Page 49 – Humble Student of the Markets

Is this the long awaited value investing revival?

Posted by Cam Hui - September 15, 2019

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

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

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

The latest signals of each model are as follows:

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

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

Is value investing back?

Have some pity on the long suffering value investing. The value style has lagged growth investing for so long that almost a generation of investors have only known about growth and FAANG stocks. The style enjoyed a recent short and short revival. Is this the start of a long awaited reversal?

Let us consider the pros and cons.

I conclude that the jury is still out whether the most recent factor reversal represents a sustainable turnaround for value investors. Tactically, market positioning had reached an extreme, and the value/growth relationship was poised for a rebound. However, it would be highly unusual to see a major leadership change without an important market disruption, such as a bear market.

Fundamental analysis leads us to conclude that a value/growth reversal depends on two factors. First, growth stocks have to decelerate, and that is already occurring owing to increased regulatory scrutiny. In addition, value portfolios, which are heavily weighted with bank stocks, need to see the yield curve steepen. Historically, the relative returns of the banking sector have been highly correlated to the shape of the yield curve. The most likely catalyst will be some form of fiscal stimulus that will improve the growth outlook, steepen the yield curve and improve banking profitability.

Ultimately, the more likely timing of a value/growth leadership turnaround will materialize in 2020 or 2021, when the combination of rising regulatory scrutiny of FAANG companies, and a more aggressive fiscal policy combine to raise economic growth expectations, which will create a tailwind for the banking heavy value portfolios.

The technical view

CNBC reported that JPM head quant Marko Kolanovic called the reversal the start of a “once in a decade” trade:

J.P. Morgan’s chief quant says that the big rotation into value names should continue, and that stocks should move higher into October, and beyond, especially if the U.S.-Chinese trade talks go well.

Marko Kolanovic, global head of the macro quantitative and derivatives strategy team at J.P. Morgan, said his view is based on how he sees investor positioning, the underperformance of value names, and the unwind of technical flows last month in equities and bonds, which drove yields fell to extreme lows. The analyst, whose reports have moved the market, says stocks can keep moving higher beyond October, aided by central bank easing and fiscal stimulus.

The set up for the trade into value and out of momentum has been in the making for awhile. The strategist points out, in a note, that the market is virtually flat since January 2018, and most of the S&P 500 gains came from defensive sectors, those with bond-like features and “secular growth” tech names. Many of those are now being sold and “incorrectly in our view, are deemed to be impermeable to economic woes,” he wrote.

Kolanovic’s analysis is heavy on technical analysis, and market positioning. The price momentum trade had become extremely crowded, and it was due for a reversal.

The stampede into momentum had left value stocks out in the cold, and momentum-value correlation had nearing historical lows.

Once the trade began to reverse, it became the signal for the start of a “once in a decade” trade. But we have seen such false starts before, is this reversal another fake-out? Historically, major turning points in market leadership have been marked by bear markets and severe dislocation. Does this mean we are about to undergo a valuation crash in the manner of 2000? Current forward P/E valuation is elevated, but nowhere near the nosebleed levels of the Tech Bubble.

While Kolanovic’s analysis is internally consistent and logical from a tactical perspective, it left me vaguely unsatisfied.

The fundamental view

For another point of view, I offer the analysis of Chris Meredith of O’Shaughnessy Asset Management (OSAM), who penned an extensive white paper on the value-growth cycle. As OSAM is a value manager, the white paper was Meredith’s way of defending the organization’s investing style.

I feel his pain. The life of a portfolio manager has its ups and downs, and over the course of a career, a manager will inevitably have to justify poor performance. In this case, Meredith has the burden of defending a style that has been out of favor for over a decade. The typical level of patience for an individual investor is 6-18 months, and about three years for institutional sponsors. Beyond those time horizons, a manager will start to face an existential crisis as the client base drains away. Even the legendary value manager John Neff had been forced to look for a job at the height of the Nifty Fifty era, just before the growth-at-any-price style crashed.

The white paper was written in a style aimed at an institutional audience, and it was widely publicized. The publicity effort was successful inasmuch as it was the focus of a WSJ article, and a Bloomberg podcast.

Meredith’s analytical framework for the growth/value cycle is based on cycles of technological revolutions and maturity.

Technological Revolutions are clusters of new technologies that cause economic upheaval over periods lasting 45 to 60 years. The cycles start with the discovery of ideas, an installation of infrastructure to make it scalable, followed by a deployment with strong growth that eventually results in maturity, where growth slows down. In her work “Technological Revolutions and Financial Capital” (2002), Carlota Perez identifies the phases of a revolution as two halves: the Installation phase and Deployment phase.

In the Installation phase of a new Technological Revolution, the previous revolution is nearing exhaustion of profitable opportunities. Then, through experimentation new social and economic norms are established for the utilization of ideas. As these concepts take shape and the form factor for utilization is established, people see the potential growth and infrastructure is laid for their widespread adoption. This Installation phase is one of creative destruction, as the new standards replace those from preceding revolutions. It is a period where wealth becomes skewed as innovators are rewarded.

As the new technology shifts to becoming the new norm, the Deployment phase begins. It takes advantage of the infrastructure laid in the Installation phase and expands to broad societal acceptance. This begins with a high growth phase, where real growth occurs, and the technological revolution diffuses across the whole economy. Entrepreneurial activity moves from building infrastructure to the application layer on top. This is a time of creative construction. Winners emerge to form oligopolies, and this growth eventually slows to the Maturity phase, where market growth stagnates.

Meredith referenced the work of Carlota Perez, who identified five growth regimes throughout America’s history, namely the industrial revolution, the age of steam and railways, the age of steel, electricity and heavy engineering, age of oil, automobiles, and mass production, and today’s age of information and communications. Each age is marked by an installation phase, when the growth style is dominant, a turning point, or maturity of the technological revolution, and deployment, when the technology becomes ubiquitous and commonplace, when value investing gains prominence.

In the Bloomberg podcast, Meredith cited the example of Amazon. The stock may have looked expensive on a valuation basis 10 years ago. Historically, value investing works because growth stocks disappoint their lofty market expectations. In this case, Amazon managed to fulfill projected growth, and if you had known that it was trading at 4 times 10-year forward earnings, it would have seemed cheap then. Today, the FAANG stocks are now at or near an inflection point because of heavy regulatory scrutiny.

One key pivoting point in any technology is when the standards is set for how the technology will be deployed across society. In the case of technology, one could argue that the introduction of the smartphone disrupted the consumption patterns of information, and we are still figuring out the matching of platform to consumption. The societal habits for whether people will use their desktop, laptop, gaming console, smart speaker, tablet or phone for communicating, shopping, gaming, and business productivity. But with the smartphone adoption curve shown before, the platform is established for delivery of information to anyone anywhere, and with embedded cookies, canvas fingerprinting, and geolocational tracking, the delivery of information on everyone to anyone.

Another key sign in standards being set are the formation of oligopolies and monopolies. For every one of the previous technological revolutions, there have been winners that have established the standards accumulated market share and became synonymous with the technology itself. The chart below shows the shift in the market leadership over the last twelve years, with the Age of Technology forming oligopolies through the FAANG stocks.

It should be mentioned that because these oligopolies are so large, one would suspect that they can’t get bigger. Amazon’s market share is 49% of online retail and 5% of total retail. While it’s one of the largest companies in the world, there’s still potential to grow. Sears didn’t grow to become 1% of GDP until the 1950s, well into the Deployment of the cycle. General Motors and Sears were the top two contributors to the Growth Portfolio25 during the synergy phase of 1942-1959, but the Value portfolio outperformed during the creative construction of deployment, where the overall economy grew and the value cycle of stocks being overly discounted and rerated was the norm.

One should not underestimate the role of regulation in how the Age of Technology plays out. The recent Senate hearings on Facebook highlight that privacy rights are far from established and could create structural issues for technology companies. Additionally, anti-trust legislation always rears its head as near monopolies exert power.

Further support of the turning point thesis came from Nordea Markets, which pointed out that there is a severe divergence between S&P 500 earnings, which does not represent the US economy, and NIPA profits,which does. This analysis does lend some credence to the idea of a Tech Bubble style valuation crash, in the manner of 2000-02, which is a major sign of market leadership change.

How does value revive?

The analysis from OSAM also left me slightly uncomfortable. While the white paper was highly comprehensive, and a masterful display of skilled quantitative analysis and undoubtedly helped to retain some OSAM assets, the main focus was a negative rather than a positive. The report concentrated on the dynamics of growth and when growth underperformed. Value beat growth when growth fails. But how do you justify value investing? Where is the positive catalyst, other than the sunset of growth industries?

To be sure, Meredith did explain that value and growth investing depend on investor expectations, and how those expectations are realized. One example was Seagate Technology as a value stock:

Value investing generates excess return by an over-discounting of future earnings relative to trailing earnings. But it requires a stabilization and recovery, alongside a rerating of valuations to the new expectations. A good example is Seagate Technology, which a number of short-sellers openly bet against in 2013. The investment thesis was that the PC market was declining with the advent of mobile computing and cloud computing, hard disk drives would be in structural decline. What wasn’t accounted for was that hard disk drives were still the best solution for large scale data centers, so demand would not decline as far as predicted. The stock began 2013 with a P/E around 4x, and price went on to more than double over the next two years through a rerating back to a P/E of 14×17. Seagate’s story is not yet complete, but those two years squeezed the short-seller while the Value investor was rewarded.

One clue came from the accompanying WSJ article which observed that value portfolios are heavily weighted in banking.

From 1926 to the war, the cheap value portfolio is crammed with utilities, the stocks that had led the electrification revolution but had become mature and dull. The go-go growth stocks were in manufacturing, with few of them cheap enough for value buyers to pick.

There is a similar industry bias today: value has heavy exposure to banks and other financial stocks, which helped it outperform before the crisis but dragged it down since. This time, the go-go growth stocks are mostly in the technology sector (although Amazon is a retailer), where value has little exposure.

A light went on. The relative performance of bank stocks has historically been correlated with the shape of the 2s10s yield curve. One explanation is the tendency of banks to borrow short and lend long, and a steep yield curve provides a headwind for banking profitability. The one glaring divergence occurred in late 2017, when the bank stocks rallied in response to the tax bill.

Policy dependence

I conclude from this analysis that a shift in the value/growth relationship is dependent on changes in policy. Growth stocks are beginning to face headwinds from increased regulatory scrutiny. Increased attention from regulators will not be enough to tank growth stocks. Microsoft became a market performer in the next decade after the Justice Department filed the United States v. Microsoft case, but the stock did not underperform.

The other catalyst is on the value side. In order for the bank heavy value portfolio to outperform, policy makers will have to steepen the yield curve on a sustainable basis. That means raising market expectations of future growth.

Let us start with monetary policy. There was a lot of hand wringing at the latest Jackson Hole meeting about what to do at the next economic downturn. Central bankers were running out of bullets, and it was evident that they were at a loss. The proposed strategy could be broadly categorized as go it alone, or coordination with fiscal authorities, otherwise known as some form of “helicopter money”.

The go it alone strategies were mainly a combination of negative interest rates (NIRP) and more quantitative easing. NIRP has two drawbacks. First, it devastates banking system profitability, as demonstrated in Europe. As well, it faces the implementation difficulty of how to keep individuals from holding the money in cash if rates are negative? Some economists, such as the formerly nominated Fed governor Marvin Goodfriend, proposed the Fed levy charges for physical currency. There have been a recent flood of papers of why NIRP may not be a good idea.

The San Francisco Fed produced a study which concluded that NIRP in Japan drove down inflation expectations.
Andy Glover at the Kansas City Fed found that NIRP can worse liquidity traps.
Larry Summers agrees. He stated in a Project Syndicate essay, “Interest-rate reductions beyond a certain point may constrain rather than increase demand”.
Ru Xi at the University of Bath found NIRP actually decreases bank lending, which is counterproductive.
Bloomberg also reported on the ugly consequences of Switzerland’s NIRP.

It had to happen sooner or later. Three prominent former central bankers (Stanley Fischer, Jean Boivin, and Philippe Hildebrande) have proposed the direct monetary financing by CB of fiscal stimulus packages, which is goes beyond Bernanke’s helicopter money 2004 proposal.

Simply put, monetary policy is nearing its limits. It is time for fiscal policy to do the heavy lifting. Reuters reported that Germany is considering a workaround fiscal stimulus program to get around its “fiscal break” spending rules:

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

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

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

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

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

There are other signs of movement on the fiscal front in Europe. The FT reported that the European Commission is scheduled on November 1 to consider a simplification of its budget rules, and revisions to its Stability and Growth Pact. Indeed, bond yields in Europe have already begun to react in anticipation of the shift from monetary to fiscal stimulus.

In the US, Moody’s found that the effects of fiscal stimulus is fading. Expect another round of fiscal prime pumping after the election, regardless of who wins the White House. If Trump wins, it will mean another round of tax cuts.

If a Democrat wins, look for more spending on healthcare and social programs, and the ascendancy of Modern Monetary Theory (MMT), which states that a sovereign country that issues debt in its own currency is only limited in its spending by what the bond market will dictate.

There have been some discussions of how much fiscal room the budget has. Philip Pilkington estimated how much larger the Federal deficit could be before inflation began to accelerate and set off an inflationary spiral, and he concluded that the fiscal deficit could rise by roughly another 5%.

I find that we could probably safely increase the current US fiscal deficit by around 5% of GDP structurally — that is, from the current level of around 3.8% of GDP to around 8.8%. This would give rise to annual real GDP growth of around 6% and a once-off shot of inflation that would drive the annual growth in CPI to around 4.9%. As I say in the paper, this would then lower the private debt-to-GDP ratio from around 200% of GDP to around 190%.

Douglas Elmendorf and Don Price of the Harvard Kennedy School wrote an op-ed in the Washington Post which made the case that there is plenty of fiscal capacity to deal with a recession.

Suppose the economy goes into recession sometime in the next year and that the Federal Reserve lowers the federal funds rate to essentially zero, as it did between December 2008 and November 2015. Now suppose that Congress and the president agree on a collection of spending increases and tax cuts twice as large as the 2009 American Recovery and Reinvestment Act. The Congressional Budget Office estimated that the recovery act increased federal spending and reduced taxes by a combined total of roughly $850 billion, so a stimulus that was twice as large would have a direct budgetary impact of about $1.7 trillion. (If an earlier Congress and president had agreed to follow the 2009 act with an additional stimulus bill of comparable size in 2011, we would have enjoyed a faster economic recovery with more job creation, and the country would be better off.)

Such fiscal stimulus would boost GDP significantly relative to what it would be otherwise: The recession would be less deep, less lengthy or both. As a result, fewer people would lose their jobs than if the stimulus did not occur, and people who did lose jobs would find new jobs more quickly. Fewer families would be evicted from their homes or be unable to pay their medical bills, and fewer graduates who enter the labor market would suffer a recession penalty in their future earnings.

Based on a large amount of economic research over the past decade, a reasonable estimate is that fiscal stimulus of $1.7 trillion under the conditions described — in particular, with the federal funds rate at zero — would increase GDP over the following few years by roughly 1½ times as much, or about $2.5 trillion. Higher GDP means higher taxable incomes, so the federal government would recoup about $0.6 trillion of the gross budgetary cost of the stimulus, leaving a net budgetary cost of roughly $1.1 trillion.

In conclusion, the jury is still out on whether the most recent factor reversal represents a sustainable turnaround for value investors. JPM’s Marko Kolanovic analysis is highly tactical in nature. While he does make a good case that market positioning had reached an extreme, the fundamental and macro underpinnings of a reversal are not present. In particular, it would be highly unusual to see a major leadership change without an important market disruption, such as a bear market.

The analysis from Chris Meredith of OSAM leads me to conclude that a value/growth reversal depends on two factors. First, growth stocks have to decelerate, and that is already occurring owing to increased regulatory scrutiny. In addition, value portfolios, which are heavily weighted with bank stocks, need to see the yield curve steepen. Historically, the relative returns of the banking sector has been highly correlated to the shape of the yield curve. The most likely catalyst will be some form of fiscal stimulus that will improve the growth outlook, steepen the yield curve, and improve banking profitability.

The week ahead

Looking to the week ahead, the market is facing a number of mixed signals. While the signals are somewhat contradictory, the weight of the evidence suggests that the advance is stalling.

Which breadth indicator should you believe? On one hand, the NYSE Advance-Decline Line (green line) has risen to new all-time highs. On the other hand, net highs-lows (middle panel) are tracing out a declining pattern even as the S&P 500 rose.

Under these circumstances, I prefer to use a close apples-to-apples comparison of market internals, which is the S&P 500 net highs-lows, because they are using the same underlying stock components. As the bottom panel shows, the NYSE Composite had been underperforming the S&P 500 for several months, until it began to bottom out and turn up in September. The differences between the two indices could lead to distortions in the NYSE A-D Line.

I am keeping an open mind, and the A-D Line signal should not be dismissed out of hand. Rob Hanna at Quantifiable Edges studied the market’s behavior when the NYSE A-D Line made a fresh high while the S&P 500 did not. The results were unabashedly bullish – but there’s a catch. The history of this signal has been very bullish since 2003, but Hanna characterized the experience prior to that was “streaky and unreliable”.

When in doubt, I also like to analyze the market relative strength of top sectors. Of the top five sectors that comprise nearly 70% of index weight, only one is showing positive relative strength. It is difficult to see how the index could advance in a sustainable way without the participation of most of the heavyweight sectors.

Notwithstanding the likely market anxiety over the attack on Saudi oil facilities, the major market event in the upcoming week will be the FOMC meeting. Make no mistake, the Fed will cut the Fed Funds rate by a quarter-point, as expected. The Fed has shown that it does not like to disappoint the market. However, it may use the opportunity to guide expectations in a hawkish manner. Currently, the market is discounting a quarter-point cut at the September meeting, followed by a quarter-point at the December meeting, with no further changes thereafter.

In the absence of trade tensions, it is difficult to see how the Fed could justify easing monetary policy. Inflation pressures are rising, as evidenced by the upward pressure in core CPI (blue line, 2.4%), core sticky price CPI (red line, 2.4%), and core PCE (black line, 1.4%).

Indeed, Fed Funds expectations for next 6 and 12 months shows the odds of more aggressive rate cuts are receding.

The future of Fed policy will depend on progress in Sino-American trade negotiations. Both sides made conciliatory goodwill gestures last week, and apparent tensions are falling. Watch for language from the Fed that the combination of strengthening inflation and falling trade tensions will compel the central bank to put monetary policy on hold.

The wildcard will be Trump. As the stock market recovers, Dow Man will be under less pressure, and he may decide to hibernate. The risk is Tariff Man will feel comfortable with the cushion afforded by the strong economy signaled by stock prices to make an appearance and derail negotiations.

In short, the risks are asymmetric, and tilted to the downside.

Tactically, the market is overbought, but indicators have not recycled from an overbought condition to neutral, which would be a sell signal. There is support at 2960, with a gap below in the 2940-2960 zone.

The market is already vulnerable to a pullback. The news of the attack on Saudi oil facilities could be the catalyst for a risk-off episode.

Ryan Detrick observed that we are nearing the peak of the September seasonality for the last 20 years. If history is any guide, the rest of the month will have a bearish bias.

Next week is also option expiry (OpEx) week. Past September OpEx weeks has shown a bullish bias, but the market reaction to the FOMC meeting could easily negate those seasonal patterns.

My inner investor remains cautiously positioned, and he is underweight stocks. Subscribers received an email alert Friday morning indicating that my inner trader had taken an initial short position. We may see further volatility in the early part of the week, and he will use any strength as an opportunity to add to his short position.

Disclosure: Long SPXU

Market breakout = FOMO surge?

Posted by Cam Hui - September 11, 2019

Mid-week market update: Last week’s upside breakout through resistance was impressive. Since then, the market has consolidated above the breakout level, but a FOMO (Fear Of Missing Out) rally has yet to materialize. In the past, such surges have been accompanied by a series of “good overbought” 5-day RSI readings, signs of buying stampedes from TRIN, only to see the rally stall when the 14-day RSI becomes oversold.

Will the upside breakout lead to a FOMO surge? Let us consider the possibilities.

A short-covering rally

So far, the internals suggest that the market strength has mainly been attributable to a short-covering rally, and a FOMO surge has yet to materialize.

The market had gotten into a crowded trade of becoming overly defensively positioned, and overly short the high beta and cyclical groups. While the reversal appeared as if price momentum had cratered, it was also a manifestation of the reversal of a variety of other factors. Gold, which had been in and uptrend, pulled back. Value stocks, which had been in a prolonged period of underperformance against growth stocks, surged. The 10-year Treasury yield reversed itself, and even the shares of long suffering Deutsche Bank rallied. These factors were all correlated, and it can be best described as a short-covering reversal.

While it is impossible to know how long this short-covering reversal will last as much depends on the behavior of the animal spirits, a number of clues reveal that it may be exhausting itself. As the above chart shows, the momentum factor is already strongly oversold on both 5 and 14 day RSI (top panel).

In addition, I had pointed out that the USD Index had reached an inverse head and shoulders target, and it had paused and started to form a bull flag continuation pattern (see Should you buy the breakout?). Similarly, the EURUSD exchange rate had broke down from a head and shoulders pattern, reached target, and began to bear flag. Both broke out of their respective bull and bear flags on Tuesday. As a reminder, excessive greenback strength exacerbate global trade tensions, raises funding risk for weak EM economies, and creates earnings headwinds for large cap US multi-nationals operating overseas. It was USD that was partly attributable to the general defensive positioning of the market, before last week’s reversal and upside breakout.

As well, a number of the factors that reversed themselves are nearing overbought or oversold levels, which could signal a pause or reversal. The Russell 1000 Value to Russell 1000 Growth is one such example of an overbought condition.

The 7-10 Year Treasury Bond ETF (IEF) is oversold on the 5-day RSI, and it is reaching levels on the 14-day RSI where declines have been arrested in the recent past.

Similarly, the small to large cap ratio is some ways a mirror image of the IEF chart. The ratio also overbought on 5-day RSI, and the 14-day RSI is nearing levels when rallies have stalled in the recent past.

What about the FOMO rally?

What does this mean for market direction? Can the short-covering bulls pass the baton to the FOMO bulls to spark a surge to new highs?

An analysis of the market internals reveals a neutral to bearish picture. The chart below shows the relative performance of the top five sectors by weight, and they comprise nearly 70% of index weight. The market cannot meaningfully move up or down without significant participation from these five sectors. As the chart shows, the three sectors (technology, healthcare, and consumer discretionary) are in relative downtrends (44.8% weight), and the other two (financials and communication services) are in relative uptrends (23.2% weight). In short, heavyweight sector relative performance tilted bearish.

Even the news that China had announced tariff exemptions on a number of products as a goodwill gesture did not move the needle In the overnight ES futures market, Here is the report from Chinese state media Global Times:

China on Wednesday announced a plan for certain US imports and companies to file for exemptions from Chinese tariffs, in a goodwill gesture that will help ease the impact of the trade war on US companies and inject fresh optimism into a new round of trade negotiations planned for October.

The US products exempted from Chinese tariffs include 16 types of products highly related to livelihood such as lubricating oil, medical linear accelerators and anticancer drugs. The State Council, China’s cabinet, will continue to work on the exemption list and will publish it “at a proper time.”

Certain imports including lubricating oil, fish meal, parva, medical linear accelerators, anticancer drugs and medicago will be exempted from retaliatory tariffs imposed on US imports from September 17, 2019 until September 16, 2020. Companies involved in the exports of products already subject to tariffs can apply for refunds from Chinese customs within six months, starting from Wednesday.

For imports such as whey and release agents, companies will no longer be subject to retaliatory tariffs imposed on US imports from September 17, 2019 until September 16, 2020. But they will not receive refunds on paid tariffs.

In fact, the announcement was met with a contemptuous tweet from Trump. The trade talks are going well, I can see.

In conclusion, the weight of the evidence suggests that the price momentum factor reversal is nearly over, and it is unlikely to spark a FOMO rally. The market is likely to consolidate sideways, until the bull and bear tug-of-war resolves itself.

My inner trader is in cash, but he is leaning slightly bearish because of the chart pattern of the USD Index indicating it is poised for another rally, as well as the signs that many of the factor reversals are nearing exhaustion. However, he is not prepared to take action until the market either rips higher and becomes overbought, or the SPX starts to fill the gap at 2940-2960.

Fun with quant: Pure and naïve factors

Posted by Cam Hui - September 9, 2019

A reader alerted me to a CNBC report of a bullish analysis by Bespoke’s Paul Hickey:

Bespoke Investment’s Paul Hickey believes a market hot streak is unfolding.

The independent market researcher is building his bullish case by zeroing in on the Citi Economic Surprise Index, which is built to measure optimism in the economy.

In the week ending Friday, the index flipped into positive after spending more than 100 days in negative territory. Hickey contends the move suggests investors are feeling more confident about the economy’s direction, so there’s a good chance stocks will rip higher.

“There are five prior periods that we’re talking about. One, three and six months later, the S&P was higher four out of five times,” Hickey told CNBC’s “Trading Nation” on Friday. “When we looked at when these prior streaks have ended and expectations have been ratcheted down enough, the market actually did quite well going forward.”

Quantitative analysts often struggle with a hidden problem called multicollinearity, which is the tendency of two variables that are closely correlated but have different effects. One example of multicollinearity is a person’s height and weight. One way of addressing this problem is to isolate the “pure” effect of a signal from its “naive” multicollinear effect.

Here is an analysis of the pure and naive effects of the Economic Surprise Index (ESI) surge factor.

What are you measuring?

The chart below shows the signals, as defined by Hickey, of the instances when ESI spent at least 100 days below zero, and then turned positive, along with market returns. While the “naive” signal appears impressive, and stock prices did rip higher in four out of five instances, a more discerning eye revealed that the rallies could be attributable to changes in policy.

2008-09: Fiscal and monetary policy makers threw everything they had in order to rescue the financial system. When ESI finally turned, it was no surprise that stock prices roared higher.
2011: The eurozone faced an existential crisis as it was unclear whether the euro would survive in the face of the Greek Crisis. The ECB finally stepped in with an LTRO program that rescued the banks, and bought time for member states to enact structural reforms. The rise in ESI was the final all-clear signal, and the stock market ripped higher.
2017: Remember the Trump tax cuts and the subsequent melt-up? Enough said.

The one instance when the ESI rose above 0 after a prolonged period in the negative was 2015, which was a shallow industrial recession sparked by tanking oil prices. During that episode, the market had a false start and the performance of the ESI signal was erratic at 50%, with the caveat that the count was very low (n=2) and doesn’t mean very much.

ESI buy signal today

What about today? To be sure, we have an ESI buy signal, but where are the policy underpinnings?

If the relief is over the Sino-American trade war, there is no news indicating that either side is about to soften its position. Xi used the word “struggle” 60 times in a speech to official media last week, so don’t hold your breath for any significant Chinese concessions. In fact, Bloomberg reported that the US trade war might expand to Europe in the near future, contrary to what was an apparent handshake agreement at the most recent G-7 summit:

U.S. is moving ahead with an investigation into a new French digital tax that could lead to import tariffs on French wine and other goods, despite hopes raised at August’s G-7 summit.

A senior Trump administration official confirmed that it’s continuing a Section 301 probe into the French measure and its impact on American digital champions including Amazon.com Inc., Facebook Inc., and Alphabet Inc.’s Google.

The probe is being conducted under the same statute used by the U.S. to levy tariffs on China as part of an escalating trade war between the world’s two largest economies, and could clear the way for targeting billions in French exports to the U.S.

French President Emmanuel Macron thought he’d avoided the threat of tariffs with an agreement at the Group of Seven meeting in Biarritz, France, saying at an Aug. 26 joint press conference with President Donald Trump that “we have reached a very good agreement.”

The French say their 3% levy on French-based revenue of digital companies, which took effect in July, is temporary until a global agreement is reached at the Organization for Economic Cooperation and Development on how to tax global digital companies that use complicated structures to shift earnings to low-tax jurisdictions. At the G-7 leaders agreed to address the issue of taxing digital companies in OECD negotiations.

As well, don`t forget the looming threat of American retaliation on the Boeing-Airbus dispute:

The U.S. is expected to get the go-ahead from the World Trade Organization in the coming weeks to impose tariffs on billions of dollars in imports from the EU as part of a long-running dispute between aerospace competitors Airbus SE and Boeing Co. Trump also faces a decision before November over whether to go ahead with his threat to impose tariffs on cars imported to the U.S. from Europe as a national security threat.

Tariff Man will ride again. Policy factors are likely to overwhelm the effects of the recent surge in ESI.

Should you buy the breakout?

Posted by Cam Hui - September 8, 2019

The latest signals of each model are as follows:

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

An upside breakout

About a month ago, I suggested that the market was in need of a valuation reset, and outlined a price and forward P/E range for the market (see Powell’s dilemma (and why it matters)). Since then, the index weakened into the top of my projected range, followed by an upside breakout from a month-long trading range.

Is it time to buy the breakout?

I believe that the decision on whether to chase the S&P 500 upside breakout is dependent on investor time horizon. The combination of a crowded short sentiment levels and positive price momentum can lead to powerful price surges. Traders can therefore take advantage of these conditions to ride the rally. In all likelihood, the S&P 500 will rise to test and possibly exceed the previous all-time highs in the coming weeks.

However, the longer term viewpoint is less bullish. Investment oriented accounts should take advantage of the market strength to fade the rally if they are overweight equities and rebalance to either a neutral or an underweight position. Valuations are stretched, the earnings outlook is mixed, and macro tail-risks remain unresolved.

A sentiment driven rally

The underpinnings of the market rally can be attributable to excessively bearish sentiment. The advance began last Wednesday on the news that Hong Kong chief Carrie Lam had withdrawn the controversial extradition bill, and the British parliament had passed measures that made a no-deal Brexit more unlikely. Stock prices gained further the next day on the news that US and Chinese trade negotiators would be meeting in early October.

Marketwatch reported that BAML strategist Michael Harnett`s Bull and Bear Indicator had flashed a contrarian buy signal, and the signal was based mainly on excessively bearish sentiment:

B. of A.’s Bull and Bear Indicator, which tracks 18 measurements on asset flow, sentiment, and price, is flashing a contrarian buy signal that hasn’t been seen since way back in January. The drop in the reading was driven in large part by asset flows out of equity and emerging market debt, Harnett said.

The indicator has a solid track record of predicting what’s next. Since 2000, global stocks rose a median 6.3% in the three months after such a buy signal was triggered, while 10-year Treasury yields increased 50 basis points.

Indeed, retail sentiment, as measured by the AAII bull-bear spread, had reached a crowded short reading in late July, and it had been recovering ever since.

Institutional sentiment has also been excessively bearish. The State Street North American Investor Confidence Index, which measures the actual positioning of portfolio managers, have also reached levels consistent with contrarian buy signals.

Given the general tone of bearishness, it was therefore little surprise that good news on the geopolitical, political, and trade fronts sparked a risk-on stampede.

The 2011 market template

I have also suggested in these pages in the past that 2011 could serve as a useful template for today`s market. The summer of 2011 was marked by high anxiety and uncertainty over a budget impasse in Washington, and a eurozone Greek Crisis. That period was marked by endless European summits, and meetings to talk about meetings. The crisis was eventually resolved when the ECB stepped in with its LTRO program as a way of buying time for member states to enact structural reforms.

Fast forward to 2019, the market is marked by anxiety over a global economic slowdown and possible recession, a Sino-American trade war, Brexit fears, and rising political tension in Hong Kong.

From a technical perspective, the consolidation period in 2011 from August to mid-October was constructive. Bearish momentum was fading, as the 5-day RSI flashed a series of higher lows even as the index repeatedly tested support. Sentiment indicators were supportive of an eventual advance, as the put/call ratio, VIX term structure, and AAII sentiment all saw fear fading. In addition, breadth was improving, as measured by an uptrend in 52-week new highs.

However, the market did stage a false breakout after a month of consolidation in early September. At that time, all of the momentum, sentiment, and breadth indicators were also helpfully bullish. Coincidentally, the BAML Bull and Bear Indicator also flashed a buy signal just before the false breakout. This false breakout was one of the few historical failures of the BAML Buy and Bear buy signal, though the indicator did later flash a useful buy signal in December 2011.

Is today`s market surge a real upside breakout, or just a fake-out?

A comparison of today’s market technical conditions with those from 2011 is not helpful in answering that question. Just like 2011, the momentum, sentiment, and breadth indicators are flashing bullish signals, and the BAML Bull and Bear Indicator also turned bullish.

2011, then and now

While the technical conditions are similar, there are a number of key differences. Let us start with sentiment, which was the principal basis for this rally. The weekly AAII survey asks what members think of the market, and since opinions can change quickly, survey readings can be volatile. By contrast, the more important monthly AAII asset allocation survey asks what members are actually doing with their money, and those readings tend to be more stable. The AAII asset allocation survey shows that while equity bullishness has retreated, overall readings are nowhere near the panic levels consistent with an intermediate term bottom.

As well, valuations are far more demanding today compared to 2011. The forward P/E ratio during the 2011 range-bound period was extremely low by historical standards. By comparison, the market is trading at an elevated forward P/E of 16.8, which is above both its 5 and 10 year averages, and just below its peak of 17.1 achieved in late July.

Perhaps as a result of the dirt cheap valuations, the 2011 bottom saw a cluster of heavy insider buying. On the other hand, there is no similar pattern of support from this group of “smart investors” today.

The earnings outlook presents a mixed picture today. Analysis from Yardeni Research, Inc. (YRI) shows that while forward 12-month margins and EPS revisions are flat to up for large cap stocks, they are deteriorating for mid and small caps (annotations are mine, while estimate revision calculations are based on YRI data).

From a top-down perspective, it is difficult to see much earnings growth visibility. The Atlanta Fed’s Q3 nowcast of GDP growth is 1.5%, and the New York Fed’s nowcast is 1.6%. In all likelihood, earnings growth is likely to decelerate as GDP growth slows from 3.1% in Q1, and 2.0% in Q2 to below 2% in Q3.

The trade war is indeed cutting GDP growth. A newly published Fed study tried to quantify these effects. The researchers did a textual analysis of major newspapers by “searching for terms related to uncertainty–such as risk, threat, uncertainty, and others–that appear in the same article as a term related to trade policy–such as tariff, import duty, import barrier, and anti-dumping”. They then correlated the frequency of these trade policy uncertainty (TPU) with variables of economic output. The Fed researchers concluded that uncertainty had knocked about 1.0% from GDP growth:

We find that the rise in TPU in the first half of 2018 accounts for a decline in the level of global GDP of about 0.8 percent by the first half of 2019. Had trade tensions not escalated again in May and June 2019, the drag on GDP would have subsequently started to ease. However, renewed uncertainty since May of 2019 points to additional knock-on effects that may push down GDP further in the second half of 2019 and in 2020.

Even though market risk appetite was buoyed by the news that American and Chinese negotiators are scheduled to meet again, the reality is there is enormous daylight between the positions of both sides. Xi Jinping mentioned the word “struggle” 60 times in a speech published last week in official media, which is a signal that China is digging for a protracted trade war. The US economy appears to be sidestepping a recession, and as long as the economic pain is manageable ahead of the 2020 election, Trump is unlikely to offer significant concessions.

Last Friday’s Jobs Report offers an example of a slowing, but non-recessionary, economy. The headline Non-Farm Payroll growth missed expectations at 130K, compared to an expected 160K. But internals reveal a picture of still robust employment. Both the prime age participation rate (LFPR) and the employment-population rate spiked, and prime age EPOP reached a new cycle high. These are not recessionary conditions.

Average hourly earnings grew at an above expected rate of 3.2%, and average weekly hours edged up back to 34.4 from a weaker than expected 34.3 the previous month. Our income proxy, which is a multiple of average hourly earnings, hours worked, and people employed, shows no recessionary signs. In short, the economy is slowing, but the pain is tolerable, and it is difficult to see how Tariff Man will give much ground.

Ultimately, stock prices depend on earnings, and valuation. If earnings momentum is mixed, and valuations are demanding, where’s the upside? The final 2011 upside breakout was sparked by ECB action, which took tail-risk off the table. Today, considerable tail-risk remains. American and Chinese negotiation positions are miles apart, and the risk of a new European front in the trade war is very real; Hong Kong protesters do not appear to be backing down from their demands; and the Brexit drama has not been fully resolved.

In conclusion, the decision on whether to chase the S&P 500 upside breakout is dependent on investor time horizon. The combination of a crowded short sentiment levels and positive price momentum can lead to powerful price surges. Traders can therefore take advantage of these conditions to ride the rally. The S&P 500 could rise to test and possibly exceed the previous all-time highs in the near future.

The week ahead

Marketwatch reported that crowded short sentiment readings were the main reason which drove the BAML Bull and Bear Indicator into a buy signal. Returns after the signals are indeed impressive. Stock prices advanced roughly two-third of the time after the signal, and the median MSCI All-Country World Index (ACWI) 3-month return was 7.8%.

While short-term price momentum has been impressive during this latest price surge episode, and there is probably a bit more upside to prices, the odds are high that this buy signal belongs to the one-third group that failed. Let us consider the bull and bear cases.

In the short run, the market is overbought and extended. However, history has shown that overbought markets can keep rising as it flashes a series of “good overbought” conditions. How can we distinguish between “good overbought” and “bad overbought”?

Technical analyst Walter Deemer pointed out that the market had experienced three 80% upside days in a five day period, which is a strong bullish signal. There were 38 such episodes since 1970, and forward returns have historically been bullish.

Make not mistake, last week`s risk-on price surge was a short covering rally that was news driven. Callum Thomas highlighted analysis from JPM which indicated hedge fund positioning was mainly long defensive plays, such as bonds, gold, and JPY, and short stocks.

How far will the short covering rally run? Price momentum bulls should not put the cart before the horse. The chart below depicts the ratio of % above the 50 dma to % 200 dma as an indicator of price momentum. Past strong momentum thrusts that accompany market advances have seen the ratio spike above 1.5. Current conditions are far from a momentum thrust, and in fact, the ratio has not even exceeded 1.0 yet.

Another view of the market can be found from cross-asset, or inter-market, analysis. The recent strength of the USD has created headwinds for risky assets. As the chart below shows, the USD Index broke up from an inverse head and shoulders pattern and also reached its target. Conversely, the EURUSD exchange rate broke down through a head and shoulders pattern and also reached its target. It was time for a pause, and the pause coincided with the current risk-on episode. The pause may not last very long. Both the USD Index and EURUSD are also tracing out symmetrical bull and bear flags, which are continuation patterns. The trigger may be the September 12 ECB meeting when it may ease further. Such an event would put downward pressure on the euro and upward pressure on the dollar.

Should the USD Index resume its rise, the rally has the potential to shift risk appetite from bullish to bearish. The longer term weekly chart of the USD Index remains bullish, as it has staged an upside breakout from a cup and handle formation. As I have pointed out before, the anticipated Treasury financing as a result of the budget ceiling deal will draw liquidity from the banking system and create a dollar shortage. This is a bullish environment for the greenback.

To be sure, bullish price momentum could continue, and there is a reasonable chance the market will test its all-time highs. A test of the old highs will have to overcome valuation hurdles, however. The market is currently trading at a forward P/E of 16.8, and a rapid test of the old highs will raise the forward P/E to 17.1, which equals the recent valuation high achieved in late July. In short, a breakout to fresh highs is likely to lack valuation support. Buying here is a pure bet on the market’s animal spirits and the Greater Fool theory of selling an over-valued asset to the next fool.

Should the bulls push the market higher early next week, I am tactically watching the behavior of the VIX Index. The VIX almost fell below its lower Bollinger Band on Friday. In the past, such episodes have seen market advances stall, which would represent an opportunity to enter a tactical short position. Another possibility is the index retreats and fills the gap at 2940-2960, which would be a good level to buy if you are bullish.

My inner investor remains cautiously positioned, and he is targeting an equity weight that is slightly below his investment policy equity target. My inner trader was stopped out of his short position, and he is in cash. He believes that the risk/reward is unfavorable on the long side, and he is waiting for an opportune time to re-enter his short position, preferably at a higher level.

