A White Swan market

Posted by Cam Hui -

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

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

 

A short-term bottom ahead

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

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

 

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

 

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

 

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

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

 

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

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

 

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

 

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

 

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

 

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

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

The markets need to adjust to that new reality:

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

 

The short and intermediate term outlook

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

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL
 

A correction, or a trade war meltdown?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

Welcome to the Q3 tantrum

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

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

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

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

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

Trade War + Currency War?

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

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

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

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

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

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

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

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

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

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

There are three problems with devaluing the currency, however.

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

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

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

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

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

The bear case

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

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

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

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

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

The bull case

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

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

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

Unemployment is low, and wage growth is strong.

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

What are you so worried about?

How much does the trade war matter?

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

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

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

A recent Bloomberg study came to a more optimistic conclusion.

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

  • How much stuff we ship around the world is not the best measure of globalization. The trade in goods may be slowing, but that’s an incomplete picture that doesn’t capture the digital realm.
  • Traditional trade measures also don’t reflect the real supply chain. A more accurate measure of trade and economic relationships involves not where a product is made but where its value is added.

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

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

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

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

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

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

Peterson Institute 2016 trade war study

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

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

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

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

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

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

Just a hiccup

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

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

Ripe for a counter-trend rally

Posted by Cam Hui -

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

 

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

 

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

 

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

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

 

Unfinished downside potential

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

 

USDCNY at 7? It’s not you, it’s me

Posted by Cam Hui -

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

 

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

 

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

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

 

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

Addressing USD strength

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

 

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

 

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

 

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

Dollar strength = Rising stress

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

 

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

 

Trump’s options are limited

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

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

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

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

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

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

What’s the cost?

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

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

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

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

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

There is a price to be paid for everything.

 

Powell’s dilemma (and why it matters)

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

What Powell couldn’t say

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

What is going on?

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

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

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

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

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

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

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

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

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

Rising risks

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

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

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

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

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

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

 

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

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

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

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

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

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

Fading business confidence

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

 

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

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

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

 

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

 

China’s surprising response

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

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

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

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

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

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

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

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

 

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

 

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

 

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

China Evergrande (3333.HK)

 

China Vanke (2202.HK)

 

Greentown China Holdings (3900.HK)

 

Country Garden Holdings (2007.HK)

 

Estimating downside risk

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

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

 

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

 

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

 

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

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

 

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

The week ahead

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

Disclosure: Long SPXU

 

A (deceptive) long-term buy signal

Posted by Cam Hui -

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

 

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

 

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

Looking for confirmation

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

 

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

 

The Fed disappoints

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

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

Short-term outlook

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

 

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU

 

A hawkish cut ahead?

Posted by Cam Hui -

As we look ahead to the July FOMC meeting this week, market expectations of additional rate cuts have moderated. The market is discounting a 100% chance of a quarter-point cut this week. It also expects an additional quarter-point cut at the September meeting, and a third rate cut by year-end.
 

 

The better than expected Q2 GDP report just made the Fed’s job a lot more complicated.
 

Signs of economic strength

Q2 GDP came in above expectations at 2.1%. What`s more, real final sales to private domestic purchasers, which is a more stable measure of GDP growth, rose 3.2%. The latest FOMC median projections of 2019 GDP growth is 2.1%. GDP growth would have to slow to 1.4% to 1.6% for the remainder of 2019 to reach 2.1%. Watch if the Fed revises 2019 growth upwards. If the economy is that strong, why does it need to continue cutting rates?
 

 

Consumer spending was on fire, personal consumer expenditures rose 4.3% in Q2.
 

 

On the other hand, the corporate sector was weak. The trade war hurt exports. Business confidence wobbled, and the uncertainty was reflected by lower business investments.
 

 

The hawks will focus on the higher growth rates. The doves will focus on the need for insurance in view of global uncertainty. In addition, inflation remains under control. FOMC’s 2019 median core PCE is projected to be 1.5%, which is slightly above the rates observed in Q1 and Q2.
 

 

The Fed has strongly signaled that it will cut by a quarter-point at its July meeting, and it is unlikely to disappoint. However, the case for additional easing is less clear. How much insurance does the Fed really need?

Watch the language on the outlook. Will the Fed revise its 2019 GDP growth projections upwards? Will the Fed start to edge away from more cuts, or will it pre-commit to any cut in September? How will it frame the narrative over future moves?
 

Do you feel lucky?

For equity investors, the FOMC meeting presents a high degree of risk. Stock prices depend mainly on two factors, the E in the P/E ratio, and the evolution of the P/E ratio itself.

FactSet reported that the beat rates from Q2 earnings season are above average, but the forecast E is falling. Since forward earnings move roughly in lockstep with stock prices, flat to falling EPS estimates opens up downside risk for equities.
 

 

The P/E ratio presents another risk. The S&P 500 trades at a forward P/E of 17.1, which is elevated compared to its history. Further rate cuts will lower the discount rate of earnings, and therefore boost the P/E ratio.
 

 

When the market has lost one leg of support from a rising E, it needs the assurance of further rate cuts to hold prices up. That said, the Powell Fed has recently adopted a far more dovish course that my past projections.

Do you feel lucky?

 

Is this how currency wars begin?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

Sleepwalking into a currency war?

As we look ahead to the FOMC meeting next week, it may be the start of a synchronized global easing cycle. The ECB signaled a dovish tone last week at its meeting. The EURUSD exchange rate weakened, and the USD Index strengthened. From a technical perspective, the USD is exhibiting bullish patterns on multiple time frames. The index staged an upside breakout on an inverse head and shoulders formation on the daily chart, with an upside measured upside target of about 99.10. Conversely, EURUSD has broken down in a head and shoulders, with a downside target of about 110.
 

 

It is also forming a possible bullish cup and handle pattern on the weekly chart, with an upside target of 107.70 to 108.00 on a breakout.
 

 

In addition, the trade weighted USD has also formed a possible cup and handle pattern that stretches back to 2002, with bullish implications.
 

 

The global nature of the seemingly coordinated central bank easing begs the question of whether monetary policy is inadvertently starting a cycle of competitive devaluation. Is this how a currency war starts?

We examine this thesis from the viewpoints of the three main currency and trading blocs, Europe, China, and the US.

From a long-term US equity investor’s viewpoint, bear markets are accompanied by recessions. Of the major global economies, the US is the least likely to fall into recession, which is positive.

However, the risk of a round of central bank easing interpreted as currency war, which leads to greater protectionism is rising. This may create some bumpiness in equity returns, but the longer term outlook is positive. Even if other economies slow into stagnation or recession, central bankers are on alert and stand ready to provide sufficient liquidity to limit contagion effects.
 

Europe: Desperate for stimulus

The case for stimulus for the eurozone economy is unequivocal. The latest PMI readings show a stalling manufacturing sector.
 

 

In particular, German manufacturing, which has been the locomotive of growth in the eurozone, has collapsed, and the 3-month to 5-year Bund yield curve has inverted for the first time since the GFC, signaling a possible recession.
 

 

The weakness in German manufacturing is important because about 50% of its GDP is exports.
 

 

The only silver lining in the PMI data is the strength of the services sector, which is holding up Composite PMI. However, the combination of soft inflation and manufacturing argues for stimulus.
 

 

The ECB faces a dilemma. Its stimulus efforts since the GFC has pushed bond yields into negative territory. The entire Swiss yield curve is negative, and the German and Danish yield curves are negative out to 20 years. Even the Greeks can borrow for 10 years at a yield less than the US Treasury. The limits to monetary policy is becoming clear.

A recent BIS working paper by Kristin Forbes lays out the limits to the current inflation fighting monetary framework used by most central bankers. Here is the abstract.

The relationship central to most inflation models, between slack and inflation, seems to have weakened. Do we need a new framework? This paper uses three very different approaches – principal components, a Phillips curve model, and trend-cycle decomposition – to show that inflation models should more explicitly and comprehensively control for changes in the global economy and allow for key parameters to adjust over time. Global factors, such as global commodity prices, global slack, exchange rates, and producer price competition can all significantly affect inflation, even after controlling for the standard domestic variables. The role of these global factors has changed over the last decade, especially the relationship between global slack, commodity prices, and producer price dispersion with CPI inflation and the cyclical component of inflation. The role of different global and domestic factors varies across countries, but as the world has become more integrated through trade and supply chains, global factors should no longer play an ancillary role in models of inflation dynamics.

Translation: In times of globalization, there are many other drivers of inflation than the factors outlined by Milton Friedman. Inflation is no longer just a monetary phenomena. Factors such “exchange rates, oil prices, other commodity prices, slack in major economies (not just at home) and international pricing competition” also affect inflation. Friedman believed that floating exchange rates would ensure external balance and insulate the economy from the outside world, putting monetary policy in full control. The actual evidence during the latest era of globalization contradicts those assertions.

The BIS paper is one sign of a paradigm change in central banking. There are limits to central bank papers, especially at the zero lower bound (ZLB). It is time for fiscal policy to pick up the slack.

In practice, however, the German resistance to fiscal stimulus is problematical, even when it is becoming evident that Germany is falling into recession. The changing of the guard from Draghi to Legarde is a positive step, as Christine Legarde is a politician who is more adept at navigating the political sensitives of member states and prod them into adopting fiscal stimulus than an economist like Draghi. However, any transition takes time, and Europe will find itself handicapped over the next 12-18 months as monetary policy will be the only stimulus tool available.

In the meantime, the ECB has no choice but to use the same old tools of lower rates and QE to stimulate, but it is increasingly pushing on a string, and in effect devaluing the euro as a result.
 

China: Stimulus or devaluation?

As we turn out signs to China, there are numerous signs the Chinese economy is slowing.
 

 

While we are always wary of the accuracy of official Chinese statistics, economic indicators from Asian trading partners are pointing to a slowdown. Japanese machine tool exports are down a whopping 38% year-over-year.
 

 

Korean exports, which is a sensitive barometer of global and Chinese growth, has fallen rapidly.
 

 

Normally, the authorities would respond with more stimulus as growth slows, especially ahead of the 70th anniversary celebration of the founding of the People’s Republic of China in October. What is puzzling is the lack of stimulus, and growing signs of financial distress.

Real estate is the most cyclically sensitive sector in China in light of its high leverage and the propensity of Chinese to put their savings into property. Yuan Talks reported that 271 property developers went bankrupt in 2019, and 34 developers in July alone. Bloomberg also reported that liquidity conditions are tightening, and these measures are hitting the real estate sector hard:

[L]iquidity is tightening again. Buoyed by what Beijing had perceived as progress in trade talks with the U.S., officials in April started turning back to President Xi Jinping’s campaign to wring excess borrowing from the financial system.

Just look at the Politburo’s language from its latest quarterly meeting. In a Communist Party statement, key phrases such as “deleveraging” started to reappear, as well as Xi’s exhortation that “apartments are for living in, not for speculation.” That’s quite a turnaround from October, when officials removed all references to corporate debt or property curbs as the trade war escalated.

As Bloomberg Intelligence analysts Kristy Hung and Patrick Wong meticulously chronicled, property deleveraging is also back in full swing, with regulators choking off all funding channels. China Evergrande Group, the most avid offshore issuer, postponed dividend payouts last week to preserve cash. Issuing dollar bonds had become an important channel for developers, accounting for roughly a quarter of non-bank financing last year.

Funding is getting tight for other junk-rated developers, too. In July, Tahoe Group Co. issued a three-year bond with a 15% coupon, doubling the interest payment it offered as recently as January 2018.

To make matters worse, low-quality borrowers in the offshore market are finding that few investors want to lend over longer horizons, which has triggered a surge of issuance in short-dated bonds. Last year, 78% of new issues had maturities of one to three years, up from less than half in 2017. This will only make default scares more common: After all, honoring interest payments is a lot easier than paying off principal, or rolling over debt.

Our own real-time indicator of monetary stimulus is stalling. The relative performance of Chinese real estate stocks is starting to roll over, after benefiting from a stimulus program that began in Q4 2018.
 

 

While conditions are not at alarming levels, and the shares of bellwethers like China Evergrande (3333.HK) remain well above long-term support, it is something that investors should keep an eye on.
 

 

Reuters reported that the Bank of Jizhou, which is based in Liaoning, is encountering liquidity problems. Regulators are meeting to address the problem. This is another sign of cracks in the Chinese financial system that could be worrisome.

Houze Song at Macro Polo recently offered an explanation for the lack of stimulus. Song believes that the Q2 slowdown has a lot to do with tapering of fiscal stimulus, and expects it to rebound in Q3. He believes “a strong stimulus is unlikely, partly because the trade war requires Beijing to conserve stimulus ammunition for future contingencies.”

In the meantime, trade war talks are stalled. The Washington Post recently reported that Huawei had been working China’s state-owned Panda International Information Technology to build out North Korea’s mobile phone networks for at least eight years until 2016. This will do little to ease trade tensions.

These developments are laying the foundation for a currency war. China’s slowdown and easing that began in Q4 led to greater domestic consumption and production, but fewer imports. Falling import demand hurt countries that heavily depend on Chinese demand, such as Korea and Germany. The ECB responded by easing policy, but the eurozone’s hands are currently tied by German intransigence against fiscal stimulus. ECB easing puts downward pressure on the euro, and creates headwinds for Chinese exports. In addition, the US-China trade war is not helping matters as companies relocate their supply chains out of China. Asian economies have no choice but to ease as well, and we have seen rate cuts from Korea and Indonesia.

