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
 

Is the market melting up?

Posted by Cam Hui -

Mid-week market update: I am leaving on a seasonal family vacation tomorrow, so posting will be lighter than usual. While the usual weekend publications will continue, tactical market interpretations are problematical this time of year when liquidity is low. However, here are some guidelines on how to think about the stock market for the remainder of 2019.

Recently, there have been more voices calling for a market melt-up. Bloomberg reported that BAML strategist Michael Hartnett called for a SPX target of 3,333 by March 3. Marketwatch also cited bullish forecasts by UBS Global Wealth Management Chief Investment Officer Mark Haefele, and Morgan Stanley’s Michael Wilson.

The technical pattern is also starting to look like the melt-up and blow-off top that began in late 2017. The SPX overran rising trend lines (twice) while shrugging off negative RSI divergences. In fact, neither the 5-day nor 14-day RSI flashed any warnings when the market finally topped out in January 2018. Today, the index has rallied above one rising trend line. Compare the late 2017 melt-up behavior with the orderly advance of mid-2018, which never significantly breached the uptrend line. and weakened as RSIs flashed negative divergences. Equally impressive is the NYSE new highs – new lows seen in the current advance.
 

 

Is the market melting up?
 

More room to run

I don’t know. If it is melting up, sentiment models indicate that the market has more room to run. Sentiment is becoming bullish in what seems to be a FOMO stampede, but readings are not extreme yet. Callum Thomas’ Euphoriameter is barely at the bottom of the target zone, indicating more room for the market to become even more euphoric.
 

 

The latest BAML Global Fund Manager Survey shows that global institutions have turned bullish, but readings are only neutral and not extreme.
 

 

Equally revealing are the State Street confidence surveys of portfolio positioning. Institutions have been piling into European equities.
 

 

But they are cautious in North America…
 

 

…and in Asia.
 

 

In the meantime, global liquidity is strong, and it is creating tailwinds for stock prices.
 

 

If this is indeed a FOMO rally, then institutions have a lot more room to pile in.
 

How to spot the top

Assuming we are undergoing a melt-up, here are some indicators that I would watch for signs that the rally is becoming unsustainable.

First, SentimenTrader has been monitoring the incidence of “melt up” news articles. We are getting close, but not quite there yet.
 

 

My own suite of short-term market sentiment indicators are not flashing warning signs yet, but readings are nearing euphoric levels. Watch this space (readers can see updated charts using this link).
 

 

I would also like to see % above 50 dma to rise above 80%, and NYSI to rise above 800 (live link). We are not there yet. In fact, these readings arguably constitute minor negative divergences that point to internal weakness, and not a momentum-driven melt-up. Watch for a breach of rising trend line support for a trading sell signal.
 

 

Medium term (1-2 week) market internals, such as net 20-day highs-lows, are reaching short-term overbought readings. But they are not high enough to be consistent with a blow-off top (live chart link).
 

 

Valuations are becoming extended. FactSet reported that the market was trading at a forward P/E of 17.8, which is above its 5-year average of 16.8, and 10-year average of 14.9. If it were to rise to the levels seen at the January 2018 highs, that would be a cautionary sign, though high valuations do not represent an actionable trading sell signal (see the latest earnings commentary from FactSet analyst John Butters here).
 

 

In conclusion, current market conditions can be best described as overbought, but not as frothy as the late 2017 melt-up, as shown by the latest update of II sentiment. We have to allow the market action to dictate the outcome.
 

 

Traders and investors have to allow for the possibility that the market is undergoing a melt-up. In that case, traders should be aware that a melt-up is likely to be followed by a meltdown. However, there are a number of signs that can warn traders of an impending blow-off top so that they can take the appropriate action to reduce risk. If, on the other hand, the market is not melting up, traders can use a breach of rising trend line support as a signal to reduce risk.

Just keep in mind the analysis from Ryan Detrick, who pointed out that market seasonality favors an advance in the last half of December – which is why we believe in Santa Claus.
 

 

My inner investor is bullishly positioned. My inner trader is also bullishly positioned, but lightly because he is unsure of whether he can monitor the markets while on vacation. Otherwise, he would have added to his long positions by now, but with tight trailing stops.

I’ll be back in the New Year.

Disclosure: Long SPXL

 

Factor investing: Theory vs. practice

Posted by Cam Hui -

As regular readers know, I have been an advocate of taking an overweight in cyclical exposure in equity portfolios (for the latest update, see Adventures in banking). While I continue to believe that the approach is sound, the reality has been less than fully satisfactory in the US. Among the cyclical groups, the semiconductors are on fire, and homebuilding stocks are weakening but remain in a relative uptrend. However, both industrial and transportation stocks have failed to hold their upside breakouts through relative downtrends, though they are still exhibiting bottoming patterns.
 

 

Here is what I believe is wrong, and it is a lesson between theory and practice in factor investing.
 

Pure vs. naive factor exposure

The disappointing returns can mainly be explained by the performance of specific large cap stocks that have dragged down certain sectors. The largest weight in the industrial stock ETF (XLI) is Boeing (BA), whose returns were plagued by the problems of the 737 MAX. The returns of the equal weighted industrial ETF against the equal-weighted SPX benchmark looks a lot more constructive.
 

 

In the course of conducting this analysis, I found another cyclical sector whose performance was weighted down by a heavyweight, namely the consumer discretionary stocks. In this case, it was Amazon (AMZN). The same comparison of the relative performance of the cap weighted consumer discretionary ETF (XLY) against the equal-weight ETF shows a similar effect. Equal-weighted consumer discretionary stocks (RCD), which minimizes the effects of AMZN, have bottomed against the market, and they are turning up.
 

 

There are several lessons to be learned. Even if your analysis comes to the right conclusion, how you implement the idea or factor makes a huge difference to returns. This exercise is also a lesson on the differences between the pure and naive exposure to a factor.

For investors who want US cyclical exposure, consider RGI, RCD, SMH, and ITB or XHB.
 

Adventures in banking

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. As well, please join and “like” our Facebook page here.
 

Would you buy this chart?

Now that we have greater clarity on the Sino-American trade relationship, as well as Brexit tail-risk, can we get back to simple task of investing?

Consider the following question. Would you buy this chart, or factor? It was in an uptrend from 2011 to 2018. It consolidated sideways for about two years, and recently staged an upside breakout to fresh highs.
 

 

It is the ratio of the KBW Bank Index to the CRB, or what I call my Fed Report Card. It measures the Fed’s ability to maintain growth and financial stability while keeping asset inflation (CRB) under control. Despite Powell’s dovish tilt after the latest FOMC meeting, the Fed is performing well on that metric.

For investors, my cross-asset analysis suggests superior return opportunities in bank and financial stocks amidst signs of a global cyclical revival.
 

A cyclical revival

More and more signs of a global cyclical upturn have been appearing, even before the news of a Phase One trade deal, and a Tory victory in the UK election that took Brexit tail-risk off the table. Macro Charts observed that global central banks are starting an easing cycle, which should be bullish for risky assets.
 

 

The Citi Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is positive for the US.
 

 

Eurozone ESI recently turned up and it is now positive after spending several months in negative territory.
 

 

Speaking of Europe, Callum Thomas recently highlighted other signs of improvement in European autos, which is a highly cyclical industry. The European auto sector may also be benefiting from the start of a replacement cycle from diesel to electric vehicles.
 

 

Even China ESI has turn positive, indicating positive surprises despite the recent gloom over decelerating growth.
 

 

There was also other upbeat timely news from Asia last week. Yonhap reported that the closely watched first 10-day December South Korean exports rose a surprising 7.7%.
 

Bullish for banks and financials

Here is why these developments are bullish for banking and financial stocks. The copper/gold and platinum/gold ratios, which are global cyclical indicators, are turning upward. Both ratios are also correlated with the 10-year yield, which is not surprising as bond yields tend to rise as growth expectations rise.
 

 

While the relative performance of bank stocks are correlated to the 10-year yield, they exhibit a tighter correlation with the 2s10s yield curve. As growth expectations rise, the yield curve steepens, which allow for better banking profitability as banks borrow short and lend long. In Europe, negative rates have destroyed the banking system, and a rising 10-year Bund yield is a positive sign for the European banking sector.
 

 

Lastly, Nautilus Research highlighted a big picture technical perspective. Using cycle analysis, they concluded we may be at the start of a long-term bullish cycle of bank and financial stock outperformance.
 

 

Even better opportunities in Europe

While I believe that US financial stocks should outperform, the real opportunity is in the beaten up European financial sector. Recently, Johannes Borgen wrote a twitter thread which revealed a shift in European banking regulation that has the potential to be bullish for the sector. (For the uninitiated, CET1 = Common Equity Tier 1 capital, NPL = Non-Performing Loans).
 

 

I think we can all agree one of the major effects and economic distress created by the financial crisis was the massive bank deleveraging. This was triggered by large losses but also by massively increased capital requirements (x3 more or less, SSM = the ECB’s Single Supervisory Mechanism).

New capital raises did offset that a bit, but not enough – because raising even more capital was too painful for shareholders. The dilution is just too large.

We can also all agree that negative rates are bad for banks (well, all except the ECB – until very recently, but that’s another story!) and that if they are to contribute to economic growth, banks need to be more profitable to improve their capital.

Unfortunately, this is harder to do than to say: IT investments take a long time to pay off, restructurings are expensive and equity isn’t cheap, NPL coverage requirements keep creeping up, rates are not going up, litigation is still there, etc.

So everybody knows (and the ECB has been crystal clear about this recently) that M&A needs to happen, there needs to be less competition in the banking market and the same cost base needs to deliver more turnover. Technically it’s possible.

So to put it bluntly: the EU’s economy needs more bank M&A. The days are long gone when supervisors were screaming about banks being too large to manage from a systemic point of view.

There are many reasons why M&A hasn’t been happening a lot: the incompleteness of the banking union is one, but that’s not enough. This does not apply to intra-border M&A – such as Unicaja + Liberbank!

A less often discussed constraint and barrier to M&A has been the position of the supervisor; a slightly schizophrenic one! Under Mrs Nouy’s stewardship, every big M&A project came with a required capital increase!

Banks were often puzzled by this, e.g. Italian banks would ask: “if the two banks have adequate NPL coverage, why do they need a bigger coverage once they combine and are more efficient?” Honestly a very good question.

And most of the time, the reason was basically this: “I’m asking you to raise capital, because I can. You’re asking something from me (authorization for the merger), I’m asking something from you (more capital.)” That’s it.

Obviously, this complicates deal making and even made some M&A projects economically meaningless.

So coming back to Unicaja + Liberbank. Since Mr. Enria took over, it seems the SSM has slightly changed its approach. Various speeches seem to imply that the SSM would not adopt the same kind of strategy before approving mergers.

And if that’s true – if the SSM stops asking for more equity each time there’s a major M&A deal – honestly, it’s a game changer. And guess what: reportedly, the SSM seems to be on board for a Unicaja + Liberbank deal with no additional equity.

And we’re not talking about a Rabobank + ABN Amro deal here. Liberbank is rated Ba2/BB+ whereas Unicaja is BBB-/Baa3. Both banks still have quite a nice stack of legacy NPA assets, included a large chunk of foreclosed real estate.

So honestly, if this merger doesn’t come with mooooar CET1, which one will?

Bottom line: even if you’re not interested in banking, keep an eye on this deal and look for the conditions requested by the SSM to approve the deal. That’s what matters.

To summarize, European banking regulation seems to be changing. The regulator’s reaction to this transaction opens the door to more banking mergers, and stronger banks. Combine that with a cyclical revival that boosts the 10-year Bund yield, banking profitability improves. The European banking sector is one that has been left for dead for about a decade. Any signs of improvement in operating and regulatory environment have the potential for these stock to go on a tear.
 

 

So go ahead, put some banking and financial stocks under your Christmas tree. You can thank me in the new year.
 

The week ahead

Looking to the week ahead, it is said that there is nothing more bullish than a stock or an index making all-time highs. But the key question for traders is whether they should buy the breakout, or sell the headlines. The market staged an upside breakout to all-time highs on Thursday on the Phase One deal news, and the index closed flat Friday but held above the breakout level.
 

 

Here are bull and bear cases.

The bull case

The bull case rests mainly on price momentum. During my tenure at a hedge fund, I learned that there are four important dates in a year. They are the quarter-end dates that the incentive fees are calculated. If a fund charges a 2 and 20 structure (2% of assets and 20% of gains), the 20% incentive fee is calculated on the return for the quarter.

On one hand, many hedge funds close down their books and flatten their positions about this time of the year because market liquidity dries up in the latter half of December. On the other hand, we also know from surveys and imputed data calculations that both traditional long-only managers and hedge funds were defensively positioned entering Q4. As stock prices began to rise, they engaged in a FOMO beta chase. Now imagine that you are a hedge fund manager whose bonus depends on your quarterly returns. You were caught off-side as the risk-on rally began. You chased beta in response, and you may nor may not be positive for the quarter. Do you shut down your book now, or continue to chase the market upwards, especially in light of numerous global upside breakouts which are holding?

Greed is good. Fear (of no bonuses) is also a great motivator. The market is starting to look like it is repeating the surge of late 2017, which was characterized by upper Bollinger Band rides on the weekly chart, punctuated by brief periods of consolidation. Now that the index has staged an upside breakout to fresh highs, could we be seeing another melt-up?
 

 

SentimenTrader documented the effects of price momentum from the effects of the upside breakouts and positive breadth. All have bullish implications. (By ACI he probably means ACWI, or All-Country World Index).
 

 

Here is MSCI ACWI:
 

 

NYSE Composite:
 

 

NYSE new highs – lows:
 

 

Financials:
 

 

Cross- asset analysis is also supportive of the bull case. The USDJPY exchange rate has been highly correlated with stock prices, and it is rising in line with increased risk appetite.
 

 

As well, the relative returns of high yield (junk) bonds is confirming the upside equity breakout.
 

 

Even before the news of the trade deal, the Natixis Risk Perception Index had been falling, indicating increased risk appetite.
 

 

FOMO risk-on!
 

Bear case

The bear case rests with the details of the fundamentals. First of all, it is unclear what exactly was agreed to in the Phase One deal as a full text has not been ironed out. The devil is still in the details. As Yahoo Finance documented, Trump’s has shown a record of exaggeration when it comes to his statements on China.
 

 

Here are some important unanswered questions about the announced Phase One deal as the deal has not been papered by the lawyers.

  • What exactly did China commit to on agricultural purchases?
  • Is the cut from 15% to 7.5% on $120 billion in tariffs a first step, or will there be more reductions?
  • What exactly are the Chinese commitments on IP protection, forced technology transfer, and currency stability?
  • What is the dispute resolution mechanism?

Kayla Tausche of CNBC reported the details of Chinese agricultural purchases, as per Robert Lightizer, but those details have not been confirmed by the Chinese. In fact, the Chinese spokesman went out of his way to dodge the question when asked about this topic during their press conference.
 

 

If Lightizer’s statement is to be taken at face value, China has committed to buying about $40 billion a year of agricultural goods from the US, with more on a “best efforts” basis. Brad Setser at the Council on Foreign Relations estimated the scale of Chinese agricultural imports. Chinese agricultural imports from the US his historically topped out at about $20 billion a year, but their total imports amount to between $40 and $50 billion. Technically, the commitment is possible. But even assuming that American farmers could produce that much output, which is questionable, it would mean a significant diversion from other countries. As well, such a surge in Chinese demand for American goowould drive up the price of food for US consumers.
 

