carney warned financial services companies need to take action to cut CO2 emissions:

Financial services have been too slow to cut investment in fossil fuels, a delay that could lead to a sharp increase in global temperatures, Bank of England Governor Mark Carney said in an interview broadcast on Monday.

His remarks painted a big cross-hair on the energy sector.

Carney cited pension fund analysis that showed the policies of companies pointed to global warming of 3.7 to 3.8 degrees Celsius, compared with the 1.5-degree target outlined in the Paris Agreement on climate change.

“The concern is whether we will spend another decade doing worthy things but not enough… and we will blow through the 1.5C mark very quickly,” Carney said in a radio program guest edited by teenage environmental campaigner Greta Thunberg.

“As a consequence, the climate will stabilize at the much higher level.”

The Economist reported that Jeremy Grantham of GMO echoed Carney’s assessment.

Late last year Jeremy Grantham, an investor routinely described as “legendary”, spoke about esg (environmental, social and governance) investing at a conference in London. His presentation was slick; his accent floated somewhere in the mid-Atlantic (Mr Grantham is English but has lived in America for ages). “I love s and g,” he began. “But e is about survival.”

As a consequence, Grantham is uber-bearish on oil stocks, to the extent that he believes investors need to make the oil industry a pariah.

Is there also a moral case for disinvestment? An argument against is that oil firms are best placed to speed the transition to solar and wind power. They have experience of managing big projects in difficult terrain. And many would say that dumping oil stocks is a pointless salve to the eco-warrior’s conscience. Bill Gates, a software mogul and philanthropist, has argued that people should not waste idealism and energy on a policy that will not cause any reduction in the use of fossil fuels. What matters are incentives set by governments: tax breaks to fund research in green energy; tax rises to discourage carbon use. But this misses the point, says Mr Grantham: “You have to make the oil industry a pariah for bad behaviour.” Only then will politicians feel the need to act.

BlackRock CEO Larry Fink released a letter to CEOs to assert, “Climate change has become a defining factor in companies’ long-term prospects.” It is time for fiduciaries like Blackrock to act.

Over the 40 years of my career in finance, I have witnessed a number of financial crises and challenges – the inflation spikes of the 1970s and early 1980s, the Asian currency crisis in 1997, the dot-com bubble, and the global financial crisis. Even when these episodes lasted for many years, they were all, in the broad scheme of things, short-term in nature. Climate change is different. Even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis. Companies, investors, and governments must prepare for a significant reallocation of capital.

While Fink did not come out and say it, his term, “a significant reallocation of capital” is code for divestment to force up the cost of capital of companies that contribute to climate change and global warming. As BlackRock’s assets under management total about $7 trillion, this statement will bound to have a chilling effect on the energy sector.

Cheap enough?

Are energy stocks sufficiently washed out? Investors have been shunning energy stocks for over a decade. The sector has undergone over 10 years of poor relative returns.

Is their valuation cheap enough? FactSet reports that the energy sector trades at a forward P/E ratio of 17.5, which is well below its 5-year average of 29.1 and 10-year average of 20.4. Before anyone writes me to complain that oil and gas stocks trade on cash flow multiples, I would point out that, on a cap weighted basis, the US energy sector is dominated by integrated companies with substantial downstream refining and marketing assets. In such instances, the use of a P/E multiple to value integrated stocks is entirely appropriate.

Moreover, the most liquid energy sector ETF,XLE has a dividend yield of 3.7%, compared to 1.7% for the market, as represented by SPY.

A long-term bullish factor

There is no doubt that energy stocks are cheap, but cheap stocks can become cheaper in the absence of a bullish catalyst, especially if investors perceive them to be in an industry in decline. However, I would like to propose a long-term bullish factor that has been ignored by the market. This factor has the potential to be the catalyst that digs these stocks out of their pariah status.

Cosmic rays.

An important article at Electroverse explains how cosmic rays (CR) and the solar cycle affect the Earth’s climate.

During solar minimums –the low point of the 11-or-so-year solar cycle– the sun’s magnetic field weakens and the outward pressure of the solar wind decreases. This allows more cosmic rays to penetrate the inner solar system as well as our planet’s atmosphere:

The solar cycle has a regular ebb and flood pattern of 11 years. The Sun is about to undergo a period of low sunspot activity. The level of cosmic ray radiation is inversely correlated with the level of sunspot activity, which affect the Earth’s climate.

More crucially however, CRs hitting Earth’s atmosphere have been found to seed clouds (Svensmark et al), and cloud cover plays perhaps the most crucial role in our planet’s short-term climate change.

“Clouds are the Earth’s sunshade,” writes Dr. Roy Spencer, “and if cloud cover changes for any reason, you have global warming — or global cooling.”

The upshot of this current solar minimum (24) –the sun’s deepest of the past 100+ years (NASA)– is a cooling of the planet, with the coming solar cycle (25) forecast by NASA to be “the weakest of the past 200 years“:

In fact, the forecast calls for a prolonged period of low sunspot (high cosmic ray) cycle that is reminiscent of the Maunder Minimum. Studies by NASA have attributed low sunspot activity to be the cause of prolonged cooling periods like the Maunder Minimum, otherwise known as the Little Ice Age of the 17th Century. For some perspective, here is a painting by Hendrick Avercamp entitled “A Scene on the Ice” documenting life in Holland during that period (see link for source).

Subsequent to the Little Ice Age, the Earth experienced another one of the Sun’s extended periods of low sunspot activity called the Dalton Minimum. This particular minimum lasted from about 1795 to the 1820s. The year 1816 was in the middle of the Dalton Minimum period. It is still known to historians as the “year without a summer”, the “poverty year”, or “eighteen hundred and froze to death”. Poor conditions were said to have been caused by a combination of a historic low in solar activity and the Mount Tambora eruption of 1815, which spewed extensive amounts of volcanic ash around the world.

It was a time of ecological disaster. 1816 saw snow in June in the U.S. and Europe. Crops failed and starvation followed, many Europeans spent their summers huddled around the fire. It was during this bleak summer that Mary Shelley was inspired to write Frankenstein and John William Polidori, The Vampyre.

The Electroverse article continued:

Solar cycle 25 is predicted to be a mere stop-off in the suns descent into its next full-blown GRAND solar minimum cycle. (GSM).

NASA has linked GSM episodes to prolonged periods of global cooling, like the Maunder Minimum. or Little Ice Age.

Viewed in this context, Anthropogenic (human caused) Global Warming, or AGW, is a blessing in disguise that offsets the effects of the cooling effects of the solar cycle. The magnitude of the cooling observed during that era dwarves the worst case scenario of climate activists. These offsetting factors would represent good news for the human race for the rest of this century.

Investment implications

What does this mean for investors?

NASA’s models for the current solar cycle, which lasts 11 years, calls for the Earth to undergo a cooling period from rising cosmic ray radiation. The models calling for a Grand Solar Minimum cycle are more speculative.

Nevertheless, the climate data that emerges over the next decade should show that the effects of AGW to be partially or fully offset by the effects of solar cycle 25. Public concerns about climate change, and policy surrounding a global climate emergency, is likely to abate, but that process will take time.

While this development is bullish for energy stocks (and agricultural commodities) in the long run, it does nothing for the energy sector over the next one or two years. The effects of the solar cycle represents only a trade setup, and not a full-blown buy signal. While political pressures are rising for solutions to climate change and global warming, the market reaction to these pressures is only beginning. As an example, CNBC reported that Microsoft aims to become carbon neutral by 2030, and eliminate its historical carbon footprint by 2050. Amazon has pledge to be “net carbon neutral” by 2040. These calls to action are reminiscent of the atmosphere during the dot-com era of the late 1990’s, when even mining companies would not dare to present to investors without a “broadband strategy”.

ESG investing is still a nascent theme. At only 2% of the market, it has much more room to expand, especially in light of Larry Fink’s call to action.

Looking over the next 12-24 months, the BAML Global Fund Manager Survey shows that while managers are underweight the sector, they have not been in such a prolonged underweight position that these stocks are hated. We have not seen the classic signs of investor capitulation and wash-out yet.

From a trader’s perspective, both US and European energy stocks remain in relative downtrends, punctuated by a brief spike owing to Iranian tensions. Until the relative downtrend shows some signs that it is ending, an underweight position remains tactically warranted.

I began this article with the rhetorical question of whether energy stocks represent a value opportunity, or a value trap. While the sector is acquiring a value characteristic, sentiment is not yet washed-out, and price momentum is still a headwind for these stocks. To be sure, there is a long-term bullish catalyst waiting in the wings, but the effects of this catalyst may not be evident for several years. For now, the bull call on energy is only a trade setup. I am inclined to wait for signs of a technical turn before turning significantly bullish on the sector.

The 2017/18 melt-up: Then and now

Posted by Cam Hui -

Mid-week market update: The stock market is over-extended. I warned on the weekend about the market’s nosebleed valuation (see Priced for perfection). The market’s forward P/E ratio of 18.4 matched the levels last seen at the 2017/18 market melt-up.
 

 

But there are some crucial differences between the last melt-up episode and the one today.
 

Crucial differences

One crucial difference is each rally was sparked by different fundamentals. As the chart below shows, the last melt-up coincided with surging EPS estimates from Trump’s tax cuts. The market cratered when the pace of upward estimate revision slowed. Today, estimate revisions are flat to slightly up. Today’s melt-up was mostly attributable to P/E expansion, not rising earnings estimates.
 

 

I had identified the nascent bull move in early November (see Buy the breakout, recession limited and How far can stock prices rise?). Investors were caught offside with excessively defensive portfolios. As it became evident that the economy was not falling into recession, a beta chase began, and cyclical stocks soared (see Here comes the beta chase).

Fast forward two months. While the slow moving institutional money is raising their market beta, the fast money is in a crowded long (h/t Liz Ann Sonders).
 

 

The Rule of 20, which raises a warning flag whenever the sum of the market P/E and inflation rate exceeds 20, is coming into play.
 

 

In addition, the relative performance of selected cyclical industries have been faltering, especially the industrial and transportation stocks.
 

 

It is time for a pause in the rally.
 

Estimating downside risk

To be sure, price momentum is still very strong right now, and I have no idea when the market will correct in the short run. However, we can estimate downside risk in a couple of ways.

As the chart below shows, the corrective phase in the last melt-up was halted at the red upward sloping trend line, which represented an -11.8% downdraft. A similar projection today yields a downside target of about 2970, or downside risk of around 10%. Secondary support can be found at about 2850, or downside risk of -14%.
 

 

From a valuation perspective, a 10% correction would translate to a forward P/E of 16.6, which is just below the 5-year average of 16.7. A decline to secondary support at 2850 means a forward P/E of 15.9.
 

 

Much will depend on how earnings estimates evolve during the latest earnings season, and the tone of the outlook corporate management gives in their earnings calls.
 

A correction, not a bear

In the short run, I had waiting for the lines in the sand that I outlined on the weekend to be crossed before turning tactically bearish. Subscribers received an email alert this morning that one of my bearish lines in the sand had been crossed, but I was waiting for the closing bell for confirmation of the signal. TLT and the 30-year yield crossed their trend lines. Since a rally in Treasuries tend to be a sign of falling risk appetite, this is a cross-asset negative risk-off signal for stocks. I therefore initiated a small short position in the stock market in my trading account.
 

 

However. the other bearish tripwire that I outlined has not been triggered. The SPX has not fallen below its 5 day moving average on a closing basis despite exhibiting negative RSI divergences.
 

 

Looking further ahead, I believe that this market is only facing a correction, and not a bear market. Despite the recent setback suffered by cyclical stocks, top down macro indicators of a global cyclical rebound  The Global Economic Surprise Index is still rising, indicating more positive than negative economic surprises.
 

 

In particular, data out of Asia is seeing a more positive tone. South Korea’s cyclically sensitive first 10-day exports rose 5.3% YoY in January, compared to -5.2% in December, though some of the positive surprise was attributable to the effects of a low base. In addition, China’s December exports rose 7.6% (vs. 3.2% expected) and imports rose 16.3% (vs. 9.6% expected), indicating strength in the Chinese economy, even before the effects of a Phase One trade deal kicks in. However, be prepared for some volatility in the January data, as the Lunar New Year falls in January this year compared to February last year.
 

 

My inner investor remains bullishly positioned. My inner trader has dipped his toe in on the bearish side.

Disclosure: Long SPXU

 

Demographics beyond the 2020s

Posted by Cam Hui -

I received some thoughtful feedback to my recent post (see The OK Boomer decade). In particular, one reader referred me to an article by Greg Ip of the WSJ regarding the demographic headwinds affecting the American labor force.

The U.S. will run out of people to join the workforce. Indeed, this bright cyclical picture for the labor market is on a collision course with a dimming demographic outlook. While jobs are growing faster than expected, population is growing more slowly. In July of last year, the U.S. population stood at 327 million, 2.1 million fewer than the Census Bureau predicted in 2014 and 7.8 million fewer than it predicted in 2008. (Figures for 2019 will be released at the end of the month.)

 

 

Population growth is dependent on two factors, fertility rate and immigration, but the US is fading in both areas:

The U.S. has had two longstanding demographic advantages over other countries: higher fertility and immigration. Both are eroding. Since 2008, the U.S. fertility rate has gone from well above to roughly in line with the average for the Organization for Economic Cooperation and Development, a group 36 mostly developed economies…

Meanwhile, the inflow of foreign migrants to the U.S. has been trending flat to lower, while trending flat to higher in other countries. Last year, the foreign-born population expanded by a historically low 200,000, according to the Census Bureau. The exact reasons are unclear. The illegal immigrant population had stopped growing before President Trump took office. Legal immigration remained above 1 million through 2018.

Indeed, the FRED Blog recently highlighted the difference between prime age population growth in the US and Canada and hinted that the widening spread may be explained by differences in immigration policy:

While fertility rates have declined a little, immigration has helped sustain population growth. Immigrants are typically of working age, so immigration can increase the working-age population specifically.

 

 

The 63 Canadian passengers (out of a total of 167) who died on the doomed Ukrainian airliner in Tehran provides a window on Ottawa’s skilled immigration policy (via Bloomberg):

They were doctors, engineers and Ph.D. students. The Canadians who lost their lives in the plane crash in Iran were mainly highly educated professionals and students, a reflection of the country’s push to attract skilled workers in the face of an aging population.

As governments around the world grapple with how to make immigration work without fanning political flames, Canada has taken a different tack, welcoming newcomers last year at the fastest pace in decades. About 12% of Canada’s post-secondary school population is made up international students, according to the country’s data agency…

“It’s really difficult to train someone on that level, integrate them and absorb them as high talent,” Parisa Mahboubi, a senior policy analyst at C.D. Howe Institute, a Toronto-based research firm, said by phone. “Doctors and dentists for example, to be able to obtain the degree that they are able to work in Canada. It takes time. It is really sad for both countries, losing those brains,” she said.

Mahboubi is Iranian-Canadian and has lived in Canada for more than 13 years.

Last year, Canada added a net 437,000 people from abroad, despite being only a tenth the size of the U.S., helping to drive its fastest population increase in decades, even with declines in fertility.

“Immigration has been a driver of Canada’s economic and cultural development. And with natural population’s slow growth, immigration contribution to growth in the labor force and even the tax base has been becoming more important,” Mahboubi said.

If labor force growth is being hampered by population growth, what does that mean for the rest of the world, and the world’s long-term economic growth potential?
 

How population drives economic growth

We know from basic economic principles that real economic growth is a function of population size, physical capital, and technology (productivity). Everything else being equal, lower population growth will mean lower real economic growth.
 

 

As these charts from Our World in Data shows, global population growth is decelerating. Birth rates are flat, while death rates are rising as older people die out.
 

 

Global population is expected to top out around 2060, with Africa as the only region showing sustained population growth.
 

 

It is always difficult to make specific forecasts, but productivity is a function of physical capital, technology, and education. Therefore all eyes are on Africa as a source of growth starting the middle of this century, and much will depend on how quickly African countries industrialize and become more affluent and educated.
 

 

For planning purposes, investors will have to begin penciling in lower global real economic growth in the models, at least for the last half of this century. This will have profound effects on expected risk-free rates, fiscal and monetary policy, and risk premiums when calculating asset price returns.

It is possible to envisage a radical shift in the economic paradigm. If growth rates are slowing, then the current regime of low and negative interest rates might become a permanent feature of the financial and economic landscape. Economists and policy makers will have to struggle with new models of how to either spur growth, or broaden and better share the gains from growth. Otherwise they will risk either financial or geopolitical instability from the effects of inequality in a low-growth environment.

 

Priced for perfection

Posted by Cam Hui -

I have been in the habit of writing a weekend publication consisting of a relatively long research piece combined with a tactical trading commentary, which has at times been very long. As an experiment, I am splitting the two up. Please let me know if you prefer the format of two shorter posts, or a combined longer publication.

As the market advanced to another fresh high, the forward P/E rose to 18.4, which roughly matches the level last seen at the melt-up high of early 2018.
 

 

From a pure valuation perspective, stock prices have risen too far, too fast. Oliver Renick, writing in Forbes, justified the elevated valuations this way:

Actually, if there’s anyone for the bears to blame, it’s themselves.

Economic data in the U.S., China and Eurozone are beating expectations by the biggest gap since early 2018 and on the longest win-streak since mid-2017, according to the sum of Citi’s economic surprise indices I compiled using Bloomberg. Geopolitical risk between the U.S. and China is fading, Brexit is on some path toward completion, a dropping dollar is providing relief to emerging economies, and the global banking system is still intact despite an unnerving foray into the land of negative interest rates. So stocks are rallying as things improve. It’s as simple as that.

Macro concerns have been resolved bullishly, one by one. The reduction of macro risk has compressed risk premiums, and conversely, boosted P/E ratios.

In other words, the market is being priced for perfection.
 

Market potholes ahead?

Here are some possible potholes that investors should be concerned about. A Chinese delegation is expected to arrive in Washington next week January 13-15 to ink a Phase One trade agreement. Could any last minute details hold up the signatures?
 

Caixin reported that China will not raise its annual low-tariff grain import quotas, which could be an impediment to its commitment to purchase more American goods as part of the Phase One deal. To be sure, there are some ways that it could fudge imports, such as diverting current indirect Hong Kong imports from the US to direct imports. Nevertheless, this development could become a last minute roadblock to a deal.
 

Fathom’s China Exposure Index (CEI), which measures the performance of US-listed firms that do business in China against their domestic peers, is already at highly elevated levels. What could possibly go wrong?
 

 

Even if the Phase One deal is concluded on time without any hitches, American trade negotiators are expected to turn their sights on the EU, which Trump has called “worse than China” on trade. EU trade negotiator Phil Hogan is scheduled to be in Washington next week for what could prove to be the start of contentious trans-Atlantic trade negotiations.

In addition, Friday’s weakish Jobs Report highlights the market vulnerability to weakening employment. Initial jobless claims has been inversely correlated to the SPX during this expansion cycle, but initial claims (blue line, inverted scale) are rolling over while stock prices (red line) continue to rise. How long can this negative divergence last?
 

 

New Deal democrat, who has done a stellar job of monitoring high frequency economic indicators, believes the jobs market is telling the story of a slowdown, but no recession.

This remains consistent with a significant slowdown. But there have been similar readings in 1967, 1985-6, 3 times in the 1990s, and briefly in 2003 and 2005, all without a recession following. So the threshold for continuing claims being a negative (vs. neutral) has not been met.

 

Giddy sentiment

Even as macro risks lurk, the sentiment backdrop tells the story of a market that is excessively bullish and vulnerable to a shock. Three of my real-time sentiment indicators are in the red. Each of these indicator capture a different dimension of investor and trader sentiment, but they are all flashing warning signs.

  • VIX Bollinger Band width narrowing, indicating volatility compression.
  • 10-day moving average of equity-only put/call ratio at historical lows, indicating bullish complacency.
  • 10-day moving average of TRIN at historical lows, indicating persistent buying pressure.

 

For the ultimate sign of giddiness, here is a tweet by Helene Meisler, market commentator and contributor at Real Money.
 

 

Joe Kennedy reportedly sold all of his stocks before the 1929 Crash when his shoeshine boy started giving him stock tips. Is this the modern day shoeshine boy moment?
 

Negative divergences everywhere

At the same time, the market is flashing negative technical divergences even as the index pushed to fresh all-time highs. The 5 and 14 day RSI, NYSE Advance-Decline Line, and % above the 50-day moving averages all failed the confirm the new highs.
 

 

This is a market that is increasingly vulnerable to a setback. Valuations are stretched, the market is priced for perfection, sentiment is positively giddy, and market internals are bearish. We just need a bearish catalyst. While price momentum remains dominant in the current environment, and the major market indices could rally further, risk/reward is unfavorable,

That said, I believe that investors and traders should react to these conditions differently. For some context, the trader at Macro Charts recently warned about how “extreme and historic complacency [is] building in markets”. He concluded:

If history is a guide, the risk-reward over the next 1-2 months is moving towards “extremely poor”, and we shouldn’t rule out a compressed (front-loaded) decline either. All that’s needed is a “catalyst”, as always just a narrative/excuse to trigger deleveraging.

Sounds dire, right? However, he examined past episode during the 2001-2005 and 2009-2020 periods when he spotted similar conditions. Maximum peak-to-trough drawdowns ranged from -4% to -17%, with an average of -8.7% and a median of -7.5%. In many of the cases, the market edged higher by about 1% before falling, so downside risk was slightly smaller than those statistics. In effect, average downside risk is in the 5-10% range.

Should investors be worried about a pullback of that magnitude? Doesn’t that just represent normal risk of holding equities? We therefore believe that investment oriented accounts are advised to remain invested but to wait to deploy new cash. The risk of a prolonged bear market is low, and downside risk is limited to a 5-10% correction and valuation reset. My inner investor is therefore still bullishly positioned.
 

Lines in the sand

On the other hand, traders should exercise caution, and take steps to either de-risk their portfolios, or set up risk management triggers to de-risk or possibly go short.

Subscribers received an email alert on Thursday indicating that I had taken profits in all of my long positions and I was in 100% in my trading account. Here are two lines in the sand that I am watching to become more aggressive and go short. The first is an SPX close below its 10 dma.
 

 

The second is a bond market rally. Either the 30-year yield or TLT has to break through the pictured trend lines. Since bond prices are roughly inversely correlated to stock prices, an upside TLT breakout is a signal that stocks may be in trouble.
 

 

My inner trader plans to take partial short positions in equities should either of these events occur. If both occur, he will take a full short position. Since both of these signals are a function of closing prices, I may not have sufficient time to alert subscribers with an email alert before the market close.

 

A 2020 commodity review

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Neutral

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.
 

A commodity bull market ahead?