The stage for competitive devaluation is set. Recall that last time the ECB and BOJ eased strongly, CNYUSD appreciated and the PBOC corrected that by devaluing the yuan and moving to a currency basket as a benchmark. In this environment, the risk is China may be forced to devalue the yuan in a sudden and disorderly manner, which creates more trade tensions and heightens the chances of more competitive devaluations.
 

America: The last island of growth

This brings us to the Fed and its decision at the July FOMC meeting. It has signaled that it plans to ease by a quarter-point, and Fed officials walked back expectations that it would ease by a half-point. Will that be enough, and what does that mean for exchange rates?

Unlike Europe, or China, the Fed’s case for monetary easing is no equivocal, and it is advertised as an “insurance cut”. To be sure, business investment is slowing because of the uncertainties from the trade war. While the American economy is slowing, it does not appear to be going into recession, as shown by the better than expected Q2 GDP growth of 2.1%.

The jobs market looks strong. Initial jobless claims are troughing, but show no signs of turning up, which would indicate a slowdown.
 

 

At the same time, rising small business selling prices are pointing to rising inflationary pressures. Small business have little bargaining power and they are therefore sensitive economic barometers. This will handcuff the Fed willingness to ease policy over the longer run.
 

 

New Deal democrat, who has done exemplary work by monitoring high frequency economic data and categorizing them into coincident, short-leading, and long-leading indicators, recently concluded that the economy is likely to stagnate, but it will not go into recession. This makes the American economy the island of global growth, and puts upward pressure on the USD despite the Fed’s expected rate cut.
 

Investment implications

What does that mean for US equity investors? The global economy is sputtering, and global central bankers are entering an easing cycle, which could spark a currency war. Under such a scenario, US equities are attractive on a relative basis.
 

 

Recessions are bull market killers. Of the major global economies, the US is the least likely to fall into recession, which is positive. Headline Q2 GDP came in at a better than expected 2.1%. More importantly, final sales, which is a better measure of growth after stripping out adjustments, was a strong 3.2%.
 

 

The S&P 500 and NASDAQ 100 made fresh highs last week, commodity price inputs are low, the labor market is strong, liquidity is plentiful, and the Fed has made it clear it wants to support further expansion. This is bullish for investors who are not afraid of the normal equity risk 10% drawdowns that occur virtually every calendar year.

However, the risk of a round of central bank easing interpreted as currency war, which leads to greater protectionism is rising. This may create some bumpiness in equity returns, but the longer term outlook is positive. Even if other economies slow into stagnation or recession, central bankers are on alert and stand ready to provide sufficient liquidity to limit contagion effects.

One way of mitigating the de-globalization effect is to tilt towards US equities with greater domestic exposure, by either holding a greater weight in mid and small caps, or underweight sectors with large foreign exposure, like the technology stocks.
 

 

The week ahead

Even though I am long-term bullish on US equities, I remain tactically cautious. Last week, I suggested that investors focus on the path of estimate revisions for clues the market outlook during Q2 earnings season (see Will stock prices surge on a Fed rate cut?).

With 44% of the S&P 500 reported, the results are not encouraging. Even though the EPS and sales beat rates are above their historical averages, the latest update from FactSet shows forward EPS revisions are stalling. In addition, elevated forward P/E valuations leaves the market vulnerable to a pullback. As the chart below shows, price and forward EPS move together coincidentally, so the string of negative revisions is worrisome.
 

 

The softness in forward EPS revisions is evident across all market cap bands. Yardeni Research, Inc. found that mid and small cap estimates are also falling. Bear in mind, however, the Yardeni data lags the FactSet data (above) by one week, and therefore results are more preliminary as only 16% of the S&P 500 had reported.
 

 

Helene Meisler, writing at Real Money, believes that the market is setting up for a volatility spike of unknown direction:

Speaking of volatility the put/call ratio for the Volatility Index was once again under 20%. Readings under 20% don’t come along very often, but back-to-back readings arrive even less frequently. In the last five years there have been six such instances, with three of them showing up since December of last year, so perhaps they are becoming more frequent.

The takeaway is not that it’s bullish or bearish, but that we tend to get some sizable moves in the market in the ensuing month. Just look at the one year chart of the S&P with the three red arrows showing the times we had consecutive low readings for the VIX put/call ratio. Two were bullish and one was a precursor to a bearish move. But none produced small moves, did they?

Here are some examples she cited of past volatility episodes when the VIX put/call ratio fell this far.

 

Should volatility spike, the short-term gyrations could be higher than in the past. CNBC highlighted analysis from JPM that the market depth of ES futures had declined, which could exacerbate the magnitude of unexpected price moves.
 

 

I continue to hold a tactical bearish bias because of the combination of negative estimate revisions and numerous technical warnings. Even as the S&P 500 tests an overhead resistance trend line, it is exhibiting negative RSI divergences, and diminishing momentum as measured by net highs-lows.
 

 

Risk appetite in both the credit and equity markets are not confirming the upside breakout to new highs. The relative price performance of junk (high yield) bonds to duration equivalent Treasuries is struggling (top panel). As well, the ratio of high beta to low volatility stocks are nowhere near the highs exhibited by the S&P 500 or the NASDAQ 100.
 

 

Other momentum indicators, such as net 20-day highs to lows, is in a downtrend.
 

 

A similar pattern of lower lows and lower highs can be found in the % above the 50 dma for the S&P 500…
 

 

And for the NASDAQ 100, which has been the market leaders during this latest rally.
 

 

The charts of non-US markets are mostly unexciting. The rally in Europe has stalled.
 

 

The stock markets of China and her major Asian partners are not confirming US equity strength, with the exception of Australia, and Taiwan, which can be described as being in a constructive uptrend.
 

 

The strength of the Australian market appears to be an outlier. Industrial metal prices have pulled back after a brief rally. The stock markets of the other resource heavy economies are not confirming Australian market strength. The advance in Canada has stalled at resistance, and the other markets have pulled back.
 

 

In short, both foreign markets and market internals are flashing warning signs on a variety of dimensions. This is not the time to be a hero. Upside potential remains limited. A volatility spike may be on the horizon. While stock prices could surge upwards, the odds favor the market hitting an air pocket.

My inner investor remains neutrally positioned. My inner trader is still short.

Disclosure: Long SPXU
 

Caution: Upside potential limited

Posted by Cam Hui -

Mid-week market update: Even as the bears were all lined up to push prices down last Friday, the bulls managed to make a goal-line stand and retain control of the tape. The index is tracing out a triangle pattern and testing resistance, while exhibiting negative RSI divergences.

In addition, other cautionary signs can be found elsewhere. While I would not necessarily discount an upside breakout to further fresh highs, current conditions argue for limited upside potential.

USD strength warning

One of the warnings come from the inverse head and shoulders breakout of the USD Index, and conversely, the head and shoulders breakdown of the EURUSD exchange rate.

The upside break in the USD is significant for two reasons. John Butters at FactSet pointed out that the best earnings growth is coming from companies with the greatest foreign exposure. A strong greenback will create sales and earnings headwinds for large cap multi-nationals.

As well, an upside technical breakout in the USD will exacerbate the risks of a currency war. Trump’s desire for a weak dollar is well-known, and this development will heighten the risk of heightened tensions.

The Robert Mueller hearings before Congress may be a trigger for a change in volatility regime. In the past, Trump has responded to threats with responses on two familiar topics, trade and border security. The last example was his surprise initiative to impose a blanket 5% tariff on all Mexican imports unless Mexico cooperated on restricting illegal crossings.

Nervous internals

Even as the SPX hears its all-time highs, internals show signs of disquiet. Short-term volatility term structure, defined as the ratio of the 9-day VIX (VXST) to the one-month VIX (VIX) has inverted, indicating nervousness. On the other hand, the 1-month to 3-month VIX (VXV) remains upward sloping, indicating complacency. A similar divergence occurred in November 2018 when the two diverged, and it was resolved with a December market sell-off.

NASDAQ stocks remain the market leaders, but NASDAQ 100 volatility has fallen dramatically, and it is now below the level of low volatility stocks as a sign of complacency. The bottom panel shows the spread between NDX and SPX volatility (purple line). The market topped out the last two times the spread fell to this level.

Market breadth is also flashing yellow flags. Even as the NASDAQ 100 rose on Monday and Tuesday, there were more lows than highs on both those days – which is another negative divergence to be wary of.

In addition, NYSI is falling while new lows are expanding, which is a sure sign that the bulls are struggling.

Jason Goepfert at SentimenTrader observed that the Hindenburg Omen, which measures internal breadth divergence, has been triggered on both the NYSE and NASDAQ:

When we see these kinds of conditions, with coincident signals on both exchanges for the first time in months, it has been exceptionally hard for the indexes to keep rising.

Callum Thomas of Topdown Charts observed that USD volatility is near record lows. Such conditions are similar to a Hindenburg Omen like bull/bear bifurcation, which could be a signal for a sharp reversal.

Historically this type of trading often precedes either a turning point, a large/violent move, or both.

The market psychology and macro realities that create this type of market is basically exactly what we see right now: significant division between bulls and bears, and competing/conflicting macro data and central banking outlook.

Liz Ann Sonders at Charles Schwab also pointed out that NDR Crowd Sentiment is becoming very stretched, which is also contrarian bearish.

I could go on, but you get the idea. None of these factors, when considered in isolation, are necessarily actionable sell signals. However, the combination of all these cautionary flags indicate that the risk/reward ratio is tilted to the downside.

A tactical call

Just to make it clear, this is a tactical call and I am not making the case for a bear market. The market remains on the cusp of a long-term MACD buy signal, but much depends on how the SPX closes at month-end, and whether the buy signal is confirmed by other major indices.

As well, cyclical stocks have caught a bid, which is constructive for the growth expectations.

My inner investor is neither bullish nor bearish. His asset allocation is roughly at the levels dictated by investment policy goals.

My inner trader remains short the market. He will cover his short if the market decisively breaks up to new highs, and add to his short position should it break down through support.

Disclosure: Long SPXU

Will stock prices surge on a Fed rate cut?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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 well-telegraphed rate cut

As we look forward to the FOMC meeting on July 30-31, the market is discounting a 100% chance of a rate cut, with the probability of a half point cut at 22.5%.
 

 

Analysis from Ned Davis Research reveals that an initial rate cut and no recession has historically lit a rocket under stock prices.
 

 

What will happen this time? Should investors be piling into equities in anticipation of a market surge?
 

Many reasons to cut

The Fed has good reasons to cut rates. Trade tensions are rising again. Bloomberg reported that Trump is threatening tariffs again after he arrived at an uneasy truce agreement in Osaka:

“We have a long way to go as far as tariffs where China is concerned, if we want. We have another $325 billion we can put a tariff on, if we want,” Trump said. “So, we’re talking to China about a deal, but I wish they didn’t break the deal that we had.”

China said Wednesday that further levies would complicate the negotiations.

“If the U.S. imposes new tariffs, this would create a new obstacle for U.S. and China trade negotiations, would make the road to coming to an agreement longer,” Foreign Ministry spokesman Geng Shuang told reporters in Beijing. “China still hopes to resolve U.S.-China trade frictions through consultation and dialogue.”

Trump and Xi called a tariff ceasefire and agreed to resume trade talks after meeting at the Group-of-20 summit in Japan in late-June, breaking a six-week stalemate. The U.S. president said he’d hold off on a threat to impose tariffs on an additional $300 billion in Chinese imports, and that Xi had agreed to buy large amounts of U.S. farm goods in exchange.

No such deal to increase agricultural purchases was made, Chinese officials familiar with the discussions said earlier. There hasn’t been any large-scale buys since the meeting in late June.

Not only are US-China trade tensions rising, a mini-trade war has erupted between Japan and South Korea. Japan is doing to Samsung what the US is doing to Huawei by restricted the exports of three key semiconductor components to Korea. In addition, the US has brewing trade disputes with other major trading partners like the EU and Japan.

The canaries in the trade coalmine are struggling. Singapore’s exports, which are often seen as a proxy for global trade, cratered 31.9% year-over-year in June.
 

 

The latest FOMC minutes contained numerous references to the words “uncertain” and “uncertainty”, which is weighing on the business confidence and the investment outlook. IHS Markit reported that global business confidence is tanking. IHS Markit chief economist Chris Williamson noted that confidence in the US and China had fallen badly. “Optimism about the year ahead has sunk especially sharply in the US and China amid escalating trade tensions: sentiment in the US is down to its lowest since 2016 and in China to the lowest since 2009”.
 

 

The latest earnings report from cyclical bellwether and railway operator CSX provided another example (via Business Insider):

“The present economic backdrop is one of the most puzzling I have experienced in my career,” James Foote, CSX’s chief executive, told investors and analysts on a conference call. “Both global and US economic conditions have been unusual this year, to say the least, and have impacted our volumes.”

CFO Mark Wallace went even further with his economic warnings, urging a resolution to the ongoing disputes between the US and countries including China, Mexico, Europe and more.

“What would help in the back half would be a resolution or clarity on trade and tariffs,” he said, ” but that is obviously beyond our control.”

In addition, the Atlanta Fed’s Q2 GDP nowcast stands at 1.6%, and the New York Fed’s nowcast is 1.5%. That is a far cry from the Q1 GDP growth rate of 3.2%. As the economy undergoes a soft patch, the risk of a trade war induced recession is rising.
 

How far will the Fed ease?

It therefore makes perfect sense for the Fed to put through an insurance cut in this backdrop of soft growth and uncertainty. Recent speeches from Fed officials have confirmed a rate cut will be enacted at the July FOMC meeting. The bigger question is how far will the Fed ease?