 

Eunice Yoon of CNBC reported that Chinese negotiators raised concerns over farm purchase commitments. First, China could be challenged at the WTO for a reallocation of purchase from other countries by other countries. As well, the commitment is for a specific value of goods, not specific quantities. If American exports are priced above market, then Beijing would have to order SOEs to buy US farm products and subsidize the imports based on prices paid and market price. In that case, would that open them up to accusations of unfair subsidies?

The devil is in the details. We do not have a deal until it is papered and signed. In the meantime, I would monitor the offshore yuan, which rallied on the news of the deal, but retraced most of its gains after many of the details became apparent.
 

 

Valuation headwinds

Another problem that the bears raise is the elevated valuation of US equities. FactSet reported that the market is trading at a forward P/E of 17.8, compared to its 5-year average of 16.6 and 10-year average of 14.9. At a 17.8 time forward earnings, the market is nearing nosebleed levels last seen at the peak of the late 2017 market melt-up.
 

 

To be sure, forward 12-month EPS is rising again, albeit slowly. The key to the justification of higher prices is a substantial improvement in earnings estimates, based on the combination of a cyclical revival, improved business confidence leading to more business investment from falling trade tensions, and an improved European outlook based on the removal of a disorderly no-deal Brexit.
 

 

Those are all tall orders. Stay tuned.
 

Resolving the bull and bear cases

Here is how I resolve the bull and bear cases from a trader’s perspective. There are two news headlines that the market reacted to, the trade deal, and the UK election that took the risk of a disorderly no-deal Brexit off the table.

Unquestionably, there are many unanswered questions around the trade deal. The most immediate effect is to eliminate the threat of escalation of the imposition of December 15 tariffs. At a minimum, that is good news which eliminated an immediate tail-risk. Undoubtedly, we will see more ups and downs as the details of the agreement are ironed out, but those are problems for early 2020.

Boris Johnson’s victory in the UK election is an unequivocal piece of good news for the markets.

In the short run, these circumstances are setting up for a Santa Claus rally into year-end and possibly into early 2020. Hedge funds and institutions were caught short, and they have been engaged in a beta chase into year-end. In addition, liquidity is expected to dry up starting next week, so any buying pressure will affect prices in a more dramatic fashion.

My inner investor is bullish positioned. He is tilted towards European equities where valuations are cheaper, and benefiting from the tailwind of a positive catalyst. My inner trader is long the market. He had been waiting for a pullback to test the early December lows, but that is an unlikely outcome at this point.

Disclosure: Long SPXL
 

Here comes the beta chase

Posted by Cam Hui -

Mid-week market update: Notwithstanding any issues traders may have with short-term volatility, the market is setting up for a year-end beta chase Santa Claus rally. After a prolong period of defensive posturing, equity fund flows are turning strongly positive again.
 

 

As the TD-Ameritrade IMX shows, retail positioning is still underweight, and the scope for more buying into year-end and 2020 is still significant.
 

 

Macro Charts also pointed out that hedge funds are now in a FOMO stampede into year-end. CTAs are ramping up their equity betas.
 

 

Global macro hedge funds are also buying.
 

 

While Macro Charts believes that the buying is unsustainable, the historical evidence is mixed as we have seen both the market flatten out and decline after such episodes, and continued rising prices after such signals. Trading volume is expected to dry up later in December, but if the buying were to continue, a melt-up is well within the realm of possibility as we approach year-end.
 

The bull and bear cases

Nevertheless, short-term technical structure suggests the market has unfinished business to the downside, at least over the next few days. First, short-term momentum has retreated from an overbought reading to neutral as of Tuesday’s close, but it has not fallen sufficiently into the oversold zone to warrant a sustainable rally. In light of today’s advance, readings are likely to have returned back into near overbought territory.
 

 

I wrote about how a VIX spike above its upper Bollinger Band is an indication of an oversold market that is ripe for a relief rally. In all likelihood, we are likely to see a re-test of last week’s lows over the next few days, but the re-test is not always successful. As the chart below shows, while the last two re-tests triggered by a VIX upper BB spike were successful, the May re-test was not, and led to a lower low. We have to allow for such a possibility.
 

 

How will the likely re-test be resolved? I don’t know, but it’s like the definition of pornography: I’ll know it when I see it.

There is a variety of opinion of the short and intermediate term outlook. Macro Charts has been highly cautious because his indicators are still bearish.
 

 

 

By contrast, SentimenTrader is short-term cautious, but intermediate term bullish.

The SKEW Index, which looks at the risk of a black swan event in equities over the next 30 days, jumped to the highest level since in more than a year.

When this happened in the past, $SPX may have struggled over the next 2 months, but rallied 92% [of the time] over the next year

That said, elevated SKEW, or the price of tail-risk protection is an indication of rising fear of extreme events, such as the uncertainty related to the December 15 tariffs, and the outcome of the UK election. These fears could be interpreted as contrarian bullish.

I believe that uncertainty over the on-again-off-again December 15 tariffs will be resolved in a benign manner. Here is how Bloomberg explained the issue:

The latest word on U.S.-China trade talks suggest the Dec. 15 tariff round won’t go into effect. Looking beyond the chatter, there’s a good reason to expect a delay: For the U.S., the December tariff round would have more costs than benefits. Using granular trade data, Bloomberg Economics calculated what share of U.S. imports from different tariff tranches come from China. For the first tranche a mere 7% of the total came from China, allowing imports to be sourced from elsewhere and the disruption to the U.S. economy to be contained. For the final tranche, the share of Chinese goods is a whopping 86% and fallout would be elevated. 

 

 

Imposing the next tranche of tariffs would really hurt the US economy. Therefore the most likely outcome is to announce a delay while talks continue.

My base case scenario calls for a rally into year-end after a brief pullback or consolidation lasting no more than a week. This is based on the combination of players with excessively defensive positions who are likely to chase beta into year-end during a period of diminishing liquidity. This represents the ideal combination for a price blow-off into the first week of January. After that, I will have to re-evaluate market conditions.

Both my inner investor and trader are bullishly positioned.

Disclosure: Long SPXL

 

The market is oversold? Already?

Posted by Cam Hui -

I was not at my desk and out at some meetings on Monday. When I returned near the end of the day, I nearly fell off my chair when I saw the VIX Index had spiked above its upper Bollinger Band again, indicating an oversold market.
 

 

Is the market oversold? Again? So soon?
 

Looking for confirmation

Short-term momentum does not appear to be oversold. In fact, they show a market that was overbought and recycling downwards, which is a short-term sell signal.
 

 

What’s going on?

The answer can be found in the VIX Index, which is designed to measure anticipated one-month volatility, and its term structure. In the past, spikes of the VIX above its upper BB have been accompanied by inversions of the term structure. The middle panel shows the short-term term structure. The ratio of 9-day VIX (VXST) to 1-month VIX (VIX) ratio (middle panel) has indeed spike to above 1, indicating rising fear. Other upper BB spikes also saw inversions or near inversions of the 1-month to 3-month VIX (VXV) ratio (bottom panel). The latest episode is somewhat different from the past. While VXST/VIX has inverted, VIX/VXV is still relatively tame.
 

 

In effect, the VXST ratio iscounting rising short-term volatility, while longer term (VIX and VXV) remain subdued. To put this into English, market uncertainty is rising because of the following events this week:

  • FOMC meeting (Wednesday)
  • ECB meeting (Thursday)
  • Trump`s decision on the December 15 tariffs (technically this weekend, but likely an announcement will occur late in the week)

Viewed in this context, the VIX spike above its upper BB is not an actionable trading signal. However, my inner trader is still long the market for other reasons.
 

A lesson for investors

The lesson for traders and investors is to avoid relying on any single indicator, and to look for confirmation before taking action.

Consider the recent example of the inverted yield curve. Remember how the 2s10s inverted, and all the Recessionistas ran around proclaiming a recession was around the corner?

At the time, I was somewhat dubious about the inverted yield curve as a recession indicator because the entire yield curve had not inverted. In fact, the longer end of the curve, as measured by the 10s30s was steepening. The vertical lines in the chart below shows the instances since 1990 when both the 2s10s and 10s30s had inverted. Equity bear markets followed short afterwards. However, the latest episode is very different from the past 2s10s inversions in two important ways:

  • The 3-month T-Bill rate were rising when the 2s10s and 10s30s inverted, indicating that the Fed was tightening. This time, 3-month T-Bill yields were falling, indicating Fed easing.
  • The 10s30s had not inverted, indicating the market did not entirely believe economic growth was tanking.

 

 

Lessons learned?

 

How far can Tariff Man dent the stock market?

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. As well, please join and “like” our Facebook page here.
 

Tariff Man returns

The markets took on a decided risk-off tone early last Monday when President Trump, aka the Tariff Man, made an early morning tweet to announce steel and aluminum tariffs on Brazil and Argentina.
 

The markets took further fright based on Trump’s comment that he had no timetable for a trade deal with China, and he was willing to wait until after the 2020 election to conclude an agreement. More importantly, Edward Lawrence of Fox Business reported that there are no current plans to delay the next round of tariffs scheduled for December 15, which is an unanticipated development as the market consensus was they would be delayed.
 

If the December 15 tariffs are enacted, what is the expected damage? How will that affect my thesis of a cyclical rebound (see An upcoming seismic shift in factor returns)?

I conclude that the reflation thesis is still intact. Both Fed policy and European fiscal policy stand poised to offset the negative effects of Tariff Man’s threats. In addition, the Fed’s study concluded that most of the negative effects on business confidence has already been felt, and stock prices have risen during that period despite Trump’s trade war.
 

Assessing the damage

What’s the damage from the trade war? Analysis from David Dollar of the Brookings Institute finds that the direct effects of the tariffs may be less than meets the eye. To be sure, the Sino-American trade war has depressed Chinese imports into the US. But instead of achieving his objective of bringing manufacturing jobs back to America, Trump’s trade has become a game of whack-a-mole as imports from other countries have risen to compensate. Another way of thinking about the issue is the capital account, which is the mirror image of the current account, which is composed of trade of goods and services. Tariffs on goods shifts the pattern of trade, but they have relatively little effect on the capital account.
 

The indirect effects of the trade war has been on business confidence, which slowed business investment. A recent Fed study tried to assess the likely damage to business confidence from the tariffs. It concluded that the current tariff regime had decreased GDP growth by 0.7-0.8%. The implementation of the scheduled December 15 tariffs would take an additional 0.3% off GDP by mid 2020. In other words, most of the negative effects of the trade war has already been felt. Remember, the current regime of tariffs on about $350 billion on Chinese goods in a trade war would have been between a medium risk and worst case analysis in 2017.
 

What does that mean for stock prices? The empirical evidence says, “Not much.” SPY has risen about 22% on an unannualized basis during that period. The bottom panel of the chart shows the relative returns of SPY relative to long Treasuries (TLT), and stocks are still ahead of bond by 6.5%. A strong SPY to TLT ratio gives room for Trump’s Tariff Man persona to be dominant, as he will believe the market and economy are strong enough for him to flex his economic muscles. By contrast, a weak SPY to TLT ratio will cause the Dow Man persona to emerge, as Trump has shown himself to view the stock market to be a barometer of his Presidency.
 

From a fundamental viewpoint, we can get some hints on how the Street’s estimates of forward 12-month earnings evolved during the same period. We begin our analysis in early 2018, after analysts had factored the one-time effects of Trump’s corporate tax cuts. From the time EPS estimates began to stabilize in early 2018 to November 2018, which is when the market was beset by the twin worries of the negative effects of the trade war and a hawkish Fed, forward EPS rose 11.9%. From November 2018 to today, forward EPS estimates are flat, rising only 0.8%, despite the Fed’s dovish about face. We therefore attribute most of the lack of forward earnings growth to waning business confidence from the trade war.
 

Based on that experience, we can see the imposition of the current tariff regime, which the Fed estimates to have slightly more than double the effect on business confidence as the December 15 tariffs, resulted in flat to slightly positive forward EPS growth. We can make a guesstimate that the December 15 tariffs, which would impose at 25% tariff rate on the remainder of Chinese imports, to result in flat to slightly positive forward earnings growth of no more than 2%.
 

The Powell Put

If the December 15 tariffs were to be implemented, what other policy actions could act to mitigate of offset the negative effects of the tariffs? I can offer two possibilities. The first is a dovish Fed.

The Powell Fed has taken a decided dovish pivot in the past few months. During his October 31 press conference, Powell emphasized the symmetric nature of the 2% inflation target [emphasis added].

We’re also, as part of our review, looking at potential innovations, changes to the way we think about things, changes to the framework that would lead us—that would be more supportive of achieving inflation on a 2 percent—on a symmetric 2 percent basis over time. That’s at the very heart of what we’re doing in the review. It’s too early to be announcing decisions. We haven’t made them yet. But we’re in the middle of thinking about ways that we can make that symmetric 2 percent inflation objective more credible by achieving symmetric 2 percent inflation. And it comes down to using your policy tools to achieve 2 percent inflation, and that is the—that is the thing that must happen for credibility in this area. So we’re committed to doing that.

After years of undershooting the target, the Fed is becoming more tolerant of a hotter inflation regime above 2%. The 2% target is not a ceiling, but an average inflation target.

Fed governor Lael Brainard added more color to the shift in thinking in a recent speech. First, she admitted that the December 2015 liftoff in rates was a policy mistake (ZLB = zero lower bound):

Forward guidance on the policy rate will also be important in providing accommodation at the ELB. As we saw in the United States at the end of 2015 and again toward the second half of 2016, there tends to be strong pressure to “normalize” or lift off from the ELB preemptively based on historical relationships between inflation and employment. A better alternative would have been to delay liftoff until we had achieved our targets. Indeed, recent research suggests that forward guidance that commits to delay the liftoff from the ELB until full employment and 2 percent inflation have been achieved on a sustained basis—say over the course of a year—could improve performance on our dual-mandate goals.

She went on to state that she would be willing to target a higher inflation rate for a set period of time if inflation had been undershooting for a similar period.

I prefer a more flexible approach that would anchor inflation expectations at 2 percent by achieving inflation outcomes that average 2 percent over time or over the cycle. For instance, following five years when the public has observed inflation outcomes in the range of 1-1/2 to 2 percent, to avoid a decline in expectations, the Committee would target inflation outcomes in a range of, say, 2 to 2-1/2 percent for the subsequent five years to achieve inflation outcomes of 2 percent on average overall. 

Today, the Fed has signaled that it is done cutting rates, and the hurdle for raising rates is quite high. How would it react if economic growth began to soften because of falling business confidence from rising tariffs? Already, the Fed’s balance sheet has been rising.
 

At a minimum, expect a Powell Put to mitigate some of the damage from rising tariffs.
 

Fiscal policy to the rescue

I have written that I expect that the cyclical rebound to be global in scope. One of the evolving tailwinds for global growth is fiscal policy. Reuters reported that Japan has launched a 13.2 trillion yen fiscal stimulus package to offset a possible post 2020 Olympics slump. However, the more promising policy development is European fiscal policy.

Joe Wisenthal at Bloomberg recently commented on the possibility of UK fiscal expansion.