It is time for a commodity review, which is timely for two reasons. First, gold bulls got excited when prices had broken out of a multi-year base last summer. They then paused and traced out a bull flag. Gold then staged an upside breakout out of the bull flag, and rose to test resistance as geopolitical tensions spiked. More importantly, the inflation expectations ETF (RINF) staged an upside breakout out of a downtrend.
 

 

The second reason is China, which has been a strong source of demand for commodities. Bloomberg reported that the market is getting excited about the prospect of a Phase One trade deal and a rebound in Chinese growth.

Investors are snapping up Chinese financial assets, encouraged by progress on trade and signs that the world’s second-largest economy may be stabilizing.

Improving confidence helped stoke a 0.5% rally in the yuan Tuesday, pushing it to its strongest level since early August. The currency punched past the key 6.95-per-dollar level, and traded on the strong side of its 200-day moving average for the first time since May. The CSI 300 Index of stocks closed at an almost two-year high as volume jumped.

The return of risk appetite in China comes amid growing optimism that Beijing and Washington may sign an initial deal on trade as soon as next week. Momentum is also improving in China’s economy, with recent data showing a recovery in the nation’s manufacturing sector continued in December.

“Risk sentiment is strong onshore,” said Tommy Xie, an economist at Oversea-Chinese Banking Corp. “There are signs of bottoming out in the economy and a more flexible monetary policy.”

Indeed, the offshore yuan has been steadily strengthening as news that a Chinese delegation is expected to visit Washington January 13-15 to sign the trade deal.
 

 

Is it time to turn bullish on gold, and commodities?

I conclude that the long-term outlook for commodity prices is constructively bullish, but current conditions argue for a bullish setup, as a secular bull market has not been signaled yet. In the short run, commodity prices are enjoying a fundamental tailwind of a Chinese cyclical revival. The only exception is gold, which is extended and poised for a pullback.
 

A technical review

Let us begin with a technical review of commodity prices. The CRB Index has been basing and range bound since mid-2015. While prices are rising, they have not staged an upside breakout yet. However, the smoothed Pring Commodity New High Indicator is performing better than the CRB, indicating positive breadth and underlying strength.
 

 

A review of the precious metals and cyclically sensitive metals, as well as lumber, tells a constructive bullish story. Gold prices have staged an upside breakout from a multi-year base. The other metals, namely silver, and economically sensitive copper and platinum, are still basing. Copper prices are still consolidating, after failing to rise when it encountered a rising trend line. Lumber prices are holding an upside breakout. Overall, the outlook for metals and other cyclical commodities is bullish.
 

 

The CRB Index is heavily weighted in the energy complex to facilitate its use as a trading vehicle. Oil prices were unable to break above resistance at about $65 for WTI and $75 for Brent despite a flare-up in Middle East tensions. Natural gas prices are weak. Energy prices have been a drag on the CRB, as evidenced by the weakness in the crude oil to CRB ratio in the past year.
 

 

The technical structure of the agricultural commodities can be best described as constructive. Agricultural prices have been basing and range bound for the last few years. Prices are trending upwards in the short run, but none have staged upside breakouts.
 

 

However, I would like to point out a possible short-term bullish catalyst for livestock prices due to the China demand from the decimation of their pig herd from African swine flu.
 

 

Here is the table referenced in the tweet.
 

 

From a technical perspective, the outlook for commodity prices can described as constructive, but it may be too early to become wildly bullish until we see definitive signs of upside breakouts. This is only a setup for a long-term bull. However, gold, which has been the leader of the CRB, appears to be due for a pullback. Commitment of Traders data (via Hedgopia) shows that non-commercial traders retreated slightly from a record net long position, and receding geopolitical tensions are likely to be the catalyst for a correction.
 

 

China: A source of rising demand

Over the next few months, signs of a revival in Chinese growth may provide the bullish underpinnings for higher commodity prices.

Market based signals are pointing to a Chinese cyclical revival. The performance of Chinese material stocks relative to global materials have spiked (top panel), while the relative performance of US and European energy and materials form sideways consolidation patterns.
 

 

Moreover, the strong relative performance of the cyclically sensitive Chinese real estate stocks and financial stocks are signaling that Beijing is back stimulating the economy.
 

 

A revival in the copper/gold and the platinum/gold ratios, which are cyclical indicators, are also signaling a new upleg in commodity demand.
 

 

The Chinese stock market is also showing signs of improving relative strength and global leadership. China should be a source of cyclical leadership, at least for the next 2-3 months.
 

 

Lastly, John Authers at Bloomberg also highlighted analysis from CrossBorder Capital which concluded that global financial systems are experiencing a surge in liquidity. While much of the surge is attributable to the Federal Reserve, the PBOC has also joined the party, which is likely to boost Chinese economic growth over the near term.
 

 

In conclusion, the long-term outlook for commodity prices is constructively bullish, but current conditions argue for a bullish setup, as a secular bull market has not been signaled yet. In the short run, commodity prices are enjoying a fundamental tailwind of a Chinese cyclical revival. The only exception is gold, which is extended and poised for a pullback.
 

The week ahead

I have been in the habit of writing a weekend publication consisting of a relatively long research piece combined with a tactical trading commentary, which has at times been very long. As an experiment, I am splitting the two up. Please let me know if you prefer the format of two shorter posts, or a combined longer publication.

The tactical trading commentary will be published tomorrow morning. Please stay tuned.

 

Buy the cannons, sell the trumpets?

Posted by Cam Hui -

Mid-week market update: The financier Nathan Rothschild was said to have coined the phrase, “Buy on the sound of cannons, sell on the sound of trumpets”. After the New York market closed last night, the news flashed across the wire that Iran had launched missile strikes at Iraqi bases housing American and Coalition military personnel. Equity futures cratered as much as -1.6%, but by the time the dust settled, the market had opened in the green on Wednesday.

Have we had a cannons and trumpets moment?

For some perspective, Ryan Detrick highlighted analysis from Sam Stovall that documented the equity market’s reaction to major geopolitical shocks since Pearl Harbor. The initial reaction and drawdown averaged -5%. If we were to exclude the events that led to major US military commitments (Second World War, Korea, Vietnam, Gulf War I, and 9/11), the average drawdown falls to -3.0%, with a median of -1.8%.
 

 

For readers who have been writing me about the Apocalyptic nature of the Iran developments, what are you so worried about?
 

A fishy tale

As the details of the Iranian missile attacks cross the tape and the market assumed a knee jerk risk-off reaction, something about the account started to sound fishy. A lot of the story wasn’t adding up.

  • Why did Iran decide to stage an attack in such an open fashion by launching missiles from its own territory, instead of using proxy militia forces as per its usual practice?
  • Iran and Iraq are allies, or at a minimum, Iran has a great deal of influence on the Iraqi government. Why was Iran attacking Iraqi bases?
  • Does this suggest that the Iraqi government was warned ahead of time?
  • If the Iraqis were warned, did they pass on the warning to the Americans?

The entire episode sounded like a form of elaborate theatre performed to show that Tehran had acted tough and retaliated against the killing of Soleimani, but it was not seeking escalation. In that case, it was time to buy the sound of cannons.

I turned out to be right. Subsequent events showed that both sides were signaling a desire to de-escalate, as evidenced by the real-time Twitter feed. First, Iran’s foreign minister tweeted that the missile strikes represented a form of proportionate retaliation, and there would be no further action if the US does not respond.
 

 

This was followed by Trump’s “all is well” tweet, which was an indication that he got the message.
 

 

The Iraqi prime minister further issued a statement that Iran had warned Baghdad that the missiles were on their way. Moreover, the LA Times reported that US military forces were tracking the Iranian missiles, and had time to take shelter.

Iran launched 15 missiles, of which 11 hit their targets and four failed in flight, according to a U.S. defense official, who said there were no reports of U.S. casualties in the attack.

Ten of the missiles hit the sprawling Asad Air Base in Iraq’s western Anbar province. U.S. radar was able to track the missiles in flight and, as a result, personnel at the base were able to take cover. The U.S. made no effort to intercept the missiles, the official said.

Subsequent to those reports, President Trump addressed the nation today and stated that Iran appears to be standing down, but he would hit Iran with “punishing economic sanctions” after the missile attacks. In other words, the attack and corresponding US reaction was part of an elaborate dance and theatre for public consumption.

So much for World War III. There will be no short-term military escalation into war, at least for now.
 

The sound of trumpets?

As a consequence of these developments, the SPX rallied to an intra-day all-time highs while exhibiting negative RSI divergences. Historically, such divergences have been early warning signs of a market top, but they do not necessarily market an immediate top.
 

 

Was that the sound of trumpets I heard? While I remain short-term bullish, the risk/reward equation is becoming less favorable for the bulls. Sentiment remains excessively bullish, which is contrarian bearish. A Bloomberg article documented how the short interest in SPY had fallen to the lowest level in two years.
 

 

In addition, hedging activity is becoming virtually nonexistent. Investors are throwing caution to the wind.
 

 

My inner investor is still bullishly positioned. At worse, we may see a 5% correction, which is a blip for an investment account.

My inner trader took some partial profits today, but he remains long the market. At current levels, the market has greater potential for a stumble. Friday’s Jobs Report could disappoint, and it is unclear whether the Chinese are prepared to actually sign a Phase One trade truce on January 15, despite the announcement by the US side.

Ride the bull, but maintain a tight leash on your risk.

Disclosure: Long SPXL

 

Fade the fear spike

Posted by Cam Hui -

Global stock markets opened the week with a risk-off tone. As the day went on, the New York market began in the red, but recovered to be positive for the day.
 

 

I wrote on the weekend that I still had a bullish tilt, but “the market action in the coming week will be highly informative of market psychology and the market’s technical structure”:

I interpret these conditions as the short-term bias to be still bullish. Our base case scenario is the melt-up is not over. The geopolitical shock represents a welcome test for both the bulls and the bears. Watch for a minor pause in the market, followed by further gains marked by negative divergences and an inverting VIX term structure. Those will be the signals for traders to sell. Assuming our bullish thesis is intact, the market is sufficiently oversold levels for prices to bounce.

My base case scenario seems to be playing out as expected.
 

Fading geopolitical risk

Even though there was some belligerent rhetoric from both Iran and Trump on the weekend, there are signs that the geopolitical fear spike is fading. Despite Trump’s bellicose tone, he is becoming increasingly isolated, and he is not receiving any support from allies. Macron (France), Merkel (Germany), and Johnson (UK) released a joint statement calling for calm.

We have condemned the recent attacks on coalitions forces in Iraq and are gravely concerned by the negative role Iran has played in the region, including through the IRGC and the Al-Qods force under the command of General Soleimani.

There is now an urgent need for de-escalation. We call on all parties to exercise utmost restraint and responsibility. The current cycle of violence in Iraq must be stopped.

We specifically call on Iran to refrain from further violent action or proliferation, and urge Iran to reverse all measures inconsistent with the JCPOA.

We recall our attachment to the sovereignty and security of Iraq. Another crisis risks jeopardizing years of efforts to stabilize Iraq.

We also reaffirm our commitment to continue the fight against Daesh, which remains a high priority. The preservation of the Coalition is key in this regard. We therefore urge the Iraqi authorities to continue providing the Coalition all the necessary support.

We stand ready to continue our engagement with all sides in order to contribute to defuse tensions and restore stability to the region.

While Trump has shown a tendency to ignore Europe, a report indicates Israel’s Netanyahu has distanced himself from the conflict.
 

 

In addition, Bloomberg reported that the Saudis have sent a delegation to Washington asking for de-escalation. They don’t want a war either.

Gulf Arab states, potential targets for retaliation after the U.S. assassinated Iran’s top general, are working on multiple tracks to try to keep tensions between Tehran and Washington from building into a military confrontation.

Saudi Crown Prince Mohammed bin Salman has instructed his younger brother, Deputy Defense Minister Khalid bin Salman, to travel to Washington and London in the next few days to urge restraint, the Asharq Al-Awsat newspaper reported, citing people it didn’t identify…

“The message from the Gulf to the U.S. is clear: They are telling Trump, ‘Please spare us the pain of going through another war that would be destructive to the region,’” said Abdulkhaleq Abdulla, a political science professor in the neighboring United Arab Emirates. “We will be the first to pay the price for any military showdown, so it’s in our best interest not to see things get out of hand.”

The Iranian regime has shown itself to be rational actors in the 40 years of its existence. While it may retaliate in a limited fashion, as evidenced by its decision to resume uranium enrichment while allowing inspection in the country, it is unlikely to push the envelope so far to threaten its own existence.

With Trump isolated, and virtually all actors wary of conflict, it makes sense to fade the fear spike.
 

The road ahead

I also wrote on the weekend that to watch for signs of negative divergence on NYSI as the sign of a top to this latest market melt-up. That scenario seems to be playing out.
 

 

Kevin Muir, otherwise known as The Macro Tourist, also advanced a theory in his latest post that the latest melt-up is likely to peak out in late January. He referred to an observation by FX trader Brent Donnelly:

My observation in past years is that the hot trades of the New Year start to work in late December and trend for the first 4 to 6 weeks of the year. Around the end of January, those trades become random. Sometimes they mean revert; sometimes they don’t.

Muir believes that Stan Druckenmiller represents the way the fast money is shifting. In a December Bloomberg interview, Druckenmiller revealed that he was bullish again:

When risk assets rebounded from a swoon in the fourth quarter of 2018 and the Fed eventually cut rates, Druckenmiller pivoted. He remains bullish heading into next year.

“We have negative real rates everywhere and negative absolute rates in a lot of places,” he said. “With that kind of unprecedented monetary stimulus relative to the circumstances, it’s hard to have anything other than a constructive view on the market’s risk and the economy, intermediate term. So that’s what I have.”

Muir summarized Druckenmiller’s position as long equities, commodities, and commodity currencies, while short fixed income. If Kevin Muir is correct, then the risk-on tone should continue until about month-end, but watch for signs of a negative NYSI divergence for a sell signal.

Disclosure: Long SPXL

 

Trading the market melt-up

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Bullish
  • 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.
 

Melt-up hangover ahead?

Back in mid-December, I rhetorically asked if the stock market was undergoing a melt-up (see Is the market melting up?). At the time, the jury was out on that question. Today, we have the answer. The market is exhibiting the classic signs of a blow-off.

CNBC reported that even the perennial bullish Ed Yardeni, who had a SPX 2020 year-end target of 3500, was openly worried about an air pocket.

″[A] 10% to 20% [correction] would be quite possible if this market gets to 3,500 well ahead of my schedule,” he said.

What should traders and investors do? If we were to use the late 2017 and early 2018 episode as a template, there are definite indications that the market has overrun its rising trend line and a soaring net new highs to lows, which are signs of a melt-up. By comparison, the advance in the summer of 2018 was far more orderly. From a technical perspective, there are not the same warnings of an imminent market top that we saw in early 2018. In January 2018, the market broke down without any negative RSI divergences, but did see a negative NYSI divergence. Today, there are neither RSI nor NYSI negative divergences, which could mean that this rally has more room to run.
 

 

The market’s risk-off reaction to the killing of Qasem Soleimani certainly presents a challenge to the bulls. Iran has vowed to retaliate for the targeted assassination, and the geopolitical risk premium has spiked as a result. Are we headed for a melt-up hangover? We discuss the bull and bear cases.

I interpret current market conditions as highly extended in the short-term, and equity prices can correct at any time. However, any pullback should be viewed as a pause in the context of a long-term bull.

The market’s knee jerk risk-off reaction to rising geopolitical risk in the Middle East is a test for both the bulls and bears. While fears of a Middle East conflict are spiking, they are unlikely to amount to much in the very short run. Iran has declared a three day period of mourning for Soleimani. Tehran is likely to play the news of the assassination as an opportunity to whip up nationalism and rally public support for its regional military campaigns. Beyond any “lone wolf” attacks inspired by Iranian rhetoric, any significant reprisal operation will takes weeks, if not months, to plan and execute. As the markets have the attention span of a 10 year-old, any geopolitical risk premium is likely to fade if there is no immediate evidence of escalation.

Traders should take steps to either reduce risk, or maintain tight trailing stops. Investment oriented accounts could take steps to rotate into non-US markets. If accounts are restricted by mandate from investing outside the US, consider either reducing equity weights, or selling covered call positions against existing long positions to reduce risk.
 

The bad news

The bear case is easy to articulate. Sentiment has become excessively bullish. The Fear and Greed Index closed Friday at 94, which is an extremely greedy condition. This index does not function well as a tactical trading sell signal, but it is a sign of a rising risk.
 

 

Callum Thomas also pointed out that the ratio of leveraged long to short ETFs is at an extreme level.
 

 

Valuations are also becoming stretched. Data from FactSet shows that the market’s forward P/E is at 18.3, which is nearly the same level seen at the melt-up peak of early 2018.
 

 

At a forward P/E of 18.3, the Rule of 20 comes into play. As a reminder, the Rule of 20 flashes a warning if the sum of the forward P/E and CPI exceeds 20.
 

 

The Rule of 20 has often been cited by Ed Yardeni as a sign of excessive valuation. No wonder Yardeni was growing concerned about a correction.

As well, the market’s confidence about a global cyclical rebound appears to be fading. New Deal democrat has been monitoring the US economy with a series of coincident, short leading, and long leading indicators, is growing worried about the corporate sector, or what he calls the “producer” side of the economy.

The producer recession appears to be deepening, and whether weakness in the producer sector spreads out to affect consumers remains an important and unresolved issue. December light vehicle sales appear to have weakened slightly, and initial jobless claims have turned negative, but consumer spending generally appears positive.

He did qualify his analysis with the caveat that a recession is not in his forecast, but a near-term soft patch for the economy is possible.Watch for possible weakness in the December Non-Farm Payroll Report due this coming Friday.

The long leading forecast remains positive. The short-term forecast remains neutral. The coincident indicators are positive. 

The theme of manufacturing weakness and consumer strength was confirmed by the December 23, 2019 publication of The Transcript, which is a monitor of earnings calls and corporate presentations.

The main takeaway is the dichotomy between a US consumer economy that is doing well and a manufacturing sector that is weak. The uncertainty and slow growth will certainly continue into 2020.

Indeed, my monitor of the relative performance of cyclical US stocks shows that only one out of four groups are in a relative uptrend. While semiconductors remain strong, industrial, homebuilding, and transportation stocks are all losing their leadership positions.
 

 

A similar picture of cyclical weakness is developing from a global perspective. Semiconductors remain the leadership, but global industrial and auto stocks are weakening and showing signs of sideways relative consolidation.
 

 

The American assassination of Iranian general Qasem Soleimani is just the icing on the bears’ cake. The ensuing risk-off episode has the potential become the trigger for a correction and meltdown after the recent melt-up.
 

The good news

While the short-term outlook appears dark, here is the good news. The equity bull market is still alive from a long-term perspective. There is no sign of a recession on the horizon. CNBC reported that Goldman Sachs is saying the economy is nearly recession proof. Goldman’s recession model shows recession risk is below 20%, and falling.
 

 

Recessions are bull market killers. In the absence of a recession, equity prices should have a positive bias.
 

 

As well, monthly MACD momentum recently flashed long-term buy signals for stocks. These signals have been extremely effective in the past at calling long-term bull markets.
 

 

A similar buy signal was also seen for non-US markets.
 

 

In addition, long-term measures of retail sentiment are showing signs of caution. Callum Thomas of Topdown Charts that cumulative equity fund flows are in a downtrend, which is contrarian bullish.
 

 

Similarly, the TD-Ameritrade Investors Movement Index (IMX) is also not exhibiting any signs of enthusiasm. Unlike sentiment surveys such as AAII, which asks how respondents feel about the market, fund flows and IMX show what investors are actually doing with their money, which are much better indicators of long-term sentiment.
 

 

Institutional sentiment has only begun from highly depressed levels. Alex Barrow at Macro Ops observed that State Street Confidence, which is based on aggregate custodial data, bottomed out in December 2018. Confidence has been slowly recovering, and readings are not even back to neutral yet. We are far away from any signs of excessive institutional bullishness.
 

 

I interpret these conditions as the bull market has a long way to run before it tops out.
 

A healthy rotation?

I would argue instead that the bull market is showing signs of a healthy rotation. Leadership is changing from US stocks to non-US markets.
 

 

In Europe, the cyclical bull is still alive. Mid-cycle cyclical stocks, such as industrial and financial companies, are consolidating after breaking out of relative downtrends. Defensive stocks, such as consumer goods, are in relative downtrends.
 

 

There are also signs of cyclical revival coming from China. China has been the major global consumer of commodities, and market signals indicate that the Chines cycle is turning up. Both the copper/gold and platinum/gold ratios, which are important cyclical indicators, are rising.
 

 

Both Australia and Canada are similar sized economies that are commodity exporters. Australia is more sensitive to Chinese demand, while Canada is more levered to the US. The AUDCAD exchange rate is tracing out a bottoming pattern, which is another market signal of Chinese economic revival.
 

 

In addition, the PBOC announced a reserve requirement (RRR) cut last week. Even before news of the RRR cut hit the tape, the relative performance of the cyclical sensitive Chinese property developers and banks has been turning up, which is additional confirmation of another upleg in Chinese growth. The strength of Chinese financial stocks is especially remarkable in the face of the news of rising bond defaults, which I interpret to be a sign that the authorities believe the economy is strong enough to tolerate failures.
 

 

As well, the USD has been showing signs of weakness. This should provide a boost to the earnings of US large cap multi-nationals, and create a tailwind for EM economies.
 

 

The cyclical rebound is still alive.
 

Investment implications

What does all this mean for investors and traders?

I interpret current market conditions as highly extended in the short-term, and equity prices can correct at any time. However, any pullback should be viewed as a pause in the context of a long-term bull.

The market’s knee jerk risk-off reaction to rising geopolitical risk in the Middle East is a test for both the bulls and bears. While fears of a Middle East conflict are spiking, they are unlikely to amount to much in the very short run. Iran has declared a three day period of mourning for Soleimani. Tehran is likely to play the news of the assassination as an opportunity to whip up nationalism and rally public support for its regional military campaigns. Beyond any “lone wolf” attacks inspired by Iranian rhetoric, any significant reprisal operation will takes weeks, if not months, to plan and execute. As the markets have the attention span of a 10 year-old, any geopolitical risk premium is likely to fade if there is no immediate evidence of escalation.

Traders should take steps to either reduce risk, or maintain tight trailing stops. Investment oriented accounts could take steps to rotate into non-US markets. If accounts are restricted by mandate from investing outside the US, consider either reducing equity weights, or selling covered call positions against existing long positions to reduce risk.
 

The week ahead

Looking to the week ahead, there is no question that sentiment has reached bullish extremes, but it is unclear whether the geopolitical shock experienced on Friday represented the bearish break that signals a correction.

SentimenTrader documented how his sentiment models had reached historically high levels that even exceeded the melt-up high of January 2018.
 