How to trade foreign cross-currents

Posted by Cam Hui - September 4, 2019

Mid-week market update: Global markets have taken a decided risk-on tone today on the news that Hong Kong leader Carrie Lam has withdrawn the controversial extradition bill. As well, the revolt in the British parliament has lessened the chances of a chaotic no-deal Brexit on October 31. On the other hand, the market was hit by some somber news earlier in the week, when the PMI reports revealed a slowing global economy.

In the meantime, US equity prices remain range-bound.

Should we interpret these developments as net bullish or bearish? The answer is, “Yes”

The bear case

The bear case is easy to make. You would have to be from Mars to know that Chinese economic statistics are unreliable, but investors can glean some hints on China by observing the economies of her major Asian trading partners. ASEAN manufacturing PMI fell to 48.5 in August, which was the fastest deterioration since the mild producer recession in 2015.

Eurozone manufacturing PMI remained in contraction territory in August, though conditions improved from July. Intermediate and investment goods sectors remained in a downturn, while consumer goods saw a solid upturn. Germany, which has been the growth locomotive of Europe, is either in or nearing recession.

In the US, ISM manufacturing fell below 50, which is contraction territory and below market expectations. The trade war is starting to bite, as evidenced by the new export orders components of both US and China’s PMIs.

This is all rather alarming. John Authers pointed out that ISM tends to lead GDP growth by about six months, indicating soft growth ahead.

Authers further observed that inventories are piling up, which is another bad sign for the economy.

If the headline of the ISM report was bad, the details were worse. Much of the business cycle is driven by the interplay between inventories and new orders. When inventories are high and new orders dwindle, there is scarcely any need for new production and economic activity stalls. When inventories have been run down and new orders recover, however, the conditions are there for a restocking boom that ends a recession. Unfortunately inventories now exceed new orders for the first time in seven years.

The bull case

Here is the bull case. The markets look ahead, and the market’s recent action suggests that much of the bad news has already been discounted. Consider the stock markets of China and her major Asian partners. If the outlook is so dire, where are the new lows? To be sure, the Hong Kong market has been beset by political uncertainty, and the South Korean market is especially sensitive to the semiconductor cycle, and the trade spat with Japan. The charts of the other markets, including the Shanghai Composite, have not set 52-week lows.

Similarly, where are the new lows in the stock markets of the eurozone. The chart below shows the stock indices of the core and peripheral markets. None are anywhere near fresh lows.

In the US, ISM’s own analysis indicates that the current reading corresponds to a GDP growth of 1.8%:

The past relationship between the PMI® and the overall economy indicates that the PMI® for August (49.1 percent) corresponds to a 1.8-percent increase in real gross domestic product (GDP) on an annualized basis.

That figure is roughly in line with the Atlanta Fed’s Q3 GDPNow of 1.5%, and the New York Fed’s nowcast of 1.8%.

Recessions are bull market killers. The American economy may be slowing, but it is not showing any signs that it is about to enter into a recession. What are you so worried about?

Headline risk

There are two key risks that investors need to consider. The first is headline risk. The market reaction today to the Hong Kong and Brexit news illustrates the upside and downside potentials of headline risk.

The biggest downside headline risk is trade. The latest news shows that while US and Chinese representatives have agreed to meet, they can’t even agree on a meeting date, nor can they even agree on the agenda to be discussed.

Former New York Fed president Bill Dudley wrote another Bloomberg op-ed today, which clarified his much criticized position on “The Fed Shouldn’t Enable Donald Trump”. Here is his key point [emphasis added]:

In my judgment, there is a risk that the Fed, by easing, might encourage the president to take even more aggressive actions on trade and in raising tariffs. This might create even greater downside risks for the economy that monetary policy might prove ill-suited to address.

But the Fed’s problems might not end there. Not only might the Fed be unable to rescue the economy, but it also might be blamed for the economy’s poor performance. This risk is higher because of the president’s ongoing attacks on the Fed.

I wanted the Fed to be more explicit that the greatest risk to the economy was the uncertainty created by the U.S. trade war with China. By making this clear, the Fed would increase President Trump’s stake in that downside risk. As a result, with more at stake, the president might be more attentive to the risks the trade war posed to the U.S. economy.

In effect, Dudley outlined my Dow Man-Tariff Man characterization of Trump’s negotiating tactics. When the markets are weak, Dow Man will do whatever he can, such as pressuring the Fed or adopting a conciliatory negotiating stance, to boost the economy and stock prices. As the markets rise, Tariff Man feels that he has sufficient cushion to get tough with the Chinese. That’s why Bloomberg reported that the Chinese consider “Trump’s credibility has become a key obstacle for China to reach a lasting deal”; and the WSJ reported, “Through a series of vacillating threats and entreaties that often seem to be decided on a whim, he has shown President Xi Jinping that he is an unreliable negotiator”. If Dow Man makes a deal, can Beijing be assured that Tariff Man will follow through?

The risks to trade is not just isolated to just China. The US has a simmering trade dispute with the EU, and it is scheduled to make a decision on escalating tariffs on selected items like European cars and French wines in November.

The rising USD

Another key risk is the strength of the USD. Greenback strength has pressured weak EM markets and economies. As the chart below shows, while the relative price returns of US high yield (junk) bonds have not confirmed the recent stock market strength, EM bonds have underperformed HY as the USD rose.

An academic study by Boz (IMF), Gopinach (Harvard), and Plagborg-Møller (Princeton) entitled “Global Trade and the Dollar” found that “a 1% U.S. dollar appreciation against all other currencies in the world predicts a 0.6% decline within a year in the volume of total trade”.

Notwithstanding the negative effects of a strong USD on global trade, USD strength is putting pressure on the Chinese economy. The Chinese yuan has weakened as a consequence of dollar strength, and Beijing responded by tightening capital controls in order to reduce the risk of capital flight. Reuters reported that free trade zones, which were formed to encourage foreign investment, have languished because of capital controls.

The strong dollar has also strained Chinese companies’ offshore finances. Bloomberg reported a widening spread between Chinese corporate onshore debt and offshore debt:

Yields are moving in opposite directions in China’s junk bond market.

Offshore, demand has weakened as escalating trade tension and a slumping yuan dampen demand for dollar notes. Concern about property developers’ ability to refinance is adding to selling pressure. Onshore, yields are falling as liquidity improves in the wake of a bank bailout.

Average yield on Chinese high-yield dollar bonds rose about 105 basis points since end-June, according to an ICE BofAML Index. The yield on five-year AA rated yuan corporate bonds, considered high-yield in the onshore market, fell 34 basis points during the same period, ChinaBond data show. Issuance of bonds rated AA or below rose to a four-month high of 22.1 billion yuan ($3 billion) in August, while junk bond offerings in the greenback declined to two-year low, data compiled by Bloomberg show.

Depleted quotas and new restrictions on offshore issuance will also weigh on dollar bond sales from developers for the rest of the year, according to a Moody’s Corp. note on Friday. China’s property sector makes up the majority of the Asian high-yield bond universe.

The poster child of the deeply indebted property developers is China Evergrande. The company now owes US$113.7b, with $53b due to mature in the next 10 months alone. Debt jumped $20b in the first half.

Bloomberg’s recent profile of Evergrande CEO Hui Ka Yan tells the story of a house of cards built on debt:

Donald Trump once called himself the “king of debt.’’ Hui Ka Yan, China’s richest property mogul, has a much stronger claim to the throne.

No one has gotten wealthier on the back of a corporate borrowing binge than Hui. His junk-rated China Evergrande Group is not only the nation’s most indebted developer, it also has the highest leverage among companies underlying the world’s largest fortunes.

Hui, who has a net worth of $35 billion, is the 26th richest person in the Bloomberg Billionaires Index. Everyone above him for whom data is publicly available — from Amazon.com Inc.’s Jeff Bezos to Las Vegas Sands Corp.’s Sheldon Adelson — has grown their fortune via companies with far more conservative balance sheets.

In many ways, Hui is more emblematic of recent trends in global business than his richer peers. Worldwide corporate debt has swelled by 26 percent over the past decade to $132 trillion as companies have taken advantage of historically low interest rates to fund their growth. Like Evergrande, many have also used borrowed cash to repurchase shares and boost dividends.

The stock recently violated a key long-term support level. Despite last night’s reflex rally in Hong Kong, the stock remains below support, which is the market’s signal of possible trouble.

Is China Evergrande too big to fail? Only time will tell, but the recent poor relative performance of China’s real estate sector is an ominous sign.

To be sure, Beijing’s policy makers have sufficient policy levers to cushion a disorderly unwind of the debt bubble. However, the costs of a rescue could be considerable, such as a devaluation and capital flight, or a Lost Decade of slow growth.

To conclude, the near-term outlook for the stock market is relatively balanced. Upside potential is balanced by downside risk. However, there is tail-risk in the form of headline trade tension risk, and the negative macro effects of USD strength.

My inner investor remains defensively positioned, and he is underweight equities. Until stock prices break out of its trading range, my inner trader is continuing to buy the dips, and sell the rips. As the market is at the top of the range, he is maintaining a short position, with a stop loss set at just above 2970.

Disclosure: Long SPXU

The rise of the Fear Bubble

Posted by Cam Hui - September 1, 2019

The latest signals of each model are as follows:

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

The Fear Bubble

Ever since the NASDAQ Bubble burst, investors have been looking for additional bubbles to be wary of. The subsequent housing boom created a subprime bubble, which was facilitated by cheap financing, and wild leverage in the financial system that eventually led to a crisis. Now everyone is a bubble hunter.

We now have a new bubble, a Fear Bubble. The Fear Bubble can be found across all asset classes, and it can be seen in the diving 10-year Treasury yield; the deeply negative 10-year Bund yield and the growing count of negative yielding European fixed income instruments; and even the forex market, as evidenced by the cratering NZDJPY cross, which is a bellwether of the carry trade. The big surprise is US equities have held up reasonably well in this fearful environment.

The Fear Bubble is creeping into the equity market. Yahoo Finance reported that Goldman analysis found that funds are now increasingly defensive.

The average large-cap mutual fund is Underweight on U.S. firms with the highest sales exposure to China and has been gradually cutting exposure to these stocks during the past 18 months, according to fresh data from Goldman Sachs. Being Underweight is another way of Wall Street saying it expects the U.S. trade war with China to overly hurt companies with outsized exposure to the country and likely, and its stock prices.

Goldman notes that mutual funds are also Underweight semiconductors housed in the S&P 500 , another sector being damaged by the escalating trade war with China and also Huawei.

Meanwhile, hedge funds have also tilted more defensive with their portfolios. Goldman’s research shows hedge funds are Underweight information technology (trade exposed, too) and financials (also trade exposed — worsening trade conditions are causing the Fed to consider lower interest rates, which hurt bank profitability).

Tech overall is the largest net Underweight among hedge funds, Goldman says.

What should investors do, and how should they position themselves in light of this latest bubble?

I conclude that global markets are undergoing a Fear Bubble. This is not the start of a bear market, but the bubble is continuing to inflate. In all likelihood, it should start to deflate at some point in Q4. This argues for a defensive equity posture for the next few months. Suggested pockets of opportunity include the combination of low volatility and high yield, as well as value stocks.

Reasons to be fearful

All bubbles begin with a good reason, they just eventually get out of hand. From a global perspective, the rush towards safety began with China’s deleveraging program, whose deflationary effects were exacerbated by the Sino-American trade war, and the effects washed upon the shores of other countries.

This chart of global exporters tells one story of global contagion, which is being spread through the trade channel. The biggest exporter in the world is China at $2.5 trillion, followed by the US at $1.7 trillion, and Germany at close third at $1.6 trillion. Taken together, the EU dwarfs the rest of the world at $6.5 trillion. As China slowed, the slowdown fed into a European slowdown, as well as China’s major Asian trading partners.

The second deflationary contagion from China has yet to be seen, and that is through the financial transmission channel. This is far more risky, as it involves leverage, which has the potential to topple the global economy in the manner of the Great Financial Crisis.

The Fear Bubble is exacerbating the risk of financial contagion from China. The USD became a safe haven as investors rushed into safe assets. Dollar strength is also helped by the scarcity of investment grade bonds in non-USD currencies, and the debt ceiling deal, whose expected Treasury financing will drain USD liquidity from the banking system, and create a temporary scarcity of USD. As a consequence, the rising USD is putting downward pressure on the yuan.

Bloomberg reported that Chinese companies have significant offshore debt that is maturing fast, and the combination of a strong dollar and weak yuan raises the potential for disorderly defaults and financial contagion.

The foreign debt built up by Chinese companies is about a third bigger than official data show, adding to the pressure on the country’s currency reserves as a wave of repayment obligations approaches in 2020.

On top of the $2 trillion in liabilities to foreigners captured in official data, mainland Chinese firms have around another $650 billion in debts built up by subsidiaries overseas, according to Bloomberg calculations. About 70% of that debt is guaranteed by entities such as onshore parent companies and their subsidiaries, the data show. The amount of maturing debt will rise in coming quarters, with $63 billion due in the first half of 2020 alone.

The prospect of Chinese companies rushing to find dollars to service liabilities comes at a time when authorities have already allowed the currency to sink below 7 per dollar amid a trade war with the U.S. The nation now risks a reprisal of what happened after the yuan’s devaluation in 2015, when foreign-debt servicing contributed to a rapid decline in the country’s foreign-currency reserves.

Not surprisingly, most of the debt is concentrated in the highly leveraged real estate sector, followed by banking.

As the Chinese economy slowed, the real estate sector has come under more stress. Our real-time monitor of Chinese property stocks shows that their relative performance is keeling over, The poor market action of these stocks is a signal that the PBOC is standing by and allowing the economy to de-lever while providing limited targeted support. Will these measures be enough? The risk of a PBOC policy error is high.

As well, China Evergrande (3333.HK), which is one of China’s largest and most indebted property developers, experienced a major support violation. According to Bloomberg, 47% of its debt matures and will have to be rolled over this year. Fortunately, the shares of the other major property developers are still holding above key long-term support levels. This is a situation that will have to monitored very carefully, as it has the potential to become China’s Lehman Moment.

The decisions facing investors on the Fear Bubble can be summarized by this chart of the 4-week moving average of AAII Bulls-Bears. Readings are at levels where the stock market has usually undergone a bottoming process, which are marked in grey. The only exception was the 2007 top, when the market continued to fall as from the realization of financial contagion risk, which are marked in yellow.

Is it different this time? Can the deflationary effects from China be contained?

Not out of the woods, but…

Let me first assure US equity investors that the chances of an ugly bear market is unlikely. Recessions are bull market killers, and there is no sign of a US recession in sight. While growth is decelerating, the signposts of a recession are not there. The consumer remains strong, and the Fed has adopted an easy monetary policy. In addition, the risk of financial contagion is low. Beijing has lots of policy levers to avoid a disorderly unwind of China’s imbalances. The more likely resolution is a slow and long glide path of much softer growth than a crash.

The recent inversion of 2s10s yield curve has been interpreted by recessionistas as the sure sign of a slowdown, this time really is different. Past inversions have mostly been caused by overly tight monetary policy, as evidenced by high real rates. This time, the real 10-year yield is low, indicating an easy Fed. It is difficult to see how a recession can happen when the Fed stands vigilant against slowing growth.

Waiting for the Fever of Fear to break

That said, the market is not out of the woods. If we are in a Fear Bubble, the Fever of Fear has not yet broken. Consider the example of the NASDAQ Bubble. the top was marked by negative divergences even as the index made new highs.

By contrast, the chart of the 7-10 year Treasury ETF shows no signs of a negative RSI divergence. The fever has not broken yet.

Still there are some hopeful signs. EM equities have been the epicenter of the latest Fear Bubble because of their China exposure. The relative performance of EM stocks to the MSCI All-Country World Index (ACWI) has bottomed ahead of the last two US equity market bottoms. In addition, EM relative bottoms have been marked by positive RSI divergences. We are now seeing the nascent signs of a positive RSI divergence. If history is any guide, we should see the stock market to bottom out and the Fever of Fear to break some time in Q4.

The top-down data tells a similar story. Global growth should resume in early 2020.

New Deal democrat‘s weekly assessment of coincident, short leading, and long leading indicators are also telling a hopeful story:

The nowcast remains positive. The short-term forecast, which has been very volatile recently, turned more positive this week (assisted by the monthly reports, most of which were also positive). The “high frequency” long leading indicators are very positive, buoyed by adjusted NIPA profits as reported in the latest Q2 GDP report.

Investing during a time of Fear

How should US equity investors position their portfolios in this environment? This chart of YTD factor returns tells an interesting story. The leading factor was leading YTD factor was low volatility, as investors who wanted to maintain equity exposure piled into what was perceived to be a defensive factor. This was followed by momentum and growth, as large cap technology and NASDAQ stocks maintained their leadership.

As our analysis indicates that the Fever of Fear has not broken, it pays to be defensive for the next few months. However, defensive sectors are already the leadership, and their prices have already been bid up, as evidenced by the outperformance of the low volatility factor.

Further analysis of the YTD factor performance chart reveals some opportunities that have defensive characteristics. How about the combination of low volatility and high yield (Ticker: SPHD)? While low volatility stocks have recently led the market, and dividend aristocrats, which is a defensive income-oriented factor have matched the market, the combination of low volatility and high yield has lagged. This may be a good place for investors who want to maintain market exposure in a defensive manner could hide out while the Fear Bubble rages.

Another factor that is becoming washed-out and out of favor are value stocks. Bloomberg reported that Michael Burry of The Big Short who called the subprime implosion is pointing to a bubble in indexing, and he is finding opportunity in small cap value:

Now, Burry sees another contrarian opportunity emerging from what he calls the “bubble” in passive investment. As money pours into exchange-traded funds and other index-tracking products that skew toward big companies, Burry says smaller value stocks are being unduly neglected around the world.

In the past three weeks, his Scion Asset Management has disclosed major stakes in at least four small-cap companies in the U.S. and South Korea, taking an activist approach at three of them.

“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally,” Burry, whose Cupertino, California-based firm oversees about $343 million, wrote in an emailed response to questions from Bloomberg News.

Active money managers have bled assets in recent years as investors rebelled against high fees and disappointing returns — a trend that prompted Moody’s Investors Service to predict that index funds will overtake active management in the U.S. by 2021. The shift has coincided with a multiyear stretch of underperformance by value stocks and, more recently, by small-caps.

As the chart below shows, even as small cap and value stocks have lagged the market, small cap value has lagged large cap value. The degree of small to large cap value underperformance is nearing the levels last seen at the GFC market bottom.

Equity investors can therefore find pockets of opportunity in value stocks, and small cap value in particular. Be aware, however, that small cap value investing carries liquidity risk, and anecdotal evidence indicate that small cap value managers are experiencing redemption pressures, and they are being force to sell into illiquid no-bid markets. As an alternative, the shares of Berkshire Hathaway has roughly matched the market (bottom panel) despite the struggle of value investing. Giving money to Warren Buffett can also be a reasonable asset allocation option into value investing.

In conclusion, global markets are undergoing a Fear Bubble. This is not the start of a bear market, but the bubble is continuing to inflate. In all likelihood, it should start to deflate at some point in Q4. This argues for a defensive equity posture for the next few months. Suggested pockets of opportunity include the combination of low volatility and high yield, as well as value stocks.

The week ahead

Looking to the week ahead, the stock market remains range-bound. As well, the Sino-American trade war is locked in an escalation and de-escalation cycle.

Make no mistake about it, the Chinese have decided that a trade deal is impossible before the 2020 election because of Trump`s erratic behavior. according to a Bloomberg report:

After a weekend of confusing signals, Trump’s credibility has become a key obstacle for China to reach a lasting deal with the U.S., according to Chinese officials familiar with the talks who asked not to be identified. Only a few negotiators in Beijing see a deal as actually possible ahead of the 2020 U.S. election, they said, in part because it’s dangerous for any official to advise President Xi Jinping to sign a deal that Trump may eventually break.