These days everyone (including me) is talking about the eventual hand-off from monetary to fiscal policy, as rates go lower and lower with seemingly little growth to show for it. But when and where it will actually happen is still to be determined. The thing with fiscal stimulus is that it’s not enough to say it’s justified, necessary or doable, a country also needs the political capacity to make it happen. So, for example, in a politically divided country (such as the U.S.) opposition parties are usually going to oppose it. It seems there’s a growing view that the U.K. may be the first out of the gate. In an interview this morning on Bloomberg TV, Saxo Bank CIO Steen Jakobsen said that he expects a Boris Johnson government to unleash the biggest fiscal expansion since the 1970s and enough growth to heal deep divisions in the U.K. Meanwhile just yesterday Steve Englander of Standard Chartered wrote that Britain is the most likely G10 country to turn to fiscal stimulus to cushion the economic impact of Brexit. In other words, between the mediocre economy, and a possible (though anything can happen) Conservative majority, the conditions just might be in place to crank up the spending. While the ongoing U.K. political drama is probably annoying to some, it will at least produce numerous interesting real-life economic experiments for people to analyze for years to come. So at least there’s that.

Across the English Channel and the North Sea, attitudes towards fiscal stimulus are shifting, especially among the Germans. The recent election of Norbert Walter-Borjans and Saskia Esken to the leadership of the SPD, which constitutes junior coalition partner to Angela Merkel’s CDU, has shifted the political winds. The CDU has traditionally been highly fiscally conservative, but Reuters reported that the new wish-list of the new SPD leadership calls for more spending:

INVESTMENT: Massive investment in schools, infrastructure and digitalization. Various figures have been mentioned, including 240 billion euros ($264.53 billion) for schools, roads, railways, and 100 billion euros for digitalization. DEBT: To pay for the investment, they want to drop Germany’s strict fiscal rules on borrowing and commitment to a balanced budget, saying this has become a fetish. Although the 2020 budget has been passed, they argue for a supplementary budget. This would break a taboo for many conservatives. Even SPD Finance Minister Olaf Scholz, who lost the leadership contest, has so far stuck to fiscal rigour. CLIMATE PROTECTION: More radical climate protection measures, including raising the price of CO2 emissions to 40 euros a tonne from 10 euros a tonne from 2021. That suggestion is in line with what many climate economists had advocated. There may be some leeway on climate measures, also on the expansion of renewable energy, not least because a 50 billion euros package of measures agreed in September has got stuck in parliament and will have to be tweaked. MINIMUM WAGE: To immediately increase the minimum wage to about 12 euros from just over 9 euros now.

No doubt, there will be the usual back and forth negotiations. There is always a possibility that the coalition falls apart and new elections are called. Should Germans go to the polls in the near future, the country will have to deal with two emergent parties, the right wing and anti-immigrant AfD, and the Greens, who are become a rising force throughout Europe. As a recent poll shows, the Greens are in second place in political popularity in Germany, eclipsing the support of the SPD.
 

That’s because climate change is regarded as an emergency in Europe, while its effects are still being debated in the US. Bloomberg reported that the EU is pivoting towards an EU Green New Deal.

The European Union is gearing up for the world’s most ambitious push against climate change with a radical overhaul of its economy. At a summit in Brussels next week, EU leaders will commit to cutting net greenhouse-gas emissions to zero by 2050, according to a draft of their joint statement for the Dec. 12-13 meeting. To meet this target, the EU will promise more green investment and adjust all of its policy making accordingly. “If our common goal is to be a climate-neutral continent in 2050, we have to act now,” Ursula von der Leyen, president of the European Commission, told a United Nations climate conference on Monday. “It’s a generational transition we have to go through.”

Translation: The Overton window on European fiscal spending is shifting, and it is colored green.
 

Investment implication

In conclusion, an escalation in the trade war is always possible, but there are offsetting bullish factors to that development. Moreover, American and Chinese negotiators are still talking and it appears that some progress is being made. The latest constructive development was the Chinese decision to waive tariffs on selected US soybean and pork imports as a goodwill gesture.

In the meantime, global growth expectations are still rising. The 2s10s yield curve is steepening after a brief period of volatility. The blowout November Employment Report Friday was further evidence of a strengthening economy.
 

The reflation thesis is still intact. Both Fed policy and European fiscal policy stand poised to offset the negative effects of Tariff Man’s threats. In addition, the Fed’s study concluded that most of the negative effects on business confidence have already been felt, and stock prices have risen during that period despite Trump’s trade war.
 

The week ahead

I have made the case in the past few weeks that the market advance was due for a pause, but any pullback was expected to be shallow. The pullback arrived early last week, and this episode of price weakness was indeed shallow. Stock prices began to rebound by mid-week, and the S&P 500 was nearing all-time high resistance by Friday. However, the relief rally left much to be desired, as the bounce left two unfilled gaps below, while exhibiting negative RSI divergences.
 

The market may be following the template for the relief rallies triggered by the oversold conditions signaled by the VIX Index closing above its upper Bollinger Band. The market bounced, but came back down to test the previous lows within 3-9 days, with the caveat that the test is not always successful. Watch for signs of positive RSI divergences should a re-test occur.

An analysis of the Value Line Geometric Index (XVG), and % above 50 dma shows that the market is probably not quite ready to push to all-time highs in this latest rally. XVG is testing a key resistance level, even though it has not risen to test its all-time highs. In addition, % above 50 dma is not exhibiting sufficient momentum to break through to new highs even as the S&P 500 nears its all-time high.
 

A review of the relative strength of the top 5 sectors that comprise just under 70% of index weight shows a constructive intermediate-term market outlook. Two sectors are in relative uptrends, one is in a relative downtrend, and two are neutral. The market cannot mount a sustainable rally without the broad participation of a majority of these sectors, and this analysis shows a neutral to slightly bullish outlook.
 

However, the analysis of sector breadth shows that three out of the five sectors are exhibiting falling net new highs, indicating the market needs to consolidate before launching a sustainable assault on the all-time highs.
 

In the short run, momentum indicators are overbought, indicating a pause or pullback is likely early next week.
 

Current market conditions are consistent with a rally later in the month. Ryan Detrick pointed out that the market typically does not begin a Santa Claus rally until mid-December.
 

The market is still climbing the intermediate-term proverbial Wall of Worry. Callum Thomas found that North American institutions are still underweight beta.
 

Thomas also observed that retail investors are also skeptical about the equity market rally.
 

Simply put, the intermediate and long term technical and fundamentals are bullish. I have written extensively about the surefire monthly MACD buy signal, which still stands. With both institutional and retail investors under-invested, there are just too many dip buyers, which suggests that any pullback should be shallow.
 

Santa Claus is coming to town. Get ready for the beta chase to begin about mid-December after a brief pause in the advance.

My inner investor is bullishly positioned and overweight equities. My inner trader is long the market, but he believes that it may be prudent to take partial profits early next week if prices don’t drop immediately. He is prepared to add to his long positions should the market re-test its lows while exhibiting positive RSI divergences.

Disclosure: Long S&P 500L

Assessing the technical damage

Posted by Cam Hui -

Mid-week market update: The stock market weakened on Monday when Trump’s early morning tweet indicated that he was slapping on steel and aluminum tariffs on Argentina and Brazil. The sell-off continued into Tuesday when Trump said in a news conference that he was in no hurry to do a trade deal with China, and he was willing to wait until after the 2020 election.
 

 

The market was already vulnerable to a tumble two weeks ago when it violated a rising trend line. This was followed by a rally to kiss the daily upper Bollinger Band, but it could not rally above the breached trend line.

The SPX gapped down on Tuesday, but formed what appeared to be a reversal candle, which was accompanied by a mild oversold reading on the 5-day RSI. The reversal was confirmed when this morning when equity future began to bounce back in sympathy with European stocks. The rally was further boosted by a Bloomberg report that “the U.S. and China are moving closer to agreeing on the amount of tariffs that would be rolled back in a phase-one trade deal despite tensions over Hong Kong and Xinjiang”.

How serious was the sell-off? What’s the technical damage?
 

Market internals

Let’s begin with the relative performance of the top five sectors of the market. These sectors comprise just under 70% of index weight, and the market cannot move meaningfully without major participation from a majority of these sectors. As the chart shows, the high flying technology sector’s leadership has stalled; consumer discretionary stocks have flattened after a period of underperformance; and two of the five sectors, healthcare and financial stocks, are in relative uptrends. That makes the bull trend a little wobbly, but it does not appear to be the sign of a major bear move.
 

 

The analysis of market leadership by market cap grouping tells a different story. Megacap and NASDAQ 100 leadership seems to be stalling, but mid and small cap underperformance is ending. Both mid and small cap stocks are forming  saucer bottoms after breakout out of relative downtrends. Are major bear moves usually characterized by emerging mid and small cap leadership?
 

 

The credit markets are telling a story of stabilization. The relative performance of high yield (junk) bonds to duration-equivalent Treasuries had exhibited a mild bearish divergence, but that gap had largely been filled with the sell-off.
 

 

An bottoming process

Short-term momentum indicators had reached sufficiently oversold conditions for the market to bounce today. This chart depicts the % above their 5-day moving averages as of last night’s close.
 

 

The VIX Index spiked above its upper Bollinger Band on Monday, indicating a market oversold condition, and the signal was further confirmed with the market weakness on Tuesday. If history is any guide, expect a short-term bounce lasting 3-5 days, followed by a pullback to test the old lows, which is not always successful.
 

 

In other words, choppiness ahead. However, seasonality analysis still favors a Santa Claus rally later in the month. Jeff Hirsch at Almanac Trader found that the odds still favor a gain for the rest of December despite a rough start.

My inner investor remains bullishly positioned. Subscribers received an email alert on Monday that my inner trader had initiated a long position in the market. The trading model is now bullish.

Disclosure: Long SPXL

 

The Achilles Heel of my bull case

Posted by Cam Hui -

In response to my last post (see Buy signal confirmed: It’s a global bull), I received an email yesterday from a long-time reader who observed that I was channeling the perennially bullish Chris Ciovacco. While my post yesterday highlighted the monthly MACD buy signal on global stocks, Ciovacco’s latest weekly video referenced the monthly MACD buy signal on the DJIA.

That said, no one could accuse me of being a permabull or permabear. My track record of major market speaks for itself. Most notably, I was correctly cautious in August 2018 ahead of the major top, and turned bullish just after the bottom in January 2019. While I was overly cautious during the summer and I expected a deeper valuation reset, I did turn bullish again after the market’s upside breakout in late October.
 

 

If history is any guide, past monthly MACD buy signals have seen prices higher 6 and 12 months later 100% of the time. However, there is one Achilles Heel of the bull case, and it’s China.
 

 

Wobbly China?

Bloomberg recently published an article entitled “China Financial Warning Signs Are Flashing Almost Everywhere”:

From rural bank runs to surging consumer indebtedness and an unprecedented bond restructuring, mounting signs of financial stress in China are putting the nation’s policy makers to the test.

Xi Jinping’s government faces an increasingly difficult balancing act as it tries to support the world’s second-largest economy without encouraging moral hazard and reckless spending. While authorities have so far been reluctant to rescue troubled borrowers and ramp up stimulus, the costs of maintaining that stance are rising as defaults increase and China’s slowdown deepens.

Policy makers are attempting to do the “minimum necessary to keep the economy on the rails,” Andrew Tilton, chief Asia-Pacific economist at Goldman Sachs Group Inc., said in a Bloomberg TV interview.

Among China’s most vexing challenges is the deteriorating health of smaller lenders and regional state-owned companies, whose financial linkages risk triggering a downward spiral without support from Beijing. A landmark debt recast proposed this week by Tewoo Group, a state-owned commodities trader, has raised concerns about more financial turbulence in its home city of Tianjin.

In addition, Caixin reported that the number of cities where with falling home prices on the secondary market are spiking.
 

 

Chinese official media Global Times also reported that sticking points remain before China and the US can conclude a Phase One trade deal. At a minimum, don’t expect a deal before December 31.
 

 

Is a global cyclical recovery possible if China is slowing?
 

Resilient China

Despite these ominous signs, the Chinese economy is exhibiting remarkable signs of resilience.  It appears that the slowdown is part of a deliberate strategy to decelerate growth in order to achieve a soft landing. The People’s Daily recently reported on Chinese premier’s Li Keqiang’s speech on the latest Five-Year Plan, which contained numerous references to “stability” that China watcher Michael Pettis interpreted as code for controlling debt:

Chinese Premier Li Keqiang stressed quality in making the 14th Five-Year Plan (2021-2025) on Monday while chairing a meeting on the new plan.

China has deepened reform in all areas and promoted wider opening up since the implementation of the 13th Five-Year Plan and fulfilled the goals listed in the plan on schedule, he said.

Following the principle of pursuing progress while ensuring stability, all regions and departments have deepened the all-round reform, taken the initiative to further open up, responded to risks and challenges from home and abroad, and maintained medium-high economic growth within a reasonable range, he said.

While the external environment is likely to be more complex with uncertainties and challenges, China is in a critical period to change its growth model, improve its economic structure, and foster new drivers of growth, he said.

So far, real-time market based indicators are indicating few signs of anxiety over the Chinese economy. The relative performance of the highly leveraged property developers to the Chinese market, as well as the relative performance of Chinese financial stocks, show that relative bottoms forming.
 

 

The charts of the Shanghai Composite, as well as the stock markets of China’s major Asian trading partners, are also showing few signs of panic. Even the Hong Kong market, which has been beset by protests and signs of economic recession, remains in an uptrend.
 

 

As well, both the official PMI, which is heavily weighted in SOEs, and the Caixin PMI, which is tilted towards smaller private companies, printed positive surprises (PMI manufacturing in white, non-manufacturing in blue, and Caixin in yellow).
 

 

Add to the mix the positive surprise in eurozone PMI, US PMI, but a miss in ISM Manufacturing, the weight of the evidence is pointing to a global cyclical rebound. (4 out of 5 ain’t bad). Overall, global manufacturing PMI rose back above 50, or expansion territory, since April.
 

 

In conclusion, while China is a concern for my bull case for global equities, there are few signs that cause immediate concern. In that case, I am inclined to give the bull case the benefit of the doubt.
 

Turning tactically bullish

On an unrelated note, subscribers received an alert today that my inner trader was conditionally turning bullish from bearish. The VIX had spiked above its upper Bollinger Band, and if it stayed there by the closing bell, it would indicate an oversold condition and a buy signal. The VIX did indeed close above its upper BB, and the trading model has turned bullish. My trading account has covered its short and established an initial long position.
 

 

The market had been in the green overnight, until Tariff Man tweeted his decision to impose steel and aluminum tariffs on Brazil and Argentina. Equity index futures began to weaken, and eventually opened in the red.
 

 

I am on records as stating that I expect any pullback to be shallow, and I interpret this as a gift from the market gods to reverse from short to long. Expect some choppiness for the rest of the week, but today`s low will likely prove to be a level of support should prices weaken again in the near future.

Disclosure: Long SPXL

 

Buy signal confirmed: It’s a global bull

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.
 

Long-term buy signal confirmed

A month ago, I highlighted a long-term technical buy MACD signal on the monthly Wilshire 5000 chart. The buy signal was not evident in global or non-US equities. As the month of November drew to a close, I can confirm that the rest of the world has caught up, and similar MACD buy signals can be found in other markets. History shows that these displays of long-term price momentum have resolved themselves in strong multi-year gains, and the index has seen gains 6 and 12 months later 100% of the time.
 