 

On the other hand, the technical structure of the market does not support an immediate pullback. Both the melt-up top of early 2018 and the top of 2019 were accompanied by negative NYSI divergences. So far, we have only seen NYSI reach an overbought level, but no negative divergence as the market moved high and NYSI failed to reach new highs.
 

 

Friday’s market reaction to the Soleimani news was also a little anomalous. Rising geopolitical tensions should see risk premiums spike, and the VIX term structure invert. Even the Volmageddon of February 2018 saw the 9-day to 1-month VIX term structure (bottom panel) invert, followed by the inversion of the 1-month to 3-month VIX ratio (middle panel). Today, the 9-day to 1-month VIX spiked but did not invert, and the 1-month to 3-month VIX barely budged from levels that can be best described as market complacency.
 

 

Cross-asset signals presents a mixed picture. The relative performance of high yield (junk) bonds to duration-equivalent Treasuries are not showing neither positive nor negative divergences.
 

 

On the other hand, the USDJPY exchange rate, which has been highly correlated to stock prices, has broken down badly. Will the stock market follow?
 

 

I interpret these conditions as the short-term bias to be still bullish. My base case scenario is the melt-up is not over. The geopolitical shock represents a welcome test for both the bulls and the bears. Watch for a minor pause in the market, followed by further gains marked by negative divergences and an inverting VIX term structure. Those will be the signals for traders to sell. Assuming my bullish thesis is intact, the market is sufficiently oversold levels for prices to bounce.
 

 

To be sure, my base case scenario is only a scenario. The market action in the coming week will be highly informative of market psychology and the market’s technical structure.

In the meantime, my inner investor remains bullishly positioned, though he may opportunistically sell some call options against existing positions in the coming days. My inner trader is also bullish positioned, but he is watching his trailing stops carefully.

Disclosure: Long SPXL

 

A Humble Student 2019 report card

Posted by Cam Hui -

Mid-week market update: Normally, this is the time I write a mid-week market update. I arrived back home last night from my vacation after celebrating two New Year’s Eves. We celebrated NYE when we connected through Taipei just as we boarded our flight home, and we arrived on the night of December 31 after crossing the International Date Line to celebrate a second. While I was keeping half an eye on the markets while I was gone, I do not have a full trading analysis just yet.

I do know that there is a growing consensus among traders that the market is melting up. Sentiment is wildly bullish, and the market is poised to fall off a cliff as soon as everyone returns to their desks on Thursday. I would highlight an observation from Ryan Detrick to cast some skepticism on the meltdown scenario.

I will have a full analysis to address the issues this weekend. Please be patient.

In the meantime, it is time to assess the Humble Student of the Markets track record for 2019.

My inner investor

Regular readers know that I have two personas, my inner investor, and my inner trader. Here is the track record of my investment calls in 2019.

Overall, the general direction of the calls were correct. Soon after the December 24 bottom of 2018, I turned bullish in January as a Zweig Breadth Thrust manifested itself. I turned more cautious during the summer as the yield curve flattened and inverted, though I was not forecasting a recession. At the time, I was anticipating a deeper valuation reset that never arrived. I later turned bullish when the index broke out to new all-time highs.

The excess caution during the summer exacted a cost for my inner investor. As shown on the chart below, the relative return line (blue, bottom) was flat during the year. The Trend Asset Allocation Model returned 22.3% during 2019, which was slightly behind a passive 60/40 benchmark return of 22.6%.

The good news is, even when the Trend Model fails, the results were not bad, and the long-term record is still very strong.

My inner trader

Here is the chart of the trading signals, otherwise known as my inner trader. Even though the trading system caught most of the major moves, it tried to short the market as it moved up in Q1, which did not help returns. It did make some profits as the market bounced around in a trading range during the summer, it did not recognize the upside breakout until it was too late.

My inner trader did made some solid returns in 2019. The hypothetical trading account was up 16.2% for the year, but it lagged the buy-and-hold benchmark, which returned 28.9%. In a market that rises strongly, any attempt at market timing will detract from returns.

I expect that 2020 should be a more friendly environment for my analytical approach, both for my inner investor and inner trader. The markets are melting up, and they will eventually pull back. In addition, this is an election year, which should also produce some fireworks and volatility. While I believe that US equity market returns should be in the mid to high single digits, the road ahead will be more bumpy.

The OK Boomer decade

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Bullish
  • 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.
 

Is demographics really destiny?

‘Tis the season for strategists to publish their year-end forecasts for 2020. Instead of participating in that ritual, this is the second of a series of think pieces of what might lie ahead for the new decade (for the first see China, paper tiger).

It is said that demographics is destiny. Tom Lee at Fundstrat recently highlighted changes in spending and debt patterns. As the Baby Boomers age and fade into their golden years, the Millennial generation is entering its prime and they are poised to seize the baton of consumer spending, and eventually, political leadership.
 

 

Demographics is destiny holds true only inasmuch as people’s desires at different ages are roughly the same. But their desires are constrained by financial circumstances. The combination of a generational shift and differences in financial circumstances has profound implications for the political landscape, policy, and investing.

I believe that the coming decade is likely be the “OK Boomer” decade that sees a passing of the baton to the Millennial cohort characterized by:

  • A greater focus on the effects of inequality
  • A political shift to the left
  • There are two policy effects that can be easily identified:
    1. The rise of MMT as a policy tool
    2. The rise of ESG investing

The question of whether these developments are good or bad is beyond my pay grade. However, investors should be prepared for these changes in the years to come.
 

Addressing inequality

The biggest issue is inequality. While every generation thinks it had a hard time, inter-generational inequality is very real. Yiqin Fu, a political science Ph.D. candidate at Stanford, found that the wealth accumulation of each generation, Boomers, Gen X, and Millennial, at specific ages have diminished. In particular, the flatness of the Millennial line is astounding, and graphically illustrates the headwinds faced by the age cohort.
 

 

This inequality gap can be observed in many ways. Variant Perception pointed out that an enormous gulf in consumer confidence has opened up between the people under 35 compared to those over 55.
 

A Yahoo Finance article documented how Millennials simply cannot afford to buy a house:
 

Many millennial renters won’t be homeowners anytime soon – even if they want to be.

Among young adult renters who want to buy a home, 7 in 10 say they simply cannot afford one, according to a recent study by Apartment List, an online real estate company. The analysis was based on responses from over 10,000 millennial renters across America.

Renters said poor credit and the burden of future monthly mortgage payments were major obstacles. But the most commonly cited challenge was saving for a down payment, with 60% of young adult renters saying this is what has kept them from buying a home.

“Millennials today will need a 20% larger down payment than baby boomers,” said Dean Baker, chief economist at the Center for Economic and Policy Research. “Housing prices are higher [even] when adjusted for inflation.”

A Bloomberg podcast with freelance writer Karen Ho explained the circumstances Millennials find themselves. Simply put, the Great Financial Crisis has scarred the cohort. Millennials began to enter the workforce just as the GFC cratered the global economy, and many were unable to get on the first rung of the ladder to wealth and financial stability. Instead, the economy restructured them out of promising entry-level jobs, leaving them only gig work with little stability, benefits, and pensions. Is it any wonder Millennials can’t afford to buy houses, or their wealth accumulation is so low compared to previous cohort?
 

A tilted playing field?

We are starting to see a radical re-think of economic assumptions and policy since the GFC. Martin Wolf recently reviewed a book by Thomas Philippon in the Financial Times that concluded that the US is no paragon of laissez-faire free market economics:

It began with a simple question: “Why on earth are US cell phone plans so expensive?” In pursuit of the answer, Thomas Philippon embarked on a detailed empirical analysis of how business actually operates in today’s America and finished up by overturning much of what almost everybody takes as read about the world’s biggest economy.

Over the past two decades, competition and competition policy have atrophied, with dire consequences, Philippon writes in this superbly argued and important book. America is no longer the home of the free-market economy, competition is not more fierce there than in Europe, its regulators are not more proactive and its new crop of superstar companies not radically different from their predecessors.

Competition policy has allowed large corporations to earn monopolistic or oligopolistic profits:

[Philippon] crisply summarises the results: “First, US markets have become less competitive: concentration is high in many industries, leaders are entrenched, and their profit rates are excessive. Second, this lack of competition has hurt US consumers and workers: it has led to higher prices, lower investment and lower productivity growth. Third, and contrary to common wisdom, the main explanation is political, not technological: I have traced the decrease in competition to increasing barriers to entry and weak antitrust enforcement, sustained by heavy lobbying and campaign contributions.”

All this is backed up by persuasive evidence. Those prices of broadband access in the US are, for example, roughly double what they are in comparable countries. Profits per passenger for airlines are also far higher in the US than in the EU.

The analysis demonstrates, more broadly, that “market shares have become more concentrated and more persistent, and profits have increased.” Moreover, across industries, more concentration leads to higher profits. Overall, the effect is large: the post-tax profit share in US gross domestic product has almost doubled since the 1990s.

 

 

Brad Setser at the Council on Foreign Relations described the US external position as “A Big Borrower and a Giant Corporate Tax Dodge”.

The argument that the United States functions as a financial intermediary that borrows cheaply to buy higher yielding financial assets—e.g. a skilled user of leverage—has a long intellectual history. And it naturally has a certain amount of appeal to many American financiers. It dates back to the original French critique of the exorbitant privilege the Bretton Woods system accorded the United States. Under the (brief) gold-dollar standard, the rest of the world was more or less required to build up dollar reserves—providing an inflow to the United States. And back in the 1960s, the U.S. current account was in balance, so the United States was using the inflows to fund riskier and higher yielding investment abroad. France was complaining that it was funding the takeover of Europe by U.S. multinationals…

The belief that the US uses its position to buy higher returning assets while issuing debt is no longer true. Setser found that the excess return on foreign investment is largely attributable to tax arbitrage, or a favorable tax treatment of offshore corporate profits embedded in the US tax code.

The excess return is entirely a function of the large profits U.S. firms book in the world’s corporate tax havens—the U.S. surplus stems from the large returns the United States appears to earn on its investments in Ireland, the Netherlands, and Bermuda. Basically, it looks to be a function of the United States’ willingness to tolerate a world where American tech and pharma companies’ offshore earnings aren’t really taxed by the United States at anything like the rate onshore profits are taxed at. Previously those profits were tax deferred, now they are largely taxed at the low GILTI rate of 10.5 percent.

In short, US policy has tilted the playing field in favor of large corporations, and this has exacerbated inequality.
 

Future policy implications

There are signs that the Overton window, or the ideas that define the spectrum of acceptable discussion, is changing on inequality policy.

Even the Fed is becoming more concerned. In an economic environment where the labor market is viewed as tight, economists in a more traditional framework would normally be concerned about the low unemployment rate causing inflationary pressures. Instead, Jerome Powell made a speech on November 25, 2019 which devoted four paragraphs to “spreading the benefits of employment”. First, he acknowledged the tight labor market has begun to benefit “low and middle income communities”:

Many people at our Fed Listens events have told us that this long expansion is now benefiting low- and middle-income communities to a degree that has not been felt for many years. We have heard about companies, communities, and schools working together to help employees build skills—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We have heard that many people who in the past struggled to stay in the workforce are now working and adding new and better chapters to their lives. These stories show clearly in the job market data. Employment gains have been broad based across all racial and ethnic groups and all levels of educational attainment as well as among people with disabilities.

He further gave a nod to Millennials by observing that the US prime age labor force participation rate had fallen behind other major industrialized countries in 2018 compared to 1995.
 

 

In a surprising “the dog that did not bark” manner, Powell did not sound like a conventional economist and raise the risks of rising inflationary pressure from low unemployment.