Recent speeches and interviews Fed speakers provide some clues of the limits of the Fed`s easing cycle. St. Louis Fed president James Bullard stated that he is in favor of cuts, but thought that a 50 basis point cut in July was going too far. In addition, the WSJ reported that Chicago Fed president Charles Evans called for precautionary cuts of 50 basis points this year:

“The economy is solid. I don’t want to be talking down the state of the economy,” but there are rising uncertainties and inflation has been persistently below the official goal, Mr. Evans told CNBC.

The Fed needs to take action to push up inflation over the 2% target to affirm that the goal is truly symmetrical and can tolerate an overshoot in the wake of a persistent shortfall in inflation relative to the goal, he said.

“In order to get inflation up to two-and-a-quarter percent over the next three years I need 50 basis points more of accommodation. And in fact, maybe that’s not quite enough,” Mr. Evans said.

“From a risk-management standpoint, it makes sense that you might think that we are little bit more restrictive [with monetary policy] than we need to be, and we need to be more accommodative” to compensate for that, he said.

The market is discounting a 75 basis points in cuts by year-end. If an uber-dove like Bullard is not convinced about a 50 basis point cut in July, and Evans is not convinced that the Fed needs more than 50 basis points, how likely is the FOMC consensus far enough along to meet expectations of further easing in 2019?

There was an unmistakable  sign that the Fed is getting ready to cut by 25 basis points at the July meeting. New York Fed president John Williams, who is a key member of the FOMC, made a speech last Thursday calling for a “go big or go home” style of monetary policy response to precautionary rate cuts:

The first: don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might. When the ZLB is nowhere in view, one can afford to move slowly and take a “wait and see” approach to gain additional clarity about potentially adverse economic developments. But not when interest rates are in the vicinity of the ZLB. In that case, you want to do the opposite, and vaccinate against further ills. When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress.

This brings me to my second conclusion, which is to keep interest rates lower for longer. The expectation of lower interest rates in the future lowers yields on bonds and thereby fosters more favorable financial conditions overall. This will allow the stimulus to pick up steam, support economic growth over the medium term, and allow inflation to rise.

The market reacted quickly and read those remarks to mean that the Fed was getting ready to cut by 50 basis points at the July meeting. By the end of the day, the New York fed issued a clarification that Williams’ speech was an academic based on 20 years of research, and it “was not about potential policy actions at the upcoming FOMC meeting”. This was an important signal that the Board believes that a 50 basis point cut was a quarter-point too far.

My base case scenario calls for a hawkish cut of 25 basis points at the July FOMC meeting, and hold out the possibility of another 25 basis points by December.  Investors may need to be prepared to be disappointed by the Fed’s guidance in the wake of the July meeting.

The moral of this story is, there are limits to what monetary policy can do. Watch how the yield curve evolves in the wake of the FOMC meeting. Will it steepen, or flatten? What happens to bond yields further out in the curve even as short rates fall?
 

A technical warning

Marketwatch reported that technician Milton Berg recently issued a warning for the stock market based on his work on the bond market, as well as his proprietary equity market indicators. Berg is known to have worked with hedge fund giants like George Soros and Stanley Druckenmiller. He called the top in 1987, and went into the Crash 20% long. He also nailed the recent Christmas Eve bottom of 2018. In the interview, Berg revealed that he went short the market on July 2.

Berg told digital financial media group Real Vision in an interview that there’s one big reason he’s out of the market for now: “We have a list of more than 100 indicators that we match to previous market peaks and of all these 100 only two are inconsistent with levels seen at market peaks.”

Here is the kicker. Both stock and bond market indicators are emitting warning signals. He turned bullish at the December 24 bottom as price momentum indicators screamed bullish, and those buy signals remain valid today. However, he said that he is uncomfortable with the rally because the stock market is behaving like a “bear market rally” because of the lack of participation of small caps and the broader global markets. He further pondered if the bull market that began in 1982 was attributable to falling bond yields. The 10-year Treasury has fallen from 15% in 1982 to under 2% in 2019, which provided a boost to stock prices. However, bond yields may be nearing a secular turn, which will cause problems for stock investors longer term.

Still, Berg says there’s is one thing that doesn’t quite add up for that view that stocks are nearing a peak. Thirty-year U.S. bonds on a 6- and 12-month basis are doing far better than they’ve ever done at a final market top, he notes.

Berg has also turned bearish on the bond market, where investors have been piling in on fears of a recession. State Street Global Advisors recently reported that bond exchange-traded funds drew a record $25 billion in June, beating by a huge margin a prior record in October 2014.

He says the bond conundrum may also send another message to investors. That the final leg of this stock market rally coincides with a bond market rally, which will signal a peak for stocks.

 

Policy uncertainty ahead

Notwithstanding any technical concerns about stocks, much of the equity market uncertainty revolves around Trump’s political strategy going into the 2020 election. Will he try for a quick deal with China by papering over the differences to kick start the American economy, or will he decide to continue bashing China as part of election strategy?

Politico reported Trump advisor Larry Kudlow conceded the US and China may never conclude a trade deal:

The United States and China may never be able to reach a trade deal because of the difficulty in resolving the relatively few remaining issues on the table, a top U.S. official said Tuesday.

During an interview at CNBC’s Capital Exchange event in Washington, White House chief economic adviser Larry Kudlow said he was an optimist by nature and still believed a deal was possible. But he used a football analogy involving his favorite team to illustrate the potential for the Trump administration to fall short.

“It’s like being on the seven-yard line at a football game,” Kudlow said. “And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone.”

“When you get down to the last 10 percent, seven-yard line, it’s tough,” he added, referring to the negotiations.

A Bloomberg article offered the viewpoint of Bank of Canada Governor Stephen Poloz, who believes that rate cuts are no panacea. There are limits to what central bankers can do in the face of trade tension induced uncertainty.

An escalation in trade tensions looks to be on the minds of bond investors, but stocks are shrugging off this possibility, according to Canada’s central bank chief.

“To put a fine point on it, the bond market pushes yields down and the stock market goes back as if nothing bad’s going to happen,” he said. “And yet the underlying shock would be clearly very bad for economic growth, would be bad for the level of productivity, would be quite harmful to profitability.”

More disconcerting news came from the US Treasury, when it put Ireland, Italy, and Germany on its watch list of currency manipulators. This is a signal that Trump may be seeking to start a currency war in addition to a trade war as his rhetoric about USD strength is becoming increasingly belligerent.

Treasury found that nine major trading partners continue to warrant placement on Treasury’s “Monitoring List” of major trading partners that merit close attention to their currency practices: China, Germany, Ireland, Italy, Japan, Korea, Malaysia, Singapore, and Vietnam.

A Bloomberg article which highlighted recent comments by Treasury Secretary Mnuchin have put the market on edge as to the possibility of currency intervention.

Foreign-exchange strategists say the risk of a U.S. move to weaken the dollar has risen after Treasury Secretary Steven Mnuchin said there’s no change in the nation’s currency policy “as of now.”

“This is something we could consider in the future but as of now there’s no change to the dollar policy,” he said in an interview Thursday following a Group-of-Seven finance ministers’ meeting in Chantilly, France.

In the eyes of Shaun Osborne at Scotiabank and Juan Prada at Barclays, the remarks left the door open to action in the foreign-exchange market. The possibility has drawn the attention of Wall Street analysts as President Donald Trump has intensified his criticism of the Fed and other countries’ currency practices. He hinted at intervention in a tweet July 3, saying Europe and China are playing a “big currency manipulation game,” and said the U.S. should “MATCH, or continue being the dummies.”

 

Earnings, earnings, earnings!

For equity investors, this begs the question of how much the Fed can do to boost stock prices in the absence of greater certainty about the global trade environment. It is unclear whether precautionary rate cuts will achieve the soft landing that the Fed is seeking. We are now seeing panicked calls like the one from Jim Bianco for deep and rapid rate cuts in order to avoid an earnings recession.

The bottom line is that stock prices depend on two factors, the P/E ratio, and the E in the P/E. If the Fed cuts rates, a lower discount rate boosts the P/E multiple, which is bullish for stock prices.

Investors will also have to monitor the E in the forward P/E ratio. The history of estimates and stock prices shows that they move more or less in lockstep. Current conditions indicate that estimate revisions are flattening out, which could indicate some sloppiness ahead for the market. In addition, elevated forward P/E valuation compared to its own history leaves little room for error, should the earnings outlook disappoint.
 

 

That said, it is still very early in the earnings season. So far, the EPS and sales beat rates are slightly ahead of their historical averages. The market’s reaction to beats and misses are also in line with historical experience.
 

 

The rate of earnings disappointment may rise. CNBC highlighted research from Well Fargo which indicated that most of the companies with the greatest exposure to China have not reported yet:

Ahead of a big week for technology earnings, the Wells Fargo Investment Institute’s Scott Wren predicts the trade war blame game is going to intensify.

Since S&P 500 companies began reporting second quarter earnings, more than a third of them have cited tariffs or the U.S.-China trade war as a headwind to profits.

Wren predicts the number will start rising sharply in the coming days as more U.S. companies with direct exposure to Asia report numbers.

“The 800-pound gorilla in the room and the easiest target out there is trade uncertainty,” the firm’s senior global equity strategist told CNBC’s “Trading Nation ” on Friday.
“You could think of a number of sectors where companies whose earnings are not great at least on a year-over-year comparison basis are going to use that scapegoat.”

Other contemporaneous indicators of the global cycle, like semiconductor sales, are pointing to some softness in global earnings.
 

 

The copper to gold ratio, which is a de-trended global cyclical indicator, is also signaling a risk-off environment.
 

 

In short, how the market reacts to Q2 earnings will be a crucial test for both bulls and bears. The downbeat guidance from cyclical companies like Alcoa and CSX is particularly disturbing for the growth outlook.

To be sure, these results are highly preliminary, and I want to keep an open mind. In the absence of any macro related shocks, these results suggest that stock prices are likely to either consolidate sideways in a choppy manner, or correct in the next few weeks.

Stay tuned.
 

The week ahead

The SPX ended the first major week of Q2 earnings season in the red, and resting on uptrend support. The stochastic has recycled downwards, which a likely pullback signal. Should trend support break early next week, the next major support can be found at about 2950, with additional support at the first Fibonacci retracement level of 2910.
 

 

Medium term (1-2 week) breadth indicators are also perched on a key support level. Past downside breaks have typically resolved with deeper corrective action.
 

 

Market internals favor the bears. The analysis of market cap leadership shows that mid and small caps have broken key relative support levels. The only leadership are the NASDAQ stocks, and narrow leadership is another warning sign of an unsustainable advance.
 

 

The analysis of NASDAQ 100 reveals another ominous divergence. Even as the NASDAQ 100 broke out to fresh all-time highs, and the NDX led the market upwards, the new high to new low spread was narrowing, and new lows managed to exceed new highs last week.
 

 

SentimenTrader pointed out that the market flashed a Hindenburg Omen last week. While the naming of the Hindenburg Omen represents a high degree of hyperbole, and it does not always forecast a market crash, the Omen is an indicator of a high degree of divergence in market internals. There are too many stocks making highs and lows at the same time. The historical record shows that such signals has resolved themselves with subpar short-term returns, though a crash is unlikely.
 

 

Another way of thinking about the divergence between new highs and lows is implied correlation. Callum Thomas pointed out that the stock market has encountered difficulty advancing when the CBOE Implied Correlation Index (right, inverted scale) is low.
 

 

Similar levels of internal divergences can also be found in the credit markets. While high yield, or junk, bonds are flashing a negative divergence with stock prices, investment grade credits have so far confirmed the equity market advance.
 

 

In addition, Mark Hulbert’s Hulbert Newsletter Stock Sentiment Index is flashing a crowded long reading, which is contrarian bearish.
 

 

Equally disconcerting is the performance of our trade war factor, which is showing signs of complacency. The shares of companies with foreign sales exposure are outperforming even as negotiations are at a standstill.
 

 

The nascent inverse head and shoulders formation of the US Dollar Index is also worrisome. While good technicians know that a head and shoulders pattern is not considered valid until the neckline breaks, a USD rally is likely to exacerbate trade tensions, and raise the odds of a currency war.
 

 

My inner investor remains neutrally positioned at the asset allocation targets specified by investment policy. My inner trader is still short. He may add to his position next week should market internals deteriorate further.

Disclosure: Long SPXU

 

A market on a knife edge

Posted by Cam Hui -

Mid-week market update: Regular readers know that I have been tactically cautious on stocks in the last two weeks, but I don’t want to give the impression that I am wildly bearish. In fact, the SPX is on the verge of a long-term buy signal, marked by the positive monthly MACD reading. Should the index close at or close to current levels by month-end, it will have flashed a buy signal that has shown to be highly effective for intermediate and long term investors.
 

 

Before anyone becomes wildly bullish here, some caution may be warranted.
 

Waiting for confirmation

First of all, I would warn that the monthly MACD buy signal has not been confirmed by a number of other indices. The broader Wilshire 5000 has not flashed a buy signal yet, though it is very close.
 

 

Global stocks have also not confirmed the buy signal either.
 

 

Similarly, we are also edging close to a MACD monthly buy signal for MSCI EAFE, but international stocks have not confirmed the SPX interim buy signal either.
 