 

This week, we review sector leadership, and where the best upside potential can be found in the markets.

I conclude that the signs of a global cyclical recovery are firmly in place. Both U.S. and non-U.S. equity indices have flashed long-term buy signals that have proven to be remarkably effective in the past.  I would favor exposure to mid-cycle sectors, such as industrials, financials, semiconductors (within technology), small-cap consumer discretionary and healthcare. Avoid late cycle sectors like energy and materials, avoid defensive sectors like consumer staples and utilities.

Buy beta! Risk on!
 

Globally bullish

The history of MACD buy signals have been uncannily bullish. The monthly MACD buy signals in the post-NASDAQ Bubble period has seen the Wilshire 5000 undergo bull markets that have lasted a minimum of two years. All of which have seen substantial gains.
 

 

The buy signal can also been seen in the MSCI World xUS Index.
 

 

Risk on!
 

Sector review: What to buy?

A review of sector exposure shows that cyclical sectors continue to be the market leaders. Semiconductors, which have been our favorite, have been on a tear relative to the MSCI All-Country World Index (ACWI). Global industrial stocks have also broken out from a relative downtrend compared to ACWI. Auto stocks, while not as strong as the other groups, have also staged a similar upside relative breakout, These are unequivocal signals of the start of a global cyclical recovery.
 

 

A US sector review comes to a similar conclusion. The framework for our sector review will analyze the relative return of the large and small cap sector to their respective large and small benchmarks, as well as the small and large cap sectors against each other. This form of analysis can reveal hidden sources of strength and weakness by disentangling sector effects from the effects of individual stock heavyweights in the sector.

Consider industrial stocks. The top panel shows that while large cap industrial stocks have only begun to strengthen against their large cap benchmark, small cap industrials have been the leaders against the Russell 2000 for most of this year. The green line in the bottom panel shows that small cap and large cap industrial stocks have roughly matched pace with each other for 2019. Small cap industrial outperformance was therefore an early sign that this sector had exhibited hidden market leadership.
 

 

The analysis of the technology sector tells a different story. While both large and small cap technology stocks are leading their respective benchmarks, small cap technology had slightly underperformed their large cap counterparts for 2019, which reflect the strength of the FAANG names. However, semiconductors have been the real market leaders within the sector. The bottom panel shows that while the NASDAQ 100 have been flat against the S&P 500, indicating a FAANG leadership stall, semiconductors have continued to rise against the technology sector for the past few months.
 

 

Should the global economy undergo a cyclical revival as I expect, it will push up bond yields. As technology stocks are mainly growth stocks with low earnings and high P/E multiples, they will act like a long duration bond with higher than average interest rate sensitivity as rates rise. Rising bond yields will therefore present a headwind for the technology sector. Better to have exposure to the more cyclical part of this sector, namely semiconductors.

Large and small cap financial stocks have shown themselves to perform very differently from each other. While the relative performance of large cap financial stocks have been highly correlated to the shape of the 2s10s yield curve (red line), the relative performance of the small cap financial sector has been more positive, but volatile. As I expect the yield curve to continue steepening in response to better growth expectations, I would overweight this sector, but with a balanced commitment to both large and small cap names. Large cap exposure should benefit from the macro effects of a steepening yield curve, while small cap exposure should see better relative, but idiosyncratic and volatile gains, from small cap exposure.
 

 

The consumer discretionary sector also presents a bifurcated picture. Large cap consumer discretionary performance has been weighed down by the poor returns of heavyweight AMZN (red line). However, the small caps in this sector are showing signs of better relative returns. Overweight this sector, but concentrate in the small caps.
 

 

Healthcare stocks show a similar level of bifurcation as the consumer discretionary sector. Small caps are strong. Overweight the sector, and small caps in particular.
 

 

There is not much that can be said about the late cyclical resource extraction sectors. Energy stocks are not showing any signs of revival, in either large or small caps. Avoid.
 

 

The same could be said of the materials sector. Avoid.
 

 

I would also underweight the consumer staples sector for a different reason. It is a defensive sector, and defensive stocks tend to lag in a cyclical rebound.
 

 

Similar comments apply to the utilities stocks. In particular, small cap utilities have been tanking relative to the Russell 2000, and small cap utilities are underperforming large cap utilities.
 

 

The real estate sector presents some opportunities for investors seeking yield. While both large and small cap REITs are performing roughly equally compared to their large and small cap benchmarks, small cap REITs are starting to turn up against large cap REITs. As well, the real estate sector should perform reasonably well in an environment when economic growth is strengthening. In addition, the household sector of the economy has been on fire, which should also give support to this sector.
 

 

For completeness, I present the relative performance of the communications services stocks, which do not have a small cap ETF. The relative performance of the cap weighted sector has been flat. The relative performance of the equal-weighted stocks in this sector relative to the equal-weighted benchmark, which is a partial proxy for small cap performance, has lagged. This is not an exciting sector. Avoid.
 

 

The cyclical rebound explained

I conducted a series of client meetings last week, and some questions arose about the fundamental underpinnings of the cyclical rebound.

The reason may be relatively simple. The global economy has become “less bad”. Jeroen Blokland pointed out that recession odds, based on Bloomberg’s economists poll, have begun to recede. This is a sign of a shift in macro and fundamental sentiment that is underpinning the broad based strength in global equity markets.
 

 

My own economic forecast has paralleled the Bloomberg survey, but with a 9-12 month lead. In October 2007, I wrote about a recession scare (see A recession in 2020?) as my suite of long leading indicators were nearing a recession signal (see the Recession Watch page for the latest readings).

Where does that leave our recession model? Conditions are neutral to slightly negative, and deteriorating. These readings are not enough to make a recession call yet, but if the pace of deterioration continues at the current rate, the models will flash a recession warning by the end of the year, which translates into the start of a recession in late 2019 or early 2020.

I concluded that the market was becoming concerned about a recession:

In conclusion, the odds of a recession are rising. The lights on my recession indicator panel are not red, but they are flickering. In addition, recession risks are rising because of the looming trade war. Technical conditions are also reflective of these risks. Investors should therefore adopt a cautious view of equities.

After the publication of that report, the stock market tanked, only to bottom about three months later on Christmas Eve, reflecting rising recession fears.

The real economy responded to that forecast as well. As the long leading indicators were designed to spot a recession about a year in advance, the market began to become extremely concerned when the 2s10s yield curve inverted, about 11 months after the publication of that report. However, conditions did not deteriorate further to warrant a recession call, and the long leading indicators have strengthened considerably and now point to little or no recession risk in late 2021.

In short, the evolution of the long leading indicators over the past year fully explains market views of economic expectations. Anxiety rose in the late summer and early fall of 2019 in accordance with the deterioration of long leading indicator conditions 12 months ago. They have since started to improve.

In conclusion, the signs of a global cyclical recovery are firmly in place. Both US and non-US equity indices have flashed long-term buy signals that have proven to be remarkably effective in the past. I would favor exposure to mid-cycle sectors, such as industrials, financials, semiconductors (within technology), small cap consumer discretionary, and healthcare. Avoid late cycle sectors like energy and materials; avoid defensive sectors like consumer staples and utilities.

Buy beta! Risk on!
 

The week ahead: Good or Bad Santa?

There was a story in the local newspaper about a mall Santa Claus getting fired for overly “naughty” pictures (link here). The question for equity investors is whether we are likely to see Good Santa, or Bad Santa this December.
 

 

I would argue that Bad Santa is likely to appear first to scare everyone, followed by Good Santa to dispense presents for all the good Wall Street boys and girls. The VIX Index fell below its lower Bollinger Band last week, which is an indication of an overbought market. Depending on how strongly the bears can seize control of the tape, initial support can be found at the rising trend line at 3135, with secondary support at the Fibonacci retracement at 3040, and strong support at the breakout of 3025-3030.
 

 

The VIX falling below the lower BB was a warning. A recycle of the VIX above the lower BB was a more effective sell signal. As my historical study of this indicator shows, the VIX falling below its lower BB resolved with weak returns, and the recycle signal had even weaker returns out to about five days after the signal.
 

 

As well, Rob Hanna at Quantifiable Edges observed that when the SPX closed at a new high on the day before Thanksgiving, the history of short-term returns have tended to be weak (with the caveat that the sample size of this study is relatively small N=7).
 

 

From a macro perspective, the bulls can forget about the prospect of any good news about a “Phase One” trade deal. President Trump signed the Hong Kong Human Rights and Democracy Act last week in support of the Hong Kong protesters. This will put a wedge between American and Chinese trade negotiators. China has made it clear it is very touchy when it comes to Hong Kong – just ask the NBA. In response to Trump’s signing the Act into law, Beijing has threatened unspecified retaliation.
 

We have some early hints from Global Times editor Hu Xijin. China intends to target key individuals with sanctions.
 

 

A Bloomberg article speculated that Beijing could take targeted political actions to retaliate:

It could hit out at U.S. companies by releasing a long-threatened “unreliable entities” list, stop buying American products, unload Treasuries or curb exports to the U.S. of rare earths, which are critical to everything from smart-phones to electronic vehicles.

On the diplomatic side, China could take measures such as halting cooperation on enforcing sanctions related to North Korea and Iran, recalling the Chinese ambassador to the U.S. or downgrading diplomatic relations. Based on the government’s responses on Thursday, none of those appeared imminent.

So far, our trade war factor, which measures the relative performance of domestically exposed Russell 1000 stocks to the overall Russell 1000, is relatively calm (black line). However, soybean prices have weakened. I am also monitoring the relative performance of Las Vegas Sands (LVS), which is Republican donor Sheldon Adelson’s vehicle that operates casinos in Macau (red line). If Beijing wanted to take a rifle shot approach to retaliation, then sanctions against Adelson could send a message to Trump and the Republicans.
 

 

The next shoe in the trade war may not have dropped just yet. As the Chinese have become more aware of Dow Man’s obsession with the stock market, don’t be surprised to see the news of any retaliation hit during US market hours.

Nevertheless, 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 bull case is also supported by fundamental momentum, as measured by earnings estimate revisions. Positive estimate revisions can be observed across all market cap bands.
 

 

My inner investor remains bullishly positioned and overweight equities. My inner trader initiated a small short position last week. Short-term momentum appears to have recycled. He is waiting for momentum to reach oversold levels before covering his shorts and reversing to the long side.
 

 

Disclosure: Long SPXU

 

Short-term risks are rising

Posted by Cam Hui -

Mid-week market update: Even though I remain constructive on the intermediate term market outlook, short-term risks are rising. The VIX Index fell below its lower Bollinger Band on Monday, which is an indication of an overbought market. In addition, the index is flashing a negative divergence on its 5-day RSI.
 

 

Historical study

Here is the historical study of what happens when the VIX falls below its lower BB. Returns are subpar and bottom out about four days after the signal. If you wait until the signal recycles, or the VIX to rise back above its lower BB, returns are immediately negative, and the market falls and flattens out for 4-5 days.
 

 

Sentiment stretched

As well, short-term market based sentiment look very complacent. Four of the five sentiment indicators that I monitor are in the high risk zone: the absolute level of the VIX, VIX term structure, VIX BB width, and the 10 day moving average of the equity-only put/call ratio. Only the the 10 dma of the TRIN is not reflecting excessive buying.
 

 

Sentiment signals, by themselves, do not constitute actionable sell signals. However, the combination of widespread complacency with active triggers such as a negative RSI divergence, or the VIX falling below its lower BB represent a short-term warning flag that the market advance is likely to stall.
 

SentimenTrader tweeted a similar sentiment warning today.
 

Subscribers received an email on Tuesday morning that my inner trader had initiated a small short position. As the day after US Thanksgiving has historically been bullish, he expects to add to his short on Friday, should prices advance.

My inner investor remains bullishly positioned. Remember that this is only a tactical warning, and any pullback should be shallow. The intermediate term path of least resistance for stock prices is still upwards.

Disclosure: Long SPXU

 

Is a trade deal imminent?

Posted by Cam Hui -

On Friday, Trump said that a trade deal with China was “potentially very close” (via CNBC):

President Donald Trump on Friday said that a long-negotiated trade deal with China is “potentially very close” following reports that an agreement might not be reached until next year.

Trump was speaking on one of his favorite television programs, “Fox and Friends,” the morning after House Democrats wrapped up a second week of public impeachment hearings.

“The bottom line is, we have a very good chance to make a deal,” Trump said.

Over the weekend, CNBC further reported “China plans stronger protections for intellectual property rights”. In addition, Chinese official media said that both sides are “very close to a phase one deal”. Are these signs that the logjam is broken? Are we on the verge of a “Phase One” deal?

Why haven’t the odds of a Trump-Xi meeting moved on PredictIt? This contract is a good, albeit illiquid, proxy for the odds of a “Phase One” deal.
 

 

Dissecting the rhetoric

Let us dissect the rhetoric from both sides. We have heard the “we are close to a deal” statements from Trump and Trump administration officials before. But here we are, we still have no deal. Is it any wonder the market hasn’t reacted?

The announcement form China is more interesting. However, I am equally skeptical because of the Chinese attitude about the concept of the rule of law. Consider these tweets from Global Times editor Hu Xijin in reaction to the Hong Kong High Court’s ruling on the the mask ban.
 

 

Here is what the principle of rule of law means for the Chinese. They expect the people to obey the law. The government is not bound by its own laws, because it is the government, and the sovereign.

So what happens when intellectual property laws are applied to State Owned Enterprises, which are arms of the government? (Asking for a friend).

Now do you understand why the market isn’t reacting to these announcements?

 

Cyclical global recovery: Easy come, easy go?

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.
 

Cyclical recovery losing steam?

About a month ago, I had suggested that investors position themselves for a global cyclical rebound (see An upcoming seismic shift in factor returns). Since then, the stock market has rallied to fresh highs, and more and more investors have jumped on the cyclical rebound bandwagon, such as Goldman Sachs (via CNBC):

“The equity market is anticipating an acceleration in US economic growth during the coming months,” David Kostin, Goldman’s chief U.S. equity strategist, said in a note Friday. “Investors who want to capture further cyclical upside can improve risk-reward by narrowing their focus to select cyclical stocks.”

Credit Suisse came out with a similar bullish equity market forecast based on a “reversal of decelerating economics”:
 

 

Jim Paulsen at the Leuthold Group is also tilting towards more cyclical exposure.
 

 

Just as everyone starts climbing on the bandwagon, the yield curve steepened, which is a signal that the bond market expects better growth, but flattened again back to roughly where it started.
 

 

It is therefore useful to issue an interim report card on the cyclical recovery thesis, and see how things are going.

To make a long story short, a review of the real-time market-based signals shows that the cyclical recovery investment theme is alive and well. A deeper analysis by region reveals more nuanced details of risks and opportunities.

Of the three major regions, Europe is the most attractive. Market-based signs of a cyclical revival and the reduction of tail-risk are becoming evident. As well, valuations are highly attractive by historical standards. The combination of cheap valuation and a reflationary catalyst gives European equities the greatest appreciation potential.

US equities are more richly valued, but US economic growth is strong and recession risk is low. Trade war risk is asymmetric. Things can’t become much worse and there is far more room for improvement.