Recent years’ data paint a hopeful picture of more people in their prime years in the workforce and wages rising for low- and middle-income workers. But as the people at our Fed Listens events emphasized, this is just a start: There is still plenty of room for building on these gains. The Fed can play a role in this effort by steadfastly pursuing our goals of maximum employment and price stability. The research literature suggests a variety of policies, beyond the scope of monetary policy, that could spur further progress by better preparing people to meet the challenges of technological innovation and global competition and by supporting and rewarding labor force participation. These policies could bring immense benefits both to the lives of workers and families directly affected and to the strength of the economy overall. Of course, the task of evaluating the costs and benefits of these policies falls to our elected representatives.

Is the Phillips Curve dead? Not yet, but it seems to be in the ambulance and policy makers are trying to revive it using extraordinary means by redefining u*, or the natural rate of unemployment. Here is what Powell said at the December FOMC press conference: “It’s already understood, I think, that even though we’re at 3.5% unemployment, there’s more slack out there, in a sense. The risks to using accommodative monetary policy…to explore that are relatively low.”

The Fed is conducting a review of its policy approach, and the review will not be complete until June 2020. Until then, the Phillips Curve remains part of the Fed’s monetary policy framework.

Fed watcher Tim Duy also noticed a shift towards a focus on inequality:

Persistently excessive unemployment has its costs. Not only does the period of low unemployment not extend long enough to spread its benefits to the most challenged sections of the labor market, but it also tips the scales toward employers when it comes to wage bargaining. Workers who are always fearful of losing their jobs have little incentive to derive a hard bargain for higher wages.

Boesler credits Minneapolis Fed President Neel Kashkari with leading the charge on this issue, arguing that the Fed policy does have a role in distribution outcomes. And he is not wrong; indeed, Kashkari tendency toward dovishness has proven more correct than not since he came on board. His concerns about inequality helped prompt him to launch the Minneapolis Fed’s Opportunity and Inclusive Growth Institute and has now found its new leader in the highly-respected economist Abigail Wozniak.

The implication for policy of a broad acceptance of idea that the Fed may have contributed to inequality in the past is that the Fed is likely to be much more cautious when raising rates and respond to economic weakness much more quickly. In other words, this adds another reason to expect rates will remain lower than what we might have thought the Fed’s reaction function would suggest.

The Overton window for economic policy is indeed shifting. Bloomberg reported that the latest Nobel laureate Abhijit Banerjee is arguing for raising taxes for redistribution as a way to spur economic growth:

How do you spur demand in an economy? By raising taxes, not cutting them, says this year’s winner of the Nobel prize for economics.

Reducing taxes to boost investment is a myth spread by businesses, says Abhijit Banerjee, who won the prize along with Esther Duflo of the Massachusetts Institute of Technology and Michael Kremer of Harvard University for their approach to alleviating global poverty. “You are giving incentives to the rich who are already sitting on tons of cash.”
A better approach would be to raise some taxes and distribute the money to people to spend, Banerjee said in an interview Monday in New Delhi, where he was promoting his book ‘Good Economics for Hard Times.’

“You don’t boost growth by cutting taxes, you do that by giving money to people,” he said. “Investment will respond to demand.”

Move over, Reagan style laissez-faire economics. Elizabeth Warren style redistribution is taking over.
 

A leftward political shift

It is said that science advances, one funeral at a time, meaning that as the old guard dies off, new ideas take their place. As the demographic profile of the American population changes, the same is likely to happen with political discourse.

The Economist documented that people don’t often change their minds, but societies do because of demographic changes.

Since 1972 the University of Chicago has run a General Social Survey every year or two, which asks Americans their views on a wide range of topics. Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart.

For example, in 1972, 42% of Americans said communist books should be banned from public libraries. Views varied widely by age: 55% of people born before 1928 (who were 45 or older at the time) supported a ban, compared with 37% of people aged 27-44 and just 25% of those 26 or younger. Today, only a quarter of Americans favour this policy. However, within each of these birth cohorts, views today are almost identical to those from 47 years ago. The change was caused entirely by the share of respondents born before 1928 falling from 49% to nil, and that of millennials—who were not born until at least 1981, and staunchly oppose such a ban—rising from zero to 36%.

 

 

The Millennial Young Turks are far more left leaning than older cohorts. Gallup also found that Millennials and Gen Z are far more favorably disposed to socialism than older generations.
 

 

The age demographic profile of the US 2018 midterm elections also tell a similar story of a shift in the political pendulum. Expect the Democrats to gain ground over the Republicans in the coming decade.
 

 

Another article in The Economist explained that Millennial socialism boils down to three big ideas, namely more government, a “Green New Deal”, and capitalism robs people of dignity and freedom.

According to the millennial socialists, more radical changes are required. Collectively, their manifesto boils down to three big ideas. First, they want vastly more government spending to provide, among other things, free universal health care, a much more generous social safety-net and a “Green New Deal” to slash carbon-dioxide emissions. Second, many argue for looser monetary policy, to reduce the cost of funding these plans.

The third plank of their thinking is the most radical. The underlying idea is that capitalism does not just produce poverty and inequality (though it does), but that, by forcing people to compete with each other, it also robs them of dignity and freedom. “The power imbalances are obvious when you enter into your employment contract,” says Mr Sunkara. For Mr Adler, capitalism “has sucked the life out of democracy”.

Millennial socialists, therefore, support the “democratisation” of the economy (or socialisme participatif, as Mr Piketty puts it), whereby ordinary people play a greater role in the production process, the market is removed from as many aspects of everyday life as possible, and the influence of the rich is drastically curtailed. Such reforms, they argue, will create happier and more empowered citizens.

These big political shifts have broad investment implications.
 

Expect rising inflationary expectations

The first is the ascendancy of the Modern Monetary Theory (MMT) as an economic paradigm. For the uninitiated, MMT states that a government that issues debt in its own currency is only constrained by the willingness and ability of the bond market to fund its debt. Japan is a prime example. Austrian economic orthodoxy would have called for a collapse of the Japanese economy from the immense debt burden, but the short JGB trade has been a widowmaker for traders for decades.

Michael Pettis set out some policy guidelines of what he called “MMT Heaven and Hell”.
 

 

MMT isn’t just about printing money, but what happens after the government prints money and the mechanisms that cause inflation. The government could print money by giving it to the rich. If the economy is capacity constrained, and the rich spend the money on productive investments, the stimulus is “MMT heaven”, or non-inflationary growth. If the government prints money to give to the poor, and the economy suffers from too little demand, then the funds in the hands of the poor spurs non-inflationary growth. A third alternative is for the government to print money and spend it on productive infrastructure, which has the same economic effect as giving money to the rich in a capacity constrained economy.

In other words, MMT adoption does not always lead to inflation. Christine Harper, the co-author of Paul Volcker’s memoir, revealed in a Bloomberg article that Volcker the Great Slayer of Inflation was surprisingly agnostic about MMT:

Another time, I asked for his view of Modern Monetary Theory, which posits that a government with its own central bank and currency can and should keep spending until the economy is running at full employment. Surely the greatest living inflation fighter would recoil at such a prospect? But instead he simply pointed out that MMT hadn’t really been tested.

For investors, this means that inflationary expectations are likely to rise, though the jury is still out on whether any implementation of MMT is necessarily inflationary. Bonds have been in a secular bull market since Volcker began to squeeze inflationary expectations out of the system around 1980. As bond yields have fallen, so has bond portfolio duration, or the price sensitivity of bonds to interest rate changes. At a minimum, expect greater price volatility from bonds.
 

The dawn of ESG investing

Another trend to expect in the coming decade is the rise of ESG (environmental, social, and governance principled) investing. Time magazine’s designation of Greta Thunberg as “person of the year” is a signal that ESG principles are inexorably on the rise.
 

 

John Authers also recounted how ESG investing has invaded the hallowed halls of Harvard and Yale, and why that’s important:

If you want to see the future of climate-based investing, you need to look at Harvard and Yale. For those tired of debates dominated by elite universities, note that I am not talking about what goes on inside those hallowed halls…Students from the two universities’ campaigns to divest from fossil fuels (Yale Endowment Justice Coalition and Divest Harvard), staged a joint invasion of the field. Both want their endowments (the two largest university nest eggs on the planet) to get rid of all exposure to oil, coal and gas. They also called for divesting from holdings in Puerto Rican debt.

This is important because university divestment campaigns have a history of working. In the 1980s, when the apartheid regime in South Africa was the target, such campaigns contributed to the pressure on the country that eventually led to the release of Nelson Mandela and black majority rule. Universities tend to be averse to negative publicity, while trustees of their endowments tend to prefer the quiet life.

Authers also highlighted an InfluenceMap report of how major funds are deviating from climate investing.

Their analysis found that the world’s 15 largest investment institutions, which have $37 trillion in assets under management between them, are collectively deviating from the “Paris-aligned” allocations needed to reach the Paris Agreement goal of stopping global temperatures rising by 2 degrees. Doing this primarily requires divestment from automakers, while making big investments in alternative energy producers. World markets as a whole deviate by 18%; the big institutions deviate by 15% to 21%.

Jeroen Blokland observed that ESG just forms 2% of the overall market, indicating enormous scope for growth. The initial shift will likely begin in Europe, as a political consensus is forming that climate change is an emergency. By contrast, the climate change threat remains a subject of debate in the US.
 

 

It is easier to identify the losers than the winners under ESG. ESG standards are still in their infancy and are evolving. Different providers are producing highly different results. However, we can definitively say that carbon emitting energy sectors are going to be the losers, such as energy giant Saudi Aramco, which staged an IPO into an unfortunate headwind.

To be sure, the poor relative returns to the oil and gas industry over the last five years has put a brake on capital investment, and the under-investment will be reflected in supply constraints in the near future that is likely to boost energy prices. While energy prices may rise, the coincidental rise in ESG investing may also serve to restrain the returns of oil and gas equities and fixed income instruments. That’s the idea behind ESG, raise the cost of capital sufficiently to discourage further investment in carbon spewing projects.

In conclusion, the coming decade is likely be the “OK Boomer” decade that sees a passing of the baton to the Millennial cohort characterized by:

  • A greater focus on the effects of inequality
  • A political shift to the left
  • There are two policy effects that can be easily identified:
    1. The rise of MMT as a policy tool
    2. The rise of ESG investing

The question of whether these developments are good or bad is beyond my pay grade. However, investors should be prepared for these changes in the years to come.
 

The week ahead

I am still on holiday this week and I am writing this on a laptop with an uncertain internet connection, so this comment will be somewhat brief.

Just before I left, I rhetorically asked if the market was melting up (see Is the market melting up?) as there were both pros and cons to the melt-up case at the time. We now have the answer. This is a market blow-off, which will inevitably be followed by a correction in the manner of early 2018.
 

 

I had outlined a number of metrics to tell if this is a market melt-up. SentimenTrader analysis of Google searches and Bloomberg stories shows that current readings exceed the late 2017 and early 2018 experience. Sentiment is supportive of the melt-up scenario.
 

 

Does this mean that the stock market is ready to peak? Not necessarily. SentimenTrader also observed that Trump’s market tweets have not exceeded the early 2018 count. So the jury is still out.
 

 

Most sentiment indicators are flashing wildly crowded long levels, but that is to be expected in a blow-off top. However, this doesn’t necessarily mean that prices will retreat right away. As an example, the Fear and Greed Index closed Friday at an astounding 92 reading, but history shows that sentiment indicators tend to be better trading signals at bottoms, rather than tops.
 

