How far can Tariff Man dent the stock market?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Tariff Man returns

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

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

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

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

Assessing the damage

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

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

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

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

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

The Powell Put

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

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

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

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

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

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

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

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

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

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

Fiscal policy to the rescue

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

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

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

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

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

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

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

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

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

Investment implication

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long S&P 500L

Assessing the technical damage

Posted by Cam Hui -

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

 

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

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

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

Market internals

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

 

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

 

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

 

An bottoming process

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

 

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

 

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

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

Disclosure: Long SPXL

 

The Achilles Heel of my bull case

Posted by Cam Hui -

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

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

 

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

 

Wobbly China?

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

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

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

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

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

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

 

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

 

Is a global cyclical recovery possible if China is slowing?
 

Resilient China

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

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

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

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

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

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

 

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

 

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

 

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

 

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

Turning tactically bullish

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

 

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

 

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

Disclosure: Long SPXL

 

Buy signal confirmed: It’s a global bull

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Long-term buy signal confirmed

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

 

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

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

Buy beta! Risk on!
 

Globally bullish

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

 

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

 

Risk on!
 

Sector review: What to buy?

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

 

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

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The cyclical rebound explained

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

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

 

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

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

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

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

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

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

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

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

Buy beta! Risk on!
 

The week ahead: Good or Bad Santa?

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

 

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

 

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

 

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

 

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

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

 

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

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

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

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

 

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

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

 

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

 

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

 

Disclosure: Long SPXU

 

Short-term risks are rising

Posted by Cam Hui -

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

 

Historical study

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

 

Sentiment stretched

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

 

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

SentimenTrader tweeted a similar sentiment warning today.
 

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

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

Disclosure: Long SPXU

 

Is a trade deal imminent?

Posted by Cam Hui -

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

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

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

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

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

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

 

Dissecting the rhetoric

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

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

 

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

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

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

 

Cyclical global recovery: Easy come, easy go?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Cyclical recovery losing steam?

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

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

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

 

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

 

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

 

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

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

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

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

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

Global outlook: So far, so good

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

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

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

 

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

 

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

 

US: Recovery and stabilization

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

 

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

 

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

 

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

 

Europe: The global bright spot

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

 

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

 

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

 

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

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

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

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

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

 

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

 

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

China and Asia: Sputtering a little

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

 

profit estimates were far weaker, indicating economic weakness.
 

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

Still bullish

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

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

 

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

 

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

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

The week ahead

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

 

What now?

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

A pause in the melt-up?

Posted by Cam Hui -

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

 

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

 

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

 

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

Plenty of warnings

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

 

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

 

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

 

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

 

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

 

The bull case

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

 

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

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

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

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

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

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

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

 

Could this FOMO surge be a mirage?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

New market highs

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

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

 

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

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

Here comes the FOMO surge

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

 

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

 

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

 

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

 

Bullish fundamental support

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

 

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

 

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

 

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

 

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

 

What’s the bear case?

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

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

 

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

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

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

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

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

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

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

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

 

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

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

 

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

 

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

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

 

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

 

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

 

Trust, but verify

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

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

 

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

The week ahead

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

 

The bad news is there are technical warnings everywhere.
 

Hindenburg Omen, Titanic Syndrome

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

Disclosure: Long SPXL

 

A correction in price, or time?

Posted by Cam Hui -

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

 

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

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

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

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

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

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

Watching for a top

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

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

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

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

 

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

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

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

 

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

A correction in time

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

 

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

 

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

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

Disclosure: Long SPXL

 

The biggest risk to the cyclical recovery

Posted by Cam Hui -

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

 

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

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

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

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

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

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

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

 

Will there be a Phase One deal?

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

Here is how Bloomberg’s outlined the risks:

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

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

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

 

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

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

 

How far can stock prices rise?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

The art of upside target projection

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

 

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

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

Ambitious targets

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

 

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

 

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

 

Valuation headwinds

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

 

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

 

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

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

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

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

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

A Third Way market scenario

How can we square the circle of these contradictory views?

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

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

 

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

 

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

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

 

The cycle turns up

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

 

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

 

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

 

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

 

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

 

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

 

The Rule of 20

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

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

 

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

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Reuters summed up the negotiation this way:

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

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

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

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

 

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

 

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

Disclosure: Long SPXL

 

Market nearing the stall zone

Posted by Cam Hui -

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

 

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

 

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

Minor stall ahead?

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

 

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

 

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

 

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

 

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

Is the Phase One deal unraveling?

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

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

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

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

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

 

Expect choppiness or mild pullback

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

 

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

Disclosure: Long SPXL

 

Buy the breakout, recession risk limited

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Buy the breakout!

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

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

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

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

Here comes the global breakout

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

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

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

Thomas added:

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

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

What about recession risk?

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

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

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

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

Consumer spending is on fire

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

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

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

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

A dovish Fed

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

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

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

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

Why worry about a recession?

Rising corporate angst

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

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

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

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

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

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

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

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

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

Corporate weakness, but no recession

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

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

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

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

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

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

A new bull?

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

SentimenTrader put it a slightly different way.

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

Any more precautionary cuts?

Posted by Cam Hui -

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

 

Are the series of precautionary cuts over?
 

Dissecting the rate cut

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

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

 

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

 

A repeat of the 1998 bubble?

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

 

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

 

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

 

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

Disclosure: Long SPXL

 

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

Posted by Cam Hui -

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

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

 

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

 

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

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

Taiwan`s weakness

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Moreover, Taiwanese life insurance companies are thinly capitalized.
 

 

An enormous foreign currency mismatch

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

What about foreign currency hedging?

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

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

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

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

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

Setser concluded:

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

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

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

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

Concentrated Ambiguity added:

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

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

China’s opportunity

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

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

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

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

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

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

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

 

The Art of the Deal, Phase One edition

Posted by Cam Hui -

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

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

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

 

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

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

 

What’s on the table?

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

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

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

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

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

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

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

,,,

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

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

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

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

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

 

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

 

What about “phase two”?

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

 

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

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

Market and political impact

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL
 

An upcoming seismic shift in factor returns

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A seismic shift ahead

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

 

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

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

 

A factor tour around the world

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

 

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

 

A Value revival

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

 

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

 

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

 

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

 

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

 

Signs of cyclical stabilization and rebound

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

 

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

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

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

 

 

Achuthan concluded:

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

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

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

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

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

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

 

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

 

Too early to buy gold, inflation hedges

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

 

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

 

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

 

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

 

Too early to buy EM

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

 

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

 

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

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

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU

 

SPX 3000 round number-itis

Posted by Cam Hui -

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

 

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

Weakening NASDAQ

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

 

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

 

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

 

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

 

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

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

 

Stay tuned.

Disclosure: Long SPXU

 

The stealth decoupling sneaking up on portfolios

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A stealth decoupling

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

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

 

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

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

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

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

The trade setup

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

 

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

 

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

What’s the pain trade?

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

 

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

 

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

 

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

 

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

 

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

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

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

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

 

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

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

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

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

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

How US stocks could lag

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

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

 

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

 

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

Key risks

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

 

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

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

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

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

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

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

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

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

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

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

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

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

 

Investment implications

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

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

 

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

The week ahead

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXU