Any more precautionary cuts?

Posted by Cam Hui -

Mid-week market update: Now that the Fed has cut rates a third time, and the upside breakout in the SPX and NDX are holding, what’s next?
 

 

Are the series of precautionary cuts over?
 

Dissecting the rate cut

Now that Brexit risks have subsided, and trade tensions are receding as the US and China have more or less had a “phase one” trade deal in place, does the Fed need to cut further? To be sure, Chile announced this morning that it was pulling out of hosting the APEC summit because of ongoing street protests, so Trump and Xi won’t be able to sign any “phase one” agreement on the sidelines, but if there is a deal, both sides will find a way for the agreement to be signed.

Arguably, inflation pressures are moderate but steady. Today’s release of quarterly core PCE prices, which is the Fed’s preferred measure of inflation, came in at 2.2%, which is above the inflation target of 2%. In the past, whenever the count of the monthly annualized PCE rate that exceeds 2% is at or above six, the Fed has felt compelled to begin raising rates. The latest August reading stands at 5, which shows moderate and steady inflation pressure.
 

 

To be sure, the market expects that this will be the final rate cut. The latest readings of the CME Fedwatch tool shows that most participants do not expect any additional action by the December meeting.
 

 

A repeat of the 1998 bubble?

One possible scenario for investors to consider is the Fed’s actions in 1998. Grant Thornton economist Diane Swonk believes that the last and third rate cut was unnecessary. She compared it to the Fed’s actions in 1998 when the Fed cut three times, which eventually fueled the subsequent equity market bubble.
 

 

Josh Brown highlighted analysis from Jon Krinsky, who observed that the MSCI All-Country World ETF (ACWI) was breaking out to new recovery highs.
 

 

The tactical trading picture remains bullish. As of last night`s close, market internals are not overbought, and they have further room to run on the upside.
 

 

The combination of trade friendly headlines, an accommodative and vigilant Fed, and strong global market action argues for an intermediate term bullish equity bias. These conditions indicate that both the short and intermediate term path of least resistance for stock prices is up.

Disclosure: Long SPXL

 

Scary Halloween story: How a weak USD could hand China a major victory

Posted by Cam Hui -

I have written before how a strong USD can be a negative for global financial stability. There are  many EM borrowers who have borrowed in the offshore USD market, and a rising USD puts a strain on their finances.

In addition, FactSet reported that companies with foreign domestic exposure have exhibited worse sales growth than companies with domestic exposure.
 

 

The USD Index staged an upside breakout out of a multi-year cup and saucer pattern with bullish implications, which was bearish for global risk appetite. More recently, it fell below the breakout line, which should be bullish for global assets. Indeed, the bottom panel shows that the relative performance of EM stocks is making a broad based bottom, just as the USD weakened.
 

 

Here is the scary Halloween story to be told around the campfire. A falling USD has the potential to hand China a major geopolitical victory without firing a single shot. In the ancient text, The Art of War, Sun Tzu wrote that a general could win by arraying his forces to exploit his enemy`s weaknesses. That way, he can achieve victory without bloodshed if it becomes evident that the enemy will collapse before any fighting begins.

Here is a little known but glaring weakness that Beijing could exploit.
 

Taiwan`s weakness

Our story begins with how the Taiwanese channel their savings, namely life insurance products. Bloomberg reported that even Taiwan`s insurance regulator called himself out over the Taiwanese insurance obsession:

Taiwan’s chief financial regulator is urging people to stop using life insurance as a way to make money and he points to his own family as part of the problem.

The widespread use of life insurance as a wealth-management product has made Taiwan into the most insured market in the world. But it has also created a level of competition and reckless offers that threaten the stability of an industry with $876 billion in assets, the Financial Supervisory Commission Chairman Wellington Koo said in an interview Monday.

“Insurance isn’t the same as savings. It’s not a wealth management product,” Koo said. “You shouldn’t take out an insurance policy instead of a wealth management product just because your bank only offers 1% on your savings.”

The problem is one Koo is personally aware of. The 60-year-old readily admits he and his wife, Taiwan’s deputy economics minister Wang Mei-hua, have nine high-return fixed term insurance policies between them. He says they were taken out on his behalf by his mother on the advice of staff at her local bank.

Life insurance assets is $876 billion, which is more than Taiwan`s GDP of roughly $600 billion.

Taiwan’s life insurance companies controlled NT$27.5 trillion ($876 billion) in assets as of the end of March, according to the Taiwan Insurance Institute, dwarfing the island’s $567 billion economy. And while they raked in a record NT$3.5 trillion in premiums last year the rate of growth is slowing. After increasing as much as 13% in 2012, premium revenue grew only 1.4% in 1Q this year.

Here is the problem. The liabilities of Taiwanese life insurance is in TWD, but they don`t have enough investment opportunities in Taiwan. The WSJ reported that they have instead invested mostly in US corporate debt.

Asia’s insurance behemoths, particularly in Taiwan, pose a growing risk to the U.S. corporate-bond market after a multiyear binge on greenback debt.

Insurers in Asia’s more developed economies have promised returns far greater than their government-bond markets can provide, and they need to hold far more assets than their domestic bond markets can satisfy.

That has left them fishing for other sources of returns, most notably in the U.S. corporate-bond market. South Korea, Japan and Taiwan’s holdings of U.S. dollar corporate bonds have more than doubled to over $800 billion in the past five years, according to the International Monetary Fund’s global financial stability report, published last week.

Corporate bond markets in the U.S. and the eurozone are 81% and 41% of the size of their life insurers’ total assets, respectively. In Korea, Taiwan and Japan, the respective figures are 10%, 8% and 4%.

This has created the possibility of financial instability as bond yields rise.

The IMF notes the risk posed by U.S. dollar bonds with call options. These allow issuers to redeem long-dated bonds early, reducing their financing costs but causing paper losses for insurers.

This is no longer simply a possibility: The risk has begun to materialize in Taiwan, where such securities are known as Formosa bonds, after the island’s colonial-era name. The plunge in U.S. rates this year has cut yields on American BBB-rated corporate debt from around 4.7% at the beginning of the year to just 3.3% today. Issuers of long-dated debt will be eager to refinance at lower rates.

While all Asian life insurers have foreign exposure, Marketwatch observed that the size of Taiwan`s exposure dwarfs all others.
 

 

Moreover, Taiwanese life insurance companies are thinly capitalized.
 

 

An enormous foreign currency mismatch

In addition to interest rate risk, the much bigger threat to Taiwanese life insurers’ financial stability is foreign currency risk. At $540 billion in foreign assets, that’s nearly Taiwan’s $600 billion in GDP.

What about foreign currency hedging?

Brad Setser at the Council on Foreign Relations and the blogger Concentrated Ambiguity has done extensive work on this topic.

First, some conventions in this analysis. For the purposes of the study of international fund flows, Taiwan is not a country. It is an economy. Taiwan is not part of the IMF or any other global financial institutions, and therefore it does not report its exposure in accordance with IMF standards. The Central Bank of the Republic of China (CBC) is Taiwan’s central bank, and it is distinctly different than the PBoC, which is China’s central bank based in Beijing.

First, let us begin with the reported unhedged foreign exchange (FX) positions. Setser reported that “life insurers’ own open FX position increased to USD 120bn as of mid-2019”. Further, “FX risks taken by households via FX denominated life insurance policies grew from practically zero in 2008 to USD 140bn”. Those are the official and stated unhedged positions.

The rest of the life insurance book is “hedged”. But how? Setser could not find the counterparties to the FX hedge, until he discovered that the CBC was providing a significant amount of the hedge by holding down the TWD exchange rate.

Had the CBC not intervened by at least USD 130bn in FX markets via its swap book, TWD would likely have appreciated and safety-oriented private sector actors in Taiwan would have been much less likely to assume long USD positions. Pondering counterfactuals might not always be helpful, yet in a world in which the CBC had not intervened sizeably, a USD/TWD exchange rate in the mid 20s would not surprise.

Setser concluded:

Given that Taiwan still maintains a large trade surplus, the CBC appears to have itself boxed in and has, at least implicitly, written a put on USD/TWD, keeping TWD weak to shield its private sector from FX losses. For most actors, this put is merely implicit: “TWD has not appreciated in the past so why should it in the future; let’s buy USD”.

For life insurance companies themselves, this put might actually be rather explicit. In a relatively closed system as Taiwan, the major actors on the demand and supply side typically know each other fairly well. This is especially the case for lifers owned by a financial holding company also operating a banking subsidiary. This would apply to three of Taiwan’s four largest insurers: Cathay, Fubon and Shin Kong. While conjecture for now, this is exactly the framework the Bank of Korea used to provide FX hedges under in a similar situation.

If lifers know the CBC is the ultimate counterparty to the majority of their current FX hedges and know that it will likely continue to be so in the future, it is much easier to run larger open FX positions. In case of difficulties, the CBC would, after all, be ready and provide additional FX hedges at reasonable rates. Switching perspectives, if the CBC knows lifers are unlikely to unwind open FX positions at the first sign of trouble, Taiwan’s authorities can be much more lenient in their regulation of FX exposures. Currently, this is most relevant for the regulation of FX exposures lifers acquire via domestically-listed bond ETFs acquiring foreign bonds FX-unhedged.

Any attempt to scale these risks suggests they are big: Lifers in aggregate currently hold ~65% of assets in foreign bonds, of which 22% is FX unhedged. This implies long USD exposures worth USD 123bn, or 14.3% of assets. Against that, lifers hold capital of USD 50bn, or 5.5% of assets. In a static environment without hedge adjustments, a 10% increase in TWD/USD thus inflicts losses of USD 12.3bn, or 22% of stated capital, on lifers. Larger moves are of course possible.

Concentrated Ambiguity added:

The CBC’s (deliberate?) influence in incentivizing private sector institutions in Taiwan to assume FX risks worth almost USD 500bn (~80% of GDP). Previous Balance of Payment turmoil usually followed FX mismatches originating from the liability side of a nation’s balance sheet – is Taiwan the first case the asset side is the driver?

To summarize, the Taiwanese life insurers have boxed the Taiwanese economy in with a “this will not end well” story. Any significant depreciation in the USD could collapse the Taiwanese financial system, not just because of life insurers’ exposure, but the implicit cheap hedge provided by the CBC. What’s more the CBC has actively suppressed the TWD by providing this hedge.
 

China’s opportunity

Now view this from China’s perspective. Even since Mao’s victory in 1949, when Chiang Kai-shek’s Nationalist forces fled to Taiwan, Beijing has coveted Taiwan and the return of Taiwan to Party rule. This outsized exposure of the Taiwanese economy’s foreign currency and interest rate exposure presents Beijing an opportunity.

Imagine the following scenario. A disinformation campaign installs a China friendly candidate in Taiwan’s presidential election in January. Then Beijing starts a two-pronged approach to put a wedge between the US and Taiwan. It plants stories to publicize the fact that Taiwan has been actively undervaluing its currency through central bank manipulation (all true).

Then Beijing goes for the kill. The PBoC begins to sell its USD holdings to buy TWD assets, which drives up the TWDUSD exchange rate. The Taiwanese financial system gets strained. At what point does it collapse? Taiwan’s GDP is roughly $600 billion. The PBoC’s assets are about $3 trillion. What price will Beijing pay to get Taiwan back?

During this financial attack on Taiwan, the US stands aside. Trump has always been highly transactional in his relationships. Besides, Taiwan has been manipulating its currency, and the Chinese military has not threatened Taiwan in an explicit fashion, so any defense treaty is not applicable in this situation.

Once Taiwan’s financial system collapses, a friendly China stated owned financial company graciously steps in to offer a lifeline by buying the life insurers and banks at pennies on the dollar. A Chinese SOE now owns the Taiwanese financial system, and a Beijing compliant candidate is the president.

The takeover is effectively complete. It is only a matter of time that Beijing and Taipei negotiates a reunification pact on Beijing’s terms. And all this was accomplished without mobilizing a PLA invasion force.

Your Halloween campfire story is over. Now go to bed, and sweet (funny) dreams.

 

The Art of the Deal, Phase One edition

Posted by Cam Hui -

The markets began to take on a risk-on tone on Friday when the news that American and Chinese negotiators had “made headway on specific issues and the two sides are close to finalizing some sections of the agreement”. Bloomberg went on to report today that the text of the “phase one” agreement is basically done, and the agreement will be signed when Trump meets Xi at the APEC summit in Chile in mid-November:

China said parts of the text for the first phase of a trade deal with the U.S. are “basically completed” as the two sides reached a consensus in areas including standards used by agricultural regulators.

The Saturday comments followed a call Friday with Chinese Vice Premier Liu He, U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin. The trade negotiators “agreed to properly resolve their core concerns and confirmed that the technical consultations of some of the text agreement were basically completed,” China’s Ministry of Commerce said in a statement on Saturday.

 

With our trade war factor in roughly neutral territory, we try to answer the following questions:

  • What’s on the table in the “phase one” deal?
  • What are the prospects for “phase two”?
  • What are the market and political implications of such a deal?

 

What’s on the table?

There are numerous press reports of what has been discussed, and the degree of agreement. Reuters reported that China has offered agricultural purchases that start at the $20bn, which represents pre-trade war levels, and far below the $40-50bn touted by Trump:

Trump has touted purchases of $40-50 billion annually — far above China’s 2017 purchases of $19.5 billion as measured by the American Farm Bureau.

One of the sources briefed on the talks said that China’s offer would start out at around $20 billion in annual purchases, largely restoring the pre-trade-war status quo, but this could rise over time. Purchases also would depend on market conditions and pricing.

In return, Bloomberg reported the US has agreed to suspend the implementation of the tariff increase originally scheduled for October 15, and the mid-December tariffs increase is still up for discussion:

A pause in the tariff escalation, but not an end of them. Trump agreed to forego an Oct. 15 increase to 30% from 25% in the tariffs collected on some $250 billion in imports from China. But the 25% tariffs haven’t gone away. And neither has the 15% tariff on a further $110 billion in goods that took effect Sept. 1, nor the threat that another $160 billion in goods will be hit Dec. 15. There is an expectation the Dec. 15 tariffs, which would hit popular consumer items like smartphones and toys, won’t take effect. But a lot of tariffs remain in place.

CNBC reported that trade czar Peter Navarro has been actively opposed to the deal, but he has little support among American negotiators. Navarro’s objections is a hint of what is not on the negotiating table in “phase one”:

Navarro has taken particular issue with the shelving of certain protections for intellectual property and technology that appeared in earlier versions of the deal, according to these three sources, who are in regular contact with Trump and the administration. Navarro has urged Trump to force China to recommit to previous promises on IP protection or walk away from a deal.

,,,

As announced, the deal would not outlaw China’s subsidizing state-owned enterprises. It would not open China’s economy to all sectors and industries, as the Trump administration had been pushing. And it would not require China to codify the deal into the law — a focal point in talks that became a dealbreaker for Xi in May.

Bloomberg further reported that the Chinese have agreed to concessions on intellectual property and an agreement on currency stability, which may have been enough to placate Navarro:

Concessions on intellectual property. From the beginning, the administration’s big target in its “Section 301” fight against China has been forcing an end to what the U.S. sees as a systematic and state-backed Chinese theft of American intellectual property. Included in the deal being finalized are commitments by China. But they are largely actions China has taken already. It passed new IP and foreign investment laws earlier this year that address the issue. It has also already set up new IP courts to prosecute cases. As always with China, the key is whether authorities enforce the laws.

Currency commitments. As members of the Group of 20 both the U.S. and China have agreed not to manipulate currency markets for economic advantage. Now they will have a bilateral commitment to do so that may lead to the U.S. removing the “currency manipulator” label it slapped on China in August.

What about the all-important agricultural purchases? Here is how much soybeans the Chinese have bought from the US (orange line). That`s right, it`s virtually nothing, and roughly in line with what they bought last year.
 

 

Moreover, Beijing wants to only commit to buying soybeans based “on market conditions and pricing”. As the following chart shows, Brazilian soybean prices are competitive with US beans, and American farmers will have to compete in the global markets to get China’s business.
 

 

What about “phase two”?

What about “phase two”? Hu Xijin, the editor of China’s official news organ Global Times, tweeted that a “phase one” deal was likely, but he didn’t hold out much hope of progress for further agreement.
 

 

If what we have heard so far from news reports is correct, then what is on the table represents an uneasy truce between both sides. China promises to buy $20 bn of agricultural products, which is roughly the pre-trade war level, and it will ramp up to $40-50 bn some time in the future. In return, the US suspends the October 15 tariff increase, and possibly the December 15 increase. Each is trying to retain negotiating leverage, either in the form of more agricultural purchases, or the suspension or rollback of tariffs. This agreement is designed to alleviate the short-term pain felt by each side. The Chinese desperately need more pork imports, and the soybeans needed to feed its pig population. The American side needs to stem the pain felt by its farmers.

Current expectations are the “phase one” agreement will be signed when Trump meets Xi at the APEC summit in mid-November.
 

Market and political impact

If this limited deal were to be signed, what are the market and political impacts? The initial market reaction has been a relief rally, as the risk of further trade war escalation diminishes. Moreover, any suspension of the tariffs scheduled for December 15 removes a threat to US consumer spending, as most of those tariffs would hit consumer goods, and just ahead of Christmas.

Longer term, however, the market and political impacts are less certain.

Former Morgan Stanley Asia chair Stephen Roach derided the deal as nothing more than a smoke and mirrors exercise:

And yet the phase one deal announced with great fanfare is a huge disappointment. For starters, there is no codified agreement or clarity on enforcement. There is only a vague promise to clarify in the coming weeks Chinese intentions to purchase about $40-50 billion worth of US agricultural products, a nod in the direction of a relatively meaningless agreement on currency manipulation, and some hints of initiatives on IP protection and financial-sector liberalization. And for that, the Chinese get a major concession: a second reprieve on a new round of tariffs on exports to the US worth some $250 billion that was initially supposed to take effect on October 1.

Far from a breakthrough, these loose commitments, like comparable earlier promises, offer little of substance. For years, China has long embraced the “fat-wallet” approach when it comes to defusing trade tensions with the US. In the past, that meant boosting imports of American aircraft; today, it means buying more soybeans. Of course, it has an even longer shopping list of US-made products, especially those tied to telecommunications equipment maker Huawei’s technology supply chain.