In off-the-cuff remarks to reporters at the Group of Seven summit in France on Monday, Trump claimed that Chinese officials called “our top trade people” and said “let’s get back to the table.” In subsequent appearances he portrayed the outreach as evidence China was desperate to make a deal: “They’ve been hurt very badly, but they understand this is the right thing to do.”

It all made for splashy headlines and momentarily boosted stocks, but nobody in Beijing officialdom appeared to know what he was talking about. Even worse, his efforts to depict China as caving in negotiations actually confirmed some of their worst fears about Trump: that he can’t be trusted to cut a deal.

“Trump’s flip flop has further enlarged the distrust,” said Tao Dong, vice chairman for Greater China at Credit Suisse Private Banking in Hong Kong. “This makes a quick resolution nearly impossible.”

The editor of Chinese official media Global Times Hu Xijin signaled that China is digging in for a prolonged trade war.

The WSJ reported that China is preparing to decouple from American technology, and it is preparing an “unreliable entity list” of American companies and individuals to sanction in the next round of escalation.

China is studying technology companies’ reliance on American suppliers, according to people familiar with the matter, an apparent attempt to assess their ability to withstand further trade-war shocks, even as Beijing prepares to roll out a retaliatory blacklist of foreign businesses.

The interagency effort, which involves officials canvassing domestic companies, has taken place over the past few months as the trade war has intensified.

A Chinese official last week reiterated plans to release “in the near future” an “unreliable-entity list” of foreign businesses and individuals that would face restrictions in their dealings with Chinese counterparts. The list, which was first floated by Beijing in May, is an apparent planned response to Washington’s attempts to shut out telecommunications giant Huawei Technologies Co.

The performance of my trade war factor (dark line) still shows relative low levels of stress. I have added an additional indicator to the trade war factor analysis. The red line represents the relative performance of Las Vegas Sands to the gaming industry. If Beijing really wanted to get political in their sanctions, they would either hobble or shut down prominent Republican donor and Trump supporter Sheldon Adelson’s Macau casinos run by Las Vegas Sands. As a new round of US tariffs are levied on Chinese imports on September 1, watch for the market’s focus to turn on when next shoe drops.

The market’s internals are still supportive of the sideways consolidation scenario. Breadth indicators are mixed. While the S&P 500 Advance-Decline Line (red line) is nearing all-time highs, the Equal Weighted S&P 500 (green line) is flashing a negative divergence of lower highs and lower lows. The broadly based Value Line Geometric Index (bottom panel) is similarly showing weakness, and a negative divergence.

A comparison of the S&P 500 A-D Line and equal-weighted index reveals an interesting result. First, the underlying stocks are all the same, so the analysis represents an apples-to-apples comparison. However, the A-D Line is a diffusion index, while the equal weighted index is weighted by price change. If a stock rises, the weight in the A-D Line is the same regardless of whether it rose by 0.1% or 1%. By contrast, the equal-weighted index measures the magnitude of the move. The divergence between the two indicates while the breadth of the advance is broad, the magnitude of the advance is weak.

The analysis of market leadership is equally revealing. The market is led by relative uptrend from megacap and NASDAQ stocks, which are just barely hanging on, while mid and small caps are in relative downtrends. This picture of narrow leadership, along with the mixed signals from the equal weighted and A-D Line, suggests that the market is not ready to stage a sustainable rally to new highs. A period of sideways choppiness is the more far more likely outcome.

In the short run, market internals are overbought and rolling over, which also supports the trading range thesis as the market closed near the top of its range Friday.

Longer term horizon models are telling a similar story. Even though the net 20-day highs-lows is at a level where it stalled before, it is showing a more constructive uptrend pattern of higher lows.

From a tactical perspective, the S&P 500 flashed a minor negative 5-hour RSI divergence on the hourly chart when it tested resistance at the open on Friday. Watch for the gap at 2890-2910 to be filled. A bearish impulse will not be confirmed until the rising trend line from last Friday’s low is broken.

My inner investor is defensively positioned and underweight equities. Subscribers received an email alert on Friday morning indicating that my inner trader had taken profits on his long positions, and he had flipped short.

Disclosure: Long SPXU

Home in the range

Posted by Cam Hui - August 28, 2019

Mid-week market update: The stock market is continuing its pattern of sideways choppiness within a range, bounded by 2825 to 2930, with a possible extended range of 2790 to 2950.

My inner trader continues to advocate for a strategy of buying the dips, and selling the rips. On the other hand, my inner investor is inclined to remain cautious until we can see greater clarity on the technical, macro, and fundamental outlook.

Buy the dips

In the short run, breadth is sufficiently oversold that current levels represent decent long side entry point for traders (indicators are as of Tuesday night`s close).

Longer term (1-2 week horizon) indicators are displaying a constructive pattern of higher lows and higher highs.

In addition, Callum Thomas` (unscientific) poll of equity sentiment on Twitter, which was conducted on the weekend, shows a bearish extreme, which is contrarian bullish.

Still range-bound

Before the bulls get overly excited, the current up-and-down pattern may not support a sustainable rally. While sentiment and breadth metrics are either oversold, or at bearish extremes, readings are highly fickle, and volatile on a daily basis. We have not seen the kind of consistent selling that usually characterizes a wash-out bottom yet.

The latest Investors Intelligence sentiment survey tells the story. Bullish sentiment has dropped considerably, which can be a sign of a short-term bottom. On the other hand, bearish sentiment has barely budged. and it has not spiked to signal the panic consistent with a durable intermediate term bottom.

An analysis of sector leadership shows the dominance of defensive sectors, all of which have exhibited recent relative breakouts. This is a signal that the bears remain in control of the tape. The good news is the aggregate weight of the defensive sectors total less than 15% of the index, and no matter how strong they are on a relative basis, they cannot drag the market down very much.

A look at the top five sectors, which comprise nearly 70% of index weight, tells a different story. With the exception of Technology, which is exhibiting a constructive leadership pattern, all of the other sectors are either lagging or range-bound on a relative basis. The stock market cannot rise without the strong participation of these heavyweights, which is more or less nonexistent.

This market structure argues for a continued sideways choppy pattern, and the appropriateness of a buy the dips and sell the rips trading strategy.

My inner investor is cautiously positioned, and he is underweight equities relative to target policy weight. Subscribers received an email alert Tuesday morning that my inner trader had taken profits on his short positions, and he had reversed to the long side. Should the market weaken back to support, he is prepared to buy more.

The trading model is now bullish. However, be aware of the volatile nature of the market, and traders are advised to adjust their position sizes accordingly.

Disclosure: Long SPXL

How not to push back against Trump

Posted by Cam Hui - August 27, 2019

Former New York Fed president Bill Dudley penned an explosive and shocking Bloomberg op-ed today:

U.S. President Donald Trump’s trade war with China keeps undermining the confidence of businesses and consumers, worsening the economic outlook. This manufactured disaster-in-the-making presents the Federal Reserve with a dilemma: Should it mitigate the damage by providing offsetting stimulus, or refuse to play along?

If the ultimate goal is a healthy economy, the Fed should seriously consider the latter approach.

Dudley ended the op-ed by abandoning the normal apolitical stance of a (former) Fed official and picking sides [emphasis added]:

I understand and support Fed officials’ desire to remain apolitical. But Trump’s ongoing attacks on Powell and on the institution have made that untenable. Central bank officials face a choice: enable the Trump administration to continue down a disastrous path of trade war escalation, or send a clear signal that if the administration does so, the president, not the Fed, will bear the risks — including the risk of losing the next election.

There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.

Wow! What were they drinking at Jackson Hole? Maybe Dudley is angling for a job at the Bundesbank.

We’ve down this road before

A cacophony of critical responses followed. The article puts the Fed`s precious independence at stake, and risks politicizing the venerable institution forever. It also enables Trump supporters to hold up as an example of the Deep State conspiracy against Trump. A Fed spokesman put out a statement disavowing Dudley’s views:

The Federal Reserve’s policy decisions are guided solely by its congressional mandate to maintain price stability and maximum employment. Political considerations play absolutely no role.

Yet, we’ve been down this road before. Sam Bell highlighted criticism by Kevin Warsh.

Matt Yglesias also pointed out that Alan Greenspan played a passive-aggressive game of opposing the Clinton administration during 1993-94.

While I sympathize with the trap the Fed finds itself caught in, Dudley’s frontal attack on Trump is wrongheaded, and creates more problems that it solves.

While I am not endorsing the following course of action, there are better ways of affecting policy than Dudley’s impetuous charge on the White House. If the Powell Fed were to push back against Trump’s policies, it should take a page out of Greenspan’s playbook by making the following points, either during Congressional testimony, or speeches by Fed officials:

The US economy is in a good place, and growing well; but
Business confidence is suffering because of trade policy, and trade tensions are creating a high level of global uncertainty;
By mandate, the Fed stands ready to cushion any slowdown; but
Monetary policy is not the only tool available, and Congress could act more effectively to promote growth by mitigating trade policy uncertainty.

Since the Fed answers to Congress, sometimes a little subtlety, and building alliances, works better than a frontal assault.

Hong Kong: The next financial domino?

Posted by Cam Hui - August 26, 2019

Bloomberg reported that Carmen Reinhart had a chilling warning about Hong Kong:

Hong Kong’s rolling political turmoil could prove a tipping point for the world economy, Harvard University economist Carmen Reinhart said.

Noting an incidence of shocks that have rattled global growth, including the intensifying U.S.-China trade war, Reinhart cited Hong Kong as among her main concerns. Having previously warned that Hong Kong faces a housing bubble, she said the world economy could be hit by “shocks with a bang or with a whisper.”

“One shock that is concerning me a great deal at the moment is the turmoil in Hong Kong,” which could impact growth in China and Asia generally, Reinhart said in an interview with Bloomberg Television’s Kathleen Hays.

“These are not segmented regional effects, these have really global consequences. So what could be a tipping point that could trigger a very significant global slowdown, or even recession — that would be a candidate, that could be a candidate,” said Reinhart, who specializes in international finance.

Indeed, the unrest has taken a toll on the local economy.

…and GDP growth expectations are tanking.

Let me calm everyone down, and you can timestamp this forecast. China will not send troops into Hong Kong in 2019, which reduces tail-risk. At the same time, however, investors should not ignore Carmen Reinhart’s warnings either.

Hong Kong’s protests in context

Did you ever have a fight with Significant Other, when the fight about X, but the real hidden issue was Y? Here are what some of the underlying issues behind the Hong Kong protests.

I left Hong Kong as a child in 1967 for Canada, when the colony was gripped by riots and bombings. The protests was sparked by a 5c increase in the fare on the Star Ferry, which was at the time the only way of getting to the island of Hong Kong from Kowloon. It eventually escalated into bombings and riots.

While the apparent problem was economic discontent, which was very real, the hidden issue was the creeping influence of Mainland China’s influence into the British colony. Not only was the Cultural Revolution at its height, local opposition to the Vietnam War did not help matters. They were daily demonstrations at the gates of the Governor’s Mansion, with protesters shouting with Mao’s Little Red Book, which I can recall by watching from a nearby hill. My parents were abroad at the time, and they were horrified when they learned of my proximity to the protests.

That was then, this is now.

When viewed from a distance, the apparent cause of the discontent is China’s heavy-handed approach of imposing an extradition bill on Hong Kong. Many of us in the West view the conflict as a protest against the imposition of China’s will on Hongkongers. While those issues are very real, there is a deeper underlying cause of the discontent.

The problem is inequality, as outlined by the New York Times. While I have met many bankers who hold HK up as an example of pure capitalism, it is also the land of yawning inequality, where the American Dream of getting ahead is all but dead.

Rents higher than New York, London or San Francisco for apartments half the size. Nearly one in five people living in poverty. A minimum wage of $4.82 an hour.

Hong Kong, a semiautonomous Chinese city of 7.4 million people shaken this summer by huge protests, may be the world’s most unequal place to live. Anger over the growing power of mainland China in everyday life has fueled the protests, as has the desire of residents to choose their own leaders. But beneath that political anger lurks an undercurrent of deep anxiety over their own economic fortunes — and fears that it will only get worse.

“We thought maybe if you get a better education, you can have a better income,” said Kenneth Leung, a 55-year-old college-educated protester. “But in Hong Kong, over the last two decades, people may be able to get a college education, but they are not making more money.”

An article in The Economist picked up on this theme of inequality and property unaffordability.

Thanks to light regulation, independent courts and a torrent of money from China, Hong Kong has long been a global financial centre. But many of the resulting jobs are filled by outsiders on high salaries, who help push up property prices. Mainlanders seeking boltholes do too. And then there is the contorted market for housing. The government artificially limits the supply of land for development, auctioning off just a little bit each year. Most of it is bought by wealthy developers, who by now are sitting on land banks of their own. They have little incentive to flood the market with new homes, let alone build lots of affordable housing. The average Hong Kong salary is less than HK$17,000 ($2,170) a month, hardly more than the average rent. The median annual salary buys just 12 square feet, an eighth as much as in New York or Tokyo.

The discontent found its focus on China’s role in Hong Kong (from the NYT):

These issues were at the fore five years ago, when protests known variously as Occupy Central or the Umbrella Movement shut down parts of the city for weeks. Similar protests, such as the Yellow Vest movement in France, echo worries that a booming global economy has left behind too many people.

Today, protesters are focusing on the extradition bill, which Hong Kong leaders have shelved but not killed, and a push for direct elections in a political system influenced by Beijing. Hong Kong, a former British colony, operates under its own laws, but the protesters say the Chinese government is undermining that independence and that the leaders it chooses for Hong Kong work for Beijing, for property developers and for big companies instead of for the people.

While I am not discounting the seriousness of the political issues, this is just another manifestation of populism that has appeared all around the world. We can see that in the politics of Marine Le Pen in France, Matteo Salvini in Italy, and Trump’s MAGA beliefs in the US. In the West, the discontent is attributable to Branko Milanovic’s finding that the era of globalization left the developed world’s middle class behind, while enhancing the income gains of emerging market economies, and the global rich elite who engineered the globalization boom. This has manifested itself in anti-immigrant views in many developed countries.

China’s likely response

While the big picture is always enlightening, and interesting, what does that mean in the real world? What will China do, and what does that mean for the risks that Carmen Reinhart raised?

There are two reasons why China is unlikely to militarily crackdown in Hong Kong in the short run. The first reason is Taiwan’s election, which will occur in January. Beijing will not intervene if it wants to keep any hopes alive of eventually coming to a One Country-Two Systems style Hong Kong solution with Taiwan. Any appearance of PLA units in Hong Kong will harden the position of the Taiwanese electorate, aid the rise of the pro-independence Democratic Progressive Party, and scuttle any prospect of discussion of reunification in the near future.

Beijing also faces some practical problems of a Tiananmen Solution in Hong Kong, as Minxin Pei pointed out in a Project Syndicate essay:

After the Tiananmen crackdown, the Communist Party of China’s ability to reinstitute control rested not only on the presence of tens of thousands of PLA troops, but also on the mobilization of the Party’s members. In Hong Kong, where the CPC has only a limited organizational presence (officially, it claims to have none at all), this would be impossible. And because the vast majority of Hong Kong’s residents are employed by private businesses, China cannot control them as easily as mainlanders who depend on the state for their livelihoods.

The economic consequences of such an approach would be dire. Some CPC leaders may think that Hong Kong, which now accounts for only 3% of Chinese GDP, is economically expendable. But the city’s world-class legal and logistical services and sophisticated financial markets, which channel foreign capital into China, mean that its value vastly exceeds its output.

In other words, the risk/reward ratio of intervention is highly unfavorable. At a minimum, don’t expect any action until the January 2020 Taiwanese election.

A contrarian buy?

If the tail-risk of Chinese intervention is largely off the table, does that mean you should be buying Hong Kong equities? Despite the decline in the HK market, valuation is hardly compelling. With the region’s economy tied to China, whose growth is experiencing some deceleration, the prudent course of action is to wait.

There is the additional risk of further escalation in the trade war. Trump is running out of Chinese imports to tariff. If he chooses to escalate tensions, the next front may be geopolitical, such as support for Taiwan, which is already evident from the latest arms sales, or overt support for Hong Kong’s protest movement.

Carmen Reinhart’s evaluation of Hong Kong as a possible tipping point is correct. The risks are still there. It is better to wait before buying.

How worried should you be about a recession?

Posted by Cam Hui - August 25, 2019

The latest signals of each model are as follows:

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

Recession fears are rising

The whiff of recession is in the air, and anxiety levels are rising. Analysis from Google Trends reveals that searches for the terms “recession” and “yield curve” have spiked.

Tariff Man is getting worried. At the nadir of last week’s stock market decline, Trump tweeted, “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election”.

The New York Times reported Trump is convinced that there is a conspiracy to distort economic data and exaggerate the prospect of a recession,

President Trump, confronting perhaps the most ominous economic signs of his time in office, has unleashed what is by now a familiar response: lashing out at what he believes is a conspiracy of forces arrayed against him.

He has insisted that his own handpicked Federal Reserve chair, Jerome H. Powell, is intentionally acting against him. He has said other countries, including allies, are working to hurt American economic interests. And he has accused the news media of trying to create a recession…

Mr. Trump has repeated the claims in private discussions with aides and allies, insisting that his critics are trying to take away what he sees as his calling card for re-election. Mr. Trump has been agitated in discussions of the economy, and by the news media’s reporting of warnings of a possible recession. He has said forces that do not want him to win have been overstating the damage his trade war has caused, according to people who have spoken with him. And several aides agree with him that the news media is overplaying the economic fears, adding to his feeling of being justified, people close to the president said.

How serious are the recession risks? What should and shouldn’t equity investors be worried about? We examine some details.

I find that investors should distinguish between real risks and red herrings for stocks. Downside equity risk from a recession is relatively low, and we are less concerned about the signal from the yield curve. If a recession is in the cards, it has to be one of the best anticipated and telegraphed slowdowns in the post-War era.

On the other hand, investors should be wary of a rising USD, and how the market may discount the outcome of the U.S. presidential election in 2020.

The yield curve signal

Numerous recession alarms have been raised based on the shaped of the yield curve. The New York Fed’s recession model, which is based on the yield spread between the 10-year note and the 3-month bill, has spiked to levels consistent with past recessions.

As an equity investor, I am inclined to discount the message from the yield curve for several reasons. For an even-handed perspective, here is what Fed watcher Tim Duy had to say about the yield curve:

I have long been a fan of the yield curve as one tool to track the economy, and it is sending unwelcome signals this year. Yields on 10-year notes fell below those on two-year notes on Wednesday for the first time since 2007. Another portion of the yield curve, the spread between three-month bill rates and 10-year yields, which is the favored recession signal for the economists at the Federal Reserve Bank of San Francisco, has been inverted since May. It’s no wonder that market participants are increasingly concerned with the economic outlook.

Historically, whenever the spread between two- and 10-year yields inverts, a recession follows six to 24 months later. The Fed, though, typically ignores this signal because inversions happen well ahead of a downturn and when the Fed is more worried about inflation than recession. Also, an inversion was often the only sign of recession. In fact, the Fed has often continued to raise policy rates after an inversion. That sequence of events – the Fed tightening after the yield curve inverts – tends to precede a recession.

Duy then raises the question of what happens if everyone is watching a single metric. Will its forecasts work as well? The Fed is watching the yield curve flatten and it has responded with an easier monetary policy.

The upshot is that the yield curve has been a good predictor of a recession in part because the Fed did not believe it had any special significance. Once the Fed finds significance in the yield curve, then its usefulness as a recession predictor likely drops sharply. In addition, downside risks to the economy have already forced the Fed to loosen policy, and more rate cuts are coming. The Fed will lower its target for the federal funds rate again in September, and a 50-basis-point cut can’t be ruled out.

Another reason I am inclined to doubt the message of the yield curve is its odd behavior during the latest inversion episode. The chart below shows the 10-year and three month spread (top panel), 10-year and 2-year spread (middle panel), and 30-year and 10-year spread (bottom panel). The unusual nature of the latest episode is how the curve has inverted. While the short end (3m10y) has inverted, and the belly of the curve (2s10s) is flattening, the long end (10s30s) has been very steep and it has only just started to flatten.