 

I am keeping an open mind as to how indicators develop. While we could very well see a long-term buy signal by July 31, the market was in a similar condition in early May when readings were on the verge of a buy signal. Trump went on to derail the rally with his famous weekend tweet that unraveled the trade talks and the equity bull run.
 

 

Tactical hurdles

In the short run, the latest upside breakout of the Dow and SPX to fresh all-time highs face a number of challenges. Sentiment has become a little frothy, which is likely to create headwinds for further short-term upside. The 8-day moving average of the equity-only put/call ratio has reached complacent levels. In the past, market rallies have tended to stall when sentiment has reached these levels of enthusiasm. Current conditions are especially problematical as short-term sentiment has moved to a crowded long condition as the index tests overhead resistance.
 

 

Jason Goepfert at SentimenTrader also sounded a couple of cautionary notes:

We saw last month that equity hedge funds apparently have a low exposure to stocks on a longer time frame. We also follow macro and commodity-trading funds, which tend to be more aggressive, leveraged, and trend-following with a shorter time frame. And they have suddenly seen the light, going from 25% short exposure in March to more than 50% long exposure by late last week.

 

 

Goepfert also pointed out that small option traders, otherwise known as the retail dumb money, are piling in on the long side, which is contrarian bearish.
 

 

Q2 earning season has begun, with the major banks kicking off the reports. While most of the financials have beaten Street expectations, the preliminary market reaction report card has been less than stellar. The sector has marginally underperformed the market, which is another cautionary sign.
 

 

From a short-term trading perspective, the SPX is perched just above a gap at 2880-2890 that could get filled. Additional support can be found at about 2950, which is the previous breakout level, Should 2950 support get violated, a gap at 2940-2950 is waiting to get filled as well.
 

 

My base case scenario calls for market choppiness and volatility for the next few weeks of earnings season, with a slight bearish bias. My inner investor neutrally positioned at his target asset allocation weights, and my inner trader is holding to his small short position.

Disclosure: SPXU

 

Questions for Judy Shelton and gold standard supporters

Posted by Cam Hui -

President Trump has nominated Judy Shelton as one of the candidates for the open seats on the Federal Reserve’s Board of Governors. While Shelton is a controversial nominee, she is less problematical than the previous two, Herman Cain and Stephen Moore.

While I certainly understand the reasoning behind a gold-backed currency, which is a way to control inflation, I have some difficult questions for Shelton and other supporters of a gold standard.
 

 

A gold standard supporter

There is no denying that Shelton is a supporter of a gold standard. She wrote a WSJ op-ed in 1998 calling for the establishment of a gold standard. Bretton Woods wasn’t good enough.

The best way to do that is to adopt a global gold standard. The Bretton Woods system was a gold exchange standard, not a gold standard. Only the U.S. was required to convert its currency into gold at a fixed rate, and only foreign central banks were allowed the privilege of redemption. If you corrected for those two flaws–by requiring all countries to maintain convertibility and by granting every individual the right to redeem–you would be back to the classic international gold standard. A modern version would provide the world with a common currency anchored by gold and redeem the promise of global capitalism.

At the height of the Great Financial Crisis in September 2008, Shelton reiterated her views in a WSJ op-ed. First, she blamed the fiat currency system as a cause of the GFC:

Whatever well-intentioned reasons existed in 1913 for creating the Federal Reserve — to provide an elastic currency to soften the blow of economic contractions caused by “irrational exuberance” (and that will never be conquered, so long as humans have aspirations) — one would be hard-pressed to say that the financial fallout from this latest money meltdown will have less damaging consequences for the average person than would have been incurred under a gold standard.

Moreover, the mission of the central bank has been greatly compromised. Can anyone have faith that Fed policy decisions going into the future will deliver more reliable money? Don’t we already know in our bones that the cost of this latest financial nightmare will be born by all of us who store the value of our labor and measure our purchasing power in the form of dollars? As John Maynard Keynes, the famous British economist, observed in his “Tract on Monetary Reform,” published in 1923:

She went on to endorse the idea of a bimetallic backed currency:

It is time to take on the task of establishing a new foundation for international economic relations and financial relations — one dedicated to open markets and based on monetary integrity. Every country is responsible for anchoring its own currency to the universal reserve asset, and every citizen has the right to convert the national currency into the universal reserve asset.

That’s how a gold standard works. A bimetallic system, linked to silver and gold, works the same way. In either case the money is fixed to a common anchor — and thus automatically functions as a common currency to serve the needs of legitimate producers and consumers throughout the world.

How would such an approach cure financial market ills? Nothing can rescue humans from occasionally making bad choices or succumbing to herding instincts. But on the same principle as democracy and free elections, embedded in the aggregate judgment of individuals over time is a wisdom that outperforms the most ostensibly savvy administrator. Sound money would go a long way toward eliminating the distortions that pervert financial decisions and credit allocations. Price signals do matter; if they don’t, then free markets don’t matter, and capitalism doesn’t work. In which case, let government dictate demand and regulate supply.

No, we need to fix the money. Literally.

 

Evaluating t gold standard within a monetary framework

How does a gold standard even work in today’s economy? Consider Milton Friedman’s monetary framework of PQ = MV, where Price X Quantity = GDP = Money supply X Velocity of money.

The idea is if you fix the growth rate of M, or money, to the natural real growth rate of the economy, you can naturally control inflation by limiting the ability of governments to borrow and spend. How do you manage the growth of the money supply (gold) in a way that is consistent with the underlying economy? At the extreme, what does the central bank do if the economy encounters an unexpected shock?

Frances Woolley, writing in Worthwhile Canadian Initiative, proposed such a shock in the fictional land of The Hobbit:

Smaug the dragon is typically viewed as a fiscal phenomenon, depressing economic activity by burning woods and fields, killing warriors, eating young maidens, and creating general waste and destruction. Yet peoples – whether elvish, dwarvish, or human – have considerable capacity to rebuild. Why did the coming of Smaug lead to a prolonged downturn in economic activity, rather than a short downturn followed by a period of rebuilding and growth?

The full economic impact of Smaug can only be understood by recognizing that the dragon’s arrival resulted in a severe monetary shock. On the left is shown Smaug’s hoard. On the right, for purposes of comparison, are the gold reserves of the Bank of England. It is clear from a simple inspection of these two figures that the amount of gold coinage Smaug withdrew from circulation represents a significant volume of currency. This would, inevitably, lead to deflation and depressed economic activity. Bank-of-england-bank-vault

Woolley made a good point. What happens if an unexpected shock dramatically changed M, or the money supply. Would the economy collapse from deflation? How should central bankers, if they exist, act under such circumstances?

While the world of The Hobbit is fictional, the reverse did occur in real life at one point in Europe. When the Spanish brought their looted Incan and Mayan gold from the New World into the Old World, it sparked an era of inflation.

Milton Friedman was right in that respect. inflation is a monetary phenomena.

How do gold standard supporters intend to control the supply of gold? Presumably, you would want the  supply to rise at roughly the natural real growth rate of the economy. How do you do that?

The same question could be posed to crypto-currency supporters. If a crypto-currency is supposed to be an alternative currency to the fiat currencies, how do you control its growth rate?
 

What about the fractional banking system?

Another issue many hard money supporters have trouble with is the idea of the fractional banking system.

Supposing you had $100 today, and you put your $100 into a bank. While the bank makes a ledger entry which states that it is holding that $100 for you, and it owes you $100, it actually puts that money to work by lending it out. Supposing that the bank pays you 1% on your $100 deposit, but it lends it out at 2% and makes a spread of 1% ot its loan.

For the purpose of financial prudence, the bank doesn’t lend out the entire $100, but lends out 90%,or $90. Lending $90 to borrower B “creates” $90 out of thin air from the leverage effects. Borrower B then deposits the $90 into a bank, and that bank lends out 90% of it, which is $81, which creates even more money out of thin air. That’s the magic of fractional banking, and that’s how the credit system works.

Here is the question for Shelton and other gold standard backers. Will you entirely do away with the fractional banking system, because it creates money out of thin air? The elimination of fractional banking under a PQ = MV framework means that M would fall dramatically, which would collapse the economy.

If I lend you 1 troy oz. of gold, what is the mechanism for determining the interest rate, which is to be paid in coinage?
 

Monetary policy implications

Shelton demonstrated her hard money bona fides in a 2012 Cato Institute paper call Gold and Government:

In this article, I propose a reform that would bring the power of market forces and competition to bear on the challenge of providing sound money while still giving government a principled role in the monetary system.

My recommendation is to introduce a special class of medium term U.S. government debt obligations to be designated “Treasury Trust Bonds (TTBs).” These zero coupon bonds would grant the holder the right to redeem in either gold or dollars. This article provides details on how TTBs would be structured and how they might spur a transition toward new global monetary arrangements.

The issuance of TTBs would fit into a pro-growth economic agenda based on limited government, low taxes, rule of law, and global free trade. Linking the dollar to gold through TTBs would be a bold step toward completing the original economic agenda laid out by President Ronald Reagan, which called for a stable dollar. Consider it a “trust-but-verify” approach to sound money.

In that paper, she went called for the establishment of a Universal Gold Reserve Bank:

The Universal Gold Reserve Bank (UGRB) would have the potential to become a sort of global monetary authority. It would function as a central bank, not in a regulatory sense, but as the initiator of open market operations based on the global reserve asset. To the extent a wide array of nations opted to combine their currencies into mutually binding gold-linked contracts (likely in accordance with contributed collateral or private market swap arrangements), a new means of providing base money would be introduced. The UGRB
would stand ready to buy or sell its own financial obligation—an instrument pegging the value of the “uni,” let’s call it, to a specific weight of gold. The central banks of participating countries would essentially serve as primary dealers for UGRB securities.

UGRB would be a global central bank:
 

 

Her UGRB proposal sounds like a variation of the Growth and Stupidity Stability Pact that supports the eurozone common currency. Since the US federal government is running enormous deficits, would a UGRB force the US to change its fiscal policy by running primary surpluses, in the manner of the adjustments forced on Greece by the European Central Bank? That proposal does not appear to be very MAGA friendly.

Maybe I am dense, but I just don’t understand the basic mechanics of a gold standard.

 

The path to a European Renaissance

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

In search of the eurozone buy signal

I had a number of discussions with readers in the wake of last week’s publication, Europe: An ugly duckling about to be a swan. The topics revolved mainly around further justification for buying into Europe, when US equities had performed so well in the last 10 years. In short, the questions were:

  • What is the valuation for Europe, and
  • Finding a bullish catalyst for their relative revival.

As to the first question, I offer the following chart from Robeco Asset Management.
 

 

The gulf in valuation, as measured by the Cyclically Adjusted P/E ratio (CAPE), provides some clear reasoning for American investors to diversify outside their home country. As well, European stocks look cheap relative to their own history. But that is not the entire story.
 

Peering under the valuation hood

There are a number of criticisms of comparing P/E ratios across borders. Notwithstanding differences in accounting standards, index composition is very different in the US compared to Europe. Moreover, forward earnings grew much faster in America than in the Old World, therefore the US market deserves a premium multiple.
 

 

This breakdown of MSCI Europe sectors by weight and forward P/E ratio reveals one side of the trans-Atlantic coin difference.
 

 

Compare MSCI Europe to the sector weight breakdown of the S&P 500. Technology accounts for a whopping 21.5% of the index in the US, compared to a scant 5.9% in Europe. By contrast, the troubled Financial stocks is 18.0% in Europe, compared to 13.1% in the US.
 

 

The S&P 500 currently trades at a forward multiple of 17.1 times earnings, which is above its 5-year average of 16.5 and 10-year average of 14.8. MSCI Europe trades at a forward multiple of 13.9. As a way of making an apples-to-apples comparison of the two indices, I calculated what the aggregate forward multiple for Europe if its sector composition is the same as the S&P 500, but each sector retained its forward P/E multiple.

The answer is 14.6 times forward earnings, compared to stated multiple of 13.9 for MSCI Europe, and 17.1 for the S&P 500.
 

Europe: A value play

In short, Europe is a diversified value play. Is it any wonder Warren Buffett did a euro-denominated bond financing? Either he is taking advantage of the ultra-low and negative rates, or he is getting ready for a major eurozone acquisition.

On this side of the Atlantic, value stocks have underperformed for so long that a lot of investors are giving up on the style. The discount seen in value stocks is approaching the lows last see at the height of the NASDAQ Bubble in 1999 and 2000.
 

I interpret these conditions to mean that Europe will start to outperform when value stocks begin to revive. But what will be the catalyst for such a turnaround?
 

De-FAANGing Big Data

One possible development that could see a value stock revival and the fall of FAANG, or Big Data, companies is increased anti-trust scrutiny. I wrote about this issue in October 2017  (see Peak FANG?) so I will not repeat myself. Instead, I will summarize the main points.

An academic study by Mordecai Kurz at Stanford tells a story of how technology companies are enjoying monopolistic profits. Here is the abstract:

We show modern information technology (in short IT) is the cause of rising income and wealth inequality since the 1970’s and has contributed to slow growth of wages and decline in the natural rate.

We first study all US firms whose securities trade on public exchanges. Surplus wealth of a firm is the difference between wealth created (equity and debt) and its capital. We show (i) aggregate surplus wealth rose from -$0.59 Trillion in 1974 to $24 Trillion which is 79% of total market value in 2015 and reflects rising monopoly power. The added wealth was created mostly in sectors transformed by IT. Declining or slow growing firms with broadly distributed ownership have been replaced by IT based firms with highly concentrated ownership. Rising fraction of capital has been financed by debt, reaching 78% in 2015.

