A 2020 commodity review

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A commodity bull market ahead?

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

 

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

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

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

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

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

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

 

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

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

A technical review

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

 

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

 

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

 

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

 

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

 

Here is the table referenced in the tweet.
 

 

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

 

China: A source of rising demand

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

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

 

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

 

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

 

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

 

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

 

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

The week ahead

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

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

 

Buy the cannons, sell the trumpets?

Posted by Cam Hui -

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

Have we had a cannons and trumpets moment?

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

 

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

A fishy tale

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

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

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

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

 

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

 

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

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

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

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

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

The sound of trumpets?

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

 

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

 

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

 

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

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

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

Disclosure: Long SPXL

 

Fade the fear spike

Posted by Cam Hui -

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

 

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

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

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

Fading geopolitical risk

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

The road ahead

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

 

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

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

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

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

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

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

Disclosure: Long SPXL

 

Trading the market melt-up

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Melt-up hangover ahead?

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

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

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

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

 

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

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

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

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

The bad news

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

 

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

 

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

The good news

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

A healthy rotation?

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

 

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

 

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

 

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

 

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

 

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

 

The cyclical rebound is still alive.
 

Investment implications

What does all this mean for investors and traders?

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

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

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

The week ahead

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXL

 

A Humble Student 2019 report card

Posted by Cam Hui -

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

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

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

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

My inner investor

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

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

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

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

My inner trader

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

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

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

The OK Boomer decade

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Is demographics really destiny?

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

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

 

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

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

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

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

Addressing inequality

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

 

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

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

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

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

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

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

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

A tilted playing field?

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

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

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

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

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

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

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

 

 

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

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

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

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

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

Future policy implications

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

A leftward political shift

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

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

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

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

 

 

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

 

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

 

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

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

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

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

These big political shifts have broad investment implications.
 

Expect rising inflationary expectations

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

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

 

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

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

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

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

The dawn of ESG investing

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

 

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

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

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

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

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

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

 

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

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

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

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

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

The week ahead

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXL

 

China, paper tiger

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Defining the China threat to America

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

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

 

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

 

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

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

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

What decoupling means

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

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

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

 

Banjo continued:

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

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

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

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

Policy options: Rsponding to the Chinese threat

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

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

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

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

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

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

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

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

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

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

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

Similar instances of geopolitical overreach can be found in Sweden:

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

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

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

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

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

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

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

 

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

Time as the Great Healer

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

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

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

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

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

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

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

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

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

The same story goes for AI hardware:

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

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

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

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

Demographic headwinds

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

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

 

 

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

 

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

 

A pivot to state control

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

 

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

 

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

 

The climate change threat

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

 

Key risk: American isolationism

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

The road ahead

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

 

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

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

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

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

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

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

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

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

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

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

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

The week ahead

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

Good luck.

Disclosure: Long SPXL
 

Is the market melting up?

Posted by Cam Hui -

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

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

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

 

Is the market melting up?
 

More room to run

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

 

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

 

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

 

But they are cautious in North America…
 

 

…and in Asia.
 

 

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

 

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

How to spot the top

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

I’ll be back in the New Year.

Disclosure: Long SPXL

 

Factor investing: Theory vs. practice

Posted by Cam Hui -

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

 

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

Pure vs. naive factor exposure

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

 

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

 

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

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

Adventures in banking

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Would you buy this chart?

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

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

 

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

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

A cyclical revival

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

 

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

 

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

 

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

 

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

 

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

Bullish for banks and financials

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

 

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

 

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

 

Even better opportunities in Europe

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

The week ahead

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

 

Here are bull and bear cases.

The bull case

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

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

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

 

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

 

Here is MSCI ACWI:
 

 

NYSE Composite:
 

 

NYSE new highs – lows:
 

 

Financials:
 

 

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

 

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

 

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

 

FOMO risk-on!
 

Bear case

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

 

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

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

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

 

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

 

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

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

 

Valuation headwinds

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

 

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

 

Those are all tall orders. Stay tuned.
 

Resolving the bull and bear cases

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

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

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

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

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

Disclosure: Long SPXL
 

Here comes the beta chase

Posted by Cam Hui -

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

 

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

 

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

 

Global macro hedge funds are also buying.
 

 

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

The bull and bear cases

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

 

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

 

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

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

 

 

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

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

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

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

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

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

 

 

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

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

Both my inner investor and trader are bullishly positioned.

Disclosure: Long SPXL

 

The market is oversold? Already?

Posted by Cam Hui -

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

 

Is the market oversold? Again? So soon?
 

Looking for confirmation

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

 

What’s going on?

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

 

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

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

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

A lesson for investors

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

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

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

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

 

 

Lessons learned?

 

How far can Tariff Man dent the stock market?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Tariff Man returns

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

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

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

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

Assessing the damage

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

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

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

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

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

The Powell Put

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

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

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

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

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

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

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

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

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

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

Fiscal policy to the rescue

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

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

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

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

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

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

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

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

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

Investment implication

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long S&P 500L

Assessing the technical damage

Posted by Cam Hui -

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

 

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

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

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

Market internals

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

 

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

 

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

 

An bottoming process

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

 

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

 

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

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

Disclosure: Long SPXL

 

The Achilles Heel of my bull case

Posted by Cam Hui -

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

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

 

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

 

Wobbly China?

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

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

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

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

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

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

 

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

 

Is a global cyclical recovery possible if China is slowing?
 

Resilient China

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

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

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

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

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

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

 

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

 

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

 

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

 

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

Turning tactically bullish

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

 

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

 

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

Disclosure: Long SPXL

 

Buy signal confirmed: It’s a global bull

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Long-term buy signal confirmed

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

 

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

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

Buy beta! Risk on!
 

Globally bullish

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

 

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

 

Risk on!
 

Sector review: What to buy?

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

 

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

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The cyclical rebound explained

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

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

 

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

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

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

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

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

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

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

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

Buy beta! Risk on!
 

The week ahead: Good or Bad Santa?

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

 

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

 

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

 

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

 

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

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

 

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

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

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

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

 

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

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

 

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

 

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

 

Disclosure: Long SPXU

 

Short-term risks are rising

Posted by Cam Hui -

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

 

Historical study

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

 

Sentiment stretched

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

 

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

SentimenTrader tweeted a similar sentiment warning today.
 

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

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

Disclosure: Long SPXU

 

Is a trade deal imminent?

Posted by Cam Hui -

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

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

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

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

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

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

 

Dissecting the rhetoric

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

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

 

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

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

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

 

Cyclical global recovery: Easy come, easy go?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Cyclical recovery losing steam?

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

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

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

 

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

 

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

 

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

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

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

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

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

Global outlook: So far, so good

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

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

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

 

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

 

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

 

US: Recovery and stabilization

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

 

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

 

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

 

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

 

Europe: The global bright spot

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

 

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

 

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

 

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

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

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

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

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

 

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

 

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

China and Asia: Sputtering a little

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

 

profit estimates were far weaker, indicating economic weakness.
 

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

Still bullish

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

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

 

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

 

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

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

The week ahead

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

 

What now?

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

A pause in the melt-up?

Posted by Cam Hui -

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

 

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

 

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

 

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

Plenty of warnings

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

 

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

 

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

 

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

 

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

 

The bull case

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

 

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

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

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

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

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

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

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