China and Asia present a mixed picture of growth. While Chinese data and policy indicate slowing growth, selected Asian data and real-time market-based indicators are suggestive of stabilization and rebound. As long as the tail-risk of a disorderly unwind of China’s debt problems do not appear, I am inclined to give the cyclical bull case the benefit of the doubt.
 

Global outlook: So far, so good

Our review will start with a big picture global perspective, then shift its focus on the three major trading blocs of the world economy, the US, Europe, and China and Asia. A month ago, I had highlighted the analysis of Sean Maher, who suggested that two catalysts for a cyclical turnaround could be a shift and replacement cycle in autos as Europeans shift from diesel to electric vehicles, and the 5G smartphone upgrade, led primarily by China.

Consider how some real-time market based indicators are performing. These are especially useful because they do not depend on reported economic statistics, which can be backward looking, but adjust instantaneously to new information as they arrive in real-time.

The chart below shows how cyclical sectors have performed relative to the MSCI All-Country World Index (ACWI). Global industrial stocks have staged a relative return rally, and they rose above a relative downtrend line, which is a signal of global recovery. Global auto stocks also rallied through a relative downtrend. While their performance has not been as strong, their technical behavior nevertheless signals the start of a rebound and possible consolidation period. Lastly, semiconductor stocks, which are the most exposed to the 5G infrastructure theme, have been on fire.
 

 

Another way of measuring the strength of the global cycle is the copper/gold ratio. Both are commodities, and therefore sensitive to the reflation factor. Copper is more economically sensitive than gold, therefore the copper/gold ratio is a filtered indicator of global cycle. As well, the copper/gold ratio has shown itself to be highly correlated to the 10-year Treasury yield, which is a proxy for growth and inflationary expectations, and the stock/bond ratio, which is an indicator of investor risk appetite. As the chart below shows, the copper/gold ratio is bottoming and in the process of turning up, which is a sign of global recovery.
 

 

So far, so good, at least from a global perspective. The global outlook can be summarized by the Citi Global Economic Surprise Index (ESI), which measures whether economic releases are beating or missing expectations. The ESI chart is shown from longer term (top panel) and shorter term (bottom panel) perspectives. The global growth outlook has stabilized and it is recovering, but it is not showing any signs of acceleration yet.
 

 

US: Recovery and stabilization

Turning to the US, the pattern of real-time price signals parallels the 2s10s yield curve, which can be best described as recovery and stabilization. In virtually all cases, the behavior of cyclical factors have recovered indicating the early signs of recovery, but they have also fallen back, but back not so far as to negate the reflation signal. These are all signs of recovery, and stabilization, but no signs of growth acceleration.
 

 

The ESI chart also tells a similar story of recovery and stabilization. Economic data has improved, but the pace of surprise has fallen back to the zero line, indicating that releases have been coming in roughly in line with market expectations.
 

 

One of the headwinds to a US cyclical recovery is the trade war. A recent Fed study quantified the effects of uncertainty on business investment. It concluded that this could reduce GDP growth by as much as 1% by 2020. However, these effects are probably already discounted by the market. As long as there is no further escalation, I consider trade war risks to be asymmetric. They can’t get much worse, and they can only get better.
 

 

We can see that in the evolution of forward 12-month EPS estimates, which are beginning to rise again after a period of stagnation.
 

 

Europe: The global bright spot

Turning to Europe, this region is becoming the bright spot of global risk appetite. In the UK, the risk of a disorderly no-deal Brexit is rapidly fading. We can see the Brexit risk premium fading in the chart of the FTSE 100, which is composed of large cap and global companies, and the smaller cap and more domestically sensitive FTSE 250. The bottom panel shows the ratio of the FTSE 250 to FTSE 100, which broke out of a relative downtrend in August and it has been rising ever since. This is a signal that it expects an improvement in outlook for companies sensitive to the domestic UK economy.
 

 

The real-time cyclical factor charts for Europe also appear to be bullish. European industrial stocks staged a relative upside breakout, indicating strength. European financial stocks are also recovering, and the relative strength of the defensive consumer goods sector is in retreat.
 

 

Here is why Europe depends on the fate of the banking sector. This tweet from Holger Zschaepitz of Die Welt reveals that the European economy is far more dependent on bank financing than the US economy, which has undergone a period of financial disintermediation.
 

 

Another bright spot on the eurozone horizon is the prospective of fiscal stimulus. There are signs that German reluctance for fiscal stimulus may be changing because of a shift in the political winds. John Authers at Bloomberg documented the rise of the Greens in Germany, who may provide the impetus for more spending – on green initiatives:

There is an argument that Germany’s economy has become the Achilles’ heel of the world economy. Certainly its negative interest rates have rippled far beyond the eurozone, while many are exasperated by the dogged German insistence on a heavy trade surplus, combined with a conservative fiscal policy. But now the best chance of changing that appears to lie in adopting radical environmental politics, and allowing a share of power for Germany’s Greens.

According to a long-running German opinion survey, the environment has recently surged to become the top issue among voters. It has displaced immigration, and is now deemed even more important than the eurozone crisis was at its height,

To compare and contrast the political environment between Europe and the US, RWE, which has been one of the worst CO2 emitters in Europe and user of lignite coal for power generation, has begun pivoting to offshore wind generation and pledges to be net carbon neutral by 2040. Imagine the same thing happening in America?

The chart below of European climate change concerns and fiscal space shows that two big northern countries, Germany and the Netherlands, have both the fiscal space and political backing for spending on green projects. This green trend may provide the opening for Christine Lagarde, the new head of the ECB, to lobby for more fiscal spending.
 

 

Even without the prospect of more fiscal stimulus, which would be long-term positive, ESI for the euro area has been improving for depressed levels. From a cyclical recovery perspective,
 

 

In short, Europe is the global bright spot from a cyclical recovery perspective.
 

China and Asia: Sputtering a little

Turning to China and Asia, the picture is more mixed. Leland Miller of China Beige Book revealed in a recent interview with Real Vision that Q3 bottom-up surveys of Chinese businesses showed a high level of weakness. While the diffusion estimates for revenues were up sequentially in two of five sector surveyed:
 

 

profit estimates were far weaker, indicating economic weakness.
 

 

The weakness in China is confirmed by the slow deterioration in ESI.
 

 

Where’s the cyclical rebound? China is a major engine of global economic growth. Can the world recover if China is weak?

Here is where data interpretation gets a little tricky. While economic statistics tell a story of deceleration, the real-time market-based indicators are more constructive. China accounts for the lion’s share of global commodity consumption, which makes measuring the health of the commodity markets a useful metric of Chinese economic growth. While the CRB Index has been flat to down, internal breadth, as measured by Pring Commodity New Highs, has been strengthening.
 

 

In addition, the AUDCAD exchange rate has stopped falling and it is moving sideways. Both Australia and Canada are global commodity exporters, but Australia is more sensitive to Chinese demand, while Canada is more levered to the American economy. The sideways movement in the AUDCAD exchange rate can be interpreted as a sign of stabilization in Chinese growth.
 

 

Even the nearby Hong Kong market, which has been battered by stories of unrest and recession, remains in an uptrend. The resiliency of a market in the face of bad news has to be considered bullish.
 

 

Last week, the much watched flash November figures for South Korean exports printed both good news and bad news. South Korean exports are important because they represent an important barometer of the global economy due to their cyclical sensitivity. The bad news is Korea exports were down again, the good news is they are improving.
 

 

Jeroen Bolkand provided a similar update of the similarly cyclically sensitive of Singapore electronic exports earlier this month. Exports are down, but they are rebounding.
 

 

In light of these mixed messages, does the Chinese growth deceleration matter? Beijing appears to have the slowdown under control, and the authorities are trying to glide the economy into a soft landing. As long as it doesn’t crash, the global cyclical rebound may still be in decent shape.

The key indicator to watch is the health of China’s property market because of the massive size of its real estate market (via Plan Maestro).
 

 

The size of the property market is explained by the fact that Chinese households have poured their savings into real estate. Mike Bird of the WSJ highlighted this chart, which showed the evolution of home buyer profiles in China. Bird pointed out that at least 80% of mortgage lending goes to buyers who already have one home, which is double the rate in 2015.
 

 

Obviously this raises the degree of risk in the financial system. However, the real-time relative performance of property developers and financial stocks in China are all showing signs of stabilization. As long as these canaries in the financial coalmine remain healthy, tail-risk should remain contained.
 

 

Still bullish

In conclusion, a review of the real-time market based signals shows that the cyclical recovery investment theme is alive and well. A deeper analysis by region reveals more nuanced details of risks and opportunities.

Of the three major regions, Europe is the most attractive. Market-based signs of a cyclical revival and the reduction of tail-risk, are becoming evident. As well, valuations are highly attractive by historical standards. Asset manager Rick Kleinbauer pointed out that dividend yields are significantly above bond yields, and the spread is starting to improve. The combination of cheap valuation and a reflationary catalyst gives European equities the greatest appreciation potential.
 

 

US equities are more richly valued, but US economic growth is strong and recession risk is low. Trade war risk is asymmetric. Things can’t become very much worse, and there is far more room for improvement. Ed Yardeni’s Rule of 20, which sounds a warning if the sum of the forward P/E ratio and the CPI inflation rate exceeds 20, is still in neutral territory. This leaves more upside potential for equity prices.
 

 

China and Asia present mixed picture of growth. While Chinese data and policy indicate slowing growth, selected Asian data and real-time market based indicators are suggestive of stabilization and rebound. As long as the tail-risk of a disorderly unwind of China’s debt problems do not appear, I am inclined to give the cyclical bull case the benefit of the doubt.

Bottom line: Stay long the cyclical rebound theme, but keep an eye out for a rapid deterioration in China’s growth outlook.
 

The week ahead

I have been warning about a minor market stall in these pages, and the market finally cooperated with my call last week. The SPX traded sideways through a rising trend line, and the sell signal was confirmed by a bearish recycle of the daily stochastic and the 14-day RSI from overbought to neutral. Further, the advance was accompanied by a negative divergence in net NYSE new highs (bottom panel). The first logical downside objective is the price gap just below 3050, with further support at the breakout level of 3025-3030.
 

 

What now?

I remain constructive on the stock market on intermediate and longer term. The latest round of consolidation is consistent with the pattern exhibited in the market melt-up of late 2017. As stock prices sprinted upwards in that period, the index went on an upper Bollinger Band ride on the weekly chart. Pauses were relatively minor and shallow. The weekly stochastic remained overbought, as it has today, and never recycled below the overbought level during that advance.
 

 

Seasonal and historical patterns are also supportive of the intermediate bull case. Jeff Hirsch at Almanac Trader found that strong YTD returns to November were typically followed by strong December markets.

The even longer term outlook continues to be bullish. I had highlighted the monthly MACD buy signal flashed by the Wilshire 5000 at the end of October. That buy signal remains in force, and if history is any guide, this should resolve itself in a multi-year bull phase.
 

 

The monthly MACD buy signal is becoming global in scope. Unless world markets totally fall apart in the upcoming week, global stocks should also flash a buy signal at the end of November.
 

 

A similar pattern can be found in the MSCI World xUS Index, which is also on the verge of a monthly buy signal.
 

 

Viewed from the context of the start of a long-term bull, this funds flow analysis is particularly revealing (h/t @chigrl). Investors have been pouring money into cash and fixed income securities for most of this year, and the reversal into equities is only starting, indicating strong upside potential longer term.
 

 

In an ideal world, here is what I am tactically watching for. My working hypothesis calls for a period of consolidation and shallow pullback. I am watching for the market to become oversold on short-term (1-2 day horizon) momentum indicators.
 

 

Slightly longer term momentum has been tracing out a pattern of lower highs. I would prefer to see this indicator zigzag its way downwards into an oversold level. That would be the ideal trading buy signal.
 

 

In life and trading, nothing ever goes exactly to plan, but we all observe and react accordingly. My inner investor remains bullishly positioned, though he sold call options on selected long positions to pick up some premium income. My inner trader sold last week and went to 100% cash, and he is waiting for an opportune time to re-enter on the long side.

 

A pause in the melt-up?

Posted by Cam Hui -

Mid-week market update: Is the market about to pause in its run-up? The latest development from Hong Kong may serve as a catalyst. In the wake of the passage of the Senate bill affirming support for the Hong Kong protesters, the bill will have to be reconciled with a similar House version, where it will arrive on President Trump`s desk for signature. China has already denounced the bill as unwarranted interference in its internal affairs. There is a chance that Trump will view it as leverage in the latest round of “Phase One” negotiations. No wonder the PredictIt odds of a Trump-Xi meeting, which is a proxy for a deal, is tanking.
 

 

A more liquid contract, the offshore yuan, has also been weakening. This is another indication that the market’s expectations of a “Phase One” deal is facing.
 

 

This tweet from Chinese official media Global Times editor Hu Xijin confirmed the sudden frosty turn in the trade discussions.
 

 

Is the prospect that an unraveling trade deal enough to spook the stock market?
 

Plenty of warnings

There have been plenty of technical warnings everywhere. The start of market melt-ups are generally characterized by breadth thrusts. This time, we are seeing signs of negative breadth divergence. Even as the market made new highs this week, net new highs were declining, and so was NYSI.
 

 

Cross-asset, or inter-market, analysis also reveals a picture of waning risk appetite. The relative price performance of high yield (junk) bonds to their duration-equivalent Treasuries is not confirming the new highs.
 

 

In addition, Macro Charts is becoming increasingly anxious in the short run. His Speculative Trading Model is wildly overbought, and it “has correctly warned of tactical pullbacks – even within strong uptrends”.
 

 

In a separate tweet on Monday, he pointed out that SPY and QQQ DSI had exceeded 90, but he did allow that the market did not necessarily pull back immediately and took time to roll over.
 

 

My own market based sentiment indicators are flashing warnings of complacency. The VIX is nearing its lows for this year; the Bollbinger Band of the VIX has tightened, indicating a possible volatility storm ahead; and the 10 day moving average of the equity-only put/call ratio has dropped to historical lows.
 

 

The bull case

Before everyone gets excited, keep the following in mind. The SPX remains in a uptrend, and there is no reason to become tactically cautious until the trend line breaks. In addition, there is strong support at 3025-3030, which is the breakout level and represents a peak-to-trough pullback of about 3%. I will leave it up to the reader whether a 3% downdraft is worthwhile trading.
 

 

Longer term, CNBC reported that Sam Stovall is super bullish for historical reasons:

“There’s something special about this year. We had a positive move in the market in both January and February,” Stovall said on Thursday. “February is the second worst month of the year — second only to September. It’s usually a digestive month.”

If history is any guide, the Santa Claus rally is just getting going:

Stovall points to another unusual characteristic of the year’s record run: Stocks hit highs this month, too.

“Throw in a new all-time high in early November and you’re essentially flat to higher 11 of 11 times,” he added.

I interpret these conditions as the market is in a strong uptrend, but it is in need of a breather to consolidate its gains. While I have no idea of whether it is likely to go down tomorrow, or the next day, the short-term bias is down, but downside risk is likely to be limited to 2-3%. My inner investor remains bullishly positioned, but he selectively sold some covered calls against existing positions.

Subscribers received an email alert this morning about possible action in my trading account. I wrote that if the index were to convincingly violate the 3115 level on a closing basis, I would sell my long position and move to cash. The sell signal was triggered, and my trading account is now 100% cash.