We explain why IT innovations enable and accelerate the erection of barriers to entry and once erected, IT facilitates maintenance of restraints on competition. These innovations also explain rising size of firms.

We next develop a model where firms have monopoly power. Monopoly surplus is unobservable and we deduce it with three methods, based on surplus wealth, share of labor or share of profits. Share of monopoly surplus rose from zero in early 1980’s to 23% in 2015. This last result is, remarkably, deduced by all three methods. Share of monopoly surplus was also positive during the first, hardware, phase of the IT revolution. It was zero in 1950-1962, reaching 7.3% in 1965 before falling back to zero in 1970. Standard TFP computation is shown to be biased when firms have monopoly power.

The business model of advertising driven companies like Facebook, Google, and Amazon show the importance of the marriage of supremacy of scale and AI. Simply put, these companies are in the surveillance business, and it is getting creepy, especially in a winner-take-all competitive environment.

A ProPublica article about how reporters were able to target ads to a group identified as “Jew haters” on Facebook shows the ubiquitous and terrifying power of Big Data companies.

Want to market Nazi memorabilia, or recruit marchers for a far-right rally? Facebook’s self-service ad-buying platform had the right audience for you.

Until this week, when we asked Facebook about it, the world’s largest social network enabled advertisers to direct their pitches to the news feeds of almost 2,300 people who expressed interest in the topics of “Jew hater,” “How to burn jews,” or, “History of ‘why jews ruin the world.’”

To test if these ad categories were real, we paid $30 to target those groups with three “promoted posts” — in which a ProPublica article or post was displayed in their news feeds. Facebook approved all three ads within 15 minutes.

While Facebook was found to be the offender in this instance, Google has a similar tracking technology and algorithms. Amazon use similar tracking techniques to suggest other items that customers can buy on its website.

At first glance, Apple appears to be largely insulated from these privacy concerns, but they are not immune. Apple’s marketing message has been that it is concerned about privacy, and it makes no money from advertising. It only source of revenue is the sale of its devices, and services on its platform. However, a recent WSJ article exposed the privacy flaws in its systems:

Congratulations! You’ve bought an iPhone! You made one of the best privacy-conscious decisions… until you download an app from Apple’s App Store. Most are littered with secret trackers, slurping up your personal data and sending it to more places than you can count.

Over the last few weeks, my colleague Mark Secada and I tested 80 apps, most of which are promoted in Apple’s App Store as “Apps We Love.” All but one used third-party trackers for marketing, ads or analytics. The apps averaged four trackers apiece.

Some apps send personal data without ever informing users in their privacy policies, others just use industry-accepted—though sometimes shady—ad-tracking methods. As my colleague Sam Schechner reported a few months ago (also with Mark’s assistance), many apps send info to Facebook, even if you’re not logged into its social networks. In our new testing, we found that many also send info to other companies, including Google and mobile marketers, for reasons that are not apparent to the end user.

We focused on the iPhone in our testing—largely because of Apple’s aggressive marketing of personal privacy. However, apps in Google’s Play Store for Android use the same techniques. In some cases, when it comes to providing on-device information to developers and trackers, Android is worse. Google recently updated its app permissions and says it is taking a deeper look at how apps access personal user information.

The biggest problem isn’t the data collection. The company that publishes my columns makes money from advertising—publisher and advertiser alike rely on customer data. The problem is, we aren’t told what tracking is going on in our apps, and we’re given very few controls to curb it.

 

The rise of the trust busters

The US government is sitting up and taking notice. The Economist reported in mid-June that the Department of Justice (DOJ) and the Federal Trade Commission (FTC) have divided the objects of their scrutiny. The FTC will focus on Amazon and Facebook, while the DOJ will focus on Apple and Google.

Signs of renewed vigour in antitrust enforcement are growing. Last week it emerged that the Federal Trade Commission, another antitrust agency, and the DOJ had agreed to divvy up the work, with the former looking into Facebook and Amazon and the latter Apple and Google (an investigation of the search firm is reportedly imminent). On June 11th, a Congressional committee opened an investigation into the impact of big tech firms on the news industry. And more than a dozen state attorneys-general are soon expected to do something similar. In another sign that big business is under antitrust scrutiny, on the same day a group of states sued to block a $26bn merger between Sprint and T-Mobile, two big mobile operators.

In laying out a case against big tech, Mr Delrahim has used some of the same arguments as many of the industry’s critics. Important digital markets, he explained, tend to be dominated by one or two firms, thanks to network effects. Such dominance is not necessarily bad for consumers. Even monopolies, such as that of Standard Oil, have led to lower prices. But price effects, he correctly argued, are “not the sole measure of harm to competition”. The view in antitrust circles is that only price matters. Web browsers, for instance, are free, but in the 1990s Microsoft’s bundling of one with its dominant Windows operating system hurt competition and innovation. The government’s successful case against Microsoft, he said, “arguably paved the way for companies like Google, Yahoo and Apple to enter the market.”

Mr Delrahim also hinted at what will be scrutinised. One area is “exclusivity agreements”, where a dominant firm imposes deals on suppliers, for instance when Microsoft forced makers of PCs to give preference to its browser. The other is mergers and acquisitions. These can be good for competition, he said, but added that there is “potential for mischief if the purpose and effect of an acquisition is to block potential competitors, protect a monopoly.”

The Democrats have seized on internet privacy as a winning political issue. In particular, if Elizabeth Warren has offered scathing criticism of Big Data companies. If either she wins the White House or takes a prominent role in a Democrat-led administration after the 2020 election, Big Data companies will come under increasing political pressure. The solutions will be either a breakup, such as splitting off Amazon Web Service from Amazon, or a high degree of utility-like regulatory scrutiny.

There are additional regulatory risks. Facebook’s Libra coin initiative, which is nothing more than a thinly disguised attempt to create a parallel payment system, is an open invitation for additional scrutiny from policy makers. As well, the latest French digital tax proposal is an illustration of the global nature of the regulatory threat to Big Data companies.
 

The Microsoft template

Even under a dire scenario of increased regulatory headwinds, the outlook for Big Data companies is unlikely to be extremely bearish. A useful template might be the antitrust action take against Microsoft in United States v. Microsoft Corp. The stock became a market performer for over 15 years after the DOJ filed its case in court.
 

 

The market has interpreted latest news of a FTC settlement of a $5 billion fine for Facebook’s privacy breaches as just a slap on the wrist. On the other hand, it could also signal just the beginning of a series of concerted attacks on Big Data technology companies.

Under a scenario where government agencies pursue FAANG stocks for antitrust violations, I expect these companies would, over time, relinquish their market leadership position. That might be the opening for value stocks to step up into the vacuum and begin a revival of the value/growth cycle.
 

The week ahead

Looking to the week ahead, the big banks will be kicking off earnings season as they report next week. Q2 earnings season could be a challenge for the market as divergent trends come into focus. As bond yields at the long end edge upwards, and the yield curve steepens, the results of earnings season will be crucial to the stock market outlook. Can the positive effects of rising earnings expectations offset the negative effects of rising bond yields, and therefore a high discount rate?
 

 

John Butters at FactSet reported that consensus expectations call for a Q2 earnings decline of -2.7%. In the past, management has tended to be overly pessimistic and the actual report beats expectations. The average five-year beat rate is 72%, and earnings have exceeded consensus by 4.8%. If history is any guide, the S&P 500 should be able to avoid an actual earnings decline in Q2.

The game of lowering guidance in order to beat estimates may be harder to play this time. FactSet reported that companies have issued the second highest level of negative guidance since they started monitoring earnings pre-announcements in 2006.
 

 

Despite the high level of warnings, forward EPS estimates revisions are still positive, though they may be flattening out.
 

 

The forward P/E ratio of 17.1 is elevated relative to its own history, which leaves little margin for error should companies either disappoint, or guide downwards during their earnings calls.
 

 

Fed chair Jerome Powell has expressed concerns over falling business confidence from the tariff disputes as one of the reasons for adopting an easier monetary policy. There were 22 references to either “uncertain” or “uncertainty” in the latest FOMC minutes that were published last week. Small business confidence and business conditions from NFIB is especially valuable as an early peek at Q2 economic conditions and as an earnings season preview. Small businesses have little bargaining power, which makes them are good barometers of the economy. The latest NFIB survey shows that optimism has pulled back.
 

 

One key measure of confidence is capital investment, which is weakening.
 

 

Even employment, which has been steadily improving because of the red-hot jobs market, is showing some signs of softness.
 

 

From a technical perspective, the relative performance of cyclical stocks confirms the fundamental analysis of economic weakness. In particular, the poor relative strength exhibited by the Dow Jones Transports is a concern.
 

 

We are seeing the rare condition of negative RSI divergences across multiple time frames. The hourly S&P 500 is flashing a negative 5-hour RSI divergence.
 

 

A negative 5-day RSI divergence can be seen in the daily price chart, along with fewer and few new highs even as the index rises.
 

 

The weekly chart also shows a t-week RSI divergence, even as the index tests rising trendline resistance.
 

 

Next week is option expiry (OpEx) week. Even though OpEx week has been historically bullish, Jeff Hirsch at Almanac Trader found that both July OpEx week, and the week after OpEx has seen subpar returns.
 

 

While excessive insider buying is more useful as a buy signal than selling is a sell signal, the latest Baron’s update of insider activity is not supporting the bull case.
 

 

The combination of all these factors suggest that the risks are asymmetric and tilted to the downside. While stock prices can continue to grind upwards, the risk of a downside break on either one or a series of unexpected news events is high.

My inner investor remains neutrally positioned and he is at roughly his asset allocation weights defined by long-term policy. My inner trader is holding his small market short.

Disclosure: Long SPXU

 

Stay cautious

Posted by Cam Hui -

Mid-week market update: I highlighted a tactical trading sell signal from the VIX Index on the weekend. The VIX had fallen below its lower Bollinger Band,, indicating an overbought market, and mean reverted above the band last Friday.
 

 

As a reminder, the historical study of such episodes since 1990 show negative returns bottom out roughly a week after the signal, which would be this coming Friday.
 

 

I stand by my trading call for a tactical defensive posture.
 

Bearish warnings

Other measures of sentiment show a wide range of disagreement. On one hand, the latest Investors Intelligence sentiment shows that optimism is building. Bullishness as risen past past the 2019 peak, and readings are similar to levels last seen in October 2019.
 

 

On the other hand, the TD-Ameritrade IMX shows a high degree of defensiveness.
 

 

However, Ned Davis Research has helpfully compiled an aggregate Crowd Sentiment Index, which shows a high degree of bullishness that historically has led to subpar returns in the past.
 

 

There are more potential potholes ahead for equity investors.The recent market weakness does not appear to be complete. Short-term breadth is falling, but the readings as of Tuesday night’s close is nowhere near an oversold condition, indicating further short-term downside risk.
 

 

As well, the weekly chart shows the market approaching a key overhead resistance level while flashing a negative divergence on the 5-week RSI – which is another warning sign.
 

 

None of these conditions necessarily mean that the market will go down tomorrow, or next week. However, they do argue for some tactical cautiousness until we see greater clarity of the fundamental outlook from Q2 earnings seasons.

My inner investor remains neutrally positioned. My inner trader is maintaining a small short position.

Disclosure: Long SPXU
 

The limits of central bank powers

Posted by Cam Hui -

With interest rates at or close to the zero lower bound, here are a couple of examples of limits to the power of central bankers.

  • The Federal Reserve: Will it still cut rates after the strong jobs report?
  • The European Central Bank: What are the limits and price of monetary stimulus?

Will the Fed cut rates?

Let us begin with the Fed. After the blow-out Jobs Report, the bond market reacted violently and there were murmurs as to whether the Fed will still cut rates. Let me lay the first concern to rest. Historically, the Fed has telegraphed its interest rate decisions. With the market expectations of at least a quarter-point cut at the next FOMC on July 30-31, the Fed is unlikely to surprise the market.

I would also note that Fed officials had cited US and global weakness, as well as uncertainty from trade tensions as the reasoning for an insurance rate cut. There has been no mention of labor market conditions as a justification.

That said, the very strong June Non-Farm Payroll print offset the weakness in the previous two months. Year/year NFP growth has been remarkably stable and range-bound during this expansion. The latest June update shows an average monthly gain of 192K.

In addition, wage inflation appears to be moderating, along with core PCE, which is the Fed’s favorite metric of inflation. This will give ammunition to the doves despite the strength of the headline NFP figure.

If the Fed were to make a mid-course correction to guide expectations, there is plenty of opportunity this week for Fedspeak. Powell is expected to speak Tuesday morning. Other important Fed speakers include vice chair Quarles and Boston Fed president Bostic (Tueday), Powell’s Congressional testimony (Wednesday and Thursday), and New York Fed president Williams (Thursday).

As Powell has pointed out, there are limits to what a central bank can do. The global economy is undergoing a period of softness, and he has no control over trade policy, which affects business confidence.

My personal view is market expectations of a rate cut cycle has become overdone. While the Fed is likely to cut at its July meeting, it is likely to signal a hawkish cut. We may see expectations change to once-and-done, or the Fed’s message moderate back to a “patient” and “data dependent” stance as part of its FOMC statement.

Paying the price of “whatever it takes”

Mario Draghi once said that the ECB would do “whatever it takes” to save the euro. It has largely been successful. The ECB unveiled an alphabet soup of programs to buy member states time to enact structural reforms. While the reform efforts have been mixed, risk premiums have shrunk dramatically. To illustrate the success of the “whatever it takes” commitment, Greek 5-year debt is roughly 0.7% below equivalent USTs.