The broad details of the agreement. (as reported in the press) does not address the bigger underlying questions:

The real problem with the phase one accord is the basic structure of the deal into which it presumably fits. From trade to currency, the approach is the same – prescribing bilateral remedies for multilateral problems. That won’t work. Multilateral problems require solutions aimed at the macroeconomic imbalances on which they rest. That could mean a reciprocal market-opening framework like a bilateral investment treaty or a rebalancing of saving disparities between the two countries that occupy the extremes on the saving spectrum.

Stripped to its core, the “phase one” agreement amounts to $20 bn in Chinese agricultural purchases in return for the suspension of some planned tariff increases. While there is some language about intellectual property protection and currency stability, they amount to nothing more than promises, and their enforcement depend on future Sino-American relations.

If enacted, the “phase one” deal as outlined is likely to only formalize a ceasefire in the trade war, and does not represent any substantive progress. Even if the deal were to be concluded with only planned tariff suspensions, and no tariff rollbacks, Trump is likely to attract criticism from both sides of the aisle in Washington. This will not help his standing in light of his political position when he is under impeachment pressure. He will need members of his own party to support him, and what amounts to a cave at the negotiation table is not helpful for Republican support.

Bottom line: The good news is both sides are talking, and the chances of further escalation in the trade war is receding. If I am correct in my assessment of a global cyclical upturn (see An upcoming seismic shift in factor returns), then the market’s expectations of trade war risk should also fade over time. The bad news is that the Sino-American trade, strategic, and diplomatic relationship has been permanently damaged. We are unlikely to see any trade peace, regardless of who wins the White House in 2020.

Disclosure: Long SPXL
 

An upcoming seismic shift in factor returns

Posted by Cam Hui -

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

A seismic shift ahead

Last week, I highlighted the rising bifurcation of US and non-US equity markets (see The stealth decoupling sneaking up on portfolios). Further factor analysis reveals a possible seismic shift in cross-asset and factor return patterns, beginning with a steepening yield curve that is signaling better economic growth expectations.
 

 

To summarize, a factor based review of equity returns leads to the following conclusions.

  • Favor non-US equity exposure over US
  • Favor value over growth, and avoid high-octane NASDAQ names
  • Favor global financials over technology
  • Position for a cyclical rebound with exposure to semiconductors, industrials, and US homebuilding
  • While the macro backdrop appears favorable, it may be too early for exposure to EM, gold and inflation hedge industries like resource extraction

 

A factor tour around the world

To explain, let us take a factor tour around the world. We begin with the behavior of financial stocks. The relative performance of this sector is historically correlated with the shape of the yield curve. A steepening yield curve is a favorable environment as it benefits institutions which borrow short and lend long. The recovery in this sector is not just limited to the US market. European financial stocks have also been turning up in this environment of better growth expectations.
 

 

At the same time, the relative performance of technology stocks have begun to roll over. Like the pattern in financial stocks, the relative weakness is synchronized among large cap, small cap, and European technology stocks. Arguably, investors have a lessened need for exposure to this growth sector as a source of growth if global growth expectations are beginning to rise.
 

 

A Value revival

This seismic shift in sector performance has also led to a shift in style returns. An analysis of the pure value and growth indices, as well as the Russell value and growth indices, reveals that the biggest differences is a value overweight in financial stocks, and a growth overweight in technology. For the geeks, a word of difference between the two types of indices is warranted. Both methodologies rank stocks by value and growth characteristics. The pure value and growth indices splits the universe in half, and float weights the stocks in each value and growth group to construct the pure index. The Russell value and growth indices, however, will have index constituent overlaps. That way, a value stock will have 20% of its “normal” weight in a growth index, and vice versa for a growth stock in a value index.
 

 

In light of the changes in growth expectations, the changes in return patterns of value over growth are therefore to be expected.
 

 

A similar pattern of sector weight differences between value and growth can be found in US and non-US equities. US stocks are far more exposed to technology, while non-US stocks are more heavily weighted in financial stocks.
 

 

The BAML Global Fund Manager Survey showed that while global managers were roughly market weight equities, their greatest overweight was in the US.
 

 

Further analysis of their sector weights shows an underweight position in banks, and overweight in technology. By inference, global institutions have an implicit bet on growth and against value. Should this factor shift continue, watch for them to scramble and reverse those positions.
 

 

Signs of cyclical stabilization and rebound

Another silver lining we are seeing are early market signals of a cyclical rebound. For one, global PMIs have stopped falling and they are beginning to recover.
 

 

Despite the recent gloom over rising trade tensions, it is possible to see a cyclical recovery without an end to the Sino-American trade war. That’s because Lakshman Achuthan of ECRI observed that a global cyclical downturn began before the start of the trade war.

In hindsight, it’s clear that actual global industrial production growth started slowing at the end of 2017. In other words, the year-over-year pace of increase in the world’s total industrial output began a sustained decline in late 2017. That’s the definition of a global industrial slowdown…

In this case, while the global manufacturing PMI also started easing at the end of 2017, its decline didn’t become evident until a few months into 2018, when the sustained nature of the downturn became increasingly difficult to dismiss as meaningless “noise.” Coincidentally, that’s just about when President Trump began his trade war, slapping tariffs on washing machines and steel and aluminum imports. Because the trade war was front and center, economists thought it was to blame for the drop in PMI and global industrial growth.

 

 

Achuthan concluded:

Looking ahead, that means at some point global growth can revive even without the trade war ending. Even so, the recovery will be credited, as always, to the prominent events of the time.

Sean Maher of Entext provided two possible fundamental drivers for a cyclical turnaround in global growth, autos and smartphones:

To sustain the recent rotation toward cyclical value, we need a rebound in two key industrial sectors we’ve been structurally bearish on since 2016/17 – autos and smartphones. In both cases, a technology shift (diesel to hybrid electric in Europe/Euro 6 equivalent in China, 4 to 5G in mobile) and the rapid rise of a second-hand market in China have dented new sales. Those postponed consumption/extended replacement cycle headwinds are now abating – mainstream German car brands have electrified, and buyers of ICE cars worried about residual values can now choose a VW e-Golf over a Tesla.

Indeed, the Ifo survey of German auto sector confidence is showing signs of stabilisation, while annualised output is also likely bottoming at just over 5m units. Last month, EU demand for new passenger cars increased by 14.5% to 1.2m units – the growth is certainly flattered by a low base following the introduction of a new emissions testing regime last year, but its striking that four of the five major EU markets saw double-digit gains. Over the first nine months of 2019, new car registrations were down 1.6% y/y but that should be turning positive into early 2020 – much of the slump in demand has been due to a technical industry transition creating consumer confusion over residual values etc. Tighter emissions standards have also been a drag in China, which adopted the local equivalent of Euro 6 for ICE engines in June this summer – sales have begun to recover since.

As for smartphones, while 5G handsets are still only about 1% of Chinese sales, with 40 cities fully networked by mid-2020 and operators offering 30-40% discounts on 3000-4500 RMB handsets (taking them closer to 4G prices), that proportion should surge toward double digits through H1. Given this upgrade cycle and flattering base effects, the overall market which has been falling 5% or so y/y in recent months should turn strongly positive by mid-2020. Pre-registrations for 5G service are approaching 10m users, even with just a handful of handsets currently available (although dozens more Chinese designs will be launched by mid next year).

As growth expectations have begun to rise, we are also seeing evidence of stabilization and rebound of cyclical stocks. A pattern of a bottom and recovery in cyclical industries is evident in the relative return patterns in the US. Semiconductor stocks, which are highly sensitive to the smartphone theme identified by Maher, have been in a multi-month relative uptrend, and the housing sector has been steadily improving since late 2018.
 

 

The stabilization theme is also evident globally. Global industrial stocks are testing a relative downtrend line as it makes a saucer shaped bottom. A similar rounded bottom can also be found in global auto stocks.
 

 

Too early to buy gold, inflation hedges

As growth and inflation expectations recover, I am always asked about gold. From a technical perspective, it is still too early for gold and inflation hedge vehicles to make a move. While gold prices have made a definitive breakout from a multi-year base, inflationary expectations are still falling, which creates headwinds for gold and inflation hedge vehicles.
 

 

The latest Commitment of Traders report analysis on gold from Hedgopia reveals that large speculators remain in a crowded long position, which is likely to put a ceiling on any price rallies in the short run.
 

 

The outlook for resource extraction stocks, which are the main vehicles for inflation hedges, depend on Chinese demand. The relative performance of Chinese material stocks are still flat and falling. The relative performance of energy stocks are still in a relative decline, and mining and materials stocks are only trying to make a relative bottom. While investors may want to consider taking an initial position in these groups, it is too early to expect outperformance.
 

 

Despite the gloomy outlook for the Chinese economy and Chinese demand for materials, there is a silver lining. The relative performance of China’s property developers appear to have stabilized. These are highly levered companies, and they are very sensitive barometers of China’s financial health because the Chinese population has poured its savings into real estate. The stabilization of their relative performance without any material financial calamities is a signal that the Beijing authorities have been able to manage a soft landing (for now).
 

 

Too early to buy EM

Another recent bullish development for global risk appetite is the weakness in the USD. A rising USD has put strains on the global financial system because of the outsized position of offshore EM and corporate debt. The USD Index staged a breakout out of a bullish cup and handle formation, but it recently retreated below the breakout level, which negates the technical pattern. This should provide a tailwind for emerging markets (EM), but EM stocks are only bottoming on a relative basis.
 

 

It is probably too early to make a full commitment to EM. The analysis of the relative performance of EM and BRIC countries reveals that two countries (Brazil and Russia) are stabilizing against ACWI, and (India and China) two are still weak. It is too early for EM, wait for some signs of better relative performance.
 

 

In summary, a factor based review of equity returns leads to the following conclusions.

  • Favor non-US equity exposure over US
  • Favor value over growth, and avoid high-octane NASDAQ names
  • Favor financials over technology globally
  • Position for a cyclical rebound with exposure to semiconductors, industrials, and US homebuilding
  • While the macro backdrop appears favorable, it may be too early for exposure to EM, gold and inflation hedge industries like resource extraction

Global institutions appear to be caught on the wrong side of these exposures. Should this seismic shift continue, expect a FOMO stampede of these trends, which should lead to better relative performance in the future.
 

The week ahead

Looking to the week ahead, market direction has been buffeted by bullish long-term momentum and short-term technical and fundamental headwinds. The SPX and NDX had consolidated sideways through uptrend lines last week. The SPX rallied on Friday to test its all-time highs, while the NDX staged an upside breakout. It is said that there is nothing more bullish than an index making fresh highs, but how bullish is this move?
 

 

The advance was accomplished on the news of progress in the Sino-American trade talks, but the fundamentals remain challenging. The market trades at a forward P/E ratio of 17.1, which is elevated and equals the levels reached last July.
 

 

For a longer term perspective, analysis from Ned Davis Research shows that current levels of elevated P/E valuations has resulted in subpar 5-year returns of 1.8% and 10-year returns of 3.4%.
 

 

More importantly, the E in the forward P/E is falling, which creates further headwinds for stock prices. Even though the EPS and sales beat rates are well above historical norms, Street analysts are revising down their earnings estimates, and the magnitude of the earnings beats are below average by historical standards.
 

 

While it is true that overbought and overvalued markets can continue to advance, technical signals are also flashing warning signs. As the index tests overhead resistance, both the 5-day and 14-day RSI are exhibiting negative divergences, and against a background of declining net highs-lows. In addition, the term structure of the VIX has reached levels indicating complacency. Past episodes have generally seen prices stall and fall.
 

 

Breadth indicators are mixed, but lean bearish. The most bullish indicator is the Advance-Decline Line, which made fresh highs last week. However, % above 50 dma, % above 200 dma, and % bullish are all exhibiting patterns of lower highs even as the SPX tests resistance.
 

 

The bearish tilt of short-term trading indicators are offset by powerful longer term bullish forces. The SPX is on the verge of a bullish outside month.
 

 

Should the SPX remain at current levels at month-end, it will flash a MACD buy signal, which has been a highly reliable indicator of higher prices ahead.
 

 

Analysis from Callum Thomas of Topdown Charts shows that the most shorted stocks are lagging the market in this advance This is an indication of genuine investment demand, rather than a “flash in the pan” short covering rally.
 

 

While the monthly MACD buy signal has not been confirmed by the broader Wilshire 5000, only minor price gains will push this index into a buy signal.
 

 

Similarly, global stocks are also on the verge of a buy signal if the market even stages even a minor advance next week.
 

 

From a trader’s perspective, much depends on market action next week. FAANG heavyweight Alphabet will report earnings Monday, with Apple and Facebook reports Wednesday. The FOMC meeting will also end Wednesday, when the Federal Reserve is expected to cut another quarter-point. However, the market expects that this will be the final rate cut for the year. In short, intermediate-term market direction will depend on whether the SPX and NDX can continue to breakout to the upside next week.

My inner investor is neutrally positioned at roughly the equity weight specified by his investment policy. My inner trader is giving the bear case the benefit of the doubt, and he is short. However, he will reverse long should the upside breakout hold next week.

Disclosure: Long SPXU

 

SPX 3000 round number-itis

Posted by Cam Hui -

Mid-week market update: At week ago, I identified two technical triangle formations to watch (see Why small caps are lagging (and what it means)). Since then, both the SPX and NDX have struggled at key resistance levels despite a generally positive news background of earnings beats, and now they have moved sideways through a rising trend line. The obvious short-term downside target are the gaps to be filled below (shown in grey).
 

 

The market seems to be afflicted with a case of SPX round number-itis, where the index advance stalls when it reaches a round number.
 

Weakening NASDAQ

Notwithstanding the all-time high exhibited by AAPL, most of the weakness is attributable to the lagging performance exhibited by the high octane go-go stocks, such as internet, social media, and IPOs.
 

 

I have been monitoring the top five sectors, which comprise nearly 70% of index weight, for clues to market direction. An analysis of the top five sectors reveals lagging performance by FAANG dominated sectors, namely technology, communication services (GOOGL, NFLX), and consumer discretionary (AMZN). It is difficult to see how the index could make much bullish headway without the bullish participation of a majority of the top five sectors.
 

 

The analysis of the relative performance of the equal weighted top five sectors tells a similar story as the capitalization weighted analysis. As a reminder, equal weighting the stocks in each sector reduces the effect of the large cap FAANG heavyweights. All sectors show the same pattern of relative performance, except for consumer discretionary stocks (bottom panel), which is outperforming were it not for the drag provided by AMZN.
 

 

The relative performance of defensive sectors also tells a similar story. Even as the market consolidated sideways, defensive sectors were creeping up in relative performance, indicating the bears were trying to take control of the tape.
 

 

Still, I find it difficult to be overly bearish on stock prices. The fundamental news backdrop from Q3 Earnings Season has generally been positive, and both earnings and sales beats are coming in at above historical norms. My inner trader remains tactically short, but he is prepared to cover most of his positions and possibly reverse long should the market retreat to fill the gaps below.

The bear is only at the door, peering inside. He is not rampaging inside the house. Downside risk should be fairly limited.
 

 

Stay tuned.

Disclosure: Long SPXU

 

The stealth decoupling sneaking up on portfolios

Posted by Cam Hui -

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Neutral (upgrade)
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

A stealth decoupling

As the Sino-American trade war has progressed into Cold War 2.0, a consensus is emerging among analysts that the Chinese economy is starting to decouple from the rest of the world. However, in the short run, there is a stealth and surprising decoupling in performance occurring in global equity markets. It’s the US market from the rest of the world.

This development is important because US equities amount to roughly half of global equity market capitalization. The chart below of major markets relative to MSCI All-Country World Index (ACWI) tells the story. US relative strength peaked out in late August and began to roll over in September. At the same time, Japan has been climbing steadily, Europe has broken out of a bottoming process, and EM equities appear to be making a relative strength bottom.
 

 

We consider the implications of this emerging trend, and what it means for equity investors.

Regular readers know that my Trend Asset Allocation Model analyzes global equity and commodity markets to determine the level of equity risk to take (see A market beating Trend Model, and what it’s saying now). Real-time market signals are indicating that the global reflationary scenario is coming into play. While there are still risks, current conditions warrant the upgrade of the Trend Model signal from bearish to neutral.

Should the global economy undergo a cyclical rebound, it will be equity bullish, and a rising tide does lift all boats. However, US equities are likely to lag, and an underweight position is the best course of action under these circumstance. We are now seeing early signs of price momentum recovery in Europe, which is where investors should overweight. It may be still a little early for an overly bullish commitment to EM, or inflation hedges like gold. I would remain at a neutral weight in these assets while waiting for more confirmation signs of more firmness in global growth.

From a trading perspective, an upgrade in the Trend Model would normally result in a bullish signal in the trading model. However, the growing divergence and decoupling of US equities from global markets makes this an uncertain bet, and I remain tactically bearish.
 

The trade setup

The latest BAML Global Fund Manager Survey gave us some clues to this trade setup. Global managers were at a roughly market weight in equities, their most overweight region was the US.
 

 

In an environment where growth expectations are low, the US was the only source of growth in a growth starved world. Consequently, managers who had hold equities stampeded into US equities, in the manner where some investors bought low volatility and defensive stocks.
 

 

In short, the allocation to US equities had become a little crowded. What could go wrong?
 

What’s the pain trade?

Under these conditions, the pain trade for investors is a cyclical recovery and a reflationary economy. Just as the relative performance of US equities peaked in late August, bond yields bottomed, and began to rise. This is a bond market signal of higher growth and inflationary expectations.
 

 

Indeed, Jeroen Blockland observed that the amount of negative yielding debt has fallen by 20% from USD 17 trillion to just over USD 13 trillion.
 

 

Inflation surprise is edging up in selected regions around the world.
 

 

Even the disappointing ISM M-PMI print that recently rattled markets is deceiving. The reading was not confirmed by IHS Markit PMI, which came in strongly and ahead of expectations.
 

 

As well, Bespoke observed that it showed a significant divergence compared to an average of regional Fed manufacturing composites.
 