 

Could this FOMO surge be a mirage?

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.
 

New market highs

Two weeks ago, I indicated that investors should buy the breakout (see Buy the breakout, recession risk limited). I cited as bullish factors strong price momentum, low recession risk, evidence of a global cyclical recovery, and evidence of institutions and hedge funds caught offside with excessively defensive portfolios.

Since then, US equity indices have soared to all-time highs, and non-US markets have risen to new recovery highs. Seemingly overnight, all the bears seem to have capitulated and turned bullish.
 

 

While I remain bullish, good investors always examine their assumptions. What could derail this bull case?

I concluded that market participants seem have gone all-on on risk in a steady FOMO stampede. While my base case scenario continues to be bullish, there is a risk that the perception of a global cyclical rebound, which is mainly led by China, could be a mirage. Prudent investors should monitor key real-time market based indicators of the Chinese economy for signs of decelerating growth, or financial stress.
 

Here comes the FOMO surge

If anyone wanted an indication that a FOMO rally is underway, the widely watched BAML Global Fund Manager Survey served as confirmation. Portfolio cash levels dropped dramatically, and global growth expectations surged.
 

 

Global fund managers piled into equities from a severely underweight position to a one-year high. However, absolute weightings remain low by historical standards, indicating further buying power.
 

 

It is not just global institutions that have embraced risk. Marketwatch reported that UBS HNW survey told a similar story. HNW accounts held a high levels of cash, but readings are down from the previous quarter.
 

 

Most global equity markets are now in uptrends. If history is any guide, this is the start of a prolonged bull phase.
 

 

Bullish fundamental support

The rally has been supported by a variety of fundamental factors. First, the global economy is recovering, as evidenced by a rising Citigroup Global Economic Surprise Index, which measures whether macro data is beating or missing expectations.
 

 

The air of gloom is definitely lifting. We saw some good news out of Germany, which is the export engine of the eurozone, avoid a recession by printing a surprise 0.1% GDP growth in Q3.
 

 

The nascent recovery is showing up in improving earnings estimates. The latest update from FactSet shows that forward 12-month estimates are rising again after a period of stagnation.
 

 

Further analysis reveals that expected Q3 and Q4 EPS growth is flat to down. Estimate risk is becoming increasingly asymmetric, and the chances of upside surprises under a cyclical recovery scenario is rising.
 

 

A similar pattern of positive earnings revisions can also be seen in Europe.
 

 

What’s the bear case?

While the weight of the evidence points to a multi-year bull phase, I do not discount the possibility that the buy signal could be a mirage.

The catalyst for the bear case is China. As this China bears’ favorite chart shows, debt levels have grown to historically unsustainable levels. Moreover, much of it is unproductive debt that will eventually have to be resolved in some fashion.
 

 

As China watcher Michael Pettis pointed out, China has painted itself into a corner, and Beijing has only a set of limited and unpalatable policy options.

To recap, all of the plausible policy choices available to Beijing are limited to one or some combination of the following three options: more unemployment, more debt, or more wealth transfers. This is because China (and indeed most economies) is limited to six economic paths, of which only three are plausibly available if Beijing wants to avoid surging unemployment:

  1. A rise in unemployment or stagnant wages. This occurs when an economy is unable to generate sufficient growth to maintain demand for workers. (The remaining five options, by definition, do generate sufficient growth.)
  2. A sustainable increase in investment. This would entail additional investment such that the growth in debt-servicing capacity exceeds the growth in debt. Although this option is technically open to Beijing, achieving it has been much easier said than done over the past decade. We can reasonably assume that Beijing is no longer capable of engineering enough productive investment to keep the economy growing fast enough to prevent a rise in unemployment or wage stagnation.
  3. An unsustainable increase in investment. This would mean an increase in nonproductive investment (in projects whose value is less than the cost of the investment), a choice that would worsen the country’s overall debt burden. China has followed this path for the past few years but may soon reach its debt limits.
  4. A sustainable increase in consumption. In China’s case, this would signify an increase in the consumption share of GDP that is driven by a corresponding increase in the household income share. (And this would likely further lead to an increase in sustainable private-sector investment.) This is the goal of Chinese rebalancing— effectively transferring wealth from elites, businesses, or governments to ordinary Chinese households—but achieving it has proven very difficult politically.
  5. An unsustainable increase in consumption. This outcome occurs when consumption growth is driven by rising household debt, which (obviously) would worsen the overall debt burden. China has followed this path for the past three years but may soon reach its debt limits. Coincidently, this path also seems to have been the main driver of U.S. growth for the past decade or more.
  6. A rising current account surplus. This option is only plausibly achievable for very small economies whose rising surpluses can be easily absorbed by the global economy.

These six pathways logically cover every possible option open to Beijing. If we exclude the second and sixth options as unrealistic, and if we acknowledge that the third and fifth choices both would lead to a rising debt burden, Beijing is effectively left with the same three aforementioned options as described in the Barron’s article [written by Pettis]: an increase in unemployment (option 1), an increase in the debt burden (options 3 and 5), or greater wealth transfers (option 4).

Bottom line: Either the Chinese economy crashes, or growth slows to a more sustainable rate so the household sector can become the engine of growth. The most recent path has involved a controlled efforts at deleveraging while providing sufficient policy support to achieve a soft landing. Beijing has mostly succeeded so far. Debt growth has slowed without any significant cracks in the financial system, and the PBOC has not panicked by turning on the credit spigots.

Chinese demand remains a major driver of global growth. The SCMP reported that the Chinese government linked National Institute for Finance and Development is projecting a GDP growth rate of 5.8% next year, which is in line with IMF estimates. If a government sponsored think tank is forecasting a sub-6% growth rate, then in all likelihood the risks to the forecast is to the downside.

Ignoring for the moment the possible effects of the Sino-American trade war, how is any of this consistent with the idea of a global cyclical recovery?

Sebastian Dypbukt Källman at Nordea tweeted that China’s real M1 growth only provided a temporary boost to the global manufacturing, but he expects momentum to dissipate going into 2020. If Källman is right, then the global cyclical recovery is a mirage, and investors should fade the FOMO risk-on surge.
 

 

However, there are two unusual points to Källman’s analysis. First, he uses a six-month rate of change, instead of the more conventional 12-month change, which will take out any seasonal effects. Second, the inflation adjustment in the “real” M1 growth rate may be suspect.

Notwithstanding the usual doubts about China’s economic statistical reporting, Chinese inflation rates are especially subject to measurement error because of the effects of African Swine Flu on pork and other food prices. Here is the latest reported CPI, which spiked because of a surge in pork prices.
 

 

Here is China’s PPI, which is deflating. Which is right? Fortunately, core CPI (ex-food and energy) has been relatively steady at 1.5%, but the question of measurement error remains. How much of the spike in food prices have leaked into core CPI, and could that have distorted the real M1 growth rate?
 

 

As a different way of addressing the issue, here are the nominal year/year M1 and M2 money supply growth rates, along with nominal GDP growth. We can make a number of observations from this chart:

  • M2 growth is far more stable than M1 growth.
  • While M1 growth is more volatile, it provides dramatic clues to trends in M2 growth, which tracks GDP growth well.
  • There is no decline in year/year M1 growth, which is in stark contrast to the Nordea analysis.

 

Real-time market data continues to be supportive of the cyclical recovery narrative. If stress levels are building in China’s financial system, we would see them in the behavior of the relative performance of the highly levered and cyclically sensitive property developers, and in the relative performance of financial stocks. So far, these indicators are not any warning signals.
 

 

The AUDCAD exchange rate has broken out of a downtrend and it is showing signs of stabilization. Both Australia and Canada are global resource exporters, but Australia is more sensitive to China’s economy, and Canada is more sensitive to the US economy. Notwithstanding the recent negative surprise in Australia’s job figures that tanked the AUD exchange rate, the AUDCAD rate is tracing out a constructive bottoming pattern indicating stabilization.
 

 

Trust, but verify

What should investors do? In the words of Ronald Reagan, “Trust, but verify.” I am inclined to give the bull case the benefit of the doubt, but I am not inclined to totally dismiss Nordea’s warnings either. These real-time signals are something to keep an eye on.

Should the market sidestep this false mirage of a cyclical rebound, the long-term outlook looks bright for risky assets. In the past, a negative 14-month RSI divergence after a monthly MACD buy signal has been a good warning sign of a major market top, which I signaled in August 2018 (see Major market top ahead? My inner investor turns cautious). However, investors should feel assured that such a signal is a long time away. The 14-month RSI is not even in overbought territory yet.
 

 

In conclusion, market participants seem have gone all-on on risk in a steady FOMO stampede. While my base case scenario continues to be bullish, there is a risk that the perception of a global cyclical rebound, which is mainly led by China, could be a mirage. Prudent investors should monitor key real-time market based indicators of the Chinese economy for signs of decelerating growth, or financial stress.
 

The week ahead

Dow 28,000! The DJIA has reached 28,000 on Friday and closed at an all-time high. Both the S&P 500 and NASDAQ Composite also closed at all-time highs. The good news is this is starting to feel like the melt-up the market experienced in late 2017. It is unusual for the index to close above its upper Bollinger Band on the weekly chart. This market has so far managed two consecutive closes above its upper BB. The last time this happened was the steady melt-up of late 2017.
 

 

The bad news is there are technical warnings everywhere.
 

Hindenburg Omen, Titanic Syndrome

Jason Goepfert at SentimenTrader observed that the NASDAQ had flashed both a Hindenburg Omen and a Titanic Syndrome on both last Wednesday and Thursday.

Cutting through all the noise of the ominous names, I wrote about the real meaning of the Hindenburg Omen back in 2014. The Titanic Syndrome is “when lows surpass highs, within seven trading days of a one-year peak”. Both the Hindenburg Omen and Titanic Syndrome are telling the same story. The Hindenburg Omen is also a signal of breadth bifurcation, which I explained this way in 2014:

The Hindenburg Omen indicator has a lot of moving parts and it is therefore confusing. I believe that the most important message in the Hindenburg Omen is the expansion of both new highs and low, indicating divergence among stocks and points to market indecision.

As the daily S&P 500 chart shows, it is unusual to see the market making new highs while net new highs drop to near zero or negative, which is what happened last week. Moreover, the 10-day correlation of the index with the VIX spiked above zero on Thursday. Notwithstanding the melt-up of late 2017, past high correlation signals have marked periods when the market advanced has stalled.
 

 

The analysis of leadership by market cap groupings reveals the Hindenburg and Titanic style bifurcations. The rally has been led by megacaps and NASDAQ stocks. Small and mid caps simply have not kept up. The NASDAQ Titanic Syndrome signal is therefore that more ominous considering that NASDAQ stocks have been the leaders, but net new highs fell below zero last week even as the index surged to a fresh high.
 

 

Macro Charts echoed the concerns raised by the Hindenburg Omen and Titanic Syndrome another way. He pointed out that market all-time highs accompanied by negative breadth occur only 0.8% of the time, which is very rare. However, these are only warning signs, and not actionable sell signals.
 

 

Sentiment is becoming frothy. The Daily Sentiment Index for the S&P 500 and NASDAQ 100 have reached 90 and 91 respectively, bullish extremes. SunTrust also reported that Mark Hulbert’s metric of newsletter sentiment is near a bullish extreme, which is contrarian bearish.
 

 

My own survey of market based sentiment indicators shows that 4 of 5 indicators are flashing red. While these indicators do not, by themselves, represent actionable sell signals, past tops has seen between 1 and 5 of these indicators sound warnings.
 

 

I am also seeing cautionary signs from cross-asset, or inter-market, analysis. The USDJPY exchange rate has been a strong indicator of risk appetite. A falling Yen (rising USDJPY) has historically been correlated with stock prices. USDJPY pulled back from an inverse head and shoulders pattern last week, which invalidates the bullish signal, though it remains in an uptrend. I interpret this as a sign that risk appetite is starting to fade.
 

 

Does this mean the trading outlooks is bearish? Well, yes and no. The short-term environment calls for caution, but a history of actionable trading signals, such as the spike in S&P 500 and VIX correlation, has generally seen pullbacks of no more than 1-2%. Trading guru Brett Steenbarger also made a similar comment about the market bifurcation theme on one occasion when the Hindenburg Omen appeared [emphasis added]:

Truly outstanding has been the plunge in my measure of correlation among stocks, which looks across both capitalization levels and sectors. Indeed, this is the lowest correlation level I have seen since tracking the measure since 2004. Correlation tends to rise during market declines and then remains relatively high during bounces from market lows. As cycles crest, we see weak sectors peel off while stronger ones continue to fresh highs. As those divergences evolve, correlations dip. Right now we’re seeing massive divergences, thanks to relative weakness among raw materials shares (XLB), energy stocks (XLE), regional banks (KRE), and small (IJR) and midcap (MDY) stocks. Why is this important? Going back to 2004, a simple median split of 20-day correlations finds that, after low correlation periods, the average next 20-day change in SPX has been -.33%. After high correlation periods, the average next 20-day change in SPX has been +1.43%.

Are you afraid of an average loss of -0.3%, with likely maximum drawdown of 1-2%? The market is undergoing a powerful uptrend. The market has been afforded lots of opportunity to fall, but it is not not responding to bad news. As an example, Market Insider reported Friday that Trump is not ready to sign a trade deal. The market shrugged off the news. This is not a weak market. Nevertheless, the current sentiment backdrop suggests that a brief pause is likely, but any pullback will probably be shallow.

My inner investor remains bullishly positioned, but he sold some covered call options against selected long positions to collect the premium. My inner trader took some partial profits late last week. He remains long the market, and he is prepared to buy any dip that may appear.

Disclosure: Long SPXL

 

A correction in price, or time?

Posted by Cam Hui -

Mid-week market update: What to make of today’s market? It is obviously overbought. The 14-day RSI is skirting the 70 level, which defines an overbought condition and that has been the reading at which past advances have temporarily stalled. Arguably, the 5-day RSI is flashing a series of “good overbought” conditions indicating strong price momentum, though it did signal a minor bearish divergence.
 

 

Neither Trump’s speech yesterday nor Powell’s testimony today revealed much new information to move the stock market. However, the market did hit a minor air pocket today over a WSJ report that the trade talks hit a snag over agricultural purchases, but the weakness has been only a blip and can hardly be described as catastrophic.

Trade talks between the U.S. and China have hit a snag over farm purchases, according to people familiar with the matter, creating another obstacle as Beijing and Washington try to lock down the limited trade deal President Trump outlined last month.

Mr. Trump has said China has agreed to buy up to $50 billion in U.S. soybeans, pork and other agricultural products annually. But China is leery of putting a numerical commitment in the text of a potential agreement, according to the people.

Beijing wants to avoid cutting a deal that looks one-sided in Washington’s favor, some of the people said, and also wants to have a way out should trade tensions escalate again.

“We can always stop the purchases if things get worse again,” said one Chinese official.

Traders will have to rely on technical analysis to read the tea leaves. Overbought conditions can generally be resolved in two ways, either a correction in price, or time. What’s the most likely outcome?
 

Watching for a top

It is said that while market bottoms are events, which are defined by panics, tops are processes that evolve over time. That is why it is much more difficult for a technical analyst to spot a top than a bottom.

Here are some indicators that I am watching. Here is a set of technical and sentiment indicators that are indicating complacency.

  • The absolute level of the VIX Index (historically low = complacency)
  • The Bollinger Band width of the VIX Index (low band width = low historical volatility = complacency)
  • VIX term structure, defined as the ratio of the 3-month VIX to 1-month VIX (low = complacency)
  • 10-day moving average of the equity-only put/call ratio (low = complacency)
  • 10-day moving average of TRIN (low = excessive buying pressure, or excessive bullishness)

Here is the chart. Current conditions 3-4 of the five boxes. But these indicators have had a spotty top calling record. A glance at past tops in the last three years show that between 1 and 5 indicators have flashed warnings. Simply put, there are too many false positives to make these indicators to be actionable sell signals.
 

 

There are, however, two excellent indicators that have flashed tactical sell signals.

  • When the VIX Index closes below its lower Bollinger Band
  • When the 10-day correlation between SPX and VIX spikes to above 1 0

Here is the chart. The sell signals worked like charms, The market advance has either temporarily stalled or pulled back whenever one of these signals were triggered in the last three years. However, neither of these indicators flashed a warning sign at the major top that occurred in late September 2018.
 

 

Neither of these indicators are in the sell danger zone today.
 

A correction in time

How can we interpret these conditions? The market is displaying strong price momentum. I have pointed out before that the broad based Wilshire 5000 flashed a long term buy signal on the monthly chart. In the past, these buy signals have lasted at least a couple of years, and resolved with higher prices 100% of the time.
 

 

In the short run, the relative strength of the top 5 sectors in the index reveals bullish underpinnings. These sectors represent just under 70% of index weight, and the market cannot move up or down without significant participation by these heavyweight sectors. Right now, three of the sectors are exhibiting relative strength, and only the smallest of the top 5, consumer discretionary stocks, are in a relative downtrend. This argues for an intermediate term bullish outlook.
 

 

In conclusion, the combination of strong intermediate term price momentum, indications of an extended market in the short run, and the lack of actionable sell signals point to a period of either consolidation or shallow pullback. Downside risk is likely to be no more than 1-2%.

My inner investor is bullishly positioned. My inner trader is long, and he is prepared to buy any dips.

Disclosure: Long SPXL

 

The biggest risk to the cyclical recovery

Posted by Cam Hui -

Evidence is piling up that the economy is undergoing a cyclical recovery after a soft patch. The technical picture confirms the cyclical rebound narrative. The market relative performance of cyclical sectors and industries are all turning up. Semiconductors are now the market leaders, though they look a little extended short-term.
 

 

Here is the latest bottom-up update from The Transcript, which is a digest from earnings calls:

Succinct Summary: The US consumer is alive and well. The return of low rates has helped give the economy a boost, especially housing. It’s not a boom but an extension of the long bull market.

Macro Outlook:
The consumer is alive and well
“…strong demand environment that once again proved that the consumer, especially the North American consumer, is alive and well…The consumer is alive and well, and they are not afraid to spend money.” – Norwegian Cruise Line (NCLH) President & CEO Frank Del Rio

Labor markets are tight
“…the low unemployment rate and the numerous alternate employment opportunities makes the job of recruitment and retention more difficult than it has been in the past, limiting our ability to fully utilize our fleet and capture additional incremental market” – US Concrete (USCR) Chairman, CEO William J. Sandbrook

There’s strong demand for medium-duty trucks
“A growing U.S. economy, coupled with high levels of consumer spending, low unemployment and low interest rates continues to drive demand for medium-duty trucks.” – Cummins (CMI) Chairman & CEO Thomas Linebarger

The US housing market is healthier than the overall economy
“…the US housing market…is now probably healthier than the economy overall.” – Redfin (RDFN) CEO Glenn Kelman

Thanks to low rates–It’s not a boom but an extension of the long bull run
“Overall low rates have strengthened home buying demand at least marginally over the course of the year…we may see broader price gains in the first half of 2020 and the return of bidding wars. It’s not a boom, but it extends the markets long Bull Run.” – Redfin (RDFN) CEO Glenn Kelman

 

Will there be a Phase One deal?

The key risk is the unraveling of the “Phase One” trade deal. We have seen this movie before. The market was given signals in May that US and Chinese negotiators were very close to a deal, then it all fell apart at the last minute.

Here is how Bloomberg’s outlined the risks:

The question on many people’s minds this Monday is whether that “substantial phase one deal” with China that President Donald Trump announced a month ago today is falling apart. There have certainly been enough conflicting signals coming out of the White House in recent days to make that a legitimate question. But the best answer to that may actually lie in the answers to another question: What happens if there isn’t a deal? So let’s consider that from the U.S. lens. There are consequences, you see.

  • The first and biggest consequence would be a further escalation in the trade wars. Trump has already put an Oct. 15 tariff increase from 10% to 15% on one tranche of $110 billion in imports from China on hold. But there’s a bigger one looming in the Dec. 15 threat for new 15% import duties on a further $160 billion in goods including consumer favorites like smartphones and toys. 
  • If Trump didn’t go ahead with either of those threats he’d be exposing his own bluff, of course. Plenty of businesses would welcome it. So too would markets. And China. The only people who wouldn’t would be the hawks in his administration. But it would also be a blow to Trump’s longer term credibility in any negotiations with the Chinese.
  • Of course, if he did go ahead with those tariffs that would leave almost all trade between the U.S. and China subject to new tariffs and the global economy would be preparing for what many economists believe would be a singular shock. U.S. consumers, who in recent months have started to encounter the costs of the trade war, would be suddenly confronting new choices and questions. “Alexa: Why is my new iPhone suddenly more expensive?”
  • That would in turn likely hit business and consumer confidence going into an election year in which Trump is already facing impeachment and a slowing economy. Though the tariffs would technically begin to be collected before Christmas this year, the way supply chains work means the effect would take months to really filter through, so the second and third quarter of next year could see peak trade-war impact. Anyone for 1% growth — or worse — going into an already acrimonious presidential election? 

My trade war factor is showing a high degree of complacency in the market. The red line measures the relative performance of Sheldon Adelson’s Las Vegas Sands (LVS), which holds major casino licenses in Macau that could be the target of Chinese political pressure should trade tensions rise. Soybean prices (bottom panel) is holding just above a key technical breakout level. All of these indicators point to expectations that a deal will be done.
 

 

Will there be a deal? The Chinese have demanded gradual rollbacks, not just suspension, of tariffs. Trump hasn’t made any decisions yet on what he will do.

We may see more clues when Trump addresses the Economic Club of New York at a luncheon tomorrow on November 12. Stay tuned.

 

How far can stock prices rise?

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.
 

The art of upside target projection

It has become evident to technical analysts that the stock market has staged a convincing upside breakout. Not only have the major global averages broken out to the upside, the monthly charts of selected indices have flashed MACD buy signals. In the past, such buy signals have indicated significant price gains, with only minor downside risk.
 

 

In that case, what is the upside potential for stocks? We estimate targets using a variety of technical and fundamental techniques, and arrived at some different answers.

I found that price targets derived from technical analysis are highly ambitious and they call for upside potential of 25% or more. By contrast, valuation and longer term projections point to highly subdued return expectations. My Third Way scenario postulates that the S&P 500 could see a price appreciation potential of 10-13%, or 3380 to 3480 before suffering a downdraft of unknown magnitude.
 

Ambitious targets

A brief survey of technical analysis revealed some astounding upside targets. Callum Thomas observed that Peter Brandt had projected an S&P 500 target of 3524.
 

 

Point and figure charting yielded a series of different results, depending on the parameters set in the charts. We tried daily, weekly, and monthly charts, with traditional and 1% boxes, and 3-box reversals. The upside target ranged from 3750 to 4100, with most clustered in the 3900-4000 range. These are all aggressive targets with upside potential of 22% or more from current levels.
 

 

While these are not purely technical targets, Callum Thomas also highlighted the bullish analysis from perennial bull Tom Lee of Fundstrat, who projected even more upside potential for stock prices.
 

 

Valuation headwinds

The sunny technical forecasts are tempered by market valuation headwinds. The S&P 500 trades at a forward 12-month P/E ratio of 17.5, which is nearing the nosebleed zone. The E in the P/E ratio would have to improve considerably to justify these multiples.
 

 

From a longer term fundamental perspective, David Merkel projected a 10-year total return of only 3.6% on September 21, 2019, when the S&P 500 stood at 2990. These forecasts have been remarkably accurate. If 3.6% return were to be realized, it would either mean that the uber-bullish technical targets are pure fantasy.
 

 

There are many ways of estimating long-term returns. Merkel explained that he tried using a variety of valuation techniques, which explained “60-70% of variation in stock returns”. He settled on a technique he found at the blog Philosophical Economics,

The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the Fed’s Z.1 report. The higher the proportion, the lower future returns will be.

There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic). When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed).

The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt. When equity is a small component as a percentage of market value, equities will return better than when it is a big component.

Bottom line: Both equity valuation and a survey of private investor positioning suggests sub-par US equity returns. The gains of 20% or more appear way too ambitious.
 

A Third Way market scenario

How can we square the circle of these contradictory views?

Investors can resolve this dilemma by recognizing that there are different time frames to the two schools of thought. The analysis of short-term macro outlook, institutional positioning, and valuation suggests that both are right. A more reasonable scenario is a bubbly market melt-up, followed by a downdraft, all in a 2-3 year time frame.

Let us first consider the issue of institutional positioning. Macro Charts analyzed stock and bond fund flows and concluded that investors had become excessively cautious, and the latest upside breakout in the major global equity markets is a signal that stock prices are ready to soar as sentiment changes from fear to euphoria.
 

 

A variety of institutional sentiment indicators all point to excessively cautious position. The latest Barron’s Big Money Sentiment Poll revealed a high degree of bearishness among US institutions. The State Street Confidence Index, which measures the actual custodial institutional holdings, also shows a below average market beta exposure.
 

 

The latest BAML Global Fund Manager Survey reveal a more nuanced view. The average global manager holds a below average equity weight while overweighting defensive sectors and underweighting cyclicals. That said, they were overweight US equities, as the US economy was the last bastion of growth in a growth starved world.

In addition, analysis from JPM shows that hedge fund equity beta is still very low. Further market gains would have the potential to spark a short-covering stampede.
 

 

The cycle turns up

The combination of an overly defensive institutional positioning and a cyclical turnaround could be the spark for a risk-on stampede. Indeed, we are starting to see signs of a cyclical revival. Robin Brooks of IIF observed that global PMIs are rebounding, indicating excessive overshoot to the downside.
 

 

There are signs of stabilization in Europe. German exports rose 1.5% month/month and it was the biggest increase since November 2017. As Germany has been the locomotive of growth and exports in the eurozone, this latest reading gives some relief to recession fears.
 

 

Real-time market data is also supportive of a turn in the cycle. The yield curve is steepening, which is a signal that the bond market expects better economic growth.
 

 

The relative performance of cyclically sensitive industries, such as global industrial stocks and global auto stocks, have bottomed and they are starting to turn up.
 

 

Chinese growth may be bottoming. IHS Markit reported that “global Metal Users PMIs soar into expansion territory in October, as boosts to the Chinese manufacturing sector encourage strong production uplifts at global users of key metals.”
 

 

Even the relative performance of Chinese property developers is constructive for the bull case. This is a highly leveraged and vulnerable sector in China. Beijing has done little to support to support these companies as growth has slowed. The revival in relative performance of these stocks is an encouraging sign that the worst of the tail-risk is behind us.
 

 

The Rule of 20

We began this exercise by trying to square the circle of highly bullish technical targets with cautious fundamental equity targets. The scenario I sketched out is an overly defensive institutional investor community that is caught offside by a cyclical revival, and chases equity market beta in a FOMO (Fear of Missing Out) rally.

While S&P 500 valuations are somewhat elevated, they are not yet at bubbly levels just yet. I refer readers to Ed Yardeni’s “Rule of 20”, which states that investors should be cautious when the sum of the forward P/E and inflation rate exceeds 20. With the forward P/E at 17.4 and CPI inflation at 1.7%, we are not there yet.
 

 

Looking out 12 months, if we were to pencil in a growth rate of 5-8% to forward earnings, and assuming that CPI remains at 1.7%, the S&P 500 would have an upside of 300 to 400 points, or a price appreciation potential of 10-13% before the Rule of 20 warning is reached. As history shows, the Rule of 20 is not a hard and fast rule.

In summary, price targets derived from technical analysis are highly ambitious and they call for upside potential of 25% or more. By contrast, valuation and longer term projections point to highly subdued return expectations. Our Third Way scenario postulates that the S&P 500 could see a price appreciation potential of 10-13%, or 3380 to 3480 before suffering a downdraft of unknown magnitude.
 

The week ahead

Looking to the week ahead, there are numerous signs that the market is setting up for a bullish stall. The Fear and Greed Index closed Friday at 91, which would normally be interpreted as contrarian bearish. However, past episodes of Fear and Greed Index spikes has seen the market either pause and consolidate its gains, or stage a shallow pullback, to be followed by more gains.
 

 

The daily S&P 500 chart tells a similar story. The 5-day RSI is flashing a series of “good overbought” conditions, which are signs of powerful price momentum. However, the advance has tended to stall out when the 14-day RSI reaches 70, but most of these cautionary signals were followed by only minor sell-offs.
 

 

The weekly chart shows that the index closed above its upper Bollinger Band. Such episodes are relatively rare. With the exception of the late 2017 market melt-up, upper BB closes have resolved themselves with sideways consolidations, but with a bullish bias.
 

 

However, market positioning is supportive of near-term weakness. Charlie McElligott of Nomura pointed out that dealer gamma and delta are at extremes together. Such conditions have usually resulted in market pullbacks.
 

 

Q3 earnings season is mostly done as 89% of companies have reported results. The latest update from FactSet shows that forward 12-month EPS constructively rose last week, but the 4-week revision rate is still negative. The EPS and sales beat rates are slightly above historical averages, but only marginally. So the jury is still out on whether the bulls can expect fundamental support.
 

 

Most sentiment models are not extreme enough to flash sell signals. As an example, the AAII Bull-Bear spread is elevated, but readings do not indicate a crowded long position.
 

 

Similarly, the Citi Panic/Euphoria has been rising, but readings are firmly in neutral territory.
 

 

Possible disappointment over the “Phase One” trade deal remains the most likely spark for market weakness. The market became excited last week when China announced that both sides had agreed to gradually reduce tariffs as part of a “Phase One” agreement. It was later denied by the White House. The editor of Chinese official media Global Times responded that proportional tariff escalations is a condition of a deal.
 

 

Reuters summed up the negotiation this way:

Officials from both countries on Thursday said China and the United States had agreed to roll back tariffs on each others’ goods in a “phase one” trade deal. But the idea of tariff rollbacks met with stiff opposition within the Trump administration, Reuters reported later on Thursday.

Those divisions were on full display on Friday, when Trump – who has repeatedly described himself as “Tariff Man” – told reporters at the White House that he had not agreed to reduce tariffs already put in place.

“China would like to get somewhat of a rollback, not a complete rollback, ‘cause they know I won’t do it,” Trump said. “I haven’t agreed to anything.”

Our trade war factor shows that the market is discounting a very low level of trade tensions. Could this be an accident waiting to happen? Please be reminded that we have been here before. Both sides were close to a deal in May before talks broke down.
 