There is one key difference between the Fed and the ECB. The Fed has operated under a dual mandate of “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates”. The sole mandate of the ECB is to fight inflation. Since inflation is falling rapidly in the eurozone, the only ECB policy option open is more monetary easing, which has pushed rates into negative territory.

There is a price for this policy, and it is being paid by the European banking sector. Over the weekend, Deutsche Bank has announced yet another restructuring plan. It is creating a “bad bank” and it is exiting the glonsl equity business.

The damage is not just limited to Deutsche Bank, but the entire sector. The chart below shows the performance of the sector against yields. While correlation does not equal causation, you get the idea.

With rates this low, or even negative, European banks are experiencing difficulty achieving profitability in their home markets. Consequently, they go out in the risk curve to chase after yield. Eventually, something has to give. The latest blowup saw Turkey’s President Erdogan fired the head of the central bank, which tanked the Turkish lira. Turkey has enormous amounts of USD denominated debt that it can’t service, which Spanish banks have excess exposure to. Just take a look at BBVA, which is just one example of problematical Spanish bank.

While Draghi’s “whatever it takes” commitment was an effective backstop to past problems in the eurozone, the ECB’s programs represent only a band-aid solution, and it illustrates the limits of the powers of central banking. In order to revive growth, Draghi has pleaded with member states with the fiscal room (read: Germany) to embark on fiscal stimulus. Right now, the region’s fiscal thrust is being led by Italy, which is one of the weakest economies.

Despite Germany’s cultural bias against debt, it is in her interest to embark on some fiscal stimulus, especially when rates are negative. German exports account for roughly half of GDP, and about 40% of its exports go to other eurozone countries. Fiscal stimulus therefore benefits the entire euro area’s growth outlook in a very direct way.

This is the part where the ECB is handcuffed as a monetary authority. Fiscal policy has to pull its weight. The appointment of Christine Legarde to be its head is a positive step for the region. To be sure, Lagarde is not an economist, but a lawyer and a politician. It will take a politician to finesse German recalcitrance against fiscal stimulus and greater fiscal integration to rescue Europe.

In addition, Bloomberg reported that the appointment of German defense minister Ursula von der Leyen to head the European Commission is also another step towards greater European integration, which includes fiscal integration. While von der Leyen is ostensibly German, she is really Macron’s candidate to head the EC:

Her immediate priorities may include promoting cutting edge digital technology and opening Europe’s economy to artificial intelligence, both issues close to Macron’s heart. But the archives suggest a deeper shared vision.

At the height of the euro crisis in 2011, many Germans were ready to expel Greece from the euro zone. Von der Leyen instead called for a “United States of Europe” to complete, rather than reverse, the process started by monetary union.

The idea of a federal superstate is taboo in these days of Brexit and populism. But the frustrations of a system where 28 states have a de facto veto were as apparent as ever in the struggle to choose a commission president just as in numerous decisions each year.

So the idea of full political integration is still out there, lurking unspoken in the background of Macron’s plans for a European tax system and a European army.

These steps are all different scenes in the grand stage of European Theatre. While the European Central Bank can play a leading role, it cannot be the only player, and there are limits to what a central bank can do.

Europe: An ugly duckling about to be a swan?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.
 

Buy the ugly duckling?

In the past few weeks, these pages have been all trade war, all the time. While that was not the original intent of this publication, headlines have conspired to turn the focus on the Sino-American relationship. Now that an uneasy truce is in place, it is time to switch gears and turn the spotlight on other unexplored parts of the market.

Finance literature since the Great Financial Crisis has been filled with the imagery of swans. Black swans. White swans. Grey swans. What is missing is the ugly duckling that grew up to be a swan. More importantly, what if an investor could identify an ugly duckling before it becomes a swan?

I have identified such a candidate. The chart below shows the relative performance of US stocks against the MSCI All-Country World Index (ACWI) in black, and the Euro STOXX 50 against ACWI in green. While there is no question that US stocks have been the winners, eurozone equities are in the process of making a broad saucer based relative bottom, and may be poised for a period of outperformance. The relative bottoming process is especially remarkable in light of the current environment of global trade uncertainty, which may be a signal of investor capitulation and the inability to respond to bad news.
 

 

Unloved and washed-out

The first prerequisite of any ugly duckling candidate is its unloved nature. As the latest BAML Global Fund Manager Survey shows, managers have replaced what was once enthusiasm with indifference. BAML reported that short eurozone equities is the fourth most crowded trade, and current positioning is 0.9 standard deviations below its long-term average.
 

 

The mircale of Europe (and the euro)

For my friends on this side of the Atlantic, file the following story under “why you don’t understand Europe”:

The Vietnam War was a war that scarred the national psyche and dramatically changed the tone of American foreign policy for a generation. If you visit the Vietnam Memorial in Washington DC today, you will find roughly 58,000 names of fallen soldiers from that period. Now imagine if instead of losing 58,000 soldiers, the 2.5 million American soldiers died during the Vietnam War, with many more wounded. For a country like the US with a population of roughly 330 million, that kind of casualty rate would mean virtually every household in America would be touched by combat, whether it’s a father, son, brother, uncle, friend or neighbor. Then 25-30 years later, which is roughly the span between the Vietnam War and 9/11, the country became involved in another conflict with a similar death toll.

Imagine the resulting national trauma.

That’s what happened to many European countries in the First and Second World Wars – and the losses quoted would be roughly what the equivalent losses are for the US on an equivalent per capita basis on par with many European countries. The Credit Suisse Global Investment Returns Handbook has documented the financial cost of a century of war in Europe. Here are the real returns to different asset classes in France over the last century. In addition to the human carnage, investors suffered devastating losses during those wars (red annotations are mine).
 

 

Here is the same analysis for Germany. In addition to the lives lost, many investors had to contend with the permanent loss of capital. Some of those “risk free” interest rates that may have been in financial models weren’t so free of risk anymore.
 

 

The UK fared much better as hostile foreign troops never set foot on its soil. On an inflation adjusted basis, its equity returns were an order of magnitude better than France or Germany.
 

 

For comparative purposes, here is the return record of US assets over the same period. Americans were fortunate to have escaped the two world wars with minimal financial damage. The Great Depression caused more equity damage than the wars. The terminal real value of equity investments was three times better than the UK’s results.
 

 

So is it any surprise that at the end of the Second World War, the leadership of Western Europe surveyed the carnage and concluded that we can never do this again. Ever. Thus the Common Market, the EEC and later the EU were born. While it was originally structured as a free-trade agreement, the political intent was to bind the two main combatants, France and Germany, so tightly together so that a European war cannot happen again. The political goals of Europe have largely succeeded. Today, if Angela Merkel mobilized the Bundeswehr and told the troops they were going to war against the French, the men would all laugh, have a beer and go home.

That is the miracle of Europe. But peace comes with a cost, and that cost is the unevenness of European integration. Outsiders have viewed the design of the common currency, the euro, with horror because of the lack of adjustment mechanisms between countries, and the lack of political and fiscal integration. Those faults are features, not bugs, of the eurozone. Admittedly, weaker economies such as Italy should never have been allowed into the euro area, but they were in the name of European solidarity.

It was therefore no surprise that periodic financial crises erupted, such as Greece. Other peripheral countries have also teetered, and the latest is Italy, which is too big to save and the source of much angst among investors. Today, eurozone manufacturing PMI is signaling a slowdown.
 

 

Even Germany, which has been the region’s locomotive of manufacturing growth, is seeing some softness.
 

 

It is therefore a puzzle that the Germans are stubbornly sticking to their austerity discipline, when some fiscal stimulus would help the economy, especially when its borrowing costs are negative for German sovereign debt that go out 20 years or less. Neighboring Austria has taken advantage of the low interest cost environment by floating a 100-year bond with a 2.1% rate last year, and it is returning to the market with another issue with a 1.2% coupon.

Why not Germany, whose growth would renew the entire region?
 

Good news ahead

Here is the good news. Europe has not only held together, but it has become stronger in the post-Brexit environment, as an article in The Economist explained:

The crises of the past decade have tested the union and found it wanting. They have also revealed its resilience. Whenever it came close to breaking up, its institutions and governments took painful and politically contentious decisions to hold it together. The European Central Bank, for example, prevented the euro’s collapse with a promise to do “whatever it takes” that horrified thrifty Germans—who nevertheless, because of the value they placed on the union’s survival, stuck with the strategy. Since the Brexit referendum in 2016 the EU’s response to the once-unthinkable shock of a large nation deciding to leave has both illustrated and strengthened its underlying cohesiveness.

Possibly as a result of having peered over more than one brink, possibly as a result of an increasingly alarming world beyond their borders, Europeans are regaining some faith in the EU. In a survey of union-wide opinion taken last September, 62% of respondents said that membership was a good thing, the highest proportion since 1992. Only 11% said it was a bad thing, the lowest rate since the start of the financial crisis (see chart 1). The Brexit mess has doubtless put off other would-be leavers; the parties which once promised referendums on leaving in France and Italy have quietly dropped the idea. But the rise in support began in 2012, four years before Britain’s referendum.

One of the problems with European integration is the vastness of Europe. Residents have no cultural connection to Europe. There is no sens of volk, but European politicians have arrived at a new paradigm: “The Europe which protects”.

A visitor from Mars—or, for that matter, Beijing or Washington—might see further integration as a prerequisite for sorting out such problems. But Europe is not America or China. It is a mosaic of nation states of wildly varying size and boasting different languages, cultures, histories and temperaments. Its aspiration to be as democratic as a whole as it is in its parts is profoundly hampered by the lack, to use a term familiar to the ancient Nemeans, of a “demos”—a people which feels itself a people. Few want a superstate with fully integrated fiscal and monetary policy, defence policy and rights of citizenship. For all that Mr Weber and other parliamentarians may want to make the elections pan-European and quasi-presidential, voters will continue to be primarily parochial.

Nevertheless, the decade of living dangerously seems to have reshaped European politics into something a bit more cohesive, if not coherent. Europe is no longer in the business of expansion, or of integration come what may. It is in the business of protection. “A Europe which protects”, a phrase you cannot avoid in the corridors of Brussels, is increasingly heard on the campaign trail, too. Policy differences now play out within a broadly shared conviction that Europe’s citizens need, and want, defending from outside threats ranging from economic dislocation to climate change to Russia to migration. Some politicians offer integration as protection; others prefer simple co-ordination. But even parties once resolutely anti-EU, such as Austria’s hard-right FPO, now demand the EU do more, not less—at least in areas like border control and anti-terrorism.

There is also hope from an economic and development point of view. One compromise that became a straitjacket for eurozone members is the Growth and Stupidity Stability Pact, which was inserted based on a German insistence that it did not want to pay for the fiscal irresponsibility of other eurozone member states, and therefore limited the fiscal room of each country in the euro. While budgetary discipline has done wonders for Germany because of its exports to the rest of the region, the Teutonic cultural bias against fiscal deficits and inflation has hampered growth in eurozone.

That may be about to change. The Greens have been climbing in the polls in Germany, and they are threatening to upend the control of Merkel’s CDU/CSU coalition.
 

 

The German Greens have different priorities than the current government. The Economist reports that Germany has faced difficulty in meeting carbon emission reduction targets:

Much of the frustration comes from Germany’s sluggish performance. In the past decade it has spent a fortune rejigging its energy system while barely reducing emissions. This embarrassment comes with a price tag; under EU rules Germany could be liable for penalties worth tens of billions should it fail to meet its 2030 target. The 2020 goal is already abandoned.

Two factors explain this. First is Germany’s ongoing dependence on coal, particularly lignite, the dirty brown sort. Thanks to hefty subsidies, renewables account for over 40% of electricity production. But Mrs Merkel’s sudden abandonment of nuclear power after a tsunami-induced meltdown at a Japanese reactor in 2011, and warped price signals that made gas-fired power uneconomical, meant that cheap coal has made up much of the rest. The last mine is due to be shuttered by 2038. Too late, say activists.

Secondly, since 1990 Germany has failed to bring down its emissions from transport. Some cities have banned diesel-powered cars from their centres, and carmakers are rewriting business models to avoid being overtaken by Chinese upstarts. But a future in which Germans zip around in electric cars is some way off. Nor are the incentives yet in place for the mass refurbishment of Germany’s housing stock.

The governing parties face dilemmas balancing climate protection with their traditional economic goals. The CDU wants to avoid harming industry, already smarting from high energy prices, and is wary of the powerful motorists’ lobby. The SPD fears for its industrial voter base. Many of the coal mines earmarked for closure lie in Germany’s east, where the hard-right Alternative for Germany is popular.

All this bolsters the Greens, with their crystal-clear pitch, made from the safety of opposition. The party gains from voters’ climate worries, but also from their frustration with a fractious coalition. Yet its success in soaking up votes from across the political spectrum hints at shaky foundations. It cannot remain all things to all voters. “We know our support is fragile,” says Kerstin Andreae, a Green MP. The party’s influence, however, is not.

Imagine a government in the not too distant future, with the Greens as a coalition partner, willing to loosen the fiscal budget strings on green technology initiatives. While it may not be the sort of infrastructure investment that Mario Draghi originally thought about, it would nevertheless signal an era of more relaxed fiscal restraint that could provide a boost to growth, not only in Germany, but also throughout Europe.