Past episodes of yield curve inversions that have preceded recessions and equity bear markets has seen the 10s30s invert as well, which has not happened this time.

Finally, the mechanism of how an inverted yield curve signals recession may not be in place this time. Sri Thiruvadanthai, who is Director of Research at the Jerome Levy Forecasting Center, pointed out that a flattening yield curve has presaged a slowdown in household leveraging.

The household sector deleveraged after the last crisis, and its balance sheet is not under stress. A flattening yield curve is unlikely to have much of an effect.

New Deal democrat’s “recession watch”

The blogger New Deal democrat has a highly disciplined recession model, and these days he sounds worried. He categorizes economic indicators into coincident, short leading, and long leading indicators. His latest concern is based on the BLS revisions in unit labor costs, which is an input into a group of corporate profit metrics as part of his long leading indicators:

One of the four long leading indicators Prof. Geoffrey Moore studied for decades, and published in 1993 is corporate profits deflated by unit labor costs. While the corporate profits data remains the same, yesterday the BLS updated unit labor costs through Q2 of this year, and made some major backward revisions going all the way to 2014.

The chief result is that, especially in the past two years, until labor costs have increased at a significantly greater rate than had been published previously – and Q2 unit labor costs rose 0.6%.

This has two effects. The first is that adjusted proprietors’ income, which is my placeholder until corporate profits is reported in two weeks, actually declined in Q2 – the second straight quarter of slight decline. But more importantly, instead of going basically sideways, NIPA corporate profits have declined sharply since their peak in 2014 – by a total of about -16%:

The recent history of his real-time outlook has been no recession, but this BLS revision makes the forecast a little wobbly.

I went back and checked my long range forecast 12 months and 6 months ago. In both cases, corporate profits were listed as a positive. These revisions mean that corporate profits would have been a negative in both periods.

Twelve months ago, I wrote that there were 4 positives and 2 negatives. Six months ago, I wrote that there were 2 positives and 3 negatives. With these revisions, the results would have been 3+, 3- and 1+, 4- respectively.

As a result, I probably would have gone on recession watch last September when it became clear that housing had peaked, and the recession watch probably would have started in Q2 of this year rather than Q4 (Remember that for me a “recession watch” is like a “hurricane or tornado watch” from the NWS – conditions are favorable, but by no means a certainty).

In other words, he would have downgraded his long-term outlook last September. As his long leading indicators look out about 12-18 months, it puts the economy in a very fragile position today. Indeed, his short leading indicator readings have been weak but volatile. In addition, the trade war has weakened business confidence, which is another negative. A recent New York Fed survey concluded that tariffs and trade policy is pushing up prices and reducing profits.

NDD concluded that the economy is undergoing a high risk period in late 2019:

As a result of the big negative revisions to adjusted corporate profits, Q2 corporate profits becomes perhaps the most important report of the last 10 years. A producer-led recession similar to that of 2001 becomes a more significant possibility. This winter remains in the bull’s eye of my recession watch.

He followed up in a separate post that he is emphatically not calling for a recession, and we are “not doomed”. To be sure, the economy is undergoing a soft patch, and it is vulnerable to shocks.

Even if the economy were to enter a downturn in Q4 2019, this does not matter as much for equity investors, because markets are inherently forward looking, and stock prices tend to look ahead 6-12 months. If there is a slowdown or mild recession in late 2019 or early 2020, arguably the market anticipated the weakness when it fell in Q4 2018.

And if you believe the stock market downdraft in late 2018 did not discount the economic weakness late this year, the slowdown will likely be similar to the mild industrial recession of 2015, when oil prices fell but the rest of the economy continued to grow. During that period, forward EPS estimates flattened, and stock prices hiccupped, but the declines in 2015 were milder than the drawdown in late 2018.

In fact, the 2015 episode provided a valuable buying opportunity, based on a valuation reset. If an equity investor cannot stomach mild setbacks like what we saw in 2015, they should not be taking equity risk.

Analysis from Callum Thomas of Topdown Charts shows that the latest soft patch is likely to be temporary in nature, and global growth is set to resume in 2020.

What are you so worried about?

Beware of USD strength

While I am not concerned about the yield curve signal and a possible late 2019 slowdown, here is what equity investors should be worried about.

The greatest risk is USD strength, as a confluence of factors are serving to put a bid on the greenback. BAML found that the US share of investment grade bonds is skyrocketing. As sovereign debt yields are pushed more and more into negative territory, this forces bond managers into USD denominated debt, and creates a demand for dollar assets.

In addition, I had highlighted in the past research from Nordea Markets indicating the debt ceiling deal is likely to drain USD liquidity from the banking system. In the past, falling USD liquidity has historically been negative for risk appetite.

A rising USD is negative for risk assets in several ways. First, it creates a headwind for the earnings of US large cap multi-nationals operating in foreign markets. As well, a rising greenback raises the risk of an adverse response from the Trump administration in the form of currency war. Lastly, it exposes the vulnerability of fragile EM economies with current account deficits. A recent McKinsey study found that a growing proportion of companies in EM economies such as China, India, and Indonesia have highly levered balance sheets.

In particular, China’s growing external debt position, which is about USD 1 trillion, is becoming a concern. Bloomberg recently report that HNA Group was forced to miss a yuan note payment in order to repay a USD bond. In addition, the shares of the highly levered property developer China Evergrande continues to test a key long-term technical support level.

The Chinese corporate sector is showing signs of stress. As a reminder, the China bears’ favorite chart shows debt at dangerous levels. Will USD strength push China over the edge?

Risk levels are rising. Stay tuned.

2020 Election risks

Another risk the market is ignoring is the 2020 election. While the election is a long way off, the latest PredictIt odds shows Elizabeth Warren ahead of front runner Joe Biden for the Democrat’s nomination.

The markets have not even begun to contemplate the possibility of a Warren presidency. Policy is likely to lurch leftward, and, at a minimum, Warren will undo the Trump tax cuts. After-tax earnings received about a 7-9% boost as a consequence of the 2017 Tax Cuts and Jobs Act. Expect the earnings boost to be unwound. To be sure, Warren`s economic policies are likely to be expansionary and re-distributive, but they will be a net negative to the suppliers of capital while a net positive to the suppliers of labor.

A Trump-Warren contest will put the markets in the unenviable position of navigating between a financial Scylla and Charybdis of Warren`s re-redistribution policies against Trump`s protectionism and tariff wars. For some perspective, Bloomberg Economics recently estimated that the trade war effects on business confidence are roughly equal or higher than the direct impact of the increased tariffs.

Readers can make their decisions based on their own political preferences, but neither outcome can be interpreted as equity bullish.

Risks and red herrings

In conclusion, investors should distinguish between real risks and red herrings for stocks. Downside equity risk from a recession is relatively low, and I am less concerned about the signal from the yield curve. If a recession is in the cards, then it has to be one of the best anticipated and telegraphed slowdowns in the post-War era. Even the New Yorker cartoonist has gotten into the act.

On the other hand, investors should be wary of a rising USD, and how the market may discount the outcome of the US presidential election in 2020.

The week ahead

Sometimes life comes at us fast. I had been suggesting in these pages that the market is in a trading range. Subscribers received an email alert on Thursday morning before the market open that the trading model had flipped from bullish to bearish. I did not expect the market to drop from the top of the trading range to the bottom. The SPX is now nearing support while exhibiting positive RSI divergences, and a positive Advance-Decline Line divergence, which is tactically bullish.

The Fear and Greed Index closed Friday at 18, which is within the sub-20 target zone that has marked market bottoms in the past. While the readings of the index is not a precise timing indicator, it does indicate the market is undergoing a bottoming process.

I had also suggested that this is not the beginning of a bear market, but a corrective episode and a welcome valuation reset (see Powell`s dilemma, and why it matters). I had projected a downside range of 2598 to 2891, and the index is in the top half of that range. The market’s current forward P/E ratio is 16.2, which is between its 5-year average of 16.5 and 10-year average of 14.8. While the decline could stop here, there may be more downside risk, along with more choppiness ahead.

One template for today’s market may be the trading range of 2011, when the market was gripped by the combination of a budget impasse in Washington and the Greek Crisis in Europe. From a technical perspective, the bottom process was marked by positive divergences in the form of improving risk appetite, as measured by the 10-day moving average (dma) of the equity-only put/call ratio, and the VIX term structure. In addition, new highs were improving as the market tested the bottom of the range.

Fast forward to 2019. The market is testing the bottom of its range, and it is flashing a positive RSI divergence, and new high breadth is improving. However, fear indicators are exhibiting higher highs, which may indicate that further consolidation or downside may be ahead. It is possible that the true trading range is not the zone marked in grey, but a wider zone defined by the 2950 breakout level at the top end, and support at about 2740 below.

Market breadth indicators suggest further consolidation or more downside from current levels. If history is any guide, it is highly unusual to see the market bottom with % above the 50 dma at the current 30 level without % above 200 dma falling below 50.

Friday’s market action demonstrated that sentiment is far more concerned about the trade war than Fed interest rate policy. If trade war anxiety is the issue, then the performance of my trade war factor indicates that there could be much more downside risk from current levels.

History doesn’t repeat, but rhymes. Instead of a range bound bottom of 2011, another alternative template for today’s market might be 2015. The market chopped around in a narrow range for most of the year, until the consolidation was resolved with a -14,0% peak-to-trough drawndown. This scenario is consistent with today’s macro backdrop of global growth and trade tension uncertainty for the next few months.

In the short run, the market is due for a bounce. Short-term (1-2 day time horizon) breadth is oversold, and at levels consistent with the start of relief rallies.

Longer term (1-2 week time horizon) breadth, however, may need further downside in the days and weeks ahead for the market to form a durable bottom.

Watch for a market friendly response from Trump soon. Even though Tariff Man was on full display last Friday, don’t be surprised to see Dow Man swing into action in the near future. An investor would almost be better off buying the long Treasury bond than stocks during Trump’s term, which reflects badly on his re-election prospects.

My inner investor has been cautiously positioned and underweight equities. My inner trader went short last Thursday. He took some partial profits on his short position on Friday, and he expects to reverse long early next week.

Disclosure: Long SPXU

Buy the dips, sell the rips

Posted by Cam Hui - August 21, 2019

Mid-week market update: The SPX has been mired in a trading range for several weeks. Even as the market is once again testing resistance, it is displaying a mild positive RSI divergences, which argues that there may be further minor upside to resistance at about 2950.

Nevertheless, this pattern argues for a trading strategy of buying the dips, and selling the rips.

Retest of lows ahead?

In addition to the apparent range-bound behavior, analysis from Urban Carmel argues for a near-term retest of the lows. The index had been down for three consecutive weeks last week before staging a relief rally. Such episodes are usually followed by a decline to retest the previous lows.

There are plenty of possible bearish catalysts in the next few days. First up is Jerome Powell’s speech at Jackson Hole this Friday. The market is pricing in 2-3 rate cuts until year-end, and the risk of disappointment is high.

Powell’s Jackson Hole speech

Since his “mid-cycle adjustment” remarks after the last FOMC meeting, retail sales has been robust, job growth, job growth slightly disappointing but still strong, and inflation is running a little hot. Powell will have his hands full in bringing the rest of the FOMC along if he wants to continue cutting rates.

Consider the recent remarks of regional Fed presidents. Here is Boston Fed president Eric Rosengren (via Bloomberg):

We’re likely to have a second half of the year that’s much closer to 2% growth. When we have a low unemployment rate, a relatively low inflation, unless that changes—and it may change—I don’t see a lot of need to take action.

San Francisco Fed president Mary Daly (via Quora):

I don’t think we’re headed towards a recession right now. When I look at the data coming in, I see solid domestic momentum that points to a continued economic expansion. The labor market is strong, consumer confidence is high, and consumer spending is healthy.

But considerable headwinds, like weaker global growth and trade uncertainties, have emerged – and they’re contributing to this fear we see in the markets that a downturn is right around the corner. So one thing I’m looking closely at is whether the mood gets so out of sync with the data that the fear of recession becomes a self-fulfilling prophecy.

My colleagues and I on the Federal Open Market Committee recently lowered the federal funds rate by 25 basis points. Speaking only for myself, I do believe this was an appropriate recalibration of policy in response to the headwinds we’re facing – along with inflation rates that continue to come in under our 2% target. However, I should stress that my support for this cut is based around my desire to see our economic expansion continue – not because I see an impending downturn on the horizon.

The 2s10s yield curve has flattened to 1 basis point, and risks are rising. It is difficult to see how Powell could satisfy market expectations.

The G7 wildcard

Then there’s the wildcard presented by the G7 summit this weekend. Recall that at the last G7 summit, Trump refused to approve the communique, left the meeting early, got into a trade tiff, and insulted his Canadian host.

US trade representative Peter Navarro went further to inflame tensions, “There’s a special place in hell for any foreign leader that engages in bad faith diplomacy with President Donald J. Trump and then tries to stab him in the back on the way out the door. And that’s what bad faith Justin Trudeau did with that stunt press conference. That’s what weak, dishonest Justin Trudeau did, and that comes right from Air Force One.”

As we approach this weekend’s summit, US trade tensions with the EU could be front and center. On the other hand, Japanese negotiators are in Washington this week for trade talks this week. Should the discussions be fruitful, it could lay the groundwork for a meeting or even a trade agreement between Trump and Abe on the sidelines of the G7.

In addition, British PM Boris Johnson is making the rounds in Berlin and Paris ahead of the G7 summit. He is trying to secure a Brexit agreement without an Irish backstop. His chances of success are nil to none, and Bloomberg reported that a no-deal Brexit is now their most likely scenario. Expect fireworks from BoJo this weekend.

Tactically, I expect some more upside tomorrow. Today’s CBOE put/call ratio is an astounding 1.30, which indicates skepticism about the market advance.

My inner trader is still long, but he is lightening up his positions at these levels.

Disclosure: Long SPXL

Peak Brexit panic?

Posted by Cam Hui - August 19, 2019

The Brexit headlines look dire and Apocalyptic. The Sunday Times published the leak of Operation Yellowhammer, which was the UK government’s base case plan for a no-deal Brexit.

Britain faces shortages of fuel, food and medicine, a three-month meltdown at its ports, a hard border with Ireland and rising costs in social care in the event of a no-deal Brexit, according to an unprecedented leak of government documents that lay bare the gaps in contingency planning.

The documents, which set out the most likely aftershocks of a no-deal Brexit rather than worst-case scenarios, have emerged as the UK looks increasingly likely to crash out of the EU without a deal.

The newspaper went on to reported that up to 85% of truck “may not be ready” for French customs, and disruption may last up to three months. In addition, the government is preparing for a hard border at the Irish border, as current plans to maintain the Irish backstop are unrealistic and unsustainable.

In other words, it’s going to be ugly, especially when Prime Minister Boris Johnson has vowed to take the UK out of the EU by October 31, with or without a deal.

Dire scenarios

Brexit will not only hurt Britain, but the rest of Europe as well. The FT recently published a chilling graphic of the losers in a no-deal Brexit. While Ireland heads the list, other European countries are likely to be sideswiped as well.

In addition, the BIS report on bank exposure shows Spanish and Irish banks most exposed to UK debt. Core Europe of Germany and France also have substantial exposure, along with Sweden.

Brexit exhaustion?

The dire nature of a hard Brexit is not a surprise for the markets. The latest BAML Global Fund Manager Survey shows the greatest regional equity underweight of global institutions is the UK.

The panic may be at a washout low. The chart below depicts the large cap FTSE 100 and the small cap FTSE 250. While the larger cap companies are more international, the smaller cap FTSE 250 stocks are more exposed to the UK economy. The relative performance of small to large cap stocks shown in the bottom panel have repeated bounced off a relative support as defined by the first low after the Brexit referendum. Moreover, the ratio is on the verge of an upside breakout out of a fallin downtrend.

This suggests that panic over Brexit has become exhaustive, and the market is becoming immune to bad news.

How to buy Brexit panic

If Brexit fears are exhaustive, what should a contrarian investor do to profit from a potential turnaround? The most obvious play would be UK stocks, but that may not be the best idea. As the chart below shows, the relative performance of UK stocks to EAFE remains in a downtrend, with no technical signs of a bottom in sight. A better way might be to buy Irish exposure, as Ireland is highly levered to the British economy. The relative performance of Irish stocks is testing a key relative support level, and appears to be in better technical shape than UK equities.

Another way would be to simply buy the British Pound (GBP), which is testing a key long-term support level.

The combination of panic exhaustion and prices at technical support is a setup for a contrarian play on Brexit panic. Any good news in such an environment is likely to send either of these two vehicles rocketing upwards. Needless to say, this is a highly speculative and risky play, so be aware of the risks should you enter into a position.

Peering into 2020: New decade, new paradigm

Posted by Cam Hui - August 18, 2019

The latest signals of each model are as follows:

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

The remarkable FAANG run

Technology stocks, and FAANG in particular, have had a remarkable run in the last decade. The chart below reveals the level of dominance.

The top panel shows the relative performance of the NASDAQ 100 (NDX) in the last 15 years (blackline). Not only is the NDX dominating the market, the NDX has also been steadily beating the equal-weighted NDX (green line), indicating that large caps within that index have outperformed small caps. The bottom panel also shows the relative performance of large cap technology (black line) and small cap technology (green line) against their respective indices. Both have led the market in the past decade.

As we peer into 2020 and the next decade, numerous signs are appearing that this cycle of technology and FAANG leadership may be coming to an end.

When the turn does come, the likely winners are gold, value stocks, and European equities. As well, you should expect subpar performance from technology and the bond market in the decade ahead.

Paradigm shift ahead

Bridgewater Associates founder Ray Dalio recently penned an essay on investment paradigm shifts. He stated one of his key investing principles as:

Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.

Over my roughly 50 years of being a global macro investor, I have observed there to be relatively long of periods (about 10 years) in which the markets and market relationships operate in a certain way (which I call “paradigms”) that most people adapt to and eventually extrapolate so they become overdone, which leads to shifts to new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm. Identifying and tactically navigating these paradigm shifts well (which we try to do via our Pure Alpha moves) and/or structuring one’s portfolio so that one is largely immune to them (which we try to do via our All Weather portfolios) is critical to one’s success as an investor.

The essay is well worth reading in its entirety, but Dalio summarized the current paradigm since 2009 this way:

Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable.
There has been a wave of stock buybacks, mergers, acquisitions, and private equity and venture capital investing that has been funded by both cheap money and credit and the enormous amount of cash that was pushed into the system.
Profit margins grew rapidly due to advances in automation and globalization that reduced the costs of labor.
Corporate tax cuts made stocks worth more because they give more returns. The most recent cut was a one-off boost to stock prices.

He went on to forecast the next paradigm this way:

I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets. Said differently, I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better and b) simultaneously, the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.

The process that Dalio described is the life and death of a bubble. You first start with a good idea. Early movers capitalize on the idea, which attracts more investors. Returns rise, and eventually go parabolic. More money rushes in, and late investors lever themselves up. The entire scheme becomes unsustainable and the bubble bursts.

Dalio went on to forecast gold is the winner in the next investment paradigm, but there are sufficient signs that a number of investment relationships have become so stretched that they are ripe for reversal.

Watch for leadership reversal

Here are some examples. Yardeni Research documented the rise of FANG stocks as a percent of market cap, sales, and earnings. While FANG accounts to about 10% of index market cap, these stocks represent a far lower proportion of sales and earnings, indicating rising valuation levels.

Another sign of an imminent paradigm shift can be found in value stocks, which are becoming extremely stretched by historical standards. The spread between MSCI World Value and Growth reached a low not seen since 1975, which marked the top of the Nifty Fifty era.

A Yahoo Finance article highlighted what JPMorgan’s quantitative strategist Marko Kolanovic called a “once in a decade opportunity” in value stocks:

“Currently, there is a record divergence between value/cyclical stocks on one side, and low volatility/defensive stocks on the other side,” Kolanovic wrote. “The level of divergence is much more significant even when compared to the dot-com bubble valuations of late ’90s.”

The point is, the gap between value stocks and low volatility stocks is unusually wide, as the chart above shows in terms of forward P/E valuation.

“While there is a secular trend of value becoming cheaper and low volatility stocks becoming more expensive due to secular decline in yields, the nearly vertical move the last few months is not sustainable,” Kolanovic wrote. “The bubble of low volatility stocks vs. value stocks is now more significant than any relative valuation bubble the equity market experienced in modern history.”

A variant of the value vs. growth relationship can also be indirectly seen in the possible relative revival of European stocks (see Europe: An ugly duckling about to be a swan?). The outperformance of US stocks can mainly be attributable of the dominance of the technology sector in the US, while technology stocks are largely absent in European markets.

Another stretched relationship can be seen in interest rate trends. The ECB has pushed rates so far down that the entire German, Dutch, and Swiss yield curves are negative. Austria’s 100-year bond is now trading at a yield of under 1%. When something gets too stretched, it reverses. This tweet from Josh Brown summarizes the intersection of low and negative yields, value investing, and European equities.

In his essay, Dalio identified gold as one of the winners in the next decade’s investment paradigm:

Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash). I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.

Indeed, we can see that gold formed a multi-year saucer bottom, and recently staged an upside breakout to a recovery high. This is an additional sign of the reversal of a stretched relationship.

Timing the paradigm shift

One of the assumptions underlying Dalio’s analysis is that investment paradigms ends when the old leaders go into a bear market. There is a washout and catharsis, out of which the new paradigm and leadership emerges.

For investors, the task of timing the top of the FAANG and technology bull is a challenge. I have identified a number of catalysts.

First, the regulatory environment is becoming less and less friendly to Big Data technology companies. American regulators are turning their anti-trust scrutiny towards tech. Europeans have led the way with privacy regulations based on the “right to be forgotten” initiatives like GDPR. These initiatives are likely to erode the business moats of many Big Data companies like Facebook, Google, Amazon, and others.

Another catalyst may come in the next recession, whenever that occurs. The ECB experience has shown that there are limits to monetary policy, and fiscal and trade policy will also have to play their part to promote economic growth.

Central bankers are running out of bullets. Pushing interest rates into negative territory has devastated the European banking sector. Joe Wiesenthal at Bloomberg suggested that “negative yields are basically the market’s way of taxing people who oppose fiscal stimulus because they don’t want to be taxed”, and “this probably all ends when rich people find that Elizabeth Warren-style 2% wealth taxes offer a better return than holding money in a bank.”

I had suggested that Europe might change when the German Greens gain greater power and push through some of their green spending proposals. This will promote growth as Germany is one of the countries in the eurozone with the fiscal room to stimulate the economy (see Europe: An ugly duckling about to be a swan?).

In the US, investors will likely have to wait until after the 2020 election. Both President Trump and the Democrats are effectively supporters of the Modern Monetary Theory (MMT), which states that a sovereign country that issues debt in its own currency cannot go bankrupt. Its debt capacity is only limited by the willingness of lenders to buy its debt. This allows greater fiscal flexibility for the government to stimulate growth. Trump would like call for more tax cuts, and a Democrat would try to pass safety net style legislation such as student debt forgiveness, Medicare for All, and green initiatives. The debate will not be over whether fiscal stimulus is necessary, but over fiscal priorities.

When the turn does come, the likely winners are gold, value stocks, and European equities. As well, you should expect subpar performance from technology and the bond market in the decade ahead.

The week ahead

How can investors and traders make sense of the volatility as we look ahead to next week and beyond? I am grateful to my former Merrill Lynch colleague Fred Meissner for the following analytical framework of separating the shorter term (daily chart) and longer term (weekly) chart perspectives.

In the short run, the market tested support at about 2845 while displaying positive RSI divergences. It was also oversold on the stochastic, and the subsequent bounce was not surprising. A likely price recovery lies ahead, and overhead resistance at 2950 is a reasonable first rally objective.

The longer term perspective on the weekly chart does not look as rosy. The index has violated a key uptrend indicating technical damage, and the weekly stochastic has rolled over from an overbought reading and it is flashing a sell signal. This kind of market structure calls for a relief rally within a trading range.

There were plenty of signs that the market was ripe for a bounce. The TRIN Index spiked above 2 twice last week, and a reading of 2 or more can be interpreted as a sign of capitulation. SentimenTrader documented what happened after such episodes when the index is above its 200 dma. Three-month returns are almost universally positive.

My own Trifecta Spotting Model had flashed an exacta buy signal last week. As a reminder, the Trifecta Model is based on three uncorrelated short-term factors for finding market bottoms:

VIX term structure: An inverted term structure indicates fear in the option market.
TRIN: A TRIN reading of above 2 can be an indication of price-insensitive selling, or a “margin clerk” market. This kind of selling can flush out the weak holders in a falling market and build conditions for an advance.
Intermediate term overbought/oversold model: The ratio of stocks above their 50 dma to stocks above their 150 dma is a momentum indicator, and a reading below 0.50 can be interpreted as an oversold extreme.

The Trifecta Model flashed an exacta buy signal last week when the first two conditions were triggered, but not the third. While oversold markets can become more oversold, exacta and trifecta signals have been usually followed by relief rallies.

Lastly, CNBC did a “Markets in Turmoil” program last Wednesday at the bottom of the sell-off. The market has historically performed well after such programs.

On the other hand, Mark Hulbert believes that while sentiment is bearish, it is not bearish enough for a durable bottom.

Consider the average recommended equity exposure among the several dozen short-term stock market timers I monitor on a regular basis (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). This average currently stands at 7.9%.

Though that average is a lot lower than the 84.2% reading that prevailed in early July, it is still markedly higher than the readings below minus 20% that accompanied the market’s late-December lows. (See below chart.)

Similar sentiment conditions can be found in the NAAIM Exposure Index. Historically, this index has provided a useful buy signal when it has fallen below its lower Bollinger Band. The index neared, but did not fall below its lower BB in the last two weeks.

In short, the bulls are not out of the woods. Considerable risk loom ahead. The UK lurching towards a disorderly no-deal Brexit, which would tank the British economy and also sideswipe the rest of Europe. The developments in Hong Kong represent a geopolitical wildcard, which could spook the markets. The USD is strengthening again, and a rising greenback raises the odds of a Trump-induced currency war, and puts pressure on fragile EM economies with high external debt levels.

One sector with rising USD debt are the Chinese property developers, and they are especially vulnerable in light of their highly leveraged balance sheets. I am particularly concerned about the price action of China Evergrande (3333.HK), which is one of China’s largest property developers. The stock tanked on an unexpected loss when it reported earnings and violated an important long-term support level. It is unclear whether the breach is specific to the company, or signs of a larger systemic problem in China’s highly leveraged real estate sector.

So far, the stock charts of the other Chinese developers that I monitor are holding up well, and the sector is showing some early signs of relative strength.

Is the relative strength turnaround genuine, or just a dead cat bounce? The jury is out on that question. The chart of the broker-dealers in 2008 reveals few clues. The performance of the industry group shows little systemic anxiety at the time of the Bear Stearns and Lehman bankruptcies.

The relief rally within the context of a range-bound market also makes sense from a political perspective. President Trump styles himself as “Tariff Man”, but he also has a different persona of “Dow Man” who measures the success of his administration by the stock market. Investors reached the point last week when they were almost better off owning the long Treasury bond than stocks since Trump’s inauguration (bottom panel). At the bottom of the relative performance range, Dow Man becomes the dominant personality and he will endeavor to support stock prices. Near the top of the range, Tariff Man feels that he has a sufficient financial cushion to act tough in the trade war with China. While Dow Man has the upper hand today, watch for Tariff Man to take over again as stock prices recover.

My inner investor is cautiously positioned and targeting an underweight position in stocks. My inner trader began buying the market last week, and he is accumulating a long position on weakness based on the results of recent research (see Audit your trading the way the pros do it).

Disclosure: Long SPXL

Audit your trading the way pros do it

Posted by Cam Hui - August 13, 2019

Traders are always interested in improving their techniques. Today, I would like to offer a framework for thinking about your trading, using the way fund sponsors evaluate investment managers, called the 5 Ps.

People: Who are you, and what’s your experience and training?
Performance: How have the returns been, and what kind of risk did you take to achieve those results?
Philosophy: What makes you think you have an edge?
Process: How do you implement the edge you have on the market?
Portfolio: Does your portfolio reflect what you are saying about philosophy and process?

With the preface that there are never any single right answer in investing and trading, I will focus on “philosophy” and “process”.

Philosophy

Many neophytes have difficulty distinguishing between the idea of an investment philosophy, and investment process. I would encourage you to think about it this way. Trading is hard, and markets are mostly efficient. A philosophy describes why you think you found a market inefficiency.

Here is an example of what a trend-following Commodity Trading Advisor might write:

Economic systems exhibit trends, or serial correlation. For example, when an economy grows in one time period, the tendency in the next period is to continue growing. That’s a trend that investors can exploit.

Managers have to be prepared to answer hard questions about their investment philosophy. One of the most difficult is, “To achieve superior returns, you have to make bets. Under what circumstances will your returns be subpar?”

I have asked that of many traders and portfolio managers, and it is surprising how many have responded, “We beat the market under all conditions.”

That is a huge red flag, and it is an indication that the manager has not fully thought through his approach. If you are making a bet, and you don’t know why the bet might fail, then you are going to blow up one day.

Wesley Grey at Alpha Architect outlined a hypothetical example of what might happen if an investor had perfect knowledge (see Even God would get fired as an active investor). He first formed a series of stock portfolios by deciles, sorted by 5-year forward returns:

Starting on 1/1/1927 we compute the 5-year “look ahead” return for all common stocks for the 500 largest NYSE/NASDAQ/AMEX firms. For simplicity, we eliminate any firms that do not have returns for a full 60 months.(2) We look at gross returns and all returns are total returns including dividends. Next, we create decile portfolios based on the forward five-year compound annual growth rate (CAGR).

We rebalance the names in the portfolio on January 1st of every fifth year. The first portfolio formation is January 1, 1927 and is held until December 31, 1931. The second portfolio is formed on January 1, 1932 and held until December 31, 1936. This pattern repeats every fifth year. To be clear, this is a non-investable portfolio that would require one to know with 100% certainty the performance of the top 500 stocks over the next 5 years.

Needless to say, the resulting portfolios had incredible returns. But what were the drawdowns of those portfolios over the study period? The worse drawdown came to -76%, and a -76% loss would get anyone fired as a portfolio manager (even God).

The perfect foresight portfolio eats a devastating 76% drawdown (Aug 1929 to May 1932). But the pain doesn’t end there, here is a chart of the drawdowns on the portfolio over time:

If you had perfect foresight, what if you formed a long/short portfolio by buying the top decile winners and shorting the bottom decile losers? Maximum drawdowns was -47%, and that would get you fired as a hedge fund manager.

The point of this exercise is not to show how hard trading is, but to illustrate the point that traders have to enunciate their market edge. In turn, it shows the risks that they are taking. In the case of the perfect foresight portfolio, you are trading off long-term information for short-term volatility.

My inner trader’s philosophy

Here is another example. I have written extensively about my trading model under the persona of “my inner trader”. This is his investment philosophy:

You can achieve superior market timing returns using a combination of capitalizing on trend following techniques (see trend following philosophy above), combined with short-term overbought/oversold models to capitalize on sentiment extremes.

The key phrase in that statement is “market timing”. On average, stock prices rise, and the odds of the market rising increases with time. If you are market timing, and you have no information, the default bet is to be long and accept equity downside risk (see perfect foresight example above).

If you choose to be defensive, either by moving to cash or shorting the market, the odds are stacked against you. The corollary example can be seen in the hypothetical performance of my inner trader’s signals. When the market is going up in a straight line, you don’t need market timing.

You use market timing in order to avoid the really ugly losses that occur in bear markets and corrections. Conceptually, you are buying a long portfolio with a put option. Put options cost money. The only thing skillful market timers can do is to minimize the price of the put.

Investment process

The investment process is the way you implement your investment philosophy. Recent analysis by SocGen shows that a substantial proportion of trading is automated. If you can outline your investment philosophy, then you should be able to automate the process.

Another implementation issue to think about is trade timing. The folks at Resolve Asset Management studied the dispersion of returns using the same investment discipline of portfolio construction using different rebalancing frequencies:

The goal of this article is to illustrate how seemingly inconsequential changes to the trading mechanics of a strategy, which have little impact on the long-term expected performance, can have a material impact on results in the short-term.

To explore this concept we will examine the results of simulations based on the exact same underlying strategy, with exactly the same universe of investments, but where a change is made to just one minor variable. Specifically, we will see how small differences in rebalance frequency can have negligible impact on long-term results, but can lead to performance differences of 10 percentage points or more over one year observation horizons.

The results were astounding. By varying rebalancing frequency between 1 and 20 days using the exact same investment discipline, the 90% range of rolling 252 day returns varied from 4.2% to 10.9%.

Evaluating my inner trader’s process

Here is another example. The hypothetical returns of my inner trader’s signals is based on execution at the closing price on the day of the signal. I performed some sensitivity analysis if the trade was done 1, 2, 3, 4, and 5 days later. As it turns out, returns were mostly better, except if I wait an extra day. The most astonishing result is performance is better at t+5, or if the trade is executed five days after the signal.

I also formed a composite portfolio where 20% of the trade is done every day for five days, instead of executing instantly at the time of the signal. Returns are slightly better (blue line) compared to the t=0 base case (black line). The returns from inception for the composite portfolio came in at 15.9%, compared to 15.2% for the current portfolio.

This example shows another component of the investment process, namely model and portfolio diagnostics. The most intense scrutiny of an investment process when returns are subpar, but that is also part of the opportunity to learn about the strengths and weaknesses of the system.

This exercise taught me the time horizon of my trading signals is longer than I think they are.

I recently came upon a saying among traders:

Give a man a trade, he’ll eat for a month.
Teach a man how to trade, he’ll be in the poorhouse in three months.

Make sure you don’t wind up in the poorhouse. Scrutinize your investment philosophy and process, and always be learning.

A White Swan market

Posted by Cam Hui - August 13, 2019

Mid-week market update: I am writing my mid-week update a day early because of the extraordinary volatility in the stock market.

My wife and I took a few days to go on a Danube river cruise. As we arrived in Vienna, we spied a white swan swimming beside our ship. The white swan seems to be an apt metaphor for today’s market, which is a market of known risks.

A short-term bottom ahead

The stock market has certainly been volatile. Last Wednesday, I suggested that the market was ready to bounce (see Ripe for a counter-trend rally). The market has duly rallied, and stalled out late last week, when I issued a trading sell signal. That sell signal just got negated by a looming buy signal today as the trading model just flipped bullish.

Urban Carmel pointed out that the 20 day moving average of TRIN has spike to levels consistent with past trading bottoms. While this indicator does not peak on the exact day of the bottom, current readings show that we are close.

In addition, my Trifecta Bottom Spotting Model, which has had an uncanny accuracy, flashed an exacta buy signal. As Stockcharts has not updated the data for the intermediate-term overbought/oversold model (bottom panel), we may have already triggered a full trifecta buy signal.

The latest BAML Global Fund Manager Survey shows that anxiety has reached new highs, as measured by the breadth of hedging activity.

While the market will likely trace out a short-term bottom this week, my base case scenario calls for a range-bound choppiness in the weeks ahead. Here is why I think stock prices will not immediately recover to test the old highs and make new ones.

USD headwinds ahead
The USD Index recently staged an upside breakout out of an inverse head and shoulders pattern, but it weakened back to test neckline support. USD strength had been one key driver of CNY weakness, which has been causing untold consternation in the markets.

Guess what, USD strength is about come back, and that`s not good for the pricing of risk assets, like stocks.

Recent research from Nordea Markets highlighted the effects of the debt ceiling deal on USD liquidity. To make a long story short, raising the debt ceiling allows Treasury to borrow, which drains dollar liquidity from the banking and financial system.

Falling dollar liquidity can cause havoc in the global financial system. The most exposed are EM countries with USD debt. From a systemic risk viewpoint, the most exposed part of the global market that could cause a “black swan” event are the Chinese property developers. These companies have been financing in USD, as Beijing’s deleveraging program pushed up domestic funding costs. Equally serious is the statement from official media China Daily that Beijing will rely on fiscal stimulus, instead of monetary stimulus to stabilize growth. In effect, the highly levered development sector can kiss any hope of preemptive rescue from the PBOC. As the chart below shows, the relative returns of Chinese real estate developers is rolling over. While conditions are not at crisis levels, the risk of a series of confidence shaking defaults is rising.

China Evergrande (3333.HK) is one of China`s largest property developers. The stock weakened last week because of poor earnings report, and it is testing a long-term support level. A breach of support could be represent a spike in systemic risk. I don’t want to sound Apocalyptic and Zero Hedge here, but China Evergrande, along with other developers, have significant levels of offshore USD debt, and a disorderly retreat in its stock price could be a warning of a Bear Stearns/Lehman 2.0 event. Fortunately, the stock price of the other developers are holding well above their respective long-term support, but this is something to keep an eye on.

The overall effect of diminished dollar liquidity puts pressure on risk appetite, as proxied by the SPX. The last few episodes of falling dollar liquidity saw stock prices decline. I don’t mean to get all Zero Hedge bearish, but falling USD liquidity from increased Treasury borrowing poses a risk to stock prices over the coming weeks and months.

The USD is enjoying bullish tailwinds from Trump’s policies. The Economist pointed out that Trump cannot have rising tariffs, a strong economy, and a weak currency all at the same time.

Mr Trump wants a booming economy, protected by tariffs and boosted by a cheap dollar, and when he doesn’t get them he lashes out. But economic reality makes these three objectives hard to reconcile. Tariffs hurt foreign exporters and dampen growth beyond America’s borders; weaker growth in turn leads to weaker currencies, as business becomes cautious and central banks ease policy in response. The effect is particularly pronounced when America is growing faster than other rich countries, as it has recently. The dollar’s enduring strength is a result, in part, of Mr Trump’s policies, not of a global conspiracy.

The markets need to adjust to that new reality:

Faced with the uncertainty created by a vicious superpower brawl, firms in America and elsewhere are cutting investment, hurting growth further. Lower interest rates are making Europe’s rickety banks even more fragile. China could face a destabilising flood of money trying to leave its borders, as happened in 2015. And further escalation is possible as both sides reach for economic weapons that were considered unthinkable a few years ago. America could intervene to weaken the dollar, undermining its reputation for unfettered capital markets. China or America could impose sanctions on more of each other’s multinational firms, in the same way that America has blacklisted Huawei, or suspend the licences of banks that operate in both countries, causing havoc.

The short and intermediate term outlook

In short, market reaction to news from Hong Kong, Argentina, and the relief from the delay of certain tariffs are mainly known white swan events. We seemed to have passed a peak bad news moment for market sentiment. Technical and sentiment indicators are nearing washout levels that warrant a market bottom this week.

Trump`s decision to delay the implementation of selected tariffs was not a big surprise. Tariff Man had huffed and puffed ahead of the election in 2020, but investors were nearing a point where they were better off in owning the long Treasury bond than the stock market. Dow Man had to swing into action, but we will undoubtedly see backtracking and Tariff Man become more prominent again once the markets have calmed down.

However, longer term sentiment has not been fully washed out. The Fear and Greed Index has not fallen into the sub-20 zone when durable bottoms have been made in the past.

In addition, the problems of USD strength from the budget agreement creates longer term sustainable headwind for stock prices. As well, the threat of a disorderly unwind of Chinese real estate developer debt, and a no-deal Brexit are longer term challenges for risk appetite. This combination of factors suggests that while the stock market is likely to trace out a short-term bottom, it will resolve itself in further range-bound choppiness in the manner of 2011.

Here are the latest readings for the current market. Assuming that the market does start a short-term rally this week, we have yet to see similar patterns of fading risk assessment and improving breadth that marks a durable market bottom.

My inner investor is preparing to sell into the rally and target a slightly underweight in equities. My inner trader has flipped from short to long, and the trading model is now bullish.

Disclosure: Long SPXL

A correction, or a trade war meltdown?