 

In Europe, growth expectations are being spurred by the combination of rising German willingness to engage in fiscal stimulus, the likely alleviation of a disorderly no-deal Brexit, and growing eurozone unity.

The news of a Brexit deal, which still has to be ratified by the British and European parliaments, was a relief for the markets, and reduced the Brexit risk premium embedded in UK and European equities. The deal outlined in the EU press release can be summarized this way:

  • Northern Ireland will remain the UK customs area, not as part of the EU customs area as per the Theresa May proposal. However, goods “at risk of entering the single market” will have EU tariffs applies.
  • Northern Ireland stays in the EU VAT regime.
  • Level playing field protections on environment stay.
  • Stormont will have a veto, but it will be limited. The Northern Ireland assembly will be able to vote on whether to continue with this arrangement four years after the transition period ends in December 2020.

A Brexit Withdrawal Agreement was not a total surprise to the financial markets. Even as the large cap FTSE 100 with greater exposure to multi-nationals struggled, the smaller cap FTSE 250, which is more exposed to the domestic economy, had been rallying since August, The ratio of the FTSE 250 to FTSE 100 (bottom panel) broke out of a relative downtrend in mid-August and has been rising strongly ever since. And even though MPs voted to postpone approval of the deal on Saturday, which necessitates a British government for an extension of the October 31 Brexit deadline, this nevertheless greatly diminishes the risk of a disorderly no-deal Brexit.
 

 

Less noticed was the Reuters report that Italian euroskeptics League leader Matteo Salvini’s assertion that the euro is irreversible.

League leader Matteo Salvini said on Monday the euro was here to stay and he hoped that nobody in his far-right, eurosceptic party would ever again raise doubts over Italy’s membership of the single currency.

The League ran at the European elections in 2014 under the slogan “No Euro” and it presented prominent anti-euro campaigners among its candidates for May’s EU ballot, when it won 34% of the vote to become Italy’s largest party.

However Salvini, who had already distanced himself from calls to quit the currency during his recent time in government, made clear his party would never again stand on an “Italexit” ticket as he bids to portray a more moderate image.

In short, the growth and risk outlook for Europe are all turning positively.
 

How US stocks could lag

While a global reflationary scenario is undoubtedly bullish for equities, it also presents a dilemma for US equity investors because US stocks are likely to lag under such circumstances. Underperformance can be attributable to three reasons, namely excess valuation, rising political risk, and trade war uncertainty.

Investors in US equities face a similar dilemma as the investors who stampeded into low volatility and defensive stocks that sparked the recent price moment trade and subsequent reversal. It has been a crowded trade, and valuations are now elevated. The forward P/E ratio on US stocks stand out compared to other major regional equities. While the US market trades at roughly 17 times forward earnings, the forward P/E for the rest of the world are clustered at low double digit levels.
 

 

Another factor investors may not have considered is political risk. It is becoming evident that Elizabeth Warren is becoming the front runner for the Democratic presidential nomination. However, the markets have not fully discounted the possibility of Warren’s candidacy. The issue will likely hit the headlines between now and Super Tuesday in March, when the nomination picture becomes more clear. The general market consensus is a Warren White House will be bearish for the markets. My own analysis (see What would an Elizabeth Warren presidency look like?) suggests that while the issues raised by Wall Street will be mildly negative, her trade policies are likely to exacerbate tensions with China, which raises the prospect of an extended trade war with China.
 

 

In addition, the handshake trade deal with China seems to be unraveling. When the agreement was announced, there was an expectation that the details would be ironed out so that Trump and Xi could ink a deal at the APEC summit in Chile in November. Now the Chinese have wavered on the commitment to buy $40 to $50 billion in agricultural products, which is understandable as that figure amounts to roughly double the peak of Chinese purchases, and they want an elimination of all existing tariffs in return. In other words, there is no deal, but both sides are still talking.
 

Key risks

There are two major risks to the global reflationary scenario. The first is slowing Chinese growth. Statistics coming out of China have been disappointing, and its Economic Surprise Index, which measures whether economic releases are beating or missing expectations, have been falling.
 

 

Xinhua reported an unusual speech by Premier Liqiang calling for the fulfillment of economic targets. China’s economic statistics, and especially GDP growth statistics, are highly massaged and virtually never miss their targets. This speech is a signal that official GDP growth will come in at the lower end of targets, and actual growth could be substantially lower.

Chinese Premier Li Keqiang on Monday called for more efforts to ensure the fulfillment of major targets and tasks for economic and social development.

Amid more complicated international situations and slowing global economic growth, the Chinese economy has maintained its overall stability so far this year, with steady progress in structural adjustment and continuous improvement in people’s livelihood, Li said in Xi’an while chairing a symposium attended by heads of some provincial governments to analyze the current economic situation.

To achieve the annual goals, China needs to place more emphasis on stabilizing economic growth and maintaining economic performance within a reasonable range, unleash more potential of domestic market demand, and foster effective investment and consumption demand, Li said.

The country should step up efforts to enhance the economy’s resilience, address downward pressure, increase employment, keep prices stable, and safeguard people’s livelihood, according to the premier.

After Li’s speech, China’s Q3 GDP printed a growth rate of 6.0%, which was below the expected rate of 6.1%, and below the Q2 growth rate of 6.2%. How does a slowing Chinese economy square with a scenario that postulates a global cyclical growth revival? In particular, how will commodity prices, EM and Asian economies exposed to China, and commodity exporting countries cope with continued deceleration in Chinese growth?

For a contrary view, China watcher Michael Pettis thinks that a GDP growth of 6.0% is actually good news as a signal of the resiliency of the Chinese economy:

The Q3 GDP growth of 6.0% probably has little to do with trade war and everything to do with declining domestic investment. On a comparable basis China’s GDP is growing by much less than 6 percent, and its is only by allowing rising debt to fund non-productive activity — and not writing down the resulting losses — that it can show growth rates even at these levels. For that reason a GDP growth rate of 6 percent, or even lower, is relatively good news. It means Beijing is serious about getting debt under control and is politically secure enough to tolerate slower [economic] activity.

Another risk is the prospect of trade war enlargement. Trump is on the verge of open a second front in the trade war, this time with the EU. The WSJ reported that Bundesbank president Jens Weidman stated a US-EU trade war would be far more devastating that a trade war with China, and it could cut GDP growth by over 0.5%.

Deutsche Bundesbank leader Jens Weidmann said Wednesday that rising trade tensions around the world have the potential to slow growth markedly, in comments that also expressed continuing concern with the European Central Bank’s stimulus efforts.

“A full-blown trade war between the United States and the European Union could cost both sides dearly,” Mr. Weidmann said in a speech in New York at the Council on Foreign Relations.

“The potential adverse effects might be considerably larger than in the case of the current trade spat with China,” and even there, things are looking worrisome. Mr. Weidmann said in the current China-U.S. squabble, “the measures that have been adopted or brought up could cut the output of both countries by more than a half percent over the medium term. World trade would be reduced by 1.5%.”

 

Investment implications

Regular readers know that my Trend Asset Allocation Model analyzes global equity and commodity markets to determine the level of equity risk to take (see A market beating Trend Model, and what it’s saying now). Real-time market signals are indicating that the global reflationary scenario is coming into play. While there are still risks, current conditions warrant the upgrade of the Trend Model signal from bearish to neutral.

In fact, a US-centric analysis could easily have been confused by the better tone to the markets. The latest risk-on tone was sparked by optimism over a possible Brexit deal on October 10, as evidenced by the jump in the GBP exchange rate. Market enthusiasm continued when American and Chinese negotiators ended their meeting in Washington the next day, and the US announced a preliminary trade deal. Simply put, the driver of the latest bull move is non-US, and an analyst focusing on mainly US events would have missed the subtle difference amidst the noise of the trade deal.
 

 

Should the global economy undergo a cyclical rebound, it will be equity bullish, and a rising tide does lift all boats. However, US equities are likely to lag, and an underweight position is the best course of action under these circumstance. We are now seeing early signs of price momentum recovery in Europe, which is where investors should overweight. It may be still a little early for an overly bullish commitment to EM, or inflation hedges like gold. I would remain at a neutral weight in these assets while waiting for more confirmation signs of more firmness in global growth.
 

The week ahead

The tactical picture for the week ahead is problematical for my trading model. By design, an upgrade in the Trend Model should result in a bullish signal in the trading model. However, the growing divergence and decoupling of US equities from global markets makes this an uncertain bet.

I had identified rising triangles in the SPX and NDX earlier in the week (see Why small caps are lagging (and what it means)), and I wrote that I was waiting for the triangles to resolve themselves. I was ready to pull the trigger on turning bullish from bearish later in the week, but both indices failed to stage upside breakouts. Instead, the two indices broke down through the rising trend line, leaving unfilled gaps below as the first downside targets. The market was exhibiting strong internals, and it had every chance to stage an upside breakout.
 

 

After all, the preliminary results from Q3 earnings season were ahead of expectations. Earnings beats were strong, why didn’t stock prices rally? Further analysis from FactSet revealed that while EPS and sales beat rates were ahead of historical averages, forward EPS estimates were falling, indicating a lack of fundamental momentum.
 

 

Internals were strong earlier last week, as most of the top five sectors were exhibiting positive relative strength, which was a signal that the market was ready to stage an upside breakout. But Technology and Communication Services faltered later in the week. That made the score 37.2% of index weight in strong sectors and 32.0% in weak sectors. It is difficult to see how the major market could rally to new highs without a majority of the sectors showing positive relative strength, as the top five sectors make up close to 70% of index weight.
 

 

Breadth was also disappointing. Net new highs-lows failed to rise, and had been in decline even as the market tested resistance.
 

 

A similar pattern of fading new highs-lows can also be seen in virtually every one of the top five sectors, except for Consumer Discretionary stocks.
 

 

Market positioning may also serve to put a lid on any market rally. Bloomberg reported that SPY shorts are near historical lows. With the market so close to an all-time high, traders were avoiding shorting the ETF. In the past, such readings have resolved with market pullbacks.
 

 

Hedgopia also observed that large speculators’ short positions in VIX futures are highest since April, “Cash itching to rally near term; medium term, tends to peak when these traders get net long, or substantially curtail net shorts.” As this is contrarian bullish for the VIX Index, and VIX is inversely correlated with stock prices, this is a bearish setup for equities.
 

 

The market may just be entering a period of negative seasonality until month-end, when it has typically begun a year-end rally.
 

 

Tactically, the decline appears to be just getting started. Momentum indicators are just recycling from an overbought condition, and they are not oversold yet.
 

 

My inner investor is re-positioning his portfolio from an underweight position in equities to market weight, but additional exposure will come from non-US markets. My inner trader is slightly changing his view from just a bearish position to buy the dip, but he is staying short and not buying just yet.

Disclosure: Long SPXU

 

Why small caps are lagging (and what it means)

Posted by Cam Hui -

Mid-week market update: One of the investing puzzles that has appeared in the last few months is the mystery of small cap underperformings. The USD Index has been strong over the last three months, which should create an earnings headwind for large cap multi-nationals with foreign operations. Instead, the relative performance of megacaps have been flat to up over this period, while mid and small cap stocks have lagged.
 

 

I unravel performance at a sector level, and discovered some unexpected insights about possible market direction.

A review of large and small cap sectors reveals that much of the difference in performance can be attributable to large cap FAANG stocks. In addition, the relative performance of small cap sectors shows some bullish green shoots. The cyclically sensitive small cap industrial sector exhibiting better relative strength, and the relative performance of small cap defensive sectors like consumer staples and utilities was not as strong, indicating a weaker than expected internals for low-beta names.
 

Unraveling small and large caps by sector

Not all stock indices are created equally. Here are the sector weights of large and small cap indices, sorted by large cap sector weights.
 

 

For another perspective, here are the differences in sector weights. Large caps are more exposed to FAANG (Technology and Communications Services), while small caps are more exposed to Industrials, Financials, and Real Estate, which are more interest rate sensitive.
 

 

Sector analysis

I went further by charting the relative performance of each sector to analyze both the sector effects and size effects, starting with the heaviest large cap sector and going to the smallest. In some cases, the analysis was not possible as there was no corresponding small cap sector ETF (Communications Services and Real Estate), but these sectors comprised very small weights in the Russell 2000 and therefore they were irrelevant to any conclusions that can be made. One of the reasons technicians use breadth analysis is to see what the broader market (troops) are doing, and not the heavyweights (generals). In principle, small cap sector analysis therefore yields a better picture of sector strength without the influence of megacap stocks, which can exhibit their own idiosyncrasies.

I will be using the same template for each sector, and here are the technology stocks. The top panel depicts the relative performance of large cap technology to large cap stocks (black line), and small cap technology to small cap stocks (green line). The bottom panel shows the relative performance of small caps to large caps (black line), and small cap technology to large cap technology. This way, we can see the sector effect in the top panel, and the size effect within the same sector in the bottom panel.

As the chart shows, technology stocks ahve been on a tear for most of this year, irrespective of market cap. While small cap technology has underperformed large caps technology for 2019, their relative performances have been roughly flat over the last 3-4 months.
 

 

The relative performance of healthcare tells a different story. While healthcare stocks have largely underperformed in 2019, small cap relative performance was roughly flat with the market since May. The bottom panel shows that there was no discernible size effect within the healthcare sector, which indicates that large cap healthcare underperformance was attributable to the differences in sector weights of large and small cap indices. In particular, the recovery in technology stocks, which had a heavier weighting in the large cap indices, pushed down the relative performance of the large cap healthcare sector.
 

 

The relative performance of financial stocks tell a similar story as healthcare. While the relative performance of large and small cap financial stocks diverged in the top panel, the relative stability of performance within sector (bottom panel) indicates the divergence was attributable to differences in large and small cap index weights.
 

 

We can distinctly dissect the FAANG effect when analyzing large and small cap consumer discretionary stocks. The top panel shows the usual relative performance of large and small cap consumer discretionary stocks against their respective indices, but I added a red line showing the relative performance of AMZN, which dominates the large cap sector. When the relative performance of AMZN tailed off in the last three months, large cap sector performance was flat, but small cap sector performance soared, and the difference was mainly attributable to one stock, namely AMZN. During the same period, the relative performance of large and small cap stocks within the sector was flat (bottom panel).
 

 

The analysis of industrial stocks reveals some possible cyclical green shoots. Even as the market worried about an economic slowdown, cyclically sensitive small cap industrial stocks outperformed (top panel), and small cap vs. large cap industrial stocks exhibited a slight rising channel (bottom panel). These could be interpreted as unconfirmed and minor “green shoots” of cyclical recovery.
 

 

Consumer staples stocks offer another hopeful sign for the bulls. When market participants stampeded into large cap consumer staples for their defensive characteristics, small cap staples did not perform as well (top panel), and small cap consumer staples continued to lag their large cap counterparts during the same period (bottom panel). The action of small caps could be interpreted as a non-confirmation of the bearish caution that had been in evidence since the market began to consolidate sideways in the past few months.
 

 

There is not much to say about the energy sector. Both large and small cap sectors are lagging their indices, and small cap energy is underperforming large cap energy.
 

 

The return pattern of utilities, which is another defensive sector, is similar to consumer staple stocks. The relative returns of large and small cap utilities to their respective indices diverged with large cap utilities showing better relative sector performance. At the same time, small cap utilities lagged large cap utilities, indicating that the defensive sector surge was not as strong as large caps.
 

 

Finally, the analysis of materials stocks yield few investment insights. The performance of both large and small cap material stocks were roughly flat with their respective indices. The weight of this sector is relatively small and has little impact on overall market performance.
 

 

Green shoots?

In conclusion, a review of large and small cap sectors reveals that much of the difference in performance can be attributable to large cap FAANG stocks. In addition, the relative performance of small cap sectors shows some bullish green shoots. The cyclically sensitive small cap industrial sector exhibiting better relative strength, and the relative performance of small cap defensive sectors like consumer staples and utilities was not as strong, indicating a weaker than expected internals for low-beta names.

As well, I wrote on the weekend that, in order for the market to sustain a rally, a majority of the top five sectors that comprise nearly 70% of index weight have to show better relative performance. That seems to be happening, but these are only “green shoots” that have lasted a few days, and market action during earnings season can be volatile.
 

 

Despite all this, my inner trader isn’t quite ready to throw in the towel on the bear case just yet. Here is the final test. There are some ascending triangles that are evident in the SPX and NDX. They will resolve themselves soon in the next few days by either breaking up, or breaking down.
 

 

Stay tuned.

Disclosure: Long SPXU

 

A moment of truth for the stock market

Posted by Cam Hui -

No, the “moment of truth” in the title has nothing to do with the preliminary trade deal announced by Trump last Friday. I have been showing concerns for some time about the market`s valuation. Based on Friday`s close, the market was trading at a forward P/E ratio of 16.9, which is above its 5-year average of 16.6 and 10-year average of 14.9.
 

 

If stock prices were to advance from current levels, the E in the P/E ratio has to improve. Earnings Season starts in earnest this week as the big banks begin reporting tomorrow. That’s the “moment of truth” for stock prices.
 

Are expectations too low?

Brian Gilmartin, who has been monitoring market earnings at Fundamentalis, thinks that “expectations seem far too subdued and pessimistic” after companies guided EPS estimates lower for Q3. However, he does believe that he needs to see EPS growth rate estimates rise from current levels.

As was covered yesterday in a broader blog post on sentiment around Q3 ’19 SP 500 earnings before the first full week of reporting begins, expectations around Q3 ’19 SP 500 are quite low – which per Bespoke – is a good sign for a positive return for the SP 500 for the 4th quarter.

That being said, as the reader will see with the following metrics, the one metric I’d like to see start to rise is the growth rate of the “forward 4-qtr estimate”.

The challenge is earnings estimates have been largely stagnant in the past few weeks. John Butters at FactSet found that forward 12-month estimates have been exhibiting a sideways zigzag pattern, which is problematical for the bull case.
 

 

The stagnation can also be found in the bottom-up derived 12-month S&P 500 target, which stands at 3321. However, the recent history of the target also shows a flattening pattern over the last few months, which is in line with the evolution of forward 12-month EPS estimates.
 