 

Next week is option expiry (OpEx) week. November OpEx seasonality has historically been below average for the bulls. The combination of sub-par OpEx seasonality, evidence of short-term exhaustion, and rising trade talk tensions could be the spark for consolidation and market weakness next week.
 

 

My inner investor is bullishly positioned as he is overweight equities. My inner trader is bullish, but he is keeping some powder dry and he is prepared to buy should the market pull back. He expects that any weakness will be relatively shallow, with downside risk of no more than 1-2%.

Disclosure: Long SPXL

 

Market nearing the stall zone

Posted by Cam Hui -

Mid-week market update: Don’t get me wrong, I am still bullish. The Wilshire 5000 flashed an important MACD buy signal on the monthly chart at the end of October. While MACD sell signals have been hit-and-miss, buy signals have historically resolved themselves in strong gains with minimal drawdowns.
 

 

The MSCI World xUS Index also flashed an interim monthly buy signal, assuming that it stays at these levels by the end of November.
 

 

These are all unequivocally bullish signals for stock prices in the longer term, but short-term conditions suggest that the market is nearing a stall zone.
 

Minor stall ahead?

Tactically, there are a number of signs that it may not be wise to add to long positions here. The SPX traced out a doji candle on Monday on a gap up, which can be a sign of indecision. The index price proceed to slightly weaken in the next two days, which is another sign that Monday’s doji was a short-term inflection point. In addition, both the 10 dma of the equity-only put/call ratio and the VIX term structure were at levels indicating complacency. While these signals are very effective as sell signals, they nevertheless indicate above average levels of market risk. On the other hand, the 5-day RSI is flashing a series of “good overbought” readings, and the net high-lows indicator is trending upwards, which are constructive bullish signals. I interpret these conditions as a market in a powerful uptrend, but may need a little time to consolidate or pull back.
 

 

Sentiment models are also pointing to a possible pullback. Andrew Thrasher observed, “When the spread between equity and volatility sentiment hit its current level stocks have continued marginally higher before short-term pullbacks occurred.”
 

 

In addition, the Fear and Greed Index stands at 8, which is above the 80 level where past rallies have stalled.
 

 

Like the other sentiment indicators, this is not an exact short selling timing indicator. SentimenTrader calculated a proxy for the Fear and Greed Index, and found that readings above 80 functioned as only marginal sell signals.
 

 

These sentiment conditions are a signal to be cautious about adding to long positions, but they do not represent an actionable sell signal for traders.
 

Is the Phase One deal unraveling?

The unraveling of a US-China “Phase One” trade deal is the most likely catalyst for a pullback. After Chile cancelled the APEC November summit because of ongoing protests, the US and China lacked a venue for Trump and Xi to meet and sign the “Phase One” deal reported negotiated by both sides. American negotiators have floated the idea of a signing in Iowa, where Xi had lived briefly during an exchange trip and has great political significance for Trump ahead of the 2020 election, or Alaska. The Chinese have reportedly used Trump’s desire for a signing in Iowa as leverage to ask for further concessions, according to a Bloomberg report:

People familiar with the deliberations say Beijing has asked the Trump administration to pledge not only to withdraw threats of new tariffs but also to eliminate duties on about $110 billion in goods imposed in September. Negotiators are also discussing lowering the 25% duty on about $250 billion that Trump imposed last year, the people said. On the U.S. side, people say it’s not clear if Trump, who will have the final say, will be willing to cut any duties.

From the Chinese perspective, the argument is that if they are going to remove one big point of leverage and resume purchases of American farm goods and make new commitments to crack down on intellectual property theft — the key elements of the interim deal — then they want to see equivalent moves to remove tariffs by the U.S. rather than the simple lifting of the threat of future duties.

Will Trump cave? The global financial markets would like to know. CNBC reported that the date of the signing may be delayed from November to December, which is a sign that the deal may be on the rocks:

The meeting between Trump and Xi could be delayed as the two sides still need to decide on the terms and a venue, Reuters reported Wednesday, citing a senior Trump administration official. The report also said it’s still possible the two countries will not reach a trade pact.

 

Expect choppiness or mild pullback

Both my inner trader and investor are bullishly positioned. However, my inner trader is tactically cautious and he is expecting a brief pullback or some near-term choppiness ahead. The 5-day RSI is constructively flashing a series of “good overbought” readings, which is bullish. On the other hand, the 14-day RSI is nearing 70, which is a level when the market has stalled and pulled back in the past year.
 

 

My base case scenario calls for a shallow pullback to a test of the upside breakout at 33303030, which represents downside risk of 1% of less from current levels. My inner trader is inclined to buy the dip should the market weaken to those levels.

Disclosure: Long SPXL

 

Buy the breakout, recession risk limited

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 (upgrade)
  • 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.

Buy the breakout!

Did anyone notice the upside breakout in the global equity indices? The breakout was not only evident in the US, but it was broad and global in nature. This is an unambiguously sign to get bullish on equities. Investors with intermediate and long term horizons should buy the breakout.

I would like to reconcile the recession risk raised by a number of readers. While a number of indicators, such as the recent yield curve inversion, tanking CEO confidence, falling ISM and Markit PMIs, and so on, are signaling recession, how can I possibly be equity bullish in the face of these risks?

A review of US recession finds that the household sector is strong, monetary policy is easy and supportive of growth, but the corporate sector is struggling. We conclude that while this may point to a slowdown, no recession is in the cards.

In conclusion, global markets are staging coordinated upside breakouts. These are unambiguous signs of a global rebound in growth. Recession risks are low. The Trend Asset Allocation Model has turned bullish. This is likely the start of a new leg in an equity bull.

Here comes the global breakout

One truism of technical analysis is that there is nothing more bullish than a stock or an index making fresh highs. The broad global breadth of the price surge has been astounding. In the US, the broad-based Wilshire 5000 flashed a buy signal that has been a highly effective indicator of past bull phases that have resolved with a virtual certainty of higher prices. The monthly MACD made a bullish crossover at the end of October. If history is any guide, higher prices are ahead.

Jason Goepfert at SentimenTrader observed that past upside breakouts of MSCI World ex-US resulted in higher prices 6 and 12 months later 100% of the time. US stocks did even better under this signal.

The broad breadth of the rally also has bullish implications. Callum Thomas of Topdown Charts pointed out that the proportion of countries with positive year/year price gains has been surging. Past instances of such breadth surges have usually signaled just the start of an equity rally. In other words, this is the signal of a new bull market.

Thomas added:

I also want to make passing reference to the rest of my analysis (I was recently on the road and talked through this with clients), which in essence is entirely consistent with the message from the breadth indicators that we are in about to enter a new bull market. On my metrics in absolute terms global equities are not expensive (slightly cheap), and indeed relative to bonds the equity risk premium actually looks pretty good. Add to that the fact that fund manager/institutional investor positioning remains fairly light (based on surveys, anecdotes and actual data from custodian accounts) as well as a clear reset in earnings expectations, sentiment is arguably contrarian bullish. And perhaps most important of all, the global monetary policy pivot is clear, material, and reinforces my core view that we see a rebound/re-acceleration in the global economy heading into 2020 (call it a late-cycle extension). In other words, it’s not just the technicals (and the implications of this analysis extend across asset classes).

I agree. All the stars are lining up for a new bull run.

What about recession risk?

Recently, there have been a lot of bearish analysis appearing on social media. I would like to address those concerns.

First, many recession indicators are being promoted by permabears who try to cherry pick the bearish data point of the day. I approach forecasting differently. My own framework consists of:

  • Determine the goalposts, or criteria, ahead of time.
  • Make sure that each indicator we use is a good forecaster on a standalone basis.
  • Recognize that no single indicator is perfect, but a portfolio of uncorrelated indicators is more effective.

That way, we can avoid the cherry picking problem of analyzing or reacting to any signal after the fact. That is why I use the forecasting framework outlined by New Deal democrat, where he has specified a series of long leading recession indicators used by Geoffrey Moore to forecast recessions about a year in advance. They can be broadly categorized as measuring the household sector, monetary conditions, and the corporate sector, or what NDD calls the producer sector.

Consumer spending is on fire

Starting with the household sector, the consumer is on fire. Consumer spending is on fire. Historically, real retail sales per capita has turned down ahead of recessions. There is no sign of a top.

Housing is a highly cyclical sector, and it is usually the biggest item in household expenses. Housing has historically peaked before past recessions. So far, there is no sign of a top in housing starts.

In addition, the real-time market signals of homebuilding stocks exhibit a bullish pattern. The group broke out of a saucer shaped relative bottom, and it is in a steady relative uptrend.

Last Friday’s strong October Jobs Report is another bullish factor in support of the household sector. The economy added 128K jobs, compared to an expected 89K, in the face of weakness from the GM strike, and a decline in temporary Census workers. Non-Farm Payroll employment was also revised upward for August and September. These figures point to strength in the jobs market, and consumer spending.

A dovish Fed

The second leg of long leading indicator measure monetary policy. Fed chair Jerome Powell signaled in the October post-FOMC press conference that the Fed is no hurry to raise rates:

I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.

The Fed is dovish, and is prepared to support growth. These are not recessionary conditions. In fact, the Fed is easing. As one measure of the level of accommodation of monetary policy, consider money supply growth. In the past, either M1 or M2 growth has fallen below CPI inflation (black line) before recessions. Today, money growth is accelerating.

Another characteristic of recessionary conditions is tightening credit conditions. As economic conditions deteriorate, banks and other lenders tighten their lending criteria. The resulting credit squeeze tanks the economy. The latest measures of financial conditions from the Chicago and St. Louis Fed shows that credit is still easy.

Why worry about a recession?

Rising corporate angst

The weak flank of the economy is the corporate sector. While it is true that corporate bond yields have historically bottomed out 2-3 years ahead of recessions, and they made a new low recently, the corporate sector is not ready to sound the all-clear.

NIPA corporate profits deflated by unit labor costs (blue line) has historically turned down ahead of recessions. That’s where the economy looks vulnerable.

The trade war has been a drag on the corporate sector. It is therefore not surprising that CEO confidence has tanked. Similarly, other survey based indicators, such as ISM and PMI, are all showing signs of weakness.

As business confidence wanes, so does business investment. A recent Fed study found that the trade war had knocked about 1.0% from potential GDP growth. No wonder the Fed has been pre-emptively easing.

From a tactical perspective, forward 12-month EPS estimate revisions are still stagnant, despite an above average Q3 earnings season. Stock prices may struggle until it becomes evident that the fundamental outlook is improving.

There are some bright spots to the earnings picture. Brian Gilmartin of Trinity Asset Management identified Consumer Discretionary and Real Estate sectors as showing positive estimate revisions.

Consumer Discretionary is housing and autos and in terns of individual stocks, it’s Amazon, McDonald’s, Home Depot, Starbucks, etc.

Those subsectors and stocks have performed well in 2019, and AT LEAST THUS FAR, analysts are taking numbers up for the consumer discretionary sector for 2020, versus the normal downward revisions.

None of this means this will hold for the next 15 months, but with the decent US job growth reported this morning, and three fed funds rate cuts in the last 3 months, nothing has changed so far for 2020 in terms of being concerned about the US consumer.

Corporate weakness, but no recession

To summarize, the US economy is going through a soft patch because of weakness in the corporate sector, but corporate weakness will not drag the US into recession. Ryan Detrick of LPL Financial recently highlighted this chart of the sources of GDP growth. While business spending (yellow bar) is weak, consumers spending (blue bar) remains strong. It is difficult to see how the economy could fall into recession in light of the difference in the magnitude of these effects.

For another perspective, Bloomberg reported former Fed chair Alan Greenspan is also calling for no recession:

We’re still in a period of deleveraging. No recession in the last half century, at least, began from a period of deleveraging.

Currency strategist Marc Chandler found signs of a “synchronized emergence from [a global] soft patch”:

There have been plenty of developments warning of a global economic slowdown. Yet, seemingly to justify the continued advance in equity prices, there has begun to be talk of possible cyclical and global rebound.

That is the new constellation, connecting the better than expected Japanese, South Korean, and Chinese September industrial output figures, a slightly stronger than expected Q3 GDP reports from the US and the eurozone. Ahead of the weekend, China reported an unexpected increase in the Caixin manufacturing PMI and a sharp rise in the forward-looking new orders component. The US labor market, which helps drive consumption and 70% of the economy, is faring better than expected. Not only was the October job growth more than expected, but the past two months had under-counted by 95k.

A new bull?

In conclusion, global markets are staging coordinated upside breakouts. These are unambiguous signs of a global rebound in growth. Recession risks are low. This is likely the start of a new leg in an equity bull. Institutions are still too bearish, and they are going to get caught leaning the wrong way. The latest Barron’s Big Money Poll shows year-end and mid-year 2020 targets below current market levels.

SentimenTrader put it a slightly different way.

That said, I reiterate my belief that US equity valuation is stretched compared to other regions in the world. Investors will find better risk/reward tradeoffs with non-US exposure.

The Trend Asset Allocation Model is now bullish. Enjoy the new bull.

The week ahead

Looking to the week ahead, the short and intermediate term outlooks look bullish. The SPX and NDX staged decisive upside breakouts over resistance to achieve all-time highs.

The weekly chart of SPX shows the index testing a rising trend line. Usually, at these junctures, it is not unusual for the market to take a breather to pull back and consolidate its gains. What is unusual about this test is past touches of the trend line were accompanied by negative 5-week RSI divergences. This time, there is no bearish divergence.

Looking at the daily chart, the challenge for the bulls is to achieve a series of “good overbought” conditions on the 5-day RSI, with pauses when the 14-day RSI reaches the 70 overbought level. Other internals appear to be constructive. Friday’s advance was accompanied by a surge in new new highs. In addition, the VIX Index has not reached its lower Bollinger Band, which is a level when past rallies have stalled.

Despite Friday’s test of overhead resistance, short-term momentum is surprisingly not overbought, indicating a possible overthrow of the rising trend line depicted in the weekly chart early next week.

The NYSE McClellan Summation Index (NYSI) stands at 706, and it is nowhere near a 1000+ overbought level yet. Past NYSI peaks in the last 10 years have seen the market stall (red), with only a small minority (red) resolving with a continued advance. These conditions suggests that this rally has more room to run.

Cross-asset analysis from the foreign exchange market is also hopeful for the bull case. The USD continues to weaken after exhibiting a failed breakout from a multi-year base. USD has two benefits. First, it alleviates any pressure on the offshore dollar market for weak credit borrowers, and reduces the risk of an EM crisis. As well, it is helpful to the operating margins of US large cap multi-nationals operating in foreign markets.

I am also watching the USDJPY rate. The Japanese Yen has been a haven for safe assets, and it is an indicator of global risk appetite. USDJPY is forming a possible inverse head and shoulders formation, and should it stage an upside breakout, it would be another bullish signal for risky assets such as stocks.

Sentiment models are mixed. The AAII bull-bear spread, while net bullish, can be said to be in neutral territory and not at an extreme reading.

On the other hand, the Fear and Greed Index reached 80 on Friday, which is at the bottom of the overbought zone where past rallies have topped out.

My inner investor is gradually moving his portfolio from a neutral position>to an overweight position in equities. My inner investor trader is long the market. He bought the upside breakout last week.

Disclosure: Long SPXL