 

For some perspective, the NASDAQ Composite sported a rare 11-day winning streak. Analysis from Bespoke (via Liz Ann Sonders) found that such instances have historically not resolved in a bearish manner.
 

 

The table of future returns after such episodes have been dominated by continued price momentum, which saw above average returns for all time horizons.
 

 

Both my inner investor and trader are bullishly positioned. Trading volume is expected to be light early in the week, but the possibility of further fast money FOMO chase still exists. My inner trader is keeping a close eye on his trailing stops in this high risk/high reward environment.

I expect to back at my desk mid-week. Stay tuned.

Disclosure: Long SPXL

 

China, paper tiger

Posted by Cam Hui -

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 Asset Allocation 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: Buy equities
  • Trend Model signal: Bullish
  • 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.
 

Defining the China threat to America

‘Tis the season for strategists to publish their year-end forecasts for 2020. Instead of participating in that ritual, this is the first of a series of think pieces of what might lie ahead for the new decade. We begin with the difficult challenge of Sino-American relations.

What is the nature of the Chinese threat to America? On the surface, it is the threat of the emergence of a new economic power, as illustrated by the FT (h/t Liz Ann Sonders). As recently as the year 2000, the US was the dominant global exporter.
 

 

Fast forward to 2019, China is ascendant, and America is in retreat.
 

 

Evan Feigenbaum had a more nuanced explanation of the issues in a half-hour interview.

From a geopolitical viewpoint, Feigenbaum made the point that China is a revisionist power, but it is not a revolutionary power like the Soviet Union, which tried to export its revolution around the world. As an example, China set up the Asian Infrastructure Investment Bank (AIIB) in parallel to the Asian Development Bank (ADB). But it’s also the third largest shareholder in the ADB. It’s also a major contributor to the IMF and World Bank. This shows that it is trying to become a regional power, and it is trying to mold global institutions in its own image, but it is not being disruptive in the same way as the Soviet Union.

Feigenbaum concluded that China is a major economy, and it is here to stay. This matters to American policy. It’s not useful to try to bury one’s head in the sand and force China to decouple. American policy makers have to be more adaptive rather than trying to rewind the clock to the 1950s and 1960s eras of Pax Americana.
 

What decoupling means

Even as the US-China trade talks remain unresolved, there is a growing consensus that, in the longer term, the two economies are going to decouple. Do you want to know what decoupling looks like? The Financial Times reported that the Party has ordered the removal of all foreign hardware and software from government offices in three years. The policy has been called “3-5-2” because replacement will occur at a rate of 30% in 2020, 50% in 2021, and 20% in 2022.

In addition, initiatives such as the PBOC’s definition of credit card encryption standards, which is incompatible to the ones used by VISA and MasterCard, but used only by state-owned Union Pay, is just one example that could split the global financial system.

Bloomberg reporter Shelly Banjo showed the way in a Twitter thread.
 

 

Banjo continued:

Some tech execs openly worrying that China’s approach to censorship and authoritarianism is bleeding into the U.S., posing a severe threat to America
Bankers confused around working on financing for companies that could be blacklisted by US
VC funds not taking money from Chinese GPs or in some cases, LPs, asking folks for copies of passports to prove US citizenship
Startups wondering what happened to the the Silicon Valley outposts of China’s Tencent, Alibaba and Baidu, which have all gone dark
Despite claims of China’s tech prowess, met with Chinese developers, scientists and students who won’t leave the US to go back to China. They want to keep research in the US, even if they are working for Chinese companies
And all of these meetings came on the backdrop of the NBA’s decision to kowtow to China, underscoring the question — what should American companies do? What are the wider implications of this?
Do you keep the wait and see attitude and keep tiptoeing in or near China with the hopes that one day things will change? Or do you call it quits and leave? I just don’t feel like waiting is a viable strategy anymore
I think you either have to call it quits or you commit and say, hey, we’re a company and our goal is profits for shareholders so we don’t care to claim a moral high ground and will fully embrace the China line.
The other worrying factor was how much China-bashing I found bordered on racism, causing the US to create this sense of other and retreat deeper inward. As a Chinese scientist, inventor, technologist, how does that make you feel?

The US National Security Strategy of 2017 made a little noticed pivot by branding China a strategic competitor. Ever since that document was published, US strategy has been focused on containing China`s rise, not just from an economic viewpoint, but on a variety of other geopolitical dimensions as well.

This paradigm shift is leading the world into a possible Thucydides’ Trap, where existing Great Powers is unable to accommodate the rise of a new Power, leading to competition, and eventually a catastrophic war. While the gloomy Thucydides’ Trap thesis explained the First World War, where European Powers was unable to cope with a newly industrialized Germany, wars are not necessarily a foregone conclusion. The West was able to deal with the rise of the Soviet Union through a containment policy after the Second World War without triggering a Third World War.

During the Vietnam War, Mao branded the US as a paper tiger. I would argue that the appearance of the Chinese threat to the US is another paper tiger, as long as the relationship is managed properly. War is not always the end result.
 

Policy options: Rsponding to the Chinese threat

There are two ways to deal with the growth of Chinese influence in the world. America can either by itself, or enlist the help of allies, to counter Chinese geopolitical creep, and take advantage of China’s missteps and overreach.

The US need to take advantage of China’s missteps in extending its influence, and step into a leadership role by enlisting allies to contain China. Consider this Drew Thompson OpEd in the SCMP, “From Singapore to Sweden, China’s overbearing campaign for influence is forcing countries to resist and recalibrate relations with Beijing”:

China’s campaigns range from overt diplomacy and public messaging disseminated through propaganda organs, to covert cyber exercises by specialised hackers and the “50-cent trolls” on social networking sites.

Its capabilities are built into the government’s vast propaganda apparatus, including the People’s Liberation Army, intelligence departments, and the foreign education and culture ministries.

The influence mission is integral to the Communist Party, most notably in the United Front Work Department, which is responsible for engaging intellectuals, including overseas and ethnic Chinese.

The elevation and rejuvenation of the United Front, and the formation of a Leading Small Group chaired by President Xi Jinping to oversee its work, has increased its bureaucratic capacity to extend China’s influence over ethnic and overseas Chinese populations.

China has made a number of mistakes in extending its political reach:

The United Front’s efforts are clearly being felt in countries with large Chinese diaspora populations, such as Australia and Canada. Pro-China “patriotic” demonstrations and the destruction of Lennon Walls in Canada are worrying Canadians that a globally assertive and nationalistic China is impinging on Canadians’ rights.

A recent poll found that less than a third of Canadians have a favourable view of China.

Similar scuffles between pro-Hong Kong and pro-Beijing protesters in Australia have punctuated inappropriate displays of Chinese nationalism on foreign soil, including the raising of a Chinese flag over an Australian police station while the Chinese national anthem was sung.

Public servants paying allegiance to a foreign country is not the manifestation of a healthy bilateral relationship but, literally, a red flag that China’s influence campaign has overreached and is damaging.

Similar instances of geopolitical overreach can be found in Sweden:

Last year, three Chinese tourists claimed they were abused by Swedish police following a dispute over their hostel reservation.

Soon after arriving in Stockholm, Chinese ambassador Gui Congyou embarked on an extensive campaign, accusing Swedish police of brutality even when a video of the incident showed police standing to one side while the tourists prostrated themselves on the pavement.

Gui conducted media interviews and released almost 60 statements criticising Sweden’s commitment to human rights and accusing it of tyranny, arrogance, racism and xenophobia.
Time for the US to re-engage Asia and be a stable counter to China

Faced with this barrage of government-sanctioned accusations, and with public opinion polls showing 70 per cent of Swedes viewing China unfavourably, Sweden announced in February that it was updating its China strategy.

In a memorandum to parliament last month, the government said: “The rise of China is one of the greatest global changes since the fall of the Berlin Wall.”

These fumbled Chinese initiatives open the door for American policy makers to create an alliance to counter growing Chinese political influence around the globe. China has funded a network of Confucius Institutes around the world to spread Chinese culture, to monitor the activities of overseas Chinese students, and to advocate for China’s position, such as the Hong Kong protests and its position on Taiwan, around the world.

Already, China’s BRI initiative is rubbing a lot of its Asian neighbors the wrong way.
 

 

Present with these openings, what is the Trump administration doing? Conducting a bean counter analysis of how much American troops in South Korea costs?
 

Time as the Great Healer

While Americans are focused on the numerous ways that China represents a threat to US interests, I would argue that the best solution is time. One major source of angst is the China 2025 industrial strategy of aiming for dominance in selected industries and technologies while favoring domestic companies. While talk of China 2025 has disappeared, Beijing has not renounced the principles behind that initiative.

If you are afraid, then does that mean you believe in industrial strategy? If industrial strategy worked, then we would all be admiring the dirigiste French with the long tradition of a strong government control of the economy, and fostering national champions.

Consider, for example, the threat of Chinese AI dominance. An article in New America indicated that China may be in for an “AI winter”:

Last December, China’s top AI scientists gathered in Suzhou for the annual Wu Wenjun AI Science and Technology Award ceremony. They had every reason to expect a feel-good appreciation of China’s accomplishments in AI. Yet the mood was decidedly downbeat.

“After talking about our advantages, everyone mainly wants to talk about the shortcomings of Chinese AI capabilities in the near-term—where are China’s AI weaknesses,” said Li Deyi, the president of the Chinese Association for Artificial Intelligence. The main cause for concern: China’s lack of basic infrastructure for AI.

More than two years after the release of the New Generation Artificial Intelligence Development Plan (AIDP), China’s top AI experts worry that Beijing’s AI push will not live up to the hype. The concern is not just that China might be in for an “AI winter”—a cyclic downturn in AI funding and interest due to overly zealous expectations. It’s also that for all China’s strides in AI, from multi-billion dollar unicorns to a glitzy state plan, it still lacks a solid, independent base in the field’s foundational technologies.

That’s because most of the basic software tools are American:

A brief glance at the infrastructure Chinese developers are using to run their algorithms reveals one reason for concern. The two dominant deep learning frameworks are TensorFlow and PyTorch, developed by Google and Facebook, respectively. A “framework” is essentially a set of programming shortcuts that makes it simpler for researchers and engineers to design, train, and experiment with AI models. Most AI research and deployment uses one framework or another, because frameworks make it possible to use common deep learning concepts (such as certain types of hidden layers or activation functions) without directly implementing the relevant math.

While Chinese alternatives to TensorFlow and PyTorch exist, they have struggled to gain ground. Baidu’s PaddlePaddle scarcely appears in either English- or Chinese-language listicles of top framework comparisons. Although it’s difficult to find reliable and up-to-date usage statistics, various informal indicators all point to a large discrepancy in usage. According to Github activity, Baidu’s PaddlePaddle trails PyTorch and TensorFlow by a factor of 3–10 on various statistics. In one Zhihu thread on comparing frameworks, only one user stood up for PaddlePaddle—the PaddlePaddle official account.

The same story goes for AI hardware:

When it comes to AI hardware, the outlook is equally troubling for China. Despite buzz in venture capital circles about Chinese AI chip startups like Cambricon and Horizon Robotics, Chinese AI developers continue to rely heavily on western hardware to train their neural networks. This is because Chinese AI chips have so far largely been confined to “inference,” or running existing neural network models. In order to “train” those neural nets in the first place, researchers need high-performance, specialized hardware. Unlike most computational tasks, training a neural network requires massive numbers of calculations to be performed in parallel. To accomplish this, AI researchers around the world rely heavily on graphics processing units (GPUs) that are mainly produced by U.S. semiconductor company Nvidia.