 

Butters also observed that industry analysts have shown a historical tendency to overestimate market performance. The 5-year historical overshoot rate was 2.8%; the 10-year overshoot rate was 2.2%; and the 15-year overshoot rate was a whopping 9.9%, which was mainly attributable to excess optimism during the GFC bear market. In the context of the bull that began in 2009, an estimate of between 2.2% and 2.8% is probably more accurate. However, the latest chart shows that the market has been underperforming bottom-up target estimates.
 

 

Who is right? Brian Gilmartin, who believes that expectations are too low, or the recent historical record of excessive overshoot?
 

The bulls are charging uphill

I don’t know. What I do know is the bulls are charging uphill. The forward P/E ratio is already elevated at 16.9. This is the equivalent of needing to score a touchdown with the clock running out while starting at your own 20 yard line. At lot has to go right.

The signals from insider activity have not been helpful. This group of “smart investors” are not exhibiting the kind of buying clusters when buys (blue line) have exceeded sales (red line). This does not mean, however, that the market is destined to fall. Insider buying can be a somewhat effective buy signal, but excessive selling has not been actionable sell signals.
 

 

As well, the market will have to evaluate the impact of the preliminary trade deal on the earnings outlook. Are the changes enough to move the needle on estimates, or improve business confidence sufficiently to lift the cloud of uncertainty that companies are willing to invest, and hire new workers? As a reminder, a recent Fed study concluded that trade related uncertainty was on course to reduce GDP growth by about 1%.
 

 

Stay tuned. That’s why this week is the “moment of truth” for the markets, and it begins tomorrow starting with the banks.

Disclosure: Long SPXU

 

A market beating Trend Model, and what it’s saying now

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 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: Bearish
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

A Trend Model update

Let me start by wishing all of my Canadian friends a Happy Thanksgiving weekend.

A post last week (see A 5+ year report card of our asset allocation Trend Model) brought forth a number of questions, and some new subscribers. To briefly recap that post, I have been publishing the signals of my Trend Model since 2013. A simulated portfolio which varied the equity allocation based on those out-of-sample signals significantly beat a passive 60/40 benchmark, and on a consistent basis. In particular, the simulated portfolio was able to cushion some of the drawdowns during bearish equity episodes. The study was a proof of concept that the Trend Model can add value to an asset allocation process.
 

 

This week, we answer the following questions:

  • What is the basis for the Trend Model
  • What is it saying now?
  • How does it react to news like the US-China preliminary agreement?

I conclude that, within the framework of a disciplined investment process, the Trend Asset Allocation Model is still signaling caution, despite the short-term noise presented by the trade deal. While I am not inclined to act in anticipation of model readings, forward looking indicators are showing some signs of a possible growth turnaround. This should put a floor on stock prices because of limited macro downside risk.
 

Model Genesis

I came upon the idea of a Trend Model for asset allocation during my tenure as a hedge fund manager. At the time, I was running a US market-neutral equity portfolio using multi-factor techniques at a Commodity Trading Advisor (CTA).

I knew little or nothing about the CTA models, other than they used moving average techniques to trade commodities. The Director of Research explained that they use a long dated moving average to establish the direction of the trend, and a short moving average for risk control. I was curious as to why trend following models worked, but the usual answer around the firm was a shrug, “I don’t know. They just work.”

On occasion, the futures traders in the next room went home with white knuckle looks on their faces. That was because the exposure of the portfolio was all aligned together. Even though the futures portfolio was diversified across many different commodities and contracts, they wound up making one big macro bet in interest rates, currencies, gold, copper, and so on. If some important economic release the next day, such as the Jobs Report or an FOMC decision, went the wrong way, the portfolio would either soar or crater.

Here was the revelation. If we were to map the exposures of a CTA portfolio into a macro-economic factor space, what these trend following models are doing is spotting macro trends, which tend to be persistent. As an example, if an economy starts to grow, the next quarterly GDP report will tend to be related to the last quarter’s growth rate, and not some random number centered around zero. That’s trend persistence.

The investment application of CTA and trend following models is to spot the trend, take advantage of the bandwagon effect. Add in an appropriate level of risk control, an investor could add alpha.

My own Trend Model uses the same principles to derive asset allocation signals. It analyzes trends from stock prices around the world, as well as commodity prices, to determine whether the global economy is reflating or deflating. A reflationary signal is equity bullish, while a deflationary signal is bearish.

So what is the Trend Model saying now? Let’s take a trip around the world by focusing on the three main trade blocs, the US, Europe, and Asia.
 

The US outlook: Weak but recession unlikely

A review of the US stock market shows that it has really gone nowhere for the past six months. The index is above the 200 day moving average (dma), the long-term trend, and just regained the 50 dma, the short-term trend, late last week.
 

 

An analysis the weekly chart shows a loss of momentum, as measured by the 14-week RSI. While most episodes of falling RSI did resolve with bear markets, stock prices did consolidate sideways in 1994 and resume an upswing without a major bear market.
 

 

From a non-Trend Model viewpoint, sentiment has been rattled by disappointing ISM reports indicating a manufacturing slowdown. In addition, leading indicators of the labor market, such as temporary jobs and the quits to layoffs ratio, are signaling a plateauing job market.
 

 

Despite the fears, a recession is unlikely, and recessions are equity bull market killers. Indeed, the latest update of the Morgan Stanley recession model shows recession odds fading.
 

 

As well, last week’s release of FOMC minutes made it clear that Fed policy makers are leaning toward another rate cut in October. The Fed stands ready to accommodate growth in the face of downside risks. Moreover, global monetary policy has been shifting to easing, and it is difficult to believe that a recession is in the near future when central bankers are in a coordinated easing mode.
 

Europe: So bad it’s good

As we turn our sights across the Atlantic, the technical picture for eurozone equities is slightly better than the US. The Euro STOXX 50 is holding above its 50 and 200 dma lines. The markets of most core and peripheral countries are also mostly above their 50 dma.
 

 

At first glance, the macro perspective appears awful. In particular, German manufacturing, which has been locomotive of growth in the eurozone, looks like an unmitigated disaster.
 

 

However, policy makers are starting to respond. Not only is the European Central Bank starting another round of monetary stimulus, but the political consensus is also moving towards the implementation of fiscal stimulus to boost growth. With the exception of Italy, there is significant fiscal room for stimulus among member countries.
 

 

Even the Germans, who have been the fiscal austerity hawks of the region, are starting to shift their views. In an act of European Theatre, Reuters reported that the Germans are considering a shadow budget to circumvent national debt rules:

Germany is considering setting up independent public agencies that could take on new debt to invest in the country’s flagging economy, without falling foul of strict national spending rules, three people familiar with talks about the plan told Reuters.

The creation of new investment agencies would let Germany take advantage of historically low borrowing costs to spend more on infrastructure and climate protection, over and above debt limits enshrined in the constitution, the sources said.

Germany’s debt brake allows a federal budget deficit of up to 0.35% of gross domestic product (GDP). That’s equivalent to about 12 billion euros ($13.3 billion) a year but once factors such as growth rates have been taken into account, Berlin only has the scope to increase new debt by 5 billion next year.

Europe’s largest economy is teetering on the brink of recession and pent-up demand for public investment from towns and cities across the country is estimated at 138 billion euros by state-owned development bank KfW.

Under the “shadow budget” plan being considered by government officials, new debt taken on by the public investment agencies would not be accounted for under the federal budget, said the sources, who declined to be named.

Limits on how much debt they could take on would instead be governed by the rules of the EU’s Stability and Growth Pact, giving Germany room to boost spending without needing a two-thirds majority in parliament to change its own debt rules.

Where will all the money go? The rise of the Greens in Germany might make this the “Greta Thunberg” moment that could rescue eurozone growth. Bloomberg reported that Europe’s $13 billion climate plan is about to get serious:

Call it the Greta Thunberg effect, democracy against the establishment, or simply an issue whose time has come.

Whatever it is, the pressure is ratcheting up for the European Union to finally get its act together on climate.

The incoming European Commission has made the climate emergency its No.1 priority. Angela Merkel is trying to revive her reputation as the climate chancellor in Germany. And Austria’s Green Party, once scorned as single-issue outsiders, is in pole position to join the next government after a surge in support in Sunday’s election.

“There’s a clear expansion in the political resonance of climate change, led by Europe, but more broadly by younger generations across the developed world,’’ Ian Bremmer, president of the Eurasia Group, said Monday in a note to clients. “More political and corporate leaders don’t want to be seen as failing to address the issue.’’

Regardless of your opinion of the spending plan, the combination of a will to spend and a way to fund the spending makes this a form of fiscal stimulus. Already, the relative performance of eurozone equities have stabilized and begun to outperform global stocks.
 

 

Asia: The Chinese elephant in the room

Turning to Asia, the technical picture is mixed. The elephant in the room is the risk of a major slowdown in China, sparked by the ongoing Sino-American trade war and Beijing’s efforts to deleverage its economy.

Economic statistics from China can be unreliable and made up. However, investors can see some hints of the region’s growth outlook by monitoring the stock markets of China and her major Asian trading partners. The charts of these markets present a mixed picture of indices that are flat to down. While the Shanghai Composite stands just above its 50 and 200 dma, roughly half of the other regional indices are above their 50 dma, and the other half above.
 

 

China is also the largest global consumer of commodities. Commodity prices, and the stock indices of countries that are major commodity exporters, show mostly a downbeat picture. The CRB Index trading below its 200 dma, and just barely holding above its 50 dma. Moreover, the stock indices of major commodity producing countries appear weak.
 

 

The weakness in commodity prices and the markets of commodity producing countries is confirmed by the relative downtrend exhibited by the cyclically sensitive global industrial stocks.
 

 

That said, the Chinese economy has been more resilient that my expectations. As real estate has been a major recipient of household savings in China, I have been monitoring the health of Chinese property development companies, which are highly leveraged, compared to the market. In the past, Beijing has resorted to credit driven stimulus to boost the economy, which has benefited the property sector. This time, Chinese authorities have refrained from opening the credit spigots. The shares of property developers have lagged the market, but few systemic risks have appeared in the financial system.
 

 

Is the trade agreement a game changer?

Tactically, the markets adopted a risk-on tone late last week on the hopes of either a mini-deal or a trade truce between the US and China. We have seen this movie before. This episode is instructive for investors managing a trend following model. What do you do in the face of breaking news that move the market?

One feature of trend following models price whipsaw that can cause excessive trading. Therefore the first rule is, “Wait for confirmation and don’t chase the news.”
 

CNBC reported that American and Chinese negotiators had reached what was in essence a preliminary agreement in principle, with details to be laid out in the next three weeks. The agreement amounts to a trade truce, with a Chinese commitment to buy more agricultural products, and a delay of the tariffs scheduled for Tuesday. Most notably, the announcement was silent on the tariffs scheduled for December 15, which is an indication that Trump wants to retain that as a source of leverage.
 

Trump told reporters at the Oval Office that phase one of the trade deal will be written over the next three weeks. The major indexes hit their session highs on this comment, with the Dow rising more than 500 points. Trump made his comments after meeting with Chinese Vice Premier Liu He in the Oval Office.

As part of this phase, China will purchase between $40 billion and $50 billion in U.S. agricultural products. Trump also said the deal includes agreements on foreign-exchange issues with China. In exchange, the U.S. agreed to hold off on tariff hikes that were set to take effect Tuesday.

At this point, it is useful to ask a few questions. First, from a technical perspective, the short-term chart shows that the market sold off as the details of the agreement were announced. Is this a case of “buy the rumor, sell the news”?
 

 

From a longer term trend follower’s perspective, the weekly chart shows the stochastics recycling from an overbought condition, which is normally interpreted as a sell signal. The index rallied but ended the week right at trend line resistance. Is the sell signal still valid, or did the news of the agreement invalidate the signal?
 

 

In order to avoid whipsaw and excessive trading, I prefer to wait for further trend confirmation next week before adopting a more bullish view on risky assets. A CNBC interview with Brookings fellow David Dollar called for caution instead of an instant knee-jerk bullish reaction:

David Dollar, a senior fellow at the Brookings Institution, warned that any deal reached by the two countries may not last. He noted there had been instances in the past when the U.S. and China appeared to have come close to reaching an agreement, only to have the tariff fight escalated all over again.

“I worry that investors look at this, they’ll be relieved tomorrow if there’s a deal but then they’re going to start asking themselves: ‘Is this really stable? Do we expect this to last for a long time? Could this perhaps fall apart in a few months?’” Dollar told CNBC’s “Squawk Box Asia” on Friday.

“It’s reasonable to worry that this might all fall apart,” he added.

That’s especially so when issues such as alleged human rights abuses in China and the Hong Kong protests have complicated negotiations between Washington and Beijing, said Dollar.

In fact, Chinese official media has not reported the discussions as a preliminary agreement, but talks with “substantial progress”. It is therefore unclear the degree of agreement today compared to May when everything blew up, and the S&P 500 was at about 2940, compared to Friday’s close of 2970.
 

 

In conclusion, a quick tour of global equity and commodity markets reveals markets that are either flat to down. By the numbers, our Trend Model calls for caution. However, forward looking indicators outside the scope of the Trend Model suggest that the global economy is likely to sidestep a recession, which would be a bull market killer.

Despite the gloom in manufacturing, some green shoots are starting to appear in PMI readings. In addition, global central banks are embarking on an easing cycle, which should cushion the effects of any slowdown.
 

 

Within the framework of a disciplined investment process, the Trend Model is therefore signaling caution, despite the short-term noise presented by the trade deal. While I am not inclined to act in anticipation of model readings, forward looking indicators are showing some signs of a possible growth turnaround. This should put a floor on stock prices because of limited macro downside risk.
 

The week ahead

Last week was a tumultuous week for the stock market, and unusually featured goal line stands by both bulls and bears at key support and resistance trend lines.
 

 

Perhaps a weekend of sober reflection can give us more answers. In the wake of the preliminary trade agreement, the absolute and relative price of soybeans are at resistance. It is an open question of whether they can stage an upside breakout on the news.
 

 

As well, short-term equity momentum is already overbought, but bullish impulses can continue rising by exhibiting a series of “good overbought” conditions. How will the market react next week?
 

 

Arguably, stock prices were ready to rise. The latest AAII investor sentiment survey showed sentiment at a bearish extreme, which is contrarian bullish. The news of the agreement was just the spark for the rally.
 

 

On the other hand, other sentiment indicators do not show such bearish extremes. The Fear and Greed Index recycled upwards without ever reaching panic levels in the last month.
 

 

The NAAIM Exposure Index, which is a weekly survey of RIA sentiment, was also not bearish enough to flash a contrarian buy signal by falling to its lower Bollinger Band.
 

 

As well, my Trifecta Bottom Spotting Model tells a similar anomalous story. Even though the 20 dma of the put/call ratio (top panel) reached elevated levels consistent with market bottoms, the two sentiment components of the Trifecta Model did not reach levels indicating fear. VIX term structure never inverted, and TRIN never spike to 2, which is a signal of price insensitive capitulation that is the characteristic of margin clerk liquidation.
 

 

To be sure, Willie Delwiche observed that sentiment models have not performed well this year as contrarian buy signals. Historically, contrarian buy signals saw stock prices surge at an annualized rate of 29.8%, but they were up at a rate of only 3.8% this year, which is roughly the same performance as neutral sentiment signals.
 

 

The poor short-term returns of this class of model may be explained by analysis from Callum Thomas, who pointed out that neutral responses in sentiment surveys have been rising steadily. This is attributable to general uncertainty over market direction, which could serve to create noise in sentiment models.
 

 

So where does that leave us? I am inclined to let the market tell us what to do next. If this were to be the start of a new bull phase, here are what the bulls will have to do. First, the top five sectors represent nearly 70% of index weight. A majority of the top five sectors will have to exhibit positive relative strength in order for the market to rise on a sustainable basis.
 

 

The monthly S&P 500 chart just flashed a MACD buy signal, which has historically been a highly reliable sign of a renewed bull move. The index has to close the month at current levels or higher.
 

 

The monthly chart of the broader Wilshire 5000 will have to confirm the MACD will have to confirm the buy signal, which it has not.
 

 

Lastly, we are about to enter Q3 earnings season, but forward 12-month EPS estimates have been mired in a flat zigzag pattern. We need to see better earnings visibility, and to see that the trade agreement will have restored some degree of business confidence.
 

 

My inner investor remains in a cautious wait-and-see mode, and he is defensively positioned with an underweight in equities. My inner trader was short going into the weekend. He is waiting for greater clarity from the market next week before making a trading decision.

Disclosure: Long SPXU

 

Time to buy Yom Kippur?

Posted by Cam Hui -

Mid-week market update: There is a trader’s adage, “Sell Rosh Hashanah, Buy Yom Kippur”. As many in the Wall Street community are Jewish, staying out of the stock market during the Jewish high holidays may make some sense. Jewish traders and investors wind down at rosh Hashanah, the Jewish New Year, and return after Yom Kippur, the Day of Atonement, which is today.

Indeed, this year’s market weakness began just around Rosh Hashanah. Moreover, the market’s decline was halted yesterday right at trend line support, and rallied today.
 

 

Is it time to buy Yom Kippur.
 

An orderly decline

Here is what’s bothering me about the “Sell Rosh, Buy Yom” narrative. The market has been undergoing an orderly decline. As a consequence, neither market internals nor sentiment has reached panic washout levels consistent with durable bottoms.

Here are just a few examples. The SPY/TLT ratio, which is a measure of risk appetite, has been falling, but it has not reached levels seen at past bottoms.
 

 

From a sentiment perspective, the ratio of the 5 day moving average (dma) of the equity-only put/call ratio (CPCE) to the 60 dma is also depressed, but it is just short of levels indicative of panic and capitulation.
 

 

My own Trifecta Market Bottom Spotting Model is also nowhere near conditions indicating a high level of fear.
 

 

What I am watching

Here are some key questions for the market. The SPX is caught between a falling trend line with a high from September 19, and a rising trend line with the low from June 3. Which will break first?
 

 

My interpretations of market sentiment and internals lead to a bearish tilt. If I am right, where will the pullback end? Arguably, it could stop at about 2880, or the 50% retracement. If the support from September breaks, the next level of Fibonacci retracement, or roughly in the area of the August lows, or possibly the intra-day August lows at 2820.