Posted by Cam Hui - August 11, 2019

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities
Trend Model signal: Bearish (downgrade)
Trading model: Bearish

Welcome to the Q3 tantrum

The stock market has enjoyed a terrific run in the first six months of 2019. Welcome to Q3, as the challenges become more evident. The Sino-American trade war is flaring up again and threatens to escalate into a currency war. While the Fed has turned dovish, it is becoming apparent that rate cuts are no panacea to the problem of slowing growth and a loss of business confidence.

For investors, the question of the day is, “Is this an ordinary correction, or the start of a recession and bear market?”

The answer lies in deciding how much the trade war matters to the US economy. My analysis concludes that the latest market tantrum is just a hiccup. In the absence of catastrophic events that cause the permanent loss of capital, like a major war or rebellion, history has shown that stock prices rise. Low double-digit drawdowns is just part of the bargain in taking on equity risk.

The market recently peaked at a forward P/E ratio of 17.1. Our analysis calls for a bottom at a forward P/E ratio of between 14.7 and 16.4, with an average of 15.5. The current forward P/E ratio is 16.7. A correction represents a valuation reset that is likely to be a buying opportunity.

Expect greater volatility in August and September. Undoubtedly there will be threats and escalations. An additional 10% tariff will be imposed on Chinese imports on September 1. Expect it to eventually rise to 25% as Beijing will probably stand firm. Moreover, the fear of a disorderly no-deal Brexit will be an overhang to Europe’s growth outlook and temper risk appetite. This period of uncertainty is likely prove to be a terrific buying opportunity for investors who can stomach some short-term volatility in anticipation of a better 2020 growth outlook.

Trade War + Currency War?

The US-China trade war is flaring up again. Trump broke the truce by announcing an extra 10% tariff of another $300 billion in Chinese imports. China retaliated by suspending all purchases of US agricultural products, and allowed the CNY to depreciate. The yuan was already overvalued, and the depreciation last week through the USDCNY 7 level was reflective of market forces. Arguably, the problem isn’t a weak yuan, but a strong USD.

Treasury Secretary Mnuchin has designated China a currency manipulator, which is a signal that a currency war may be about to begin.

The Omnibus Trade and Competitiveness Act of 1988 requires the Secretary of the Treasury to analyze the exchange rate policies of other countries. Under Section 3004 of the Act, the Secretary must “consider whether countries manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” Secretary Mnuchin, under the auspices of President Trump, has today determined that China is a Currency Manipulator.

By law, the US has to consult with the IMF, though it is not required to take the IMF’s advice:

As a result of this determination, Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.

The IMF is not likely to give the US much satisfaction. Its July 2019 report gave China a clean bill of health. Most analysis show that China stopped manipulating its currency about five years ago, and any recent intervention has been to keep the yuan stronger than warranted. Even then, the sanctions spelled out in Omnibus Trade and Competitiveness Act of 1988 are not exactly onerous. Undoubtedly, the Chinese are deathly afraid of “expedited negotiations”.

If the Secretary considers that such manipulation is occurring with respect to countries that (1) have material global current account surpluses; and (2) have significant bilateral trade surpluses with the United States, the Secretary of the Treasury shall take action to initiate negotiations with such foreign countries on an expedited basis, in the International Monetary Fund or bilaterally.

In the meantime, other central banks responded with surprise rate cuts. India, Thailand, the Philippines, and New Zealand all unexpectedly cut rates. This may be the start of a stampede that begins a round of competitive devaluation, and global currency war.

My view is investors should not over-react to the prospect of a Chinese devaluation and currency war. The weakness in the yuan was attributable partly to USD strength, and China’s response to rising US tariffs. Citi observed that the devaluation has virtually offset all of the effects of the tariffs.

FT Alphaville highlighted the analysis by well-known China watcher Michael Pettis, who pointed out that a devaluation runs counter to China’s long-term desire to rebalance its economy:

There are three problems with devaluing the currency, however.

First, it works for China by spreading the cost of US tariffs on to all of China’s trading partners, and not just to the US, which may only increase global tensions.

Second, it may raise further concern among wealthy Chinese worried about protecting the value of their wealth and so intensify flight capital.

And finally, a devaluation works by transferring income from net importers, who in China are the household sector, to net exporters and those long dollars, ie the tradable goods sector and the central bank. As the PBoC [People’s Bank of China] has pointed out many times before, in order to reduce its reliance on debt for growth, China needs to do the opposite, ie rebalance income in favour of ordinary households.

Pettis believes Trump’s tariffs and trade war with China has not improved the American trade position either. He pointed to a chart by David Dollar, which shows while the US trade deficit with China fell in H1 2019, the decline was offset by rising trade deficits with other trading partners.

This begs the question: What exactly did the trade war and possible looming currency war accomplish, other than to dent business confidence and slow global growth?

The bear case

Here is the bear case scenario for the next 12-18 months. The trade war is back on. We will see continued escalation, and retaliation. The Sino-American trade war becomes a currency war, which drags other trading partners into the conflict. We have already seen considerable loss of business confidence, which is creating a drag on capex and investment. Here is how Powell expressed concerns about business confidence and global weakness during the latest post FOMC press conference:

[Businesses] don’t come in and say we’re not investing because the federal funds rate is too high. I haven’t heard that from a business. What you hear is that demand is weak for their products. You see manufacturing being weak all over the world. Business investment is weak and I wouldn’t lay all of that at the door of trade talks. I think there’s a global business cycle happening with manufacturing and investment and that’s been definitely a bigger factor than certainly we expected late last year. I think global growth started to slow down in the middle of last year, but that has gone on to a greater extent. And by the way, trade policy uncertainty has also been I think more elevated than we anticipated.

The Eurodollar market is now discounting deeper Fed Funds rates cuts, but lower rates is no panacea. During these periods of panic, earnings matter more than interest rates. The latest update from FactSet shows forward EPS estimate revisions have been flat to down.

The global economy is slowing. The industrial metals to gold ratio, which is a filtered indicator of the global cycle, is in decline. This ratio is highly correlated to the stock/bond ratio, which is a risk appetite indicator. In short, when the global cycle turns down, stocks tend to underperform bonds.

The perception of contagion risk is rising. The relative performance of stock markets of China and her major Asian trading partners to MSCI All-Country World Index (ACWI) is weak, which reflects market concerns that slowing Chinese growth could drag the rest of Asia into a recession.

The bull case

Here is the bull case scenario, which rests on the premise that the US is largely insulated from a global slowdown.

Assuming the American economy sidestep a recession in H2 2019, the US economy revives in 2020.
The driver is low commodity prices from the global slowdown, which results in lower input costs, and consumer strength. The American consumer is on fire. Real retail sales per capita is still rising, and historically it has peaked ahead of recessions.

While the trade war will be an overhang, household balance sheets have been repaired since the last recession. If the consumer wants to spend, there is lots of debt capacity.

Unemployment is low, and wage growth is strong.

In this cycle, it was the corporate sector that has piled on debt, but monetary policy is easy. There are few signs of a credit squeeze that tanks economic growth. Corporate balance sheets are unlikely to break.

What are you so worried about?

How much does the trade war matter?

How can we choose between the bull and bear case scenarios? The answer lies in deciding how much the trade war matters to the US economy.

Jerome Powell stated that he didn’t have a good estimate for the effects of a trade war in the last post FOMC press conference:

You know, the mechanical effects of the tariffs are quite small. They’re not large as it relates to the U.S. economy. The real question is what are the effects on the economy through the confidence channel, business confidence channel. And again, very, very hard to tease that out. I’ve seen some research, which, you know, which says that they are meaningful, meaningful effects on output as to say not trivial. And I think that that sounds right, but it’s quite hard to get—there is no way to get an accurate measure…

A recent Bloomberg study came to a more optimistic conclusion.

We’re more exposed to the global products, services, ideas and people than ever — just in different ways:

How much stuff we ship around the world is not the best measure of globalization. The trade in goods may be slowing, but that’s an incomplete picture that doesn’t capture the digital realm.

Traditional trade measures also don’t reflect the real supply chain. A more accurate measure of trade and economic relationships involves not where a product is made but where its value is added.

In other words, measure value-added, not just the value of the trade. The ubiquity of global supply chains creates double counting problems when analysts use the traditional metrics of trade flows.

Traditional trade measures also don’t reflect the real supply chain. A more accurate measure of trade and economic relationships involves not where a product is made but where its value is added.

Companies are more multinational than ever. China hawks in Washington, for instance would welcome “decoupling” of the U.S. and Chinese economies. But with such large markets abroad, few in business see that as a realistic prospect.

Trump’s tariffs are the exception, not the rule. As he erects trade barriers, most of the U.S.’s main trading partners are continuing to lower import duties and sign deals.

Innovation is increasingly global. At the center of U.S. complaints about China is intellectual property and what the U.S. argues is a long and systematic pattern of IP theft encouraged by the Chinese state. But increasingly experts say the incentives are changing for China.

In other words, Trump’s tariffs will not kill globalization. Sooner or later, the market will come to that realization.

Peterson Institute 2016 trade war study

For a second opinion, I dusted off a Peterson Institute study written in September 2016. The study projected the possible effects of a trade war. It modeled three trade war scenarios based on the assumption that a war would begin as soon as Trump took office in early 2017:

In the full trade war scenario, the United States imposes a 45-percent tariff on nonoil imports from China and a 35-percent tariff on nonoil imports from Mexico. China and Mexico respond symmetrically, imposing the same tariffs on U.S. exports.
In the asymmetric trade war scenario, China and Mexico do not retaliate symmetrically with an across-the-board tariff. China retaliates on specific U.S. goods and services. With the dissolution of NAFTA, Mexican tariffs on all U.S. goods would snap back to their MFN levels, which currently average about 8 percent. The modeling in this scenario is not contingent on the Moody’s macro model or the imposition by the United States of across-the-board tariffs of a specific level on China and Mexico.
In the aborted trade war scenario, U.S. tariffs are imposed for only a single year, because China and Mexico concede to U.S. demands, the U.S. Congress overturns the action, or President Trump loses in the courts, or the public outcry is such that the administration is forced to stand down.

The effects on economic growth are shown in the following chart. In a full trade war, GDP growth would flatten out for two years and the economy would enter a mild recession. The aborted trade war, on the other hand, would see growth slow, but the economy would be able to avoid recession.

The following table summarizes the model results. In particular, we focus on GDP growth, and the difficult to model effects on business investment. In the worst case (full-blown trade war) scenario, investment spending skids badly and bottoms out at -9.5%, and the economy undergoes a mild recession. In the more optimistic (aborted trade war) scenario, business investment falls -3.5% for two years, but the economy avoids recession.

Here is the report card on the Peterson forecasts. The latest durable goods report shows that new orders fell -1.9% year/year in June, and that was an improvement from a -3.8% rate in May. Since Trump has not seen fit to impose a 45% tariff on Chinese imports, and there are no new tariffs on Mexico, the trade war of 2019 lies somewhere between the full blown war and the aborted war scenarios modeled by the Petersen Institute. The behavior of durable goods orders bears out that assessment.

Based on the results of these two studies, I conclude that the trend of decline in business investment is not weak enough to push the US economy into recession, especially in light of a robust consumer and a Federal Reserve that stands ready to act.

Just a hiccup

Viewed in this context, the latest market tantrum is just a hiccup. In the absence of catastrophic events that cause the permanent loss of capital, like a major war or rebellion, history has shown that stock prices rise. Low double-digit drawdowns is just part of the bargain in taking on equity risk.

When I put the bull case scenario with the Petersen Institute study and Bloomberg’s analysis of global trade patterns, my base case calls for a H2 growth slowdown, with a rebound in 2020 into the 1-2% region. The growth scare would shake out the stock market, and provide a base for revival later this year.

Last week, I made a number of downside projections based on the market’s behavior during recent corrective episodes (see Powell’s dilemma, and why it matters). The market fell into the target range and staged a relief rally. My tactical assessment is there is more unfinished business on the downside, but if history is any guide, this should be just a run-of-the-mill correction.

The market recently peaked at a forward P/E ratio of 17.1. My analysis calls for a bottom at a forward P/E ratio of between 14.7 and 16.4, with an average of 15.5. The current forward P/E ratio is 16.4. A correction is likely to be a valuation reset that is likely to be a buying opportunity.

The week ahead

Looking to the week ahead, I stand by the view outlined last week that the market is undergoing a corrective episode, which has more unfinished business to the downside. The SPX broke down through an uptrend line indicating considerable technical damage. It staged a relief rally back up to test and stall right at trend line resistance. It would be unusual to see a V-shaped rebound and the bull phase to resume as if nothing had ever happened. At a minimum, this kind of market structure calls for a period of choppiness and sideways consolidation.

Sentiment has not fully washed-out. Typically sentiment will fall to capitulation levels before a durable bottom is made. One example is the Fear and Greed Index falling to under 20.

To be sure, the latest AAII sentiment survey shows the bull-bear spread falling to wash-out levels. However, the survey suffers from a small sample size, and the same participants are not the same in each week`s survey. AAII had the following comment about the latest unusual results where bearishness spiked precipitously.

The survey period runs from Thursday through Wednesday. Reminders to take the survey are sent out every Monday.

Many individual investors have been monitoring trade negotiations, particularly between the U.S. and China. Last Thursday’s threat by President Donald Trump to impose new tariffs and the subsequent drop in stock prices likely had a significant impact on this week’s readings. Additionally, a separate survey we recently conducted among AAII members found that 48% expect a recession to start within the next 12 to 24 months.

Also having an influence on sentiment are Washington politics, geopolitics, valuations, corporate earnings, monetary policy and interest rates.

Other sentiment surveys, such as Investors Intelligence, saw bullishness fall, but did not see a similar surge in bearishness.

More evidence of unfinished business to the downside came from momentum indicators. Subscribers received email alerts of a short-term buy signal last week, and subsequent sell signal Thursday based on % of stocks above the 5 dma recyling from an oversold to overbought condition.

Even as the short-term % above 5 dma surged to an overbought condition, the slightly longer % above 10 dma indicator is exhibiting a series lower lows and lower highs, indicating breadth deterioration.

Net 20 day new highs-lows, which is an indicator with a longer time horizon, is also displaying a similar pattern of lower lows and lower highs.

What can turn me bullish? I would like to see a gradual recovery in new highs before becoming more constructive on stocks. While new highs have risen marginally to break the recent downtrend, I would like to see a more prolonged bottoming pattern before sounding the all-clear signal.

As well, the Zweig Breadth Thrust Indicator flashed an oversold condition last Monday, which is a setup for a possible breadth thrust. The market has 10 days after the oversold condition to rise to an overbought reading, which would be a signal of a bullish breadth thrust. Last Tuesdy was day 1. While a ZBT buy signal is always possible and I am keeping an open mind on this matter, I am not holding my breadth.

My inner investor has adopted a more defensive view on stocks. He is aiming to lighten up his equity position from a neutral weight to a slight underweight on rallies.

My inner trader scalped a minor gain last week when he caught the brief rally. He took profits last Friday, and he is back to a short position in the market.

Disclosure: Long SPXU

Ripe for a counter-trend rally

Posted by Cam Hui - August 7, 2019

Mid-week market update: My trading model has turned bullish, and there are plenty of signs that the market is ripe for a relief rally. There was the CNBC Markets in Turmoil program Monday, which as SentimenTrader pointed out, tends to mark short-term bottoms.

As well, the McClellan Oscillator (NYMO) fell to levels on Monday that are consistent with past tradable bottoms.

The Zweig Breadth Thrust indicator also provided signs of a short-term bottom. The ZBT buy signal consists of two components. First the market has to become oversold, and then it has to rally into an overbought condition into a short period of time. In the past, an oversold condition (vertical lines) have been a reasonably good signals that a rally is imminent. The market achieved the oversold signal on Monday.

A study of recent ZBT oversold signals shows that the length of the subsequent rallies have lasted between one day to two weeks, with one week being the best estimate. Subscribers received an alert today indicating that my trading account had bought the market. I expect this rally to last about a week, and I will exit the long position early next week.

If you did jump on the long trade, another way of timing the exit is to monitor the % above 5 dma indicator. Wait for it to recover back into an overbought condition, just as it did during past episodes where the market fell to an initial low and then recovered as part of a longer term correction.

Unfinished downside potential

My base case scenario calls for a rally, and then more weakness ahead. John Murphy at Stockcharts (paywall) pointed out that the market lacks sector breadth participation:

SECTOR BREADTH ISN’T BROAD ENOUGH…One of the ways to measure the strength of the stock market’s uptrend is to see how many of its eleven sectors have hit new highs with the major stock indexes. In a strong uptrend, most market sectors should be confirming the market’s move to a record high. Unfortunately, that’s not the case this year. In fact, six of the eleven sectors have fallen short of record highs. And most of ones that have hit highs are defensive in nature. That’s not a good sign either.

Five market sectors have hit record highs this year. Three of them are bond proxies like REITs, utilities, and consumer staples. All three are also defensive in nature and usually lead major market advances in the late stages of a bull market. The two others to hit new highs are consumer discretionary, which is more economically-sensitive, and technology. Tech traditionally does better when investors are looking for growth that isn’t available elsewhere. That’s not exactly a vote of confidence.

The stochastics on the weekly SPX chart has barely begun to flash a sell signal. At a minimum, I would like this indicator to retreat to at least 50, or neutral territory.

Credit market risk appetite is not confirming the rebound. The relative performance of high yield (junk) bonds to duration-adjusted Treasuries continues to lag.

Sentiment has begun from an excessive bullish level, but readings have not capitulated to excessively bearish levels yet.

After Monday’s close, I conducted an (unscientific) Twitter poll of short and longer term sentiment. The one-week outlook was tilted slightly bearish.

The longer term three-month outlook is far too sanguine. While I recognize the limitations of Twitter polls, these results, combined with the II sentiment survey, leads me to believe that the market is in need of a further decline before sentiment can properly reset.

Tactically, I am looking to scalp some short-term profits into next week. The initial upside objective is to fill the gap between 2900 and 2925, which happens to be two Fibonacci retracement levels. Additional resistance can be found at 2950, which coincides with another Fibonacci retracement objective, and the site of the past breakout and resistance.

My inner investor remains neutrally positioned. My inner trader just went long the market today for a scalp, and the trade should last for about a week.

Disclosure: Long SPXL

USDCNY at 7? It’s not you, it’s me

Posted by Cam Hui - August 5, 2019

The market has adopted a risk-off tone today because the Chinese yuan rose above the rate of 7 to 1 to the USD. The move was positioned as retaliation for Trump`s new tariffs. In addition, China has halted all purchase of American agricultural goods.

What did you expect? The controlled depreciation of CNY is not unexpected. The chart below of the Chinese yuan ETF shows that it had been unusually strong compared to the trade weighted dollar. Viewed in this context, the PBOC devaluation in 2015 was fully justified. Today’s fall is reflective a decision by the PBOC to stop leaning against the market winds.

To put it differently, the broader problem isn’t CNY weakness, but USD strength.

To be sure, there is some validity to the trade retaliation thesis for CNY weakness. John Authers at Bloomberg published this analysis on May 20, 2019 from Deutsch Bank. The latest tariff regime argues for an offsetting USDCNY rate of 7.41.

Seeing USDCNY blow through 7, however, is attributable mainly to USD strength, not trade tensions.

Addressing USD strength

As I pointed out recently (see Is this how currency wars begin?), the USD Index has staged an upside breakout out of an inverse head and shoulders formation. Since I penned those words, the USD has rallied further and it is nearing its short-term upside target, and EURUSD is nearing its downside target.

In addition, the weekly chart of the USD shows an upside breakout out of a longer term cup and handle pattern, with considerable upside potential.

The weekly point and figure price chart is projecting a measured move to 112.86.

This development, along with the Fed’s failure to cut rates by a half-point instead of a quarter-point, is undoubtedly a source of consternation for President Trump. It is well-known that Trump would like to see a weak greenback, which makes US exports more competitive. But what is the price of a weak dollar, and what would it cost him to achieve such an outcome?

Dollar strength = Rising stress

The strength of the USD is creating stress in the global financial markets. EM currencies have been falling, and that will put pressure on weak EM currencies with large current account deficits and foreign currency funding, such as Turkey and South Africa.

Bloomberg reported that a dollar funding squeeze is spreading around global markets.

Trump’s options are limited

Why I fully understand why Trump wants a weaker USD, his options to force the dollar down are limited.

The most direct method is foreign exchange intervention, but in the absence of agreement from major foreign central bankers, the US Treasury’s firepower is highly limited, and any attempt at intervention will not be seen as credible by the FX markets.

Trump could lean on Jerome Powell and the Federal Reserve to ease further, and in a more forceful manner. Falling rates would narrow the interest rate differential between dollar assets against the EUR and other currencies. Everything else being equal, it would put downward pressure on the USD.

That course of action is limited by his direct ability to control FOMC decisions. Boston Fed president Eric Rosengren was one of the two dissenting votes on the decision to ease by a quarter-point. Rosengren took the unusual step of publishing a series of charts to justify his decision.

The unemployment rate is near 50-year lows
The trimmed mean PCE inflation rate is near 2%, which is the Fed’s target
The US economy is growing somewhat faster than potential
The cost of credit is not elevated
Market volatility is not elevated
Credit spreads are not elevated
Stock prices are near all-time highs

In other words, there are plenty of reasons to oppose a rate cut, and the two dissenting votes were signs that Powell was having difficulty on achieving a consensus to lower rates. In that case, it will be even more difficult for Trump to manhandle the Fed.

What’s the cost?

While Trump’s reasoning for a weaker currency are purely tactical, Bloomberg pointed out that there has been no discussion of the strategic issues of the reversal of the US Treasury’s long-standing strong dollar policy.

The strong-dollar dogma was introduced by then-Treasury Secretary Robert Rubin in 1995 as a way to bolster foreign demand for U.S. Treasuries, and it helped cement the dollar’s long-standing status as the world’s reserve currency of choice. The pledge to not devalue the greenback encourages international investors and U.S. trading partners to park their cash in U.S. assets.

A weaker dollar would offer some benefits. U.S. manufacturers would get a leg up in selling their products abroad—their wares would become cheaper for foreign customers. At the same time, American companies and people buying imports would see prices rise. Abandoning the policy would also have implications for global markets and, in the long run, for U.S. government finances. Foreigners’ faith in the dollar makes them more willing to hold U.S. debt, bringing down the interest rates the Treasury Department must pay.

Should Trump decide to abandon the strong dollar policy, he will undoubtedly reap some short-term benefits as the currency weakens, but the US Treasury will soon be running trillion dollar deficits in the near future. Who will fund all that debt? How much will bond yields have to rise to compensate for the weaker USD?

Trump’s nuclear option for weakening the USD would be to try to either sideline or fire Jerome Powell. The USD would crater, but so would stock prices.

There is a price to be paid for everything.

Powell’s dilemma (and why it matters)

Posted by Cam Hui - August 4, 2019

The latest signals of each model are as follows:

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

What Powell couldn’t say

The message from Jerome Powell’s post-FOMC press conference was confusing. The overall economic outlook was positive, but the Fed was nevertheless cutting the Fed Funds target rate by a quarter-point. It was advertised as an “insurance” cut. Powell went on to spook the markets by stating that it was not the start of an easing cycle, but walked that partially back by holding out the possibility of more cuts.

What is going on?

Josh Barro, writing in the New York Times, read between the lines and outlined what Powell couldn’t say. The Fed was reluctant to cut rates, but it believed that monetary policy was forced to offset the negative effects of the trade war.

One of the key factors the Fed must respond to is the specific economic mess Trump creates when he upsets the global trade regime, and the size of that mess requires a qualitative assessment. Powell can’t say “We’ll cut rates in September if Trump threatens Xi Jinping seven times on Twitter, but not if he only does it five times”; he’s going to have to make a judgment call about where we stand with trade (and about how businesses and investors are responding based on their own assessments about where we stand with trade) when the time comes.

“I would love to be more precise, but with trade, it is a factor that we have to assess in a new way,” Powell said, diplomatically. “It is not something that we have faced before and we are learning by doing,” he said at another point.

Powell also made it clear that the Fed is staying neutral and not taking sides in the trade war:

“We play no role in assessing or evaluating trade policies other than as trade policy uncertainty has an effect on the U.S. economy in the short and medium term,” he said. “We are not in any way criticizing trade policy; that is really not our job.”

The two dissenting votes against the rate cut was evidence of the reluctance of Fed policy makers to ease interest rates. In addition, former New York Fed president Bill Dudley, who was able to speak more freely, wrote in Bloomberg Opinion that he believed that only one cut was necessary.

After analyzing all the risks and calculating possible downside risk, I conclude that the stock market is poised for a correction and a valuation reset. Based on recent and past history of corrective episodes, I project a S&P 500 downside target of 2598 to 2891, with an average of 2738, or a -9.3% drawdown. From a valuation perspective, this translates into a forward P/E ratio of between 14.7 and 16.4, with an average of 15.5.

Assuming the economy manages to sidestep a recession, these projections appear to be reasonable, as valuations would bottom out at between slightly below its 10-year average or at its 5-year average. It would represent a valuation reset that presents itself as a buying opportunity.

Like the Federal Reserve, I am data dependent, and all bets are off if an actual recession were to develop.

Rising risks

Here is the Fed’s dilemma. The American economy is sputtering, but still growing. On the other hand, trade tensions are threatening to derail the global economy. Even before US negotiators went to Shanghai for another round of trade talks last week, Trump tweeted out that he does not expect a deal to be signed until after the 2020 election [emphasis added]..

China is doing very badly, worst year in 27 – was supposed to start buying our agricultural product now – no signs that they are doing so. That is the problem with China, they just don’t come through. Our Economy has become MUCH larger than the Chinese Economy is last 3 years….
..My team is negotiating with them now, but they always change the deal in the end to their benefit. They should probably wait out our Election to see if we get one of the Democrat stiffs like Sleepy Joe. Then they could make a GREAT deal, like in past 30 years, and continue
…to ripoff the USA, even bigger and better than ever before. The problem with them waiting, however, is that if & when I win, the deal that they get will be much tougher than what we are negotiating now…or no deal at all. We have all the cards, our past leaders never got it!

In the wake of Powell’s forward guidance, the market’s expectations of a third rate cut evaporated. . According to the CME’s Fedwatch Tool, it began to discount one more cut at the September meeting, and the odds of the third rate cut was pushed out to 2020. Needless to say, this was contrary to Trump’s desire for deeper and more monetary easing.

Right on cue the next day, Trump the Tariff Man doubled down on his trade war belligerence by announcing on Twitter a 10% tariff on an additional $300 billion of Chinese imports on September 1 [emphasis added].

Our representatives have just returned from China where they had constructive talks having to do with a future Trade Deal. We thought we had a deal with China three months ago, but sadly, China decided to re-negotiate the deal prior to signing. More recently, China agreed to…
…buy agricultural product from the U.S. in large quantities, but did not do so. Additionally, my friend President Xi said that he would stop the sale of Fentanyl to the United States – this never happened, and many Americans continue to die! Trade talks are continuing, and…
…during the talks the U.S. will start, on September 1st, putting a small additional Tariff of 10% on the remaining 300 Billion Dollars of goods and products coming from China into our Country. This does not include the 250 Billion Dollars already Tariffed at 25%…
…We look forward to continuing our positive dialogue with China on a comprehensive Trade Deal, and feel that the future between our two countries will be a very bright one!

The stock market had been rallying on Thursday in the aftermath of the FOMC meeting, but Trump’s tweet instantly torpedoed stock prices, and the odds of three rate cuts in 2019 was back on the table. So much for “one and done”.

In addition to the US-China trade war, the trade spat between South Korea and Japan has the potential to disrupt the global supply of semiconductors. For readers unfamiliar with the dispute, a South Korean court ruled last year that Japanese firms had to compensate Korean workers forced to work in Japanese factories during Japan’s occupation of Korea in 1910-1945. Japan disputes the compensation claim, and argues that a post-war settlement had already been reached. Tensions rose, and Japan restricted the exports of key high tech materials for semiconductors to South Korea. Talks to calm matters broke down, and Japan removed South Korea from a list of countries with minimal trade restrictions. The removal of South Korea from the list creates a non-tariff barrier. and implies that any Japanese exports will have to be screened to ensure that they are not used for weapons or military applications.

When Trump tweeted that an agreement was out of reach until the election, escalation was inevitable. There is a growing consensus in Washington that China is becoming a problem. Moreover, the Democratic contenders for the presidential nomination are increasingly showing their protectionist stripes. The Democrats televised two series of debates between a large group of candidates last week. While some of the more centrists in the first night were supportive of open trade, Bloomberg reported that Bernie Sanders and Elizabeth Warren, who are considered on the left wing of the Party, campaigned on a theme of inequality and anti-globalization:

“For decades we have had a trade policy that has been written by giant multinational corporations to help giant multinational corporations,” Senator Elizabeth Warren said. “If they can save a nickel by moving a job to Mexico, they’ll do it in a heartbeat.”

“If anybody here thinks that corporate America gives one damn about the average American worker, you’re mistaken,” said Senator Bernie Sanders. “If they can save five cents by going to China, Mexico, or Vietnam or anyplace else, that’s exactly what they would do.”

More specifically, Warren has unveiled a policy platform based on economic nationalism. In the second night of debates, every single candidate, including front runner Joe Biden, cheered the death of USMCA, despite House Speaker Nancy Pelosi’s declared desire to approve the treaty. In addition, Biden stated that he would oppose TPP in its present form.

Protectionism is on the rise in Washington. Regardless of what happens in negotiations, Trump will be under increasing pressure from the Democrats to be tough on China and other trading partners in 2020.

Fading business confidence

The rationale behind the Fed’s “insurance cut” is the effect of the trade war on business confidence. New Deal democrat recently wrote that while the household sector remained strong, the producer side of the economy, or the corporate sector, is suffering from fading business confidence which is showing up in durable goods orders.

The risk is tanking business confidence could drag the economy into recession, though he did have a caveat to his analysis:

Note that in the last producer-led recession, in 2001, durable goods orders had declined over 10% prior to its onset. At the moment, the quarterly average decline is a little under half of that.

The softness in durable goods orders is confirmed by weakness in the small business survey of capital expenditure plans. Small business data is particularly useful at turning points, because they have little bargaining power and they are highly sensitive barometers of the economy.

The Chemical Activities Barometer has shown itself to be a leading indicator for industrial production, is weakening, indicating further softness in the months ahead.

China’s surprising response

Across the Pacific, Beijing’s response to the weakness in its economy has been surprising. China Daily published an announcement that China would not respond with further monetary easing, but rely on fiscal stimulus in H2 2019:

China will not change its real estate policies to provide short-term stimulus to the economy, but instead will make fiscal policy more effective and “keep liquidity reasonably ample” in the second half of this year, participants in a top leadership meeting said on Tuesday.

“The long-term management mechanism of the real estate sector should be implemented and the industry will not be used as means to stimulate the economy in the short term,” Xinhua News Agency reported on the meeting of the Political Bureau of the Communist Party of China Central Committee. Xi Jinping, general secretary of the CPC Central Committee, presided over the meeting.

“Proactive fiscal policy and prudent monetary policy should be well implemented,” the report said. “Fiscal policy should be strengthened and made more effective, and the tax and fee reduction policy should be implemented more thoroughly.”

Participants agreed that “monetary policy should be neither too tight nor too loose, and liquidity should be kept reasonably ample”, the report said.

This is a surprising development on a number of levels. In the past, the authorities have resorted to monetary pumping to economic weakness, which has buoyed the highly leveraged property sector. The October 1 anniversary of the founding of the PRC is fast approaching, and no one wants to see the economy falter ahead of the celebration. Either Beijing believes the economy is recovering, or it is taking a serious risk with its economy.

To be sure, there are signs that growth deceleration is moderating. Both official and Ciaxon manufacturing PMI came in ahead of expectations, but readings were below 50, which indicate contraction. Services PMI were in expansion territory, but they were slightly below expectations. The main takeaway is stabilization.

Signs of stabilization could also be seen in China’s Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations.

The lack of monetary pump priming can be seen in the real-time relative performance of Chinese real estate stocks.

The PBOC is taking a big risk by foregoing monetary stimulus to support the property sector. Not only are real estate developers high leveraged, and therefore vulnerable to default risk, the real estate sector is large, and Chinese households have ploughed their savings into real estate. The Financial Times reported that the number of Chinese households owning two or more properties has risen to 40% from less than 30% in three years. While Beijing has a stated policy of rebalancing the growth driven of the economy from infrastructure to the consumer sector, the health of the property market is a key indicator of household wealth.

If the highly leveraged property development sector were to wobble, the entire house of cards could come tubmling down. I am monitoring the share price of selected Chinese developers listed in Hong Kong. So far, so good. All of them are holding above key long-term support levels, but this will be something to keep an eye on.

China Evergrande (3333.HK)

China Vanke (2202.HK)

Greentown China Holdings (3900.HK)

Country Garden Holdings (2007.HK)

Estimating downside risk

In light of these risks, my base case scenario the US equity market calls for no recession, but a correction and valuation reset. Based on recent experience, I try to estimate the downside risk.

In many ways, the current setup is reminiscent of 2015, when the market advance began to stall in the first few months and flashed a series of negative divergences (see Why I am bearish and what would change my mind). The index went on to weaken in a shallow manner, bounced, and finally corrected by -14%.

More recent episodes saw pullbacks of -7.6%, -11.5%, and -20.2%. If we were to throw out the -20% loss and because it represents a major bearish episode, which is unlikely, we project a range of 2598 to 2891, with an average of 2738, or a -9.3% drawdown.

We can also see the scale of a projected pullback from a valuation perspective, if we were to assume that forward 12-month EPS were to remain unchanged, which is a reasonable starting point as estimates have been falling in the last few weeks. The market recently peaked at a forward P/E ratio of 17.1. The aforementioned technical projects would see the market bottom at a forward P/E ratio of between 14.7 and 16.4, with an average of 15.5.

Assuming the economy manages to sidestep a recession, these projections appear to be reasonable, as valuations would be bottom out at between slightly below its 10-year average, or at its 5-year average. It would represent a valuation reset that presents itself as a buying opportunity.

This exercise at estimating downside risk involves many moving parts, whose futures are not known. Will the trade war escalate further in 2019? How many more times will the Fed cut rates for the remainder of this year, and will it matter? If the Fed is easing into a slowing economy and falling earnings estimates, investors are likely to focus more on the deteriorating outlook more than interest rates, at least in the short run. We can see that forward EPS are flat in the last few weeks, which is creating a headwind for stock prices.

Like the Federal Reserve, I am data dependent, and all bets are off if an actual recession were to develop.

The week ahead

Looking to the week ahead, it is obvious that the market had sustained considerable technical damage. While I had estimated the intermediate downside risk, it is less clear what the short-term outlook is.

For some context, I had a question from a reader in response to a previous post, A (deceptive) long-term buy signal:

I’d like a little bit of clarification…. you wrote the two opposite things in the latest post.

“Should stock prices weaken, the risk of a deeper pullback is high. The equity position of trend following CTAs and risk parity funds are at a crowded long reading.”

“My inner trader is short. Any pullback is likely to be relatively shallow. Initial SPX support can be found at about 2950, with additional support at about 2910.”

I am afraid that I did not answer him in a clearer manner. The apparent contradiction is a difference in time horizons. My base case scenario calls for a deeper intermediate term correction. The first comment referred to a longer term outlook, but for a trader with a 3-5 day time horizon, the market is likely setting up for a short-term bounce as it is at or near my initial downside targets.

We can see the typical behavior of the market after the VIX Index spikes after a period of relative calm. The VIX spends several days above its upper Bollinger Band (BB), and the market becomes highly oversold on 5-day RSI (marked by shaded areas). This is followed by a short relief rally where the VIX falls below its upper BB, and a subsequent decline to further lows. The index is currently nearing a test of its 50 dma, and sits just above a Fibonacci retracement level at about 2910. Expect some minor weakness to start the week, followed by a bounce.

This is likely the start of a multi-week corrective episode. I had been tactically cautious in these pages for the last few weeks, and I had warned about numerous cases of excessive bullishness and negative technical divergences. Most recently, Mark Hulbert observed that his Hulbert Newsletter Stock Sentiment Index was in overly exuberant territory, and the market was ripe for a pullback. Under such circumstances, stock prices are unlikely to turn up again without a sentiment reset.

Callum Thomas also pointed out that the AUM of leveraged long equity ETFs are at an extreme level compared to leveraged short ETFs. The combination of extreme sentiment and sudden stock market air pocket argues for a sentiment recycle.

Similarly, I am waiting for the Fear and Greed Index to fall under 20, where the market had bottomed out in the past.

In the short run, momentum has become excessively oversold that a relief rally can happen at any time.

The equity-only put/call ratio spike Friday to levels last seen at the February and December 2018 bottoms. While daily put/call ratios are not precise timing tools, it is a sign that panic was in the air.

In short, last week`s downdraft has caused sufficient technical damage that it is difficult to see how the bulls can quickly regain control of the tape. That said, the market structure is setting up for a bounce, followed by further declines, which is likely going to see further lows of unknown magnitude, and in an unknown time frame.

My inner investor remains neutrally positioned. The current episode of weakness is probably just a blip and represents a typical market pullback. If investors cannot stomach this kind of minor volatility, then they should not be taking equity risk in their portfolios.

My inner trader is short. Should stock prices weaken further early next week, he is prepared to take partial profits in his short positions. On the other hand, if the market were to stage a relief rally, he stands ready to add to his bearish positions.

Disclosure: Long SPXU

A (deceptive) long-term buy signal

Posted by Cam Hui - July 31, 2019

Mid-week market update: It is month-end, and the day after an FOMC meeting. Regular readers may recall that I have been monitoring the monthly MACD indicator for a long-term buy signal. Troy Bombardia recently highlighted what happens when the SPX flashes a long-term buy signal. Subsequent one-year returns have been almost all positive.

The verdict is in, the index has flashed a long-term MACD buy signal.

While the signal is constructive for the long-term outlook, let me temper your enthusiasm.

Looking for confirmation

The SPX buy signal has not been confirmed by other indices. I found that the monthly MACD buy signal works slightly better when applied to the broader Wiltshire 5000 (WLSH). WLSH did not confirm the buy signal.

As well, the buy signal was not confirmed by the even broader global index.

The Fed disappoints

I was correct when I suggested earlier in the week that the Fed might enact a hawkish cut (see A hawkish cut ahead?). Powell corrected market expectations by stating that the quarter-point cut was a mid-cycle policy adjustment, and not the start of a rate cut cycle. He did, however, hold out the possibility of further cuts, which will be dependent on incoming data.

The appearance of two dissenters to the easing decision, by KC Fed president Esther George and Boston Fed president Eric Rosengren, were signs that the FOMC is highly divided. The bar to further cuts will be high, and new data will have to deteriorate significantly for the Fed to cut further.

Short-term outlook

In response to the FOMC decision, the 2s10s yield curve flattened dramatically, indicating expectations of slower growth. Stock prices also adopted a risk-off tone. The SPX breached a short-term uptrend, indicating the bulls had lost control of the tape, and briefly tested secondary support at about 2950. In addition, the VIX Index rose above the top of its Bollinger Band (BB), which is an indication of an oversold condition. Past BB breaches have been resolve with a quick recovery, and more prolonged VIX spikes that were associated with deeper pullbacks, and it is unclear how the latest episode will turn out.

Troy Bombardia also studied what happens after the Fed cuts rates when the market is near an all-time high. It did not perform well over the next month, but longer term returns have been positive.

I remain short-term cautious. II sentiment is overly bullish.

NASDAQ stocks have been the leadership in this latest rally, and NDX DSI is also somewhat stretched.

Should stock prices weaken, the risk of a deeper pullback is high. The equity position of trend following CTAs and risk parity funds are at a crowded long reading. Any sustained retreat could see a stampede for the exits as these systematic strategies unwind their long positions.

In addition, the months of August and September have been seasonally weak for equities.

My inner investor continues to be constructive on equities. He is neutrally positioned, and he is waiting for confirmation of the monthly MACD buy signal from broader indices like WLSH.

My inner trader is short. Any pullback is likely to be relatively shallow. Initial SPX support can be found at about 2950, with additional support at about 2910.

Disclosure: Long SPXU