Originally designed for computer graphics, the parallel structure of GPUs has made them convenient platforms for training neural networks. SenseTime’s supercomputing center DeepLink, for instance, is built on a staggering 14,000 GPUs. However, GPUs are not the only hardware platform that can train neural nets. Several chips including Google’s Tensor Processing Unit (TPU) and field-programmable gate arrays (FPGAs) from companies like Intel and Xilinx will likely reduce the importance of Nvidia GPUs over time. Notably, none of these competitors to the GPU are Chinese.

Why are there no Chinese competitors challenging the GPU’s reign? The answer, according to Sun Yongjie, a notable tech blogger in China, is that Chinese AI chips are created for “secondary development or optimization” rather than replicating fundamental innovations.

Force China to decouple, then you force them to build their own infrastructure, instead of remaining integrated with Western researchers.
 

Demographic headwinds

Another headwind that China faces is demographics. The Economist observed China is about to get old before it gets rich.

The coming year will see an inauspicious milestone. The median age of Chinese citizens will overtake that of Americans in 2020, according to UN projections (see chart). Yet China is still far poorer, its median income barely a quarter of America’s. A much-discussed fear—that China will get old before it gets rich—is no longer a theoretical possibility but fast becoming reality.

 

 

This table from China watcher Michael Pettis tells the Chinese demographics story in an even more dramatic way. By 2050 China’s population will be 4% lower than today, while it’s working-age population will have declined by 12%.
 

 

China’s population may even age faster than these projections. These estimates are based on the standard assumption that the fertility rate rises from the current rate of 1.6 to 1.7-1.8 live births per woman. New estimates from The Economist’s Economic Intelligence Unit the fertility rate is far lower than initially thought, and “peak population comes four years sooner that the UN’s baseline ‘medium-fertility’ variant”.
 

 

A pivot to state control

Another threat to Chinese dominance is Xi Jinping’s pivot to greater Party control of the economy. Instead of Deng Xiaoping’s “it is indeed glorious to be rich” philosophy that unleashed the power of private enterprise that have led to China’s ascent, Xi has asserted power and tightened the State’s grip on the economy. Consequently, SOE profitability has grown at the expense of the privately owned SMEs. But the ROAs of SOEs continue to lag SMEs. Moreover, this policy pivot has stopped the development of an independent judicial system and enforcement of property rights in favor of Party control. In addition, senior SOE managers wear the dual hats as Party committee members and corporate executives, which complicates corporate governance issues. This has the potential to either lead to a capital strike, or capital flight. If China, Inc. is the combination of SOEs and SMEs, then expect its competitive position to erode over the course of the next decade.
 

 

China will also have eventually deal with their mountain of debt. As a reminder, this is the China bears’ favorite chart.
 

 

A recent WSJ article highlighted some of the woes of the Chinese banking system, much of which are concentrated in the smaller banks. During China’s hyper-growth period, there have been thousands of smaller local banks controlled by local politicians that were being used for their pet projects. These banks relied much more on wholesale funding than on retail deposits. If it were not for the implicit government guarantees, many of these small local banks would have collapsed a long time ago. Beijing’s preferred solution is to merge the bad banks, as they appear, with stronger large banks. But this sets up a Japanese 1990’s problem of bank zombification – which was the catalyst for the start of Japan’s Lost Decades.
 

 

The climate change threat

Another potential threat to the Chinese growth engine may come from climate change. A new study published in Nature Communications revealed that a new study indicates rising sea levels from climate change means the coastlines are three times more exposed than previously thought, and China accounts for 15-28% of the total population threatened by rising sea levels, Especially at risk is Pearl River Delta (Guangzhou and Shenzhen) and Shanghai. These models project that most of Shanghai may be under water by 2050.
 

 

Key risk: American isolationism

In summary, I have made the case that the Chinese economic threat is mostly a paper tiger, and Chinese growth is likely to converge to developed market levels by the end of the 2020s. How the world manages that transition will be key to sustaining global growth and geopolitical stability over the next decade.

The biggest threat to the stability of the global economic order is American isolationism.
Even if American policy makers wanted to contain China’s rise, unilateralism and a singular focus on trade is precisely the wrong way to do it. Ian Bremmer of GZERO Media pointed out that China has invested an order of magnitude more in Latin America than the United States. In light of Trump’s isolationist bent, and transactional approach to foreign policy, it may not be long before someone asks, “Who lost Brazil, or Mexico, and so on?”
 

 

More importantly, will someone ask, “Who lost South Korea?” Yahoo Finance recently reported that China and South Korea signed a defense agreement in the wake of American demands on Seoul to pay for US troops:

The defence ministers of South Korea and China have agreed to develop their security ties to ensure stability in north-east Asia, the latest indication that Washington’s long-standing alliances in the region are fraying.

On the sidelines of regional security talks in Bangkok on Sunday, Jeong Kyeong-doo, the South Korean minister of defence, and his Chinese counterpart, Wei Fenghe, agreed to set up more military hotlines and to push ahead with a visit by Mr Jeong to China next year to “foster bilateral exchanges and cooperation in defence”, South Korea’s defence ministry said.

Seoul’s announcement coincided with growing resentment at the $5 billion (£3.9bn) annual fee that Washington is demanding to keep 28,500 US troops in South Korea.

These American fumbles have created a geopolitical opening for the Chinese. The SCMP reported that former Chinese trade negotiator Long Yongtu said that China would prefer Trump to be re-elected, because he is so easy to read:

The US president’s daily Twitter posts broadcast his every impulse, delight and peeve to 67 million followers around the world, making him “easy to read” and “the best choice in an opponent for negotiations,” said Long Yongtu, the former vice-minister of foreign trade and point man during China’s 15-year talks to join the WTO nearly two decades ago.

“We want Trump to be re-elected; we would be glad to see that happen,” Long said during Credit Suisse’s China Investment Conference yesterday in Shenzhen.

Long, who turned 76 in March, has retired from active ministerial posts and doesn’t speak for China’s government in matters concerning the domestic affairs of other countries. But the comment from someone considered the elder statesman of China’s trade diplomacy does offer a hint of the thinking in Beijing’s policymaking circle, as officials grapple with how best to handle the bruising trade war between the two largest economies on Earth.

Despite his fickleness, Trump is a transparent and realistic negotiator who is concerned only with material interests such as forcing China to import more American products, on which Beijing is able to compromise, Long said. Unlike his predecessors, Trump does not pick fights with China on hot-button geopolitical issues such as Taiwan or Hong Kong, where Beijing has little room to manoeuvre, said Long, who now heads the Centre for China and Globalisation, a Beijing-based think tank.

“Trump talks about material interests, not politics,” Long said in an interview with South China Morning Post in Shenzhen. “Such an opponent is the best choice for negotiations.”

While the US is distracted on trade, China could increase its geopolitical reach in Asia and the rest of the world. Already, Trump is visibly abandoning the US leadership global position, and leaving a vacuum for another Great Power to step in. Here are two examples, Japan and South Korea, two key US allies in Asia, are engaged in a very visible trade spat, The US has stepped aside from the dispute, and China has moved in to try and mediate. In addition, the PLA Navy engaged in joint naval exercises with Saudi Arabia. As America retreats from its role as superpower, China moves in.

In effect, American policy is at risk of falling into the Kindleberger trap, as explained by this article in The Diplomat:

Professor Joseph Nye Jr. raised an important new concept of the “Kindleberger trap” weeks ago. It follows late MIT professor Charles Kindleberger’s classical arguments that the Great Depression in the 1930s was caused by the shortage of global public goods provision when the isolationist United States refrained from assuming the responsibility while the Great Britain lost its capability to play the role. Nye thus cautions the American leaders to be wary of a China that seems to be too weak to take international responsibility rather than too strong as the now popular concept “Thucydides Trap” implies.

This new warning deserves close attention. It reminds us that global order cannot function efficiently without sufficient public goods provision from powerful states. However, we must also note that the reality today also diverges significantly from the 1930s. In fact, the actual challenge now is not that the established power has lost its capability while the rising power is unwilling to assume responsibility. Instead, as shown by President Donald Trump’s isolationist “America First” inaugural address and President Xi Jinping’s pro-globalization speech in Davos, the current situation is much more that the established power still enjoys power superiority but refuses to assume its responsibility while the rising power is eager to play a greater role but still lacks sufficient capability.

 

The road ahead

There are still reasons to be optimistic. The US-China relationship is still deep and difficult to unwind. John Authers recently highlighted analysis comparing the degree of integration of the Soviet Union and China to the global economy. China is not the Soviet Union, and any Cold War style containment will be difficult.
 

 

It is also instructive the story of TikTok, which is one of the few Chinese social media companies that have been successful. The WSJ reported that it is trying to distance itself from its Chinese roots in order to keep growing.

TikTok this year made history as China’s first social-media company to make it big in the U.S. Now, TikTok wants to shed its label as a Chinese brand.

As TikTok faces mounting scrutiny from U.S. lawmakers and regulators, some employees and advisers in recent weeks have approached senior executives to suggest ways the company could rebrand, according to people familiar with the discussions.

Ideas discussed include expanding operations in Southeast Asia, possibly Singapore—which would allow executives to distance the video-sharing app from China—and rebranding it in the U.S., the people said.

The rupture has largely been contained. China’s brand of revisionist power means that it is unlikely to seek a direct geopolitical confrontation with American forces. It is not the Soviet Union, who tried to export its revolution abroad. There are not even any proxy wars, where each side supports one faction in a local conflict. Business Insider reported that the old Cold War warrior Henry Kissinger declared that the US and China are “in the foothills of a Cold War”:

Legendary former US diplomat Henry Kissinger warned that if the trade war is left uncontrolled, it could spiral into a conflict like World War I.

“If conflict is permitted to run unconstrained the outcome could be even worse than it was in Europe. World War I broke out because a relatively minor crisis could not be mastered,” Kissinger said at a session of the New Economy Forum, organized by Bloomberg.

However, Beijing is trying to to redefine global institutions, and take leadership. Active examples include its BRI initiative to extend its global influence, the seeding of Confucius Institutes around the world to extend its soft power, and the formation of AIIB to take a leadership role in Asia. The risk is an American withdrawal from established global institutions like the United Nations, IMF, and WTO, which leaves a vacuum for Beijing to assume a great leadership role.

Another risk is the growing alliance in DC against China, which exists across the aisle, and allied with business and labor interests, serve to enlarge the rupture in the relationship. This could lead to an isolationism which could disrupt global institutions that have been the foundation of post-War global stability.

In conclusion, this essay is my own equivalent of American diplomat George Kennan’s “long telegram” of 1946, in which he argued that if the Soviet Union was properly contained, it would collapse under the weight of its internal pressures. However, if the Sino-American relationship is properly managed, the fears over the strategic threat from China will prove to be as alarmist as the fears that arose in the late 1980’s over Japanese dominance of the global economy.

For investors…navigating the coming era of decelerating Chinese growth will be the key to asset returns. The losers are readily identifiable. Economies exposed to Chinese growth, such as Asia and resource exporting countries like Australia, New Zealand, Canada, and Brazil will see sub-par growth as China slows. The winners are less obvious, and depend on the trajectory of US foreign policy, as well as the reaction of other major players like the EU and Japan.
 

The week ahead

As I am traveling this week, I don’t have any more to add, other than the guidance offered in my previous post (see Is the market melting up?). I have included a number of key links in that post that update the technical conditions of the market that readers can monitor.

Good luck.

Disclosure: Long SPXL