Here is what I am watching. The Value Line Geometric Index, which is an equal weighted and broadly based index of stocks, is very weak, and it is weaker than most of the major market indices. Will it break support shown in the chart shown below? As well, will other breadth indicators, such as % above 50 dma and % above 200 dma, break the support lines drawn?
 

 

Watch the internals as they test support. If support were to break, it would signal a deeper correction.

My inner investor is defensively positioned. My inner trader initiated a small short position on Monday, with the idea that he would average in over the coming days. But he pulled back from his dollar averaging program with Tuesday’s decline. Your own mileage may vary, and it depends on your risk appetite.

Disclosure: SPXU

 

A 5+ year report card of our asset allocation Trend Model

Posted by Cam Hui -

For years, I have been publishing the readings of my Trend Model on a weekly basis. As a reminder, the Trend Model is a composite model of trend following models as applied to global stock prices around the world, as well as commodity prices.
 

 

The model has three signals:

  • Bullish: When there is a clear upwards, or reflationary, global trend
  • Bearish: When there is a clear downwards, or deflationary, global trend
  • Neutral: When the trend signals are not discernible

The first derivative of the Trend Model, i.e. whether the signal is getting stronger or weaker, and combined with some overbought/oversold indicators, has performed admirably as a high turnover trading model (see My Inner Trader and this ungated version for non-subscribers). However, I have never produced a full report card for the Trend Model. While the actual signal dates were always available on the website, I never got around to compiling the performance record because I was always tied up on other projects, and the task never got to the top of the pile.

After several repeated requests from readers, here is the report card of the Trend Model. I want to make clear that this study represents the real-time track record of actual out-of-sample signals. These are not backtested. The results were solid, and the analysis was also revealing about what an investor should expect when using this model for asset allocation.
 

The Study

I published model signals on a weekly basis, and the publication date was on weekends. I compiled a record of published model signals back to December 31, 2013. While there was data available before that date, model signals were not always published and therefore the study became unreliable because of the interpretative nature of reading the report.

The chart below maps the history of the signals. Buy signals are marked by vertical green lines, neutral signals by black lines, and sell signals by red lines.
 

 

The high turnover experienced in the first couple of years was disconcerting, and it was mainly attributable to the relatively flat and trendless market of those years. But that is a feature, not a bug, of trend following models. They have a tendency to get whipsawed and do not perform well in a flat trendless market. In response, I made some minor tweaks to reduce the turnover, and to add overbought/oversold filters so that it doesn’t chase markets when they are at emotional extremes. The model has largely unchanged since mid-2015.

As the model signals were published weekly, here are some simplifying assumptions I made to measure performance.

  • The vehicle used to measure returns was SPY for equities, and IEF for bonds.
  • All returns are total returns, which includes dividends and distributions, and assumes reinvestment of all dividends and distributions.
  • All trades are done on at the closing price on the following Monday (or Tuesday after a long weekend) after the publication of the signal.
  • There are no commission costs.

 

How not to use the model

With those assumptions in mind, here are some ways to use and not to use the model. First, I would encourage readers not to use it as a trading model. We already have a high frequency trading model that has worked well (see My Inner Trader and this ungated version for non-subscribers).

That said, here is how the Trend Model has performed as a trading model, based on these assumptions:

  • Buy SPY on a buy signal;
  • Short SPY on a sell signal;
  • Hold cash, on a neutral signal, and assume 0% interest on cash holdings.

How would that have performed against a simple 60/40 passive portfolio of 60% SPY and 40% IEF, which was rebalanced weekly? The chart below tells the story. While the long/short portfolio did beat the 60/40 benchmark, it exhibited a higher level of risk, as measured by standard deviation and maximum drawdown. As well, relative performance (light blue line) was highly volatile.
 

 

First lesson. This is not a trading model. This is an asset allocation model.
 

Trend Model performance

As the Trend Model is an asset allocation model, I used these assumptions to measure its performance:

  • On a buy signal: Hold 80% SPY, 20% IEF
  • On a neutral signal: Hold 60% SPY, 40% IEF
  • On a sell signal: Hold 40% SPY, 60% IEF

Both the model portfolio and benchmarks were rebalanced to their targets on a weekly basis, though I recognize that no portfolio manager would actually trade that frequently. The chart below tells the story of performance. The returns of the Trend Model portfolio beat the benchmark over the test period of over five years. Volatility, as defined by standard deviation, of the two portfolios were the same, but the maximum drawdown of the Trend Model portfolio was 3.1% better than the 60/40 benchmark.
 

 

Further analysis of the relative performance line (light blue) reveals the difference. While the trend of outperformance was relatively steady and upward sloping over the test period of over five years, there were several spikes in relative returns. These spikes tended to occur during periods of equity market corrections. Simply put, the Trend Model was able to offer better downside protection during bear phases, and maintain relative performance during bull and neutral phases of the equity market.

This test of the Trend Model was based on a set of reasonable assumptions. In particular, the allocation was based on a +/- 20% band around a classic 60/40 balanced portfolio. that can be easily implemented by investors, and by portfolio managers while adhering to the typical risk tolerance monitoring regimes of their firm’s Compliance Department.

This study was a proof of concept that the Trend Model can form an invaluable way of enhancing returns to a portfolio while reducing realized downside risk. As each investor will have different choices of investment vehicles, and differing benchmarks, your mileage will obviously vary.

I will be updating the track record of this model on a monthly basis at Trend Model report card.

 

The Art of the Deal (with Chinese characteristics)

Posted by Cam Hui -

Our trade war factor has been heating up, though readings remain in neutral. A secondary index (red line) measures Sheldon Adelson’s Macau casinos operator LVS against other gaming stocks (inverted). As Adelson is a major Republican donor, and the casino licenses expire in 2022, the licenses represent another form of backdoor pressure that Beijing can apply to trade relations.
 

 

Chinese and American negotiators are scheduled to meet again on Thursday, October 10 for another round of trade negotiations. There have been conciliatory gestures on both sides, but what are the chances of a deal?
 

What does Trump really want?

It is difficult to see how a comprehensive deal could be agreed on, as it is highly unclear what Trump really wants. On one hand, the transactional Trump is focused on narrowing or eliminating the trade deficit by bring back manufacturing back to American shores. On the other hand, Navarro has long complained about China’s business practices and industrial strategy of favoring domestic and state owned companies, intellectual property theft, and the ability of foreign companies to operate in China.

Imagine if we were to wave a magic wand and Navarro got all of his wish list. China’s economic access restrictions disappears, and the economy becomes fully westernized. It would encourage an offshoring stampede in light of their cheap labor costs. The trade deficit would rise, not fall.

What does Donald Trump really want?

A technological iron curtain?
In addition, Hal Brands wrote a Bloomberg opinion piece that US trade practices are affecting western leading countries in Asia. He cited Singapore as an example. Singapore is officially neutral, but it is “a partner that acts like an ally”:

Singapore has pulled off a shrewd balancing act in a contentious neighborhood. Singapore’s dynamic economy has been buoyed by Chinese trade and investment, and its population is mostly ethnic Chinese. Yet getting too close to a powerful China can be dangerous, so Singapore’s government has long viewed Washington as a critical counterweight to Beijing’s power. As that power has increased in recent decades, so has Singapore’s security cooperation with the U.S.

Singapore’s armed forces regularly train with (and in) the U.S., and Singapore hosts the U.S. Navy’s Logistics Group Western Pacific as well as deployments of littoral combat ships and P-8 maritime surveillance planes. U.S. aircraft carriers conduct port visits in Singapore, a visible reminder that Washington takes an interest in the country’s security. Singapore remains officially neutral; unlike the Philippines, it does not have a treaty relationship with the U.S. Yet if the Philippines is an ally that acts like a partner, as a senior U.S. official once put it, Singapore is a partner that acts like an ally.

If Trump were to continue on the current course of action that decouples China’s economy from the rest of the world, America’s partners and allies will have to choose sides.

The trend toward seeing the U.S.-China competition as “a conflict between two systems, almost two civilizations” is “very worrying,” he said. The U.S. should not delude itself into thinking that pressure can bring about the collapse of the Chinese Communist Party; it should bear in mind that an economic and technological divorce between the world’s leading powers would create an impossible situation for America’s friends “so deeply enmeshed with the Chinese.” If the U.S. insists that these countries choose sides, it might not like the results: “Where is your part of the world, and who will be in your system?”

At the same time, Lee acknowledged that China’s behavior has become more truculent, due to rising geopolitical ambitions and growing internal difficulties. He also argued that China can no longer act like a developing country, but must bear its “share of responsibility upholding and supporting the global system” that has made it so rich and powerful. If a disastrous geopolitical showdown is to be averted, “statesmanship, consistency, perseverance and wisdom” will be required from both sides.

The prospect of a “technological iron curtain” coming down in the Pacific will have devastating effects on growth, not just in the US, but for the Asia-Pacific region.

A larger confrontation with China will be economically painful for U.S. — but it could be economically devastating for America’s key allies and partners in the Asia-Pacific, all of which are deeply interdependent with Beijing in commercial, financial and technological terms. The prospect of a technological or economic Iron Curtain coming down is alarming for countries whose economic interests pull one way while their security interests pull another. To be sure, the U.S. can’t compete successfully with China unless its friends become less dependent on Beijing: Some selective de-coupling from the Chinese economy is important, even if wholesale de-coupling remains implausible. Yet the only way to get countries such as Singapore to reduce their dependence on Beijing is to vastly deepen the possibilities for economic, financial and technological integration within the U.S.-led coalition. Here, America presently seems like an uncertain partner, at best.

Here is one example of just one incident of how tensions have hurt American businesses. Houston Rockets GM Daryl Morey recently tweeted support for the protesters in Hong Kong.
 

 

In response, China cut off all cooperation with the Rockets. This was an enormous blow to the team, as the Rockets was the second most popular team in China behind the Warriors. Hall of Famer Yao Ming played for the Rockets and popularized basketball in China. Tencent, the NBA digital rights holder in China, blacked out the broadcast of all Houston Rocket games. As a measure of the importance of China to the league, an NBA press release in July had announced a five-year expansion of the Tencent-NBA partnership that is worth $1.5 billion, and reported that 490 million Chinese fans, which is more than the size of the US population, watches NBA games on the Tencent platform.

The NBA issued the following statement as a way of trying to repair the situation. Regardless of whether you support or oppose the NBA’s position, remember the league’s business is making money, and not politics, so it is understandable that it took the steps it did to mitigate the damage.

“We recognize that the views expressed by Houston Rockets General Manager Daryl Morey have deeply offended many of our friends and fans in China, which is regrettable. While Daryl has made it clear that his tweet does not represent the Rockets or the NBA, the values of the league support individuals’ educating themselves and sharing their views on matters important to them. We have great respect for the history and culture of China and hope that sports and the NBA can be used as a unifying force to bridge cultural divides and bring people together.”

As another example of forcing allies and partners to choose sides, Bloomberg reported that Chinese students are increasingly avoiding American schools, and they are looking elsewhere. At at minimum, expect America’s current account with China, which measures services as well as goods, to fall.

“There is a shift,” says Jerry He, executive vice chairman of Bright Scholar Education Holdings Ltd., based in the southern Chinese city of Foshan. Bright Scholar in the past year has purchased more than a dozen boarding and language schools, with U.K. campuses in Cambridge, Canterbury, and London. “With the tensions between the two countries, things that have happened in the news made some Chinese parents hesitant, and they have had second thoughts about where they will send their kids.”

The number of Chinese undergraduates accepted to British schools increased 10.4% last year, to 10,180, according to the Universities and Colleges Admissions Service, a nonprofit that works with almost 400 schools in the U.K. The number of Chinese students applying jumped 30%, to more than 19,700.

Much is at stake for U.S. institutions, many of which have welcomed the influx of Chinese students, who typically pay full tuition. Chinese students in the U.S. generated $22 billion in total economic impact last year, according to Rahul Choudaha, executive vice president of global engagement and research at Studyportals, a consulting firm headquartered in the Netherlands.The realignment will undoubtedly crash Asian growth rates and cause a regional recession. Without knowing the actual timing, and effects, it is impossible to forecast whether it could also cause a US recession as well.

Is this what Donald Trump wants?
 

A mini-deal?

The Chinese have very likely to interpret recent events as weakening Trump’s political position, which will harden their negotiating position and makes it unlikely for them to give much in the way of concessions. They will see the combination of the House’s impeachment investigation, and Trump’s recent public call for China to investigate the Bidens of his deteriorating clout.

In addition, October 10, the date of the negotiation, holds a special meaning in Chinese history. It was the date of the Sun Yet-sen’s uprising that ultimately toppled China from imperial rule. While the anniversary is more observed in Taiwan than Mainland China, it nevertheless.represents a key date in Chinese history, and negotiators are unlikely to concede much on a historic date like that.

Bloomberg reported that Chinese negotiators are preparing to come to the table with a mini-deal:

Chinese officials are signaling they’re increasingly reluctant to agree to a broad trade deal pursued by President Donald Trump, ahead of negotiations this week that have raised hopes of a potential truce.

In meetings with U.S. visitors to Beijing in recent weeks, senior Chinese officials have indicated the range of topics they’re willing to discuss has narrowed considerably, according to people familiar with the discussions.

Vice Premier Liu He, who will lead the Chinese contingent in high-level talks that begin Thursday, told visiting dignitaries he would bring an offer to Washington that won’t include commitments on reforming Chinese industrial policy or the government subsidies that have been the target of longstanding U.S. complaints, one of the people said.

That offer would take one of the Trump administration’s core demands off the table. It’s emblematic of what analysts see as China’s strengthening hand as the Trump administration faces an impeachment crisis — which has recently drawn in China — and a slowing economy blamed by businesses on the disruption caused by the president’s trade wars.

Will Trump accept a mini-deal? He is on record as only entertaining an all encompassing deal, but he has been known to change his mind in the past.

However, consider the following political calculation. Trump’s attacks have weakened Joe Biden, who has been the front runner for the Democrat’s nomination for president. As well, Bernie Sanders’ medical difficulties have also lessened his chances for securing the nomination. This leaves Elizabeth Warren a clear shot at becoming Trump’s opponent in 2020. Warren has outlined her own brand of economic nationalism (see What would an Elizabeth Warren Presidency look like?), and she would shred Trump with his supporters if he were to conclude any weak mini-deal with Beijing.
 

 

In conclusion, expect platitudes, and some possible signals of progress. At best, the scheduled increases in US tariffs will be delayed. Don’t expect any breakthroughs. Trump is too boxed in to make a deal with Xi.

 

Whatever happened to the Momentum Massacre?

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 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: Bearish
  • 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.
 

An update on the Momentum Massacre

Remember the Momentum Massacre? Too many investors were in a crowded short in the stock market. The cautiousness was manifesting itself in the price momentum factor, which was showing up in low volatility, low beta, defensive, and value stocks. The crowded short and long momentum trade began to unwind in late August, and accelerated when the SPX staged an upside breakout from its trading range at 2960 in early September.

The reversal was dramatic enough that JPM quant Marko Kolanovic called it a “once in a decade trade” (per CNBC). He made the case that both hedge fund and institutional positioning was too cautious, and a short-covering rally would spark a stampede by the slow moving but big money institutional behemoths to buy beta. Moreover, the reversal could also be a signal for a long awaited turn from growth to value investing.

Since then, returns to the price momentum factor has stabilized and begun to turn up again. It is time for an update.
 

 

More importantly, our analysis of the returns to differing factors and sectors is revealing of likely future market direction.
 

A factor and sector update

Here is what has happened since the Momentum Massacre. So far, the institutional stampede into equity beta has not materialized. The long low volatility and short high beta pair trade has begun to turn up again, indicating a continued reduced equity risk appetite.
 

 

Credit market risk appetite, as measured by the relative duration-adjusted price performance of high yield (junk) bonds, remain in the doldrums.
 

 

In addition, the relative performance of defensive sectors have been recovering, even before last week’s dramatic market sell-off.
 

 

A subtle change in leadership

The market action in the wake of the Momentum Massacre reveals a subtle change in leadership. The growth to value style relationship predictably reversed when the price momentum factor cratered. However, value and growth relative performance has stabilized and remained range-bound. Unlike the other factors, growth did not recover and resume its relative uptrend.
 

 

This is attributable to the faltering leadership of the high octane NASDAQ stocks. An analysis of the absolute and relative performance of the NASDAQ 100, however, shows the weakened position of this part of the market.
 

 

The market is falling out of love with growth, and especially loss making hyper-growth stories. This was evident by the less than enthusiastic reception of the WeWork IPO, and the disappointment response to delivery misses at Tesla. If these conditions were to continue, it would mean a liquidity squeeze at the high growth and loss making part of the market, which could crash risk appetite.
 

 

Before the Momentum Massacre, stock prices were being partially held up by NASDAQ leadership even as the Street pivoted to low-beta and defensive names. In other words, investors were holding a barbell portfolio of NASDAQ and defensive stocks. Now one end of the barbell, the high octane NASDAQ stocks, is breaking.

The only visible sector leadership is the defensive sectors. An analysis of cyclical stocks show that they cannot be relied upon for leadership, with the possible exception of semiconductors.
 

 

The combination of a lack of either growth or cyclical leadership and the defensive sectors the only men left standing leads me to conclude that the path of least resistance for stock prices is down.
 

Where’s the valuation support?

I reiterate the view from early August (see Powell’s Dilemma and why it matters) that the US economy is not headed for a recession, which takes the risk of a major bear market off the table. However, valuations were elevated and the stock market was in need of a valuation reset.

The S&P 500 is trading at a forward P/E ratio of 16.5, which is slightly below its 5-year average of 16.6 and above its 10-year average of 14.8. Valuations are mildly elevated, but stocks are neither wildly cheap nor expensive.
 

 

What about the E in the forward P/E ratio? Analysis from Yardeni Research, Inc. reveals that forward 12-month estimate revisions have been flat to down. While readings can be volatile on a week-to-week basis, mid and small cap estimates have been consistently trending downwards, and large cap estimates fell last week. In the absence of a bullish catalyst, such as a surprise US-China trade deal, it is difficult to see how US stock prices could rise very much in the face of mildly elevated valuations and weak estimate revisions.
 