In addition, the news that IMF director Christine Legarde is to be named the head of the European Central Bank is also supportive of growth in the eurozone. Bloomberg summarized her views on monetary policy. Legarde’s views puts her very much in the pragmatists’ camp, and she would make a good successor to Mario Draghi:

  • Outright Monetary Transactions: Legarde has voiced support for Draghi`s never used “whatever it takes” tool.
  • Negative interest rates: She is in favor of negative interest rates to deal with the problem of zero lower bound.
  • Quantitative Easing: She has voice support for QE.
  • Fiscal support: Legarde is above all, a politician, who realizes the limits of monetary policy, and will do what she can to prod member states (especially the Germans) to support growth with fiscal measures.

Here is the clincher for the European bull case. Bloomberg reported that Warren Buffett is borrowing in euros, which may be a prelude to an acquisition in the not too distant future:

Warren Buffett’s Berkshire Hathaway Inc. is selling debt in Europe. For those of us on the Buffett M&A watch, the move certainly raises an eyebrow.

Berkshire has hired banks to manage a benchmark sale of 20- and 30-year bonds in euros, as well as in pounds, Bloomberg News reported Tuesday, citing a person familiar with the matter. It would be the Omaha, Nebraska-based company’s first euro-denominated bond deal since 2017 and the first time it’s ever sold debt in pounds.

Berkshire would be joining a trend of U.S. companies, such as Deere & Co., looking to take advantage of cheaper borrowing costs for long-dated euro notes. But in the case of Berkshire, the debt sale also stirs up speculation about whether Buffett is moving closer toward making an acquisition in Europe, something he’s wanted to do for a while.

If Buffett is seeing value in Europe, does that mean he sees an ugly duckling which could turn into a swan?
 

Short-term outlook

The short-term outlook for Europe is also turning up. There is good news on the trade front. Even as Trump retreats from global trade, the EU is expanding to fill the void. The latest trade pact between the EU and the Mercosur countries is a signal that when America retreats, Europe is waiting in the wings to advance. Finally, European companies could gain a foothold in Latin America and get a jump on their American competitors.

The Citigroup Europe Economic Surprise Index (ESI), which measures whether high frequency economic data is beating or missing expectations, is rising after being deeply negative for all of 2019.
 

 

Earnings estimates for the Europe X-UK region are following a similar pattern as ESI. They appeared to have troughed and starting to rise again.
 

 

From a technical perspective, the Euro STOXX 50 has staged an upside breakout to fresh highs, and a number of other countries are also undergoing upside breakouts. Most notably, troubled peripheral country indices such as Italy and Greece (yes, that Greece) are leading the way upwards.
 

 

Finally, I would like to add a word about the UK, which is the only major European market that is not part of the eurozone, and probably will not be part of the EU soon. The British economy is slowing. More importantly, until the details of Brexit are resolved, I do not consider it to be an investable market because of the uncertainties involved.
 

 

In conclusion, eurozone equities appear to be poised for long-term superior performance. The short-term perspective is also supportive of the bull case. This may be a case of an ugly duckling that is on the verge of turning into a swan.
 

The week ahead

Looking to the week ahead, there are numerous signs that the bulls are in trouble. The first hint came last Monday, when the market staged a half-hearted attempt at a rally after the good news of a Sino-American trade truce. The market gapped up, and then spent most of the session losing ground, until a rally in the last hour recovered some ground. To be sure, prices did rise to new all-time highs later in the week, but the advance was characterized by declining volume.
 

 

The market is overbought on both a short-term and long-term basis. Short-term breadth reached an overbought condition and it is now beginning to roll over, which is interpreted by traders as a tactical sell signal.
 

 

From a longer term perspective, the Daily Sentiment Index (DSI) reached 90 last week. While DSI is not a precise trading indicator, past readings at similar levels has seen the market advance either stall out, or form a blow-off top (January 2018).
 

 

Similarly, SentimenTrader constructed a Trump Tweet-o-Meter of his stock market tweets. While the Tweet-o-Meter is also not a precise timing indicator, it does have a contrarian element when readings are high.
 

 

Another concern is the lack of leadership in this rally. The analysis of leadership by market cap shows that megacap stocks are in relative decline. Mid and small cap stocks broke down on a relative basis and they have not recovered above their breakdown levels. The only market leadership that can be seen are NASDAQ 100 stocks, whose relative price action can only be described as somewhat lethargic. Can the market really sustain an advance with such anemic leadership?
 

 

In addition, the relative performance of cyclical stocks is not feeling the love of the bulls. I interpret this to mean that market expectations for both domestic and global growth are low as we approach Q2 earnings season.
 

 

If neither Technology (NASDAQ) nor cyclical growth are the underlying drivers of higher stock prices, what about interest rates? The much stronger than expected June Jobs Report on Friday cast doubt to the thesis that the Fed would be starting a rate cut cycle. Even before the blow-out Jobs Report, the 2s10s yield curve had been flattening, indicating the bond market expected slower growth. That said, the 10s30s remain steep at a spread of 0.50%.
 

 

Tactically, stock prices appear ready to weaken. The 14-day RSI reached an overbought level and pulled back, which have been decent short-term pullback signals in the past. In addition, the latest advance has been accomplished with fewer and fewer S&P 500 new highs, which is another negative divergence. The first logical support for a pullback is the breakout level at 2950, which secondary support at about 2890.
 

 

Lastly, the VIX Index fell below its lower Bollinger Band last week and mean reverted above that level on Friday. My own historical study of such signals since 1990 indicate that the market is likely to weaken over the next week.
 

 

Don’t get me wrong, I am not wildly bearish. As we approach Q2 earnings season, EPS estimates are still being revised upwards, indicating positive fundamental momentum.
 

 

In addition, the S&P 500 has a buy signal on the monthly chart, though the signal has not been confirmed by other major indices. In the past, such signals have been sure fire indicators of a sustained advance. Should the index remain at Friday’s levels by month-end, the buy signal will be complete.
 

 

I interpret current conditions as the signals of the start of a sideways consolidation. The market is likely to be choppy in the weeks ahead as it responds to the day-to-day news from earnings season, as well as any political developments such as Robert Mueller’s scheduled Congressional testimony on July 17, and the FOMC meeting at month-end.

As the S&P 500 approaches 3000 round number resistance, recall the market`s struggle when the index first hit 1000, and 2000. Keep in mind the historical experience may or may not mean anything because of the smallness of the sample size (N=2).
 

 

My inner investor remains neutrally positioned at about the asset allocation specified by investment policy. My inner trader is short the market. He expects further weakness in the week ahead.

Disclosure: Long SPXU
 

New highs are bullish, but…

Posted by Cam Hui -

Mid-week market update: It is said that there is nothing more bullish a stock or an index can do other than to make new highs. Both the DJIA and the SPX made fresh all-time highs today. While that may appear to be bullish, there are plenty of warning signs beneath the surface that this advance may not be entirely sustainable.

One of the missing ingredients in this rally is momentum. The SPX is exhibiting a negative 5-day RSI divergence, indicating flagging momentum even as the index made new highs. In addition, the VIX Index fell below its lower Bollinger Band, indicating an extremely overbought condition.
 

 

Other divergences

Another warning sign can be seen in the risk appetite in the credit markets. Even as stock prices made new highs, the relative price performance of high yield (junk) bonds did not confirm the advance.
 

 

Sentiment flashes warnings

Sentiment models are becoming excessively bullish. The latest II sentiment readings show that % bulls have recovered. This is not an outright sell signal, but some caution is warranted.
 

 

Our normalized equity put/call ratio is also at or in the complacency zone, which is contrarian bearish.
 

 

Where’s the breadth thrust?

The analysis of the top five sectors of the market reveals lackluster leadership. Since these sectors make up nearly 70% of index weight, the market cannot advance in a sustainable fashion without signs of strong leadership from a majority of these sectors.
 

 

In the meantime, short-term breadth is already at overbought levels as of Tuesday night’s close, and readings will be even more extended based on Wednesday’s rally.
 

 

The combination of all these factors argue for a short-term stall. My inner trader entered into a small short position on Monday, and he may add to that position should the market strengthen further.

Disclosure: Long SPXU

 

Will the Fed cut after the trade détente?

Posted by Cam Hui -

The results out of the Trump-Xi summit were slightly better than market expectations. Not only do we have a trade truce, a suspension of escalation, but Trump promised that American companies can sell to Huawei.

Now that we have achieved a detente of sorts, the CME’s Fedwatch Tool shows the market is still discounting a 100% likelihood of a quarter-point rate cut at the July FOMC meeting, and a 21.4% chance of a half-point cut.
 

 

Is this for real? Will the Fed disappoint the markets?
 

Why the Fed should cut

Let’s consider the factors that argue for and against a cut. The main reasons for a cut is the weakness of the US and global economy. In addition, the trade war is not over, and the Osaka meeting only achieved a truce while tensions remain high. This creates a high level of uncertainty that is undermining confidence which could tank the economy even as it undergoes a soft patch.

Economic growth is slowing. The Atlanta Fed’s Q2 GDPNow is tracking at 1.5%, while the New York Fed’s nowcast is at 1.3%. That’s quite a slowdown compared to the red hot 3.2% growth rate in Q1.
 

 

In addition, global PMIs have been falling all around the world, which is indicative of a synchronized global slowdown.
 

 

CEO confidence has also been falling rapidly. While it is relatively easily to measure the first-order effects of tariffs, estimating the second-order effects of a loss of confidence is less precise. However, the historical record does show that current readings point to a possible air pocket in growth ahead.
 

 

In his latest speech, Jerome Powell voiced concerns over global growth and how the loss of confidence may be leading to a slowdown in business investment:

Let me turn now from the longer-term issues that are the focus of the review to the nearer-term outlook for the economy and for monetary policy. So far this year, the economy has performed reasonably well. Solid fundamentals are supporting continued growth and strong job creation, keeping the unemployment rate near historic lows. Although inflation has been running somewhat below our symmetric 2 percent objective, we have expected it to pick up, supported by solid growth and a strong job market. Along with this favorable picture, we have been mindful of some ongoing crosscurrents, including trade developments and concerns about global growth. When the FOMC met at the start of May, tentative evidence suggested these crosscurrents were moderating, and we saw no strong case for adjusting our policy rate.

Since then, the picture has changed. The crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy. Our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. For example, the limited available evidence we have suggests that investment by businesses has slowed from the pace earlier in the year.

The combination of these factors all argue for a precautionary, or insurance, rate cut.
 

Why the Fed should not cut

One of the arguments for a rate advanced by the dovish regional presidents such as Neel Kashkari and James Bullard is the subdued nature of inflation. The Dallas Fed maintains a series called trimmed mean PCE, which is PCE after throwing out the highest and lowest elements. Trimmed mean PCE is said to be a more stable measure than core PCE, which excludes the volatile elements of food and energy.

However you measure it, the monthly annualized core PCE and trimmed mean PCE are well above the Fed’s target of 2%. While the year/year rate of core PCE has been stable at 1.6%, trimmed mean PCE has been at 2.0% for the last two months. These readings do not support the case for monetary easing based on low inflation.
 

 

However, I would argue that it is the uptick in inflation that is transitory. Historically, the Fed has faced pressure to raise rates whenever the % of times in the last 12 months that the annualized core PCE has exceed 2% is greater than 50%. As the chart below shows, inflationary pressures have been easing. While they have edged up a little, current conditions can hardly be described as uncontrolled runaway inflation. At a minimum, the Fed should be on pause, and a slight easing bias would not be unusual under the circumstances.
 

 

Watching the Jobs Report

The upcoming Jobs Report this Friday will be another crucial data point in the dove-hawk debate at the Fed. Another big miss like the May report will solidify the case for a rate cut.

Historically, initial jobless claims has either slightly led or been coincidental with the unemployment rate. Since initial claims during the survey week for the June report missed expectations, I am inclined to forecast a slight miss on NFP.
 

 

I will also be watching the evolution of temp jobs, which has historically led NFP. The quits to layoffs rate, which is reported in the JOLTS and not the NFP report, has also shown a similar leading relationship. There are some early signs of softness in both temp jobs and quits to layoffs. If the economic soft patch continues, I would expect the weakness in these two indicators to become even more evident.
 

 

In conclusion, I expect the data to be supportive of a July quarter-point rate cuts. As for market expectations of two more quarter-point cuts by the December meeting, they will be no slam dunks. The Fed will be data dependent, and it will be a question of how the economic and confidence outlook evolves.

 

A framework for a Sino-American relationship

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A framework for Sino-American relations

The anticipation is over. The Trump-Xi summit is done. Did you think that things would be so easy, and everything could be solved in a single meeting?

The market came into weekend knowing that there was a high degree of uncertainty surrounding the summit, but the consensus was both sides would agree to a trade truce. Mytrade war factor, which measures the relative performance of companies with pure domestic revenues, was complacent about the prospects of a trade war.
 

 

The option market behaved in a similar way. The ratio of 9-day implied volatility (VXST) to one-month volatility (VIX) exhibited only mild signs of anxiety, and levels were not high compared to recent history.
 

 

The market was indeed fortunate that the outcome was slightly better than market expectations. Not only did both sides agree to a truce while discussions continue, and Trump has lifted a temporary ban on on American companies selling equipment to Huawei.

Notwithstanding the short-term results from the summit, here are some issues that investors and policy makers should think about in terms of the future Sino-American relations.

  • If this is a war, what costs is America willing to bear?
  • Is this a trade war, or something more?
  • How much support can the Fed offer, and what are the implications of the Fed’s actions?