 

Ed Yardeni also observed that the soft ISM Manufacturing PMI is bad news for S&P 500 revenues as the two series have historically been closely correlated with each other.
 

 

As well, upside potential may be limited because the market is not being supported by insider buying.
 

 

That said, the American economy is not at risk of a recession despite the recent market angst over the soft ISM data. New Deal democrat monitors high frequency economic releases and categorizes them into coincident, short leading, and long leading indicators. His latest update shows while manufacturing may be in a slowdown, the consumer is very strong, and there is little chance of a full-blown recession.

The forecast across all time frames remains positive, although the recently volatile short-term forecast is only weakly so. Please note that the less timely but more reliable index of short leading indicators is negative primarily due to a heavier weighting of manufacturing measures, as I wrote about earlier this week. Also note the global weakness reflected in the further decline in commodity prices. The indication is that the manufacturing/production side of the economy is in recession, but it has not brought down the much larger non-manufacturing consumer sector, which remains very positive.

In the absence of recession risk, downside risk is limited. In the study I published in early August, I had projected downside risk of 2591 to 2891, with the mid-range at 2738. The subsequent market weakness pushed the index into the upper end of that range. I stand by my previous analysis. Current conditions suggests that the valuation reset is incomplete.
 

 

Downside risk is well within the normal parameters of equity risk. The maximum projected drawdown from current levels is only about 10%. Be patient, and you should be able to deploy cash at more attractive levels.
 

The week ahead

I have been calling for a return of volatility in these pages (see Where have you gone, Vol-a-tility) and it arrived in spades last week. In fact, Jeff Hirsch at Almanac Trader pointed out the month of October has historically seen the highest realized volatility. Last week’s market action featured a dramatic sell-off and an equally dramatic rebound.
 

 

Is the correction all over? Is it safe for investors to get back in the water?

I don’t think so. Firstly, sentiment models are not flashing signs of capitulation that are usually observed at intermediate term bottoms. As an example, last week’s AAII weekly sentiment survey saw the bull-bear spread decline, but levels are not low enough to be contrarian bullish. Past signals at these levels have historically been a hit-and-miss affair.
 

 

Mark Hulbert thinks so too. His Hulbert Stock Newsletter Sentiment Index (HSNSI) is not at levels that are fearful enough for durable market bottoms.
 

 

Similarly, while the Fear and Greed Index has fallen, readings are not low enough seen at past bottoms indicating bearish capitulation.
 

 

From a technical perspective, the stock/bond ratio (SPY/TLT) has not reached sufficiently oversold levels seen at past bottoms either.
 

 

Tactically, the market did become sufficiently oversold to warrant a relief rally. Subscribers received email alerts on Wednesday and Thursday outlining the trading tripwires under which I would cover my short positions, which was done near the close on Thursday. The short covering trigger was the VIX Index falling below its upper Bollinger Band after closing above. However, I did not flip from short to long because I believed the rally is nothing more than a dead cat bounce.

How far can the bounce go? An examination of past VIX upper BB bounce signals reveals some clues. In the past, the relief rally has petered out at about a 61.8% Fibonnaci retracement level. If history is any guide, that would put the short-term upside target at the resistance level of 2960, which also acted as resistance during past upside breakouts.
 

 

In the short run, traders can expect possibly one or two more days of strength before the rally stalls. Past VIX BB rebound signals has seen momentum indicators reach overbought levels as shown in the chart below.
 

 

My inner investor remains defensively positioned and underweight equities. My inner trader took profits in his short positions late last week. He is waiting for a rally near the 2960 level before re-entering his short position in anticipation of further price downside in the weeks ahead.

 

How deep a pullback?

Posted by Cam Hui -

Mid-week market update: Regular readers will know that I have been relatively cautious on the stock market outlook for several weeks, and my inner trader has been short the market since September 13, 2019 when the SPX was over 3000. The index violated the 50 dma, broke support at 2960 and filled the gap at 2940-2960 yesterday. The decline was sparked by a miss on ISM Manufacturing PMI, which Jeroen Blokland pointed out is closely correlated to stock prices.

Lost in the bearish stampede was the observation of IHS Markit economist Chris Williamson that Markit M-PMI had been strong; ISM had overstated growth during the 2016-18 period; and ISM is maybe understating growth now.

Divergence is possibly related to ISM membership skewed towards large multinationals. IHS Markit panel is representative mix of small, medium and large (and asks only about US operations, so excludes overseas facilities)

Is this just an over-reaction, or the start of a major pullback?

The intermediate-term outlook

When analyzing the market, it is important to view the outlook in different time frames. From an intermediate term technical perspective, the weekly chart shows a recycle of the stochastic from overbought condition, which is a bearish signal.

In addition, the stock/bond ratio depicted by the SPY/TLT chart shows that the 14-day RSI is not oversold yet. Historically, this measure has either reached a minimum of a near oversold condition before the market has bottomed.

While these charts suggest greater downside risk, it is entirely possible that the market could rally first before making an ultimate low.

Short-term outlook

Subscribers received an email alert this morning before the market open that outlined my tactical trading decision tree. I had pointed out before that the VIX Index rising above its upper Bollinger Band has signaled a market oversold condition in the past. The only question is whether the VIX would mean revert today, or continue to rise and remain above its upper BB.

I also wrote in my email that I would cover my short position if the VIX were to recycle below its upper BB, and maintain my short if it were to go on an upper BB ride. We have our answer. The VIX Index is going on an upper BB ride, expect further weakness in the next few days. One sign to watch for is an oversold signal on the 14-day RSI, which has been a signal for a short-term bottom in the past.

Waiting for THE BOTTOM

Looking past the short-term outlook, it is difficult to see how the market could make a sustainable bottom at these levels. My Trifecta Bottom Spotting Model is hardly showing any signs of fear.

The Fear and Greed Index is falling, but readings are nowhere near panic levels.

As well, the latest II Sentiment readings came in with a minor surprise. II Bulls edged up from 55.1% to 55.3%, which is unusual considering that the stock market had been declining for the past two weeks.

There is lots of opportunity for headline induced volatility ahead. The WTO has sided with the US in the Airbus dispute, and allowed $7.5B in retaliatory tariffs. BLS reports the September Jobs Report on Friday (see What to watch for in Friday’s Jobs Report). Chinese and American trade negotiators are expected to meet again next week. In addition, watch for the continuing saga of Impeachment Theatre.

Despite the dramatic sell-off seen in the last two days, I expect that the market will weaken further in the days and weeks ahead. My inner investor remains defensively positioned, and my inner trader is still short the market.

Disclosure: Long SPXU

What to watch for in Friday’s Jobs Report

Posted by Cam Hui -

BLS will be publish the September Jobs Report this Friday. This report will be important for a number of reasons, and it will answer some key questions for investors and policy makers.

First, the unemployment rate has been troughing. If history is any guide, a rising unemployment rate after a trough has been signals of recessions. This was documented in the Sahm Rule, which was developed as a way to trigger automatic stabilizers and a real-time recession signal. 

 

 

The Sahm Rule triggers a signal “When 3-month moving average national unemployment rate exceeds its minimum over previous 12 months by 0.5 pct points”. A similar technique is also used at iMarket Signals as a recession warning. Currently, there is no recession in the forecast. 

 

Leading indicators

Besides the headline Non-Farm Payroll and Average Hourly Earnings releases, a number of internals in the report have been useful leading indicators. In the past, temporary jobs and the quits to layoffs ratio, which is contained in the JOLTS report that is released next week, have led NFP growth. Temp job growth have been plateauing. The August report showed a temp job growth of 15K, but that was boosted by census hiring of 25K. I will be watching the September report for signs of weakness. In addition, the quits to layoffs ratio edged down in July, which may also be a sign of a slowing jobs market. 

 

 

The bull and bear cases

Here are the bull and bear cases. New Deal democrat observed that initial jobless claims continue near expansion lows and there are no signs of consistent weakness. The jobs market may be near or at a plateau, but the expansion is continuing. 

 

 

On the other hand, Nordea  Markets pointed out that the employment components of both the manufacturing and services PMI have been weak, which is indicative of a weak NFP report. 

 

 

As for me, I use a simplistic rule of monitoring the initial jobless claims report during the NFP survey week to see if initial claims beat or missed expectations. Initial claims came in low, or beat expectations, during the September NFP survey period. I therefore expect a strong than expected headline print. The internals, such as temp jobs, is another matter that I will have to examine at the time of the report. 

 

 

If my simple model is correct, and we do see a better than expected NFP print, the report will further push the Economic Surprise Index upwards. The combination of continuing positive economic surprises, and a stronger than expected jobs market will serve as ammunition for the hawks within the Federal Reserve to delay the timing of a rate hike cut at the next FOMC meeting. 

 

 

In that case, watch for bond yields to rise. 

 

What would an Elizabeth Warren Presidency look like?

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 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: Bearish
  • 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.
 

Discounting a Warren Presidency

It began with two respected polls of Iowa and New Hampshire voters which showed Elizabeth Warren leading Joe Biden and the rest of the field for the Democrats` race for president, Last week, a national poll reported that Warren caught the previous front runner Biden by 27% to 25%, Wall Street has started to become unsettled at the prospect of a Warren nomination. A Washington Post article indicates that there is only concern, but no panic:

Wall Street is sounding the alarm over Sen. Elizabeth Warren’s rise in the Democratic presidential race, as investors start to grapple with the possibility the industry scourge secures her party’s nomination.

One investor joked that the stock market wouldn’t even open if the Massachusetts senator became president; a segment on CNBC featured the idea that married couples could get divorced rather than be subjected to Warren’s “wealth tax.”

For now, the rising nerves are mostly evident in chatter. There’s an emerging consensus that a Warren presidency would hurt the stock market — yet there’s little evidence that investors are pricing in the risk.

“From a pure markets perspective, a Warren nomination hardly seemed ‘priced in,'” Chris Krueger of Cowen Washington Research Group writes. He offers a few theories why that’s the case: The election remains far away; Warren could be seen as a weaker Trump foe; or that Warren will moderate her pitch if she secures the nomination. “In any event, buckle up.”

Warren`s odds of securing the nomination at PredictIt has soared in the last few days. This presents the picture of two main contenders. Warren and Biden have left the rest of the field behind. (For the uninitiated, the PredictIt market allows participants to buy and sell contracts based on events. If that event occurs, the contract pays out at $1.)
 

 

Expect the markets to begin to price in the prospect of a Warren win in the days and weeks ahead. For investors, it is time to consider the implications of a Warren White House.

I conclude that many of the often raised tax related concerns expressed by Wall Street are relatively minor in nature. Assuming no multiple contraction, I estimate them to come a 5-10% haircut on stock prices, which is well within the normal bounds of equity risk.

The much bigger risk is the Warren trade policy’s focus on “economic patriotism”. Her approach to trade has the potential to spark a prolonged cold war with China. With it, we could also see a bear market or widespread global slowdown by 2021. Moreover, it could seriously damage the existing global supply chains and usher in an era of global instability in trade relations.
 

Understanding the Warren surge

An LA Times article captures the zeitgeist of Elizabeth Warren`s electoral surge in Iowa. She has adopted a strategy of re-focusing the angst that elected Trump by reframing the issue as a problem of inequality.

In her rallies, Warren taps into much of the same voter anger toward government and the political system that President Trump feeds on, while offering a dramatically different solution.

Where Trump plays off his supporters’ resentment of “the elites,” Warren denounces the corrupting power of money. She has honed her case into a succinct argument that she laid out this way at an event Thursday evening in Iowa City:

“Whatever issue brought you here tonight, whether it’s gun violence, healthcare, education — whatever brought you here — there’s a decision to be made in Washington: I guarantee, it’s been influenced by money.

“When government works for the wealthy and the well connected, when government works for those who have money, when government works for those who hire armies of lobbyists and lawyers and is not working well for everyone else, that is corruption pure and simple, and we need to call it out for what it is.”

She studiously avoids mentioning her rivals by name but offers an unmistakable contrast with Biden when she declares that “we’re not at a moment where you can say, ‘I know, I’ve got two statutes over here and one regulatory change over there, and we’ll change the head of a department over there.’ No, we need big, structural change in this country.

“How do we get there? I’ve got a plan.”

Democrats go to Warren rallies and become energized. By contrast, they go to Biden rallies to be reassured.

Although Warren, who turned 70 in June, is only 6 ½ years younger than Biden, who will turn 77 in November, voters don’t seem to view the two as similar in age. Her rallies, from the jogging onstage that invariably opens them through the lengthy selfie line that ends them, convey a message of vigor.

The crowd at her Thursday evening event was about 10 times larger than Biden’s, and about 900 stayed for as long as an hour and a half afterward to get selfies with the candidate.

Susan Futrell and Flora Cassiliano, neighbors in Iowa City, were near the end of the line. Both said they were still weighing several candidates but praised Warren’s energy and stamina.

Even CNBC host Jim Cramer expressed grudging admiration for Elizabeth Warren, despite the widespread Wall Street opposition over her policies.

CNBC’s Jim Cramer said Thursday that he has a soft spot for Democratic presidential candidate Elizabeth Warren because she has really spent her career thinking about how to help people.

“You have a soft spot for her, it seems,” “Squawk on the Street” host Carl Quintanilla said to Cramer.

“Yes,” Cramer replied, saying it’s “because I think she has thought about the people who are not doing well in the country, and that is great.”

Those remarks add another layer to this week’s back-and-forth between the Massachusetts senator and the “Mad Money” host, who on Tuesday said Wall Street executives were telling him that her 2020 bid has “got to be stopped.”

 

Expect more taxes and regulation

What does that mean for the markets? Warren’s signature initiatives are higher taxes and more regulation. She has proposed a wealth tax on fortunes over $50 million, with a higher rate on billionaires. While Wall Street will undoubtedly focus attention on the wealth tax, the marginal effect on the markets and the economy is likely to be minor compared to some of the other measures.

At a minimum, expect her to unwind the Trump corporate tax cuts, which resulted in a one-time gain of 7-9% in after tax EPS.
 

 

Warren`s work on the banking regulation will also put the banks in the crosshairs of more government regulation. In effect, she knows where all the bodies are buried, and which bank buried which body. One indicator to keep an eye on is the relative performance of banking stocks. In the past, technical breakdowns of relative performance have been warnings of major bearish episodes, The last break, which occurred in September 2019, led to a -20% downdraft in the S&P 500. In particular, technical relative breakdowns of the large cap banks have either been led by or coincidental with the behavior of the regional banks (bottom panel). As the relative performance of the regional banks weakens and approaches all-time lows, pay particular attention to this indicator as a barometer of the health of the sector, and the market.
 

 

In addition, Warren has shown strong support for Medicare For All. I have doubts as to whether such a proposal would ever be passed. Obama had control of both chambers of Congress, and it was a struggle to even pass the Affordable Care Act. It is difficult to see how Warren could pass Medicare For All. Nevertheless, the healthcare sector would be hurt under these measures, and the healthcare providers would be especially hard hit.
 

 

The silver lining

It is easy to enumerate all the market and economic headwinds of Warren`s policies. Not all is doom and gloom. There are a number of silver linings in the dark cloud that investors should be aware of.

First, Warren`s policies are highly redistributive in nature. Proposals, such as student debt forgiveness, are designed to lessen inequality and put more money in the pockets of middle and lower income earners. Instead of the Republican formula of providing greater incentives for the owners of capital to invest and boost the economy based on a “trickle down” effect, her initiatives are aimed at Main Street, which will eventually benefit Wall Street based on a “trickle up” effect. While it is difficult to quantify the overall effects of a broader based stimulus, there will be a positive effect on economic growth. The gains, however, will be shared differently under a Warren administration compared to past Republican presidents.

In addition, Medicare For All could prove to be a source of long-term competitive advantage for America, which Warren Buffett explained in a PBS interview.

First, healthcare costs are a far greater drag on American competitiveness than corporate taxes. Healthcare costs have grown from 5% of GDP in 1960 to about 17% today. Other major industrialized countries spend far less per capita, and achieve better results. That is a source of competitive advantage for America’s trading partners. While Buffett is known to have supported Hillary Clinton in the last election, his partner Charlie Munger, a Republican, agrees with Buffett’s assessment of healthcare as an impediment to American business.
 

 

Healthcare costs are skyrocketing out of control. Buffett believes that a single payer system, otherwise known as Medicare For All, is the best way to control escalating costs. Indeed, the WSJ reported that the cost of employer coverage for a family plan has risen steadily and topped $20,000 a year.
 

 

Undoubtedly, Wall Street will express a lot of anxiety over Warren’s tax proposals. While I believe that their net effect will be negative for both the economy and suppliers of capital, these concerns are really a red herring. The wealth tax may be worrisome for the ultra-rich, but the net effect on Main Street is likely minimal. Notwithstanding the effects of the wealth tax, let us guesstimate the effect of these measures on the stock market.

  • Subtract the one-time earnings boost of the Trump tax cuts of 7-9%. Assuming no changes in P/E multiples, stock prices fall by 7-9%.
  • Subtract the effects of increased regulatory scrutiny on banks. Assume that this group craters by an additional 10-15% net of the market. Since financial stocks account for 13% of the index, stock prices fall by an additional 2%.
  • Add back the income broadening effect on middle and low income earners, which will stimulate the economy. Effect is unknown, as it will be difficult to quantify.
  • Add back the long-term boost in competitiveness to American business if Medicare for All is implemented (as per Buffett and Munger). Effect difficult to quantify.

Overall, this amounts to a 5-10% haircut on stock prices, which is well within the normal bounds of equity risk. While the effects are unpleasant, they are by no means catastrophic.
 

 

However, there is one elephant in the room in the discussion of Warren’s policies, and it is trade.
 

The (trade) elephant in the room

Elizabeth Warren recently released a plan to completely overhaul trade policy based on the principles of “economic patriotism”. The plan is going to unsettle global markets because of her broad principles on trade:

  • Recognize and enforce the core labor rights of the International Labour Organization, like collective bargaining and the elimination of child labor.
  • Uphold internationally recognized human rights, as reported in the Department of State’s Country Reports on Human Rights, including the rights of indigenous people, migrant workers, and other vulnerable groups.
  • Recognize and enforce religious freedom as reported in the State Department’s Country Reports.
  • Comply with minimum standards of the Trafficking Victims Protection Act.
  • Be a party to the Paris Climate agreement and have a national plan that has been independently verified to put the country on track to reduce its emissions consistent with the long-term emissions goals in that agreement.
  • Eliminate all domestic fossil fuel subsidies.
  • Ratify the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.
  • Comply with any tax treaty they have with the United States and participate in the OECD’s Base Erosion and Profit Shifting project to combat tax evasion and avoidance.
  • Not appear on the Department of Treasury monitoring list of countries that merit attention for their currency practices.

This plan is aimed directly at China. This initiative is likely to create a long-term rupture in the trade relationship between the two countries and foster the decoupling of the two economies.

Warren’s approach to trade is ultimately protectionist, but in a manner that is different from Trump. Trump has focused on the dual objectives of the trade deficit and China’s practice of restricting foreign competition to favor domestic industries, but the objectives are inherently contradictory. The US cannot at the same time want to reduce the trade deficit, and want China to open its economy to foreign companies, which would increase the trade deficit.

By contrast, Warren’s focus is on principled trade, which hardens back to the days of Jimmy Carter, whose administration was focused on human rights. The same focus on human and labor rights will be major impediments to reaching a trade agreement with the Chinese. As a reminder, Warren sponsored the Uyghur Human Rights Policy Act of 2019, which underlines her commitment to human rights but will prove to be a source of friction in negotiations with Beijing. In addition, the imposition of environmental standards, along with human and labor rights demands, will make a trade agreement with China all but impossible.

In addition, there are a number of other obstacles to a comprehensive trade agreement with China. As the Chinese economy has grown and matured, Bloomberg reported that Australia has joined the US in calling for China to drop its developing nation status. This means that China will lose many exemptions accorded developing countries, and it will be treated the same way as advanced economies.

If the election were to pit Trump against Warren in 2020, expect a deep freeze in Sino-American trade relations, and a new cold war to begin. T. Greer recently revealed in a Twitter thread China’s unusually frank view of its relationship with the US from a member of the politburo [edited for brevity].

Huang Qifan gave a speech on the trade war a few days ago . It is eye opening. The ideas in it aren’t really new, but they are expressed with such frankness (+with so little Communist cant) that I triple checked this guy is who I thought he was.

Huang is a central committee member. Currently works as Financial and Economic Affairs Committee of the NPC. Not a small fry.

He divides his speech into four sections. The first section discusses why the 2013-now is actually a “new era” in China’s economic development…

Huang starts off by explicitly addressing the argument for ceding to American demands (what he rather colorfully compares to ‘letting them punch our face… in hopes they will feel pity for us and decide to stop”). His rebuttal to this argument is very simple: look at Japan.

Japan, he says, is a vassal state (属国）of the Americans. Since 1945 the Japanese have done everything the Americans have ever wanted them to. And what has been the result of Japanese benevolence/cravenness? Nothing! Despite Japan toeing the American line time and again, the United States “bullies” Tokyo. The 1980s trade show off is the central example of his case, but he spends a whole paragraph talking about how humiliating it must be to be Shinzo Abe. Abe spends all of this time “fawning over Trump, playing golf for him” but has it resulted in Abe obtaining anything? To the contrary, there was this one time when a big ol red carpet was laid out for the two guys at a state dinner, and Trump walked right down the center of it. To stay by his side, Abe had to walk off of the red carpet all together. And that, Huang reminds us, “was in Japan!” Abe plays all that golf and Trump still hogs the red carpets of Japan. How embarrassing to be Abe–and how foolish, Huang says, to think that personal relationships or chemistry between leaders matter. What matters is national interest.

And it is in America’s interest to keep down China.

Huang uses numbers to justify the point. We went from 4% of America’s GDP to 60% in just 40 years. Give it another 15 and we will be ahead of them. The Americans will not allow it.

They have been the global top dog（世界的老大）for several decades. As big boss, they have broken rules whenever they feel the need, conflating their domestic rules with international ones. Huang specifically ties the Meng extradition case to the Iraq war as examples of American rule-breaking and “bullying.” Having acted this way as the big boss for so long, the Americans fear that China will do the exact same thing to them once China becomes #1 (他想着如果有一天你也是老大了，你也这么来对我那怎么办) so the Americans will try to hold you down.

Interestingly, Huang doesn’t really condemn the Americans for this. He calls it “inevitable.” And that is one of the themes of this speech–with or without Trump, America trying to hold China down is inevitable. That is just what powerful countries to do challengers.

Now this is where things get interesting. He says, in effect, that the Americans are right to fear being surpassed by China. Why? ‘cuz Socialism with Chinese Characteristics is simply a far better way to reach the top and stay there than the American system will ever be.

This speech is an unequivocal signal that Chinese leadership is digging for the long fight. While there are some in the US and in particular in the Trump administration who believe that since China will cave because their economy is hurting, nothing could be further from the truth. A recent World Bank report on China, which is signed and endorsed by the Chinese government, is already projecting slower growth rates over the coming decade. Moreover, growth could slow to as low as 1.7% by 2031 in an adverse scenario. In short, slower growth is already part of their base case scenario, and Bejing is bracing for pain.
 

 

In addition, an Ipso poll comparing which country are on the right and wrong track shows China at the top, indicating broad support for government policies.
 

 

By my estimation, growth will be at the low end of the range. Productivity growth will lag as Xi Jinping has pivoted to a command-and-control model to suppress dissent and division, the use of party cadres instead of technocrats as sources of policy and their implementation, and the reliance of SOEs as ways to control the path of economic growth. These measures will, in the end, stifle growth by suppressing the faster growing SMEs, and reduce growth potential through lower productivity.
 

 

These circumstances are setting up some dire conditions for world growth. If the electoral contest is between Trump and Warren, it’s going to be a long cold war. For investors, a reversal in global trade will have chilling effects on global growth. The following IMF analysis models the effects of rising Sino-American tariffs, but the message is unmistakable. A slowdown in Chinese growth will sideswipe most of Asia. As well, it will have negative effects on commodity exporting economies like Australia, New Zealand, Canada, and Brazil. This could all begin in 2021 should Elizabeth Warren win the race for the White House.
 

 

In summary, I believe many of the often raised tax related concerns expressed by Wall Street are relatively minor in nature. Assuming no multiple contraction, I estimate them to come a 5-10% haircut on stock prices, which is well within the normal bounds of equity risk.

The much bigger risk is the Warren trade policy’s focus on “economic patriotism”. Her approach to trade has the potential to spark a prolonged cold war with China. With it, we could also see a bear market or widespread global slowdown by 2021. Moreover, it could seriously damage the existing global supply chains and usher in an era of global instability in trade relations.
 

The week ahead

The weakest week strikes again! Last week, I highlighted analysis from Rob Hanna of Quantifiable Edges who found that last week was reliably the weakest week of the year from a seasonal viewpoint. Right on cue, the SPX fell -1.0% last week.
 

 

On balance, I judge the tactical outlook to be tilted to the bearish side. The stochastics indicator recycled from an overbought readings last week, which is a sell signal, but conditions are not oversold yet. The market decline was arrested at support at its 50 dma and at about 2960, with a partial fill of the gap at 2940-2960. However, the index may be constructively tracing out a bull flag formation, which is a bullish continuation pattern. Keep an eye on the VIX Index (bottom panel), as closes above its upper Bollinger Band signal an oversold condition and a short-term bottom.
 

 

However, the bulls should not get overly excited just yet. The weekly chart shows the stochastic rolling over from an overbought condition and it is about to flash a sell signal on a weekly time frame.
 

 

Risk appetite indicators are not supportive of gains and they are not showing any signs of bullish divergence. The relative duration-adjusted price performance of high yield bonds have been signaling a bearish divergence for several months, and it is a signal of negative credit market risk appetite. In addition, the poor market reception of the Peloton IPO exposed another gaping wound in equity risk appetite. The PTON IPO was not an isolated incident, IPOs had been lagging the market since early August (bottom panel).
 

 

Analysis from Strategas revealed that private market multiples now exceed public market multiples. Is it any wonder why IPOs are struggling?
 

 

Bloomberg also reported that risk aversion is rising in the credit market:

At a quick glance, everything seems wonderful in the world of risky credit. In September alone, companies have raked in more than $52 billion by tapping the U.S. leveraged-loan and high-yield bond markets.

But look a little closer and cracks start to emerge. Lots of cracks.

In recent weeks, a slew of companies — typically those considered the riskiest of the risky — have been forced to either ratchet up interest rates or dangle sweeteners to drum up investor demand and complete deals. A few more — including at least four this month — have been yanked from the market entirely.

One common refrain coming from investors is that they don’t want to touch companies with excessive debt, especially those from struggling sectors or with businesses that could suffer more in a downturn. Particularly problematic: companies rated B3 by Moody’s Investors Service or B- by S&P Global Ratings, one step away from the junk market’s riskiest tier.

“If you’re looking to finance an LBO in the wrong sector or a business vulnerable to a slowdown, that’s tougher,” said John Cokinos, co-head of leveraged finance at RBC Capital Markets. “The loan market has limited appetite for new B3 rated deals, and the high-yield market is pushing back on highly levered deals.”

Global risk appetite has not been helped by recent USD strength, which continued to rally after a brief pullback and consolidation after an upside breakout out of a multi-year base.
 

 

Historically, USD strength (inverted in the chart below) has not been helpful to the relative strength of EM stocks, which are high beta and cyclical stocks in the global market.
 

 

There is also bad news on the fundamental front. FactSet reported that forward 12-month estimate revisions, which had turned positive for several weeks, stalled and turned negative last week. While the latest reading may be a data blip, it could also be an indication of weakening fundamental momentum. This leaves little room for error when the market trades at a forward P/E ratio of 16.8, which is ahead of its 5-year average of 16.6 and 10-year average of 14.8.
 

 

FactSet also reported that the rate of Q3 negative guidance is higher than average, and most of the warnings are clustered in the high flying and high beta technology sector.
 

 

Is the bottom near? Probably net yet. The market is not yet oversold, even on a short-term basis.
 

 

If history is any guide, the stock/bond ratio should bottom once the 5-day RSI becomes oversold, and the 14-day RSI reaches a near oversold reading. We are not there yet.
 

 

My inner investor remains cautiously positioned. My inner investor is maintaining his short position.

Disclosure: Long SPXU

 

Where have you gone, Vol-a-tility?

Posted by Cam Hui -

Mid-week market update: I have been writing in these pages about the remarkable muted equity market volatility. Indeed, Luke Kawa observed on Monday that realized volatility had fallen to historical lows.

Recent developments indicate that volatility may be about to return to the markets. This reminds me of the lyrics of a song that I vaguely remember from my youth:

Where have you gone, Vol-a-tility?
A nation turns its lonely eyes to you…
Woo woo woo…

Event-driven volatility

Stock prices opened Tuesday on a slight upbeat note, until Trump made a highly assertive speech at the United Nations on trade that was directed mainly at China. Even China’s latest conciliatory gesture to allow limited tariff exemptions for the purchase of American soybeans failed to move the markets.

Later in the day, House Speaker Nancy Pelosi announced that the House would begin impeachment proceedings against Trump. Indeed, the PredictIt betting odds of an impeachment has skyrocketed in the last few days, even before the Pelosi announcement.

Almost immediately, analysts searched market history of how stock prices behaved during the last two impeachment proceedings. The results were very different. The market weakened considerably during the Nixon impeachment hearings, but that era was marked by a recession. Stock prices were generally firm during the Clinton impeachment proceedings, but the NASDAQ Bubble was just taking off.

I will let readers make their own political judgments about the current episode, but it is clear that investors cannot come to any definitive conclusions about what might happen next based on political history (n=2). However, Trump has shown a pattern of deflecting criticism by re-focusing the news cycle when he is threatened to two familiar topics that are under his control, border security and trade. Moreover, the impeachment inquiry could prove sufficiently distracting that substantive trade discussions becomes all but impossible for the Trump administration. This environment can only mean one thing for the markets.

Volatility.

A bearish bias

While the market could certainly be volatile with prices going upwards, my inclination is to expect a bearish bias in the days and weeks ahead.

The following chart of the stock/bond ratio, which is an indicator of risk appetite, tells the story. The SPY/TLT ratio has shown an up-and-down pattern which were marked by overbought and oversold readings. While the fit isn’t perfect, the market was already undergoing a risk-off phase even before the latest news hit the tape. If history is any guide, this will not bottom out until the 14-day RSI becomes oversold.

The weekly stochastic is overbought and it is poised to recycle to neutral. Past episodes have been effective sell signals.

As well, my monitor of the top 5 sectors that comprise nearly 70% of index weight is also telling a bearish tale. Virtually all sectors are exhibiting negative relative strength. It would difficult for the market to rally without a substantial participation of most of these sectors.

The market is also facing seasonal headwinds. Ryan Detrick observed that the market is entering a period of negative seasonality until Thanksgiving.

From a tactical perspective, short-term momentum was approaching a near oversold condition as of Tuesday night’s close, which showed a recovery today.

The market successfully tested its 50 day moving average, and support at about 2960. However, the daily stochastic has turned south, which is a bearish signal.  We may see a short-term rally back to the declining trend line in the next couple of days.

My inner investor remains defensively positioned. My inner trader is short, but a 1-3 day bounce could happen at any time. He is prepared to add to his short positions should the market stage what would be expected to be a brief relief rally.

Disclosure: Long SPXU

Why I am cautious on US equities

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 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: Bearish
  • 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.
 

The bull and bear cases

In light of my recent cautious views, I have had a number of intense discussions with readers about the equity outlook for the next 3-6 months.  I would like to explain my reasoning by analyzing the bull and bear cases.
 

 

The bull case

The bull case for equities rests mainly on momentum, which can be seen at both the technical, macro, and fundamental dimensions.

It is important to preface these remarks with definitions of technical momentum. There is the price momentum factor, which posits that stocks which outperform will continue to beat the market. The price momentum factor suffered a recent reversal, and its outlook is uncertain. On the other hand, asset price momentum, which is based on the theory that outperforming asset classes will continue to rise, is still going strong. One manifestation of asset price momentum is FOMO, or the Fear of Missing Out.

There is plenty of academic evidence for the psychology of price momentum. A Bloomberg article outlined one example of the herding effect in musical tastes:

Over a decade ago, a celebrated paper by sociologists Matthew Salganik, Peter Dodds and Duncan Watts tried to answer such questions. They asked: When a song turns out to be a spectacular success, is it because it’s really great, or is it just because the right number of people, at an early stage, were seen to like it?

Salganik and his colleagues created a control group in which people could hear and download one or more of dozens of songs by new bands. In the control group, people were not told anything about what anyone else had downloaded or liked. They were left to make their own independent judgments.

The researchers also created eight other groups, in which people could see how many people had previously downloaded songs in their particular groups. Here was the central question: Would it make a big difference, in terms of ultimate numbers of downloads, if people could see the behavior of others?

It certainly did. While the worst songs (as established by the control group) never ended up at the very top, and while the best songs never ended up at the very bottom, essentially anything else could happen. If a song benefited from a burst of early downloads, it could do really well. If it did not get that benefit, almost any song could be a failure. In short, the judgments of a few early movers could initiate a social cascade, making or breaking a song.

One preliminary bullish sign of asset price momentum can be seen in the monthly S&P 500 MACD signal. Should the index remain at these levels by the end of September, this indicator will generate a long-term buy signal for the market. As the chart below shows, past buy signals have been very prescient at calling bull trends.
 

 

There is an important caveat. The monthly chart of the broader Wilshire 5000 has not confirmed the monthly MACD buy signal, though it is very close.
 

 

Nor has it been confirmed by global stocks, or the EAFE Index (chart not shown).
 

 

In the short term, the upside breakout by the S&P 500 at 2950 was accompanied by evidence of a breadth thrust, which is a sign of bullish asset price momentum.
 

 

However, that analysis does come with another caveat. Price momentum signals like breadth thrusts have been less effective in the last decade because of a herding effect, probably exacerbated by investors and traders crowding into the price momentum factor.
 

 

To summarize the technical bull case, the market is flashing a bullish breadth thrust, and it is on the verge of an unconfirmed long-term MACD buy signal. Should stock prices continue to rise in the coming weeks, we should have bona fide case for a FOMO stampede.
 

Macro and fundamental momentum

The bull case does not just rest on technical momentum, but macro and fundamental momentum as well. The Citigroup Economic Surprise Index, which measures whether high frequency economic data is beating or missing expectations, has been on a tear lately. This is an indication that the economy is improving much faster than expected.
 

 

Callum Thomas at Topdown Charts observed that global monetary policy is easing, which should lead to a recovery in PMIs in the near future. A rebound in the global cyclical outlook in early 2020 is imminent.
 

 

Earnings estimates have begun to turn up in an uneven fashion. Forward 12-month margin and EPS estimates are recovering for large cap S&P 500 stocks. However, they are still declining for mid and small caps.
 

 

To summarize, the bull case rests on momentum. The slowdown in the global economy appears to be bottoming out. Earnings estimates are starting to improve. The improvement in fundamentals is being reflected in technical price momentum. Investors should hitch a ride on the bullish train.
 

The bear case

I hate to sound like an old fogey, but one of the reasons for caution is valuation. The market trades at a forward P/E ratio of 17.0, which is above its 5-year average of 16.5 and 10-year average of 14.8. Even though the E in the P/E ratio is rising, valuations are elevated at 17 times forward earnings. It is difficult to envisage much upside without postulating an irrational investment bubble in stock prices.
 

 

As a reminder, the stock market is not the economy, and NIPA profits better reflects the American economy. We can see a similar effect when we chart S&P 500 profits against NIPA profits. The last time this degree of divergence occurred was the top of the NASDAQ Bubble.
 

 

A second reason to be cautious is the uncertainty in trade negotiations. The Sino-American trade war is unlikely to be resolved in the near future. That’s because Trump really doesn’t know what he wants from the Chinese. Linette Lopez explained the dilemma in a Business Insider editorial:

It is easy to forget that initially this trade war was about making China’s markets fairer for US businesses — ending favoritism for domestic companies, forced technology transfers, and intellectual-property theft. In March 2018, US Trade Representative Robert Lighthizer wrote a report to Congress outlining all these issues and all the ways China was in violation of World Trade Organization rules. It all made sense.

But at the same time there was Trump and his obsession with trade deficits — with getting China to buy more US stuff. This did not, and still does not, make any sense. In sophisticated economies, bilateral trade deficits don’t mean anything.

Lighthizer wants changes that would make China a more free-market economy like the US. Trump wants changes that further distort the Chinese economy by explicitly forcing it to buy goods from one place rather than another. The former is capitalism. The latter is Trump’s variety of populist nationalism. And they do not play well together.

“There are various ways in the short run to reduce the bilateral trade deficit, but this would be done in ways that are essentially market-distorting,” Lee Branstetter, a Carnegie Mellon University economist, told Business Insider.

These two conflicting goals have repeatedly caused issues during the on-again, off-again negotiations. Think back to December: Trump ratcheted up the tariffs, China managed to negotiate a temporary peace by promising to buy US soybeans, negotiations resumed, and then they collapsed as China refused to yield to the US’s conflicting demands.

Before, Trump making a trade deal with China “was always about setting the rules and structures and accepting the market outcomes,” Branstetter said.

Now it’s about sales.

And on the other hand, if Lighthizer’s objectives (changing the rules to open up China for US companies) are met, it’s likely that Trump’s core nationalist objectives (forcing companies to move to the US) will suffer.

Chinese and American negotiators are scheduled meet yet once again. However, this internal contradiction in the US negotiating position continues to overhang the talks. As Trump vacillates between the two goals, his frequent flip-flops undercuts his own negotiating team, and confuses the Chinese. In addition, US attention is likely to turn towards the EU, and a new front in the trade will could open.

Another possible bearish development that I have not seen any analyst discuss is the implication of the Democrat battle for the presidential nomination. While Joe Biden is currently leading in the polls, Elizabeth Warren is well ahead in the better odds at PredictIt. The market has not begun to discount the possibility of a Warren presidency, whose policies would unsettle the markets.
 

 

Let us consider the best and worst case analysis for the earnings outlook. In the best case scenario, the US concludes a comprehensive trade agreement with China. Global protectionism drops, and so does business uncertainty. Earnings growth revert to a pre-protectionism path. Forward earnings rise to about 190 per share. In the worst case, a Warren White House unwinds the Trump corporate tax cuts, and earnings, which received a one-time bump of about 7-9%, drops by the same amount.
 

 

Consider the valuation effects of the best case scenario. Forward P/E would drop from 17.0 to 15.9, which represents moderate value, but that does not make the stock market extremely cheap. In reality, the best and worst case scenarios will never be achieved. Even if the US and China were to come to a trade agreement, implementation would be slow, and confidence would not recover instantly. As well, Warren’s ability to reverse the corporate tax cuts is dependent on which party controls the Senate. Even if the Democrats were to win the upper house, it is unclear whether Senate Democrats would agree with her proposals. In addition, her re-distributive policies would have some stimulative effect of unknown magnitude. Middle and lower income Americans will find more in their pockets, which would boost consumer spending.
 

 

In short, equity risk/reward is unfavorable on a valuation basis. It is difficult to see how much upside potential could be achieved in light of the policy risks facing investors.
 

Resolving the bull and bear cases

Putting it all together, here is how I resolve the bull and bear cases.

Here is the big picture. Investors had herded into a crowded short and overly defensive position, and that trade reversed itself. The reversal was evidenced by the dramatic cliff dive exhibited by the price momentum factor. A lot of the fast hedge fund money was forced to buy equity beta by its risk managers.
 

 

The big question is: Will the slow but glacial institutional money follow and pile into the beta trade? Domestic managers in North America were still defensively positioned as of last report.
 

 

My judgment is “no”. Institutional funds have longer time horizons than individuals or hedge funds, and they have longer time horizons where valuation plays a much bigger role in the decision process. Valuations are too high, and the risk/reward is unfavorable. In addition, while domestic equity managers are short beta, the BAML Global Fund Manager Survey shows that global managers had been piling into US equities as the last source of growth. It is therefore difficult to see where additional demand will appear in the face of stretched valuation, and an overweight position by non-US managers.
 

 

Another signal of caution comes from insider activity. While high insider selling is not useful as a sell signal, we are not seeing the sort of insider buying clusters that mark a buy signal either. This is another indication that insiders do not consider the shares of their own companies to be cheap.
 

 

In fact, Mark Hulbert reported that CFO confidence from the Duke CFO Magazine Global Business Outlook survey is plunging.

According to the survey, 53% of CFOs expect a recession no later than the third-quarter of next year. When asked if a recession will begin by the end of next year, the percentage grows to 67%.

 

 

This does not mean, however, that investors should totally abandon equities. While US equity valuation is stretched, equity valuation outside US borders are far more reasonable. However, each region does come with its own sets of risks. Emerging markets depend on the USD, which has been strengthening, and resolution in the Sino-American trade war. The eurozone economy is weak, and it is dependent on exports to China, and therefore it has a high beta to Chinese growth, which is slowing. The UK is facing a strong binary risk of a no-deal Brexit, which would also sideswipe Europe if it left the EU in a disorderly fashion.
 

 

Pick your poison, but at least the risk/reward ratio is more attractive than a commitment to US equities.
 

The week ahead

Looking to the week ahead, the market may be setting up for a volatility spike. If a time traveler from the future appeared last weekend and told you that the stock market would trade in a tight 0.5% range after a major attack on Saudi oil processing facilities, would you have believed him? That is precisely what has happened. the market traded in a tight range despite the news of the Saudi attack, and the FOMC meeting. The market may be overly complacent about volatility and risk.
 

 

Realized volatility has been unusually low, but it may be setting up for a new spike. The VIX Index became oversold on the 5-day RSI, and past oversold episodes in the past year have usually been resolved with VIX rallies. In addition, the latest instance occurred with a positive RSI divergence, which is volatility bullish, but equity bearish.
 

 

One bearish trigger may be renewed USD strength. The USD Index had been tracing out a possible bull flag, which is a bullish continuation pattern. The Index staged a minor, but unconfirmed, breakout from the flag pattern on Friday. This could be the start of a new dollar rally which could unsettle markets.
 

 

The pain of a strong USD will be felt most acutely in EM economies. As the following chart of credit market risk appetite shows, the relative price performance of high yield (junk) bonds (black line) is already tracing out a negative divergence against the stock market. The relative price performance of EM bonds (red line) weakened when the USD rallied. EM bonds are now trading in line with HY bonds, which are negative signs for equity prices.
 

 

In addition, a strong USD will pose headwinds for large cap multi-nationals operating overseas. Even then, an analysis of the relative performance by market cap bands is uninspiring. Megacaps are range bound on a relative basis. Mid and small cap stocks remain in relative downtrends, and NASDAQ leadership is also uninspiring. Should USD strength depress the relative strength of megacap multi-nationals, where will the leadership come from if the market is to rally to new highs?
 

 

Similarly, the relative performance of high beta groups does not reveal any pattern of dynamic bullish leadership. Most are in relative downtrends, or range bound.
 

 

How can the market rally to new highs if leadership is so insipid?

As well, the bulls cannot depend on a tailwind from a crowded short readings on sentiment models. Trader sentiment has normalized. Exhibit A is the weekly AAII survey, where bulls now outnumber bears.
 

 

Investors Intelligence also shows a similar pattern of sentiment normalization. Arguably, the net bull-bear II spread could be interpreted as becoming close to a crowded long.
 

 

The Goldman Sachs Sentiment Indicator also tells a similar story. Goldman reported that hedge fund net exposure is now highest since July 2018, and foreign investors are piling into US equities.
 

 

In the short run, momentum indicators are falling and only in neutral territory, indicating that the market may have more room to fall in the early part of the week.
 

 

The market is also facing seasonal headwinds next week. Rob Hanna at Quantifiable Edges observed that the week after September option expiry has historically been the weakest week of the year for stocks. “Since 1960 the week following the 3rd Friday in September has produced the most bearish results of any week.”
 

 

My inner investor remains cautiously positioned. My inner trader is short the market, and he will watch how the S&P 500 behaves as it nears support at 2950 before taking further action.

Disclosure: Long SPXU

 

A predictable no surprise market

Posted by Cam Hui -

Mid-week market update: Subscribers received an alert last Friday that I had turned tactically cautious on the market. So far, this has been a fairly predictable market with few surprises.

Rob Hanna at Quantifiable Edges documented how stock prices have been during FOMC days when the SPX closed at a 20-day high the day before. That’s because the market had risen in anticipation of a positive announcement from the Fed, and the reaction is at best a coin toss.
 

 

Today’s roller coaster market action was no surprise. That said, the late day rally was likely sparked by a misinterpretation of Powell’s comment about the balance sheet which traders took to mean another round of quantitative easing is imminent. . As a reminder, “organic balance sheet growth”, which is the term Powell used, is not quantitative easing.
 

Market internals tilt bearish

Market internals are not supportive of further strength after the recent upside breakout from resistance. I had observed that the relative strength of the top 5 sectors are trading heavy. Of the five, only one (financials) is displaying positive relative performance, and since that sector`s relative returns have been highly correlated with the 2s10s yield curve, financial leadership was no surprise. That said, today’s flatten the yield curve market reaction will create some headwinds for this sector. Overall, 3 of the other 5 sectors are underperforming, with one (healthcare) possibly stabilizing. Since these five sectors comprise just under 70% of total index weight, it is difficult to envisage how the market could rise on a sustainable basis without the bullish participation of a majority of them.
 

 

In addition, the VIX Index is also setting up for a volatility spike. In the past, oversold readings on the 5-day RSI have been setups for a rise in the index, and RSI recycled from oversold to neutral on Monday. The near-term upside target for the VIX is 17.5 to 19.5. As stock prices tend to be inversely correlated with volatility, this is a bearish signal for equities.
 

 

While the bulls have pointed to the new highs reached by the NYSE Advance-Decline Line, other internals are flashing cautionary signals. The net new highs for the NYSE, SPX and NDX are all showing patterns of lower highs and lower lows even as the market broke out.
 

 

So far, these are not surprises. The universe is unfolding as it should. The only question is whether support at 2960 holds, and whether support breaks, which fills the the gap at 2940-2960.
 

Sentiment nearing a crowded long

Lastly, I would point out that the latest update of II Sentiment shows that net bulls and bears have recovered to levels that are nearing bullish excesses. This is another sign of a setup for a short-term downdraft.
 

 

My inner investor remains cautiously positioned, and he is underweight equities relative to his investment targets. My inner trader initiated a small short position last Friday.

Disclosure: Long SPXU

 

3 supply shocks that could derail the economy

Posted by Cam Hui -

As the market reacts the weekend attack on Saudi oil facilities, the level of anxiety is mounting. Forbes published an article on Sunday entitled “Attacks on Saudi Arabia are a recipe for $100 oil”.

Bloomberg that this represents the biggest disruption to global oil supply since the Iraqi 1990 invasion of Kuwait.

 

As visions of the 1974 Arab Oil Embargo and the ensuing recession dance in traders’ heads, this is a timely reminder that the FOMC is meeting this week. Should the supply curtailment become prolonged, how should policy makers react to supply shocks? As well, there is a case to be made that the world is facing more than just one supply shock.
 

Supply shocks explained

What is a supply shock? Nouriel Robini explained it this way in a Project Syndicate essay:

Over time, negative supply shocks tend also to become temporary negative demand shocks that reduce both growth and inflation, by depressing consumption and capital expenditures. Indeed, under current conditions, US and global corporate capital spending is severely depressed, owing to uncertainties about the likelihood, severity, and persistence of the three potential shocks.

When he wrote the essay, Roubini was referring to the supply shock from the Sino-American trade and currency war, the emerging cold war between the two countries, and a possible third shock involving oil supplies. All three shocks have manifested themselves, and there is little policy makers can do.

In fact, with firms in the US, Europe, China, and other parts of Asia having reined in capital expenditures, the global tech, manufacturing, and industrial sector is already in a recession. The only reason why that hasn’t yet translated into a global slump is that private consumption has remained strong. Should the price of imported goods rise further as a result of any of these negative supply shocks, real (inflation-adjusted) disposable household income growth would take a hit, as would consumer confidence, likely tipping the global economy into a recession.

Consider the supply shock stemming from the trade war. A recent Fed study concluded that trade policy uncertainty was on course to reduce GDP growth by about 1%.

 

The latest NFIB small business confidence survey is revealing, as small businesses have little bargaining power and their views are sensitive barometers of the economy. Trade uncertainty erodes business confidence, and capital expenditures plans get delayed. As the NFIB survey shows, capex plans are rolling over.

 

Despite Trump`s desire for lower interest rates, there is little the Fed can do to boost the economy even if it were to lower rates. Credit conditions are already very easy. But if confidence about business conditions are low, lowering the cost of credit will have minimal effect on growth.

 

I would add that trade war uncertainty is not just limited to friction between the US and China. Politico reported that Trump is likely to open up another front in the trade war. This time it will be against the European Union.

The United States has gotten the green light to impose billions of euros in punitive tariffs on EU products in retaliation for illegal subsidies granted to European aerospace giant Airbus.

Four EU officials told POLITICO that the World Trade Organization ruled in favor of the U.S. in the long-running transatlantic dispute and sent its confidential decision to Brussels and Washington on Friday.

The decision means that U.S. President Donald Trump will almost certainly soon announce tariffs on European products ranging from cheeses to Airbus planes. One official said Trump had won the right to collect a total of between €5 billion and €8 billion. Another said the maximum sum was close to $10 billion.

Roubini suggested that the proper short-term policy response to these supply shocks is both monetary and fiscal easing (good luck with passing fiscal stimulus ahead of the election):

Given the potential for a negative aggregate demand shock in the short run, central banks are right to ease policy rates. But fiscal policymakers should also be preparing a similar short-term response. A sharp decline in growth and aggregate demand would call for countercyclical fiscal easing to prevent the recession from becoming too severe.

However, there is little policy makers can actually do over the medium term, as the economy is facing a demand shock (capex drying up from trade war uncertainty, an oil spike is a de facto tax increase). The economy just needs time to adjust to these shocks. An inappropriate policy response will only lead to stagflation.

In the medium term, though, the optimal response would not be to accommodate the negative supply shocks, but rather to adjust to them without further easing. After all, the negative supply shocks from a trade and technology war would be more or less permanent, as would the reduction in potential growth. The same applies to Brexit: leaving the European Union will saddle the United Kingdom with a permanent negative supply shock, and thus permanently lower potential growth.

Such shocks cannot be reversed through monetary or fiscal policy making. Although they can be managed in the short term, attempts to accommodate them permanently would eventually lead to both inflation and inflation expectations rising well above central banks’ targets. In the 1970s, central banks accommodated two major oil shocks. The result was persistently rising inflation and inflation expectations, unsustainable fiscal deficits, and public-debt accumulation.

Oxford Economics put some numbers on what could be a dire scenario. The firm modeled what a sustained oil spike would do to growth and inflation in dire case scenarios. Even at $80 oil, inflation would rise to levels that would restrain the Fed from easing, regardless of how much pressure Trump puts on Powell.

 

Add in the uncertainty restraining business investments, and you have the makings of stagflation induced slowdown.
 

The oil shock

As I write these words, it is difficult to assess the impact of the oil shock. We have seen short-term oil spikes before, and prices can normalize as the underlying supply situation gets resolved. There are two major questions to consider. How long will it take for flow rates to come back online?

The second and more difficult question is what steps Saudi Arabia can take to prevent a repeat of similar incidents. The energy analyst John Kemp explained it this way in a series of tweets:

ABQAIQ has long been identified as the #1 security risk in the oil market given its centrality to the Saudi export system — it is the top target for terrorists, dissidents, foreign special forces and in the event of armed conflict with Iran.

ABQAIQ’s vulnerability means it is one of the most heavily guarded places on Earth and it has long been thought that it was safe in most circumstances short of war with Iran

SAUDI ARABIA has armed guards to protect the perimeter. The kingdom’s security services target internal threats. The CIA has a large station in the kingdom. And U.S. service personnel are present in significant numbers in the Eastern Province.

ABQAIQ was assessed to be relatively secure from most threats short of open armed conflict with Iran. The recent attack (whether by drone or missile) has falsified that assessment

ABQAIQ attack will force major re-evaluation not only of risks in the oil market (where it has highlighted vulnerability to single point of failure) but also the kingdom’s security strategy (including Yemen conflict and relations with Iran, the United States and regional powers)

SAUDI strategy has been to reinforce alliance with USA; support maximum sanctions on Iran; forward posture in Yemen, Syria and to lesser extent Iraq; while oil system and homeland remain secure. Abqaiq attack raises question whether conflict can be kept outside kingdom’s borders

ABQAIQ attack has hit the most central and critical node for the oil market and at the very core of the kingdom’s political security

ABQAIQ has always been a much greater source of risk for the oil market than Strait of Hormuz. But until the last 48 hours it was assumed to be a high consequence low probability danger so was largely discounted. That won’t be possible any more

For those familiar with electricity and other critical systems that employ N-1 planning to deal with contingencies, Abqaiq was the N in the world oil market

Short-term question is how to repair Abqaiq and how to protect it from further attacks. Long-term question is how to reduce reliance on the site by increasing redundancy and re-routing oil flows

Even if the infrastructure damage were to be repaired quickly, expect a supply security risk premium to be embedded in oil prices for the foreseeable future.

In addition, this is President Trump`s first real foreign policy test based on a situation that was not based on his initiative. He recently dismissed John Bolton, a known Iran hawk, as National Security Adviser. How he handles this challenges could be crucial to his re-election chances, not to mention a possible source of geopolitical instability. Will the market have to price in a Trump uncertainty premium, as well as a security risk premium to oil prices?

 

These conditions can’t be positive for stock prices when the market closed last week at an elevated forward P/E of 17.0.

 

In the meantime, get some popcorn, sit back, and enjoy the show.