In the absence of trade war risk, the intermediate-term equity outlook is bullish. There is no signs of a recession on the horizon. The Fed has signaled that it stands ready to “act as appropriate to sustain the expansion”. There is little more that the bulls could ask for.
 

The costs to America

If this is a war, sacrifices will have to be made. What costs are Americans willing to bear? A simple framework offered by Jason Furman is the cost-benefit analysis in a Twitter thread.
 

 

Chris Balding recently wrote a thoughtful post entitled “How Should We Think About the Costs Associated with Challenging China?” in which he distinguished between positive and negative costs:

We need to distinguish between positive and negative costs. By positive cost I mean a transaction where money is spent and a tangible good, service, or investment is received in return. Think of R&D, where money is expended and there is a tangible activity that is paid for with money in the expectation it produces a tangible intellectual property asset. A negative cost is a transaction where there is a less direct line between money spent or foregone and the expected return. Think for instance of imprisoning a robber. There is no tangible investment made though a cost is incurred but the expectation is that incarceration will correct behavior. Positive costs expect to produce positive outcomes via greater goods while negative costs hope to produce positive outcomes via reduction in negative events, outcomes, or costs.

There is a consensus for incurring positive costs, such as infrastructure spending, as a way to challenge China:

To address how best to deal with China, many people across the partisan aisle, are almost excited to incur positive costs. What is the old saying about politics, never let a good crisis go to waste. Consequently, everyone has news ways to spend money that frequently require tortured logic of how best to deal with China but still channels money to their preferred project. Building out the Acela from DC to Boston may or may not be a good idea, I personal think it is not, but it is difficult to see how producing one high speed rail line will stand up to China, especially on the cost to benefit ratio. This does not even necessarily mean that the project is bad as a stand alone project, however, especially under a budget constraint, a little discernment is called for about how best to challenge or compete with China.

The challenge is agreeing on incurring negative costs:

Where most people begin to get uncomfortable is when they are asked to bear negative costs associated with challenging China. This is a thorny topic for a couple of reasons. First, while positive costs distribute funding they also impose little direct cost given the use of sovereign debt market to fund most of the increased spending (assuming there is no offsetting tax increase). Second, there is very little way to predict what all the negative costs will be. Third, while benefits tend to widely shared, costs are borne by very narrow discrete groups or people making them much more vocal. With all those caveats let’s still try and explore what negative costs we should be considering.

Examples of negative costs are the proposed on Huawei and other Chinese suppliers, which have created hardship for rural telecom providers that are suddenly faced with the expense of replacing their Huawei telecom equipment.

Another example is the growing suspicion and scrutiny of ethnic Chinese scholars in American research institutions. The atmosphere has become so poisoned that the president of MIT wrote the following open letter in support, not only of Chinese researchers, but talented immigration in general:

To the members of the MIT community,

MIT has flourished, like the United States itself, because it has been a magnet for the world’s finest talent, a global laboratory where people from every culture and background inspire each other and invent the future, together.

Today, I feel compelled to share my dismay about some circumstances painfully relevant to our fellow MIT community members of Chinese descent. And I believe that because we treasure them as friends and colleagues, their situation and its larger national context should concern us all.

The situation
As the US and China have struggled with rising tensions, the US government has raised serious concerns about incidents of alleged academic espionage conducted by individuals through what is widely understood as a systematic effort of the Chinese government to acquire high-tech IP.

As head of an institute that includes MIT Lincoln Laboratory, I could not take national security more seriously. I am well aware of the risks of academic espionage, and MIT has established prudent policies to protect against such breaches.

But in managing these risks, we must take great care not to create a toxic atmosphere of unfounded suspicion and fear. Looking at cases across the nation, small numbers of researchers of Chinese background may indeed have acted in bad faith, but they are the exception and very far from the rule. Yet faculty members, post-docs, research staff and students tell me that, in their dealings with government agencies, they now feel unfairly scrutinized, stigmatized and on edge – because of their Chinese ethnicity alone.

Nothing could be further from – or more corrosive to ­– our community’s collaborative strength and open-hearted ideals. To hear such reports from Chinese and Chinese-American colleagues is heartbreaking. As scholars, teachers, mentors, inventors and entrepreneurs, they have been not only exemplary members of our community but exceptional contributors to American society. I am deeply troubled that they feel themselves repaid with generalized mistrust and disrespect.

The signal to the world
For those of us who know firsthand the immense value of MIT’s global community and of the free flow of scientific ideas, it is important to understand the distress of these colleagues as part of an increasingly loud signal the US is sending to the world.

Protracted visa delays. Harsh rhetoric against most immigrants and a range of other groups, because of religion, race, ethnicity or national origin. Together, such actions and policies have turned the volume all the way up on the message that the US is closing the door – that we no longer seek to be a magnet for the world’s most driven and creative individuals. I believe this message is not consistent with how America has succeeded. I am certain it is not how the Institute has succeeded. And we should expect it to have serious long-term costs for the nation and for MIT.

For the record, let me say with warmth and enthusiasm to every member of MIT’s intensely global community: We are glad, proud and fortunate to have you with us! To our alumni around the world: We remain one community, united by our shared values and ideals! And to all the rising talent out there: If you are passionate about making a better world, and if you dream of joining our community, we welcome your creativity, we welcome your unstoppable energy and aspiration – and we hope you can find a way to join us.

“Researching while Asian” is becoming the new “driving while black”. The Economist rhetorically asked if the US is losing its appeal to brainy foreigners (and not just the Chinese):

America—like every advanced economy—increasingly needs to attract the most highly educated talent possible. The high-skilled, who tend to congregate with other high-skilled people, usually in cities and universities, are more likely to be wealth creators, in finance or creative industries and well-placed to exploit new technology. Entrepreneurs, university graduates and others with demonstrable talent are in high demand. How a country attracts and keeps the highest-skilled migrants, therefore, is a measure of its likely future strength.

Historically, America has far exceeded rival countries in appealing to brainy foreigners and putting them to work, for example in how it gets foreigners into employment after they graduate from its universities. But under Mr Trump that crown is slipping.

Take a look at a typical ranking of the top universities around the world, and most of them are American. Education has historically been America`s competitive advantage, but many of the scholars at US schools are not native born. The US is increasingly making it difficult for American schools to admit talented foreign students.

The OECD, a think-tank for mostly rich countries, this week spelled out America’s problem. In pure terms of attractiveness to the high-skilled around the world, the authors of a new report say that America still ranks as the most popular place. Across seven indicators the think-tank studied for its measure of “talent attractiveness”–including unemployment levels, tax rates, gender equality, how easy it is for the family of a talented individual to settle and more—America still stands out as the most tempting destination for the brainy.

But on a second set of indicators the country fares worse. These include whether an applicant is likely to be denied a visa, how tight quotas are for the highly skilled, and the time and hassle involved in getting an application processed. Count in those considerations and America’s appeal to the most talented international workers falls sharply. The OECD ranks America behind several other rich countries, including Australia, Sweden, Switzerland, New Zealand, Canada and Ireland.

 

Measuring the AI race

What about crucial technologies like artificial intelligence? Isn’t China catching up quickly?
 

MacroPolo analyzed AI research and talent to cut through a lot of myths about the US-China rivalry in AI research, and the results are revealing. When they compared the top 1% of AI research talent, while there was a significant minority that came from China, the majority of researchers are affiliated with American universities.
 

 

Of the top 20% of AI researchers, about one-quarter come from China. However, the majority of them gravitate to the US to work or study.
 

 

This illustrates the strength of America’s competitive advantage in a leading edge topic like AI research. There is a clustering effect of top researchers at work. Elite researchers want to live and work in places where they can interact with other leading lights in their field.

These examples illustrate the extent of the “negative costs” that are borne by very specific groups. In the case of the heightened scrutiny of Chinese scholars and researchers, these measures erode America’s long-term competitiveness. This Bloomberg article about how the FBI is purging Chinese scientists from cancer research, which is a basic science, illustrates my point about how American competitiveness will be hobbled in the future. Instead of attracting top talent to America, they might migrate to some of the other countries identified by the OECD.
 

A trade war, or something more?

Another consideration that Trump and other American policy makers will have to decide on is whether the conflict with China is just a trade war, or a strategic competition that was outlined in the 2017 National Security Strategy.

If the dispute is purely a trade war, former American trade negotiator Wendy Cutler suggested that common ground can be found if there is sufficient political will. As an example, she cites the difference between the Chinese demand of lifting all tariffs as part of an agreement, compared to the American position of keeping tariffs in place until China implements its commitments under any treaty:

The current score card consists of $250 billion of Chinese imports and $110 billion of U.S. imports facing tariffs as high as 25%. China wants all of these tariffs lifted; the U.S. wants them to stay in place until China demonstrates a solid record of implementation. One solution would be to keep in place only the first tranche of U.S. tariffs hikes applied to $50 billion of imports, with a clear timeline for the remaining tariffs to be lifted tied to implementation bench marks. The U.S. could argue that these tariffs were specifically designed to hit those Chinese products benefiting from lax Chinese intellectual property practices, unlike the remaining $200 billion. China could point to its success in getting the U.S. to lift the bulk of the tariffs, while pointing to a path for removing the rest.

Another key sticking point is China’s demand for balance, or equality in a trade treaty:

Given the huge bilateral imbalances and Chinese unfair trade practices, it is only natural the U.S. believes the talks must focus on Chinese obligations. China, on the other hand, has a deep-seated disdain for “unequal treaties,” and is insisting that any deal include U.S. commitments. The key to addressing the issue may be the optics. Instead of phrasing commitments as applying solely to China, language for certain obligations can easily apply to both without the U.S. having to do anything. For example, since the U.S. has a strong intellectual property protection regime, it could easily agree that obligations in this chapter apply to it as well. This would allow China to claim the deal is two-way.

These are just a couple of examples of how negotiators could bridge seemingly intractable gaps in respective positions. A trade agreement is possible if the political will is there.

On the other hand, if the dispute is a strategic competition, what are the foreign policy dimensions to the conflict?

Some of Trump’s foreign policy signals have been highly confusing and contradictory. On one hand, the US has approved the sale of an arms package to Taiwan, which China regards as a renegade province and unwarranted interference with internal affairs. Similarly, US support for the protesters in Hong Kong is not winning them any friends in Beijing.

On the other hand, Trump tweeted last week that

China gets 91% of its Oil from the Straight, Japan 62%, & many other countries likewise. So why are we protecting the shipping lanes for other countries (many years) for zero compensation. All of these countries should be protecting their own ships on what has always been….

….a dangerous journey. We don’t even need to be there in that the U.S. has just become (by far) the largest producer of Energy anywhere in the world! The U.S. request for Iran is very simple – No Nuclear Weapons and No Further Sponsoring of Terror!

Notwithstanding the spelling mistake (“strait” instead of “straight”) and inaccuracies about the percentage of oil China receives from the Middle East, is he announcing a policy of American withdrawal from the region, and asking for others to step in? Is he inviting the People’s Liberation Army Navy to guarantee the security of oil tankers in the Gulf? Does he realize that such a decision implicitly cede regional security throughout South Asia and the South China Sea to the PLA Navy?
 

 

A supportive Fed?

For investors, another variable to consider is Fed policy. The market has fully discounted at least a quarter-point rate cut at the July FOMC meeting, with a 22% chance of a half-point cut. Analysis from Bianco Research reveals the probability of market disappointment falls rapidly as we approach the date of the meeting. Since we are just beyond the 30 day window in the chart, a rough estimate of a July rate cut stands at about 75%.
 

 

Should the Fed choose to cut rates at its July meeting, it will have achieve the unusual milestone of initiating an interest rate reduction cycle when financial conditions are looser than any time in the history of the Chicago Fed’s National Financial Condition Index.
 

 

What will the Fed do? Chairman Powell has made it clear that he is concerned about global economic weakness and trade tensions as sources of instability. In the event of a trade war, he will do everything he can to support economic growth.

On the other hand, what happens in the case of a long drawn-out trade truce? There are some clues from Powell’s latest speech on June 25, 2019. He reiterated his concerns about trade, the global economy, and the loss of business confidence putting the brakes on capital expenditures:

The crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy. Our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. For example, the limited available evidence we have suggests that investment by businesses has slowed from the pace earlier in the year.

Powell reiterated “the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”. The phrase “act as appropriate to sustain the expansion” translates to at a July cut, but investors expecting three quarter-point rate cuts in 2019 might be disappointed because of the Fed’s data dependency. Even St. Louis Fed president James Bullard, who is one of the most dovish members of the FOMC, recently told Bloomberg TV that while he dissented at the June meeting and argued for a 25 basis point insurance cut, a 50 basis point cut would be overdone.

Another variable to consider that is related to Fed policy is the US Dollar. Trump has managed to drag the Dollar into the agenda at the G-20 by complaining about the strength of the greenback. Everything else being equal, an accommodative Fed will tend to weaken the USD. Indeed, the history of the spread between US and eurozone rates has been astounding. The recent signals of Fed easing has begun to weaken the USD, and there is a lot of room for the spread to narrow.
 

 

Market implications

A Fed decision to make an about-face to switch to an easy money policy would be very bullish for risky assets. Troy Bombardia detailed past instances when the stock market rallied at least 15% over the past six months and the Fed cut rates. If history is any guide, the odds lean bullish.
 

 

Moreover, falling US rates puts downward pressure on the USD. This would relieve any pressure on EM economies under stress, which is another factor supportive of a risk-on environment.

As we approach Q2 earnings season, FactSet reports that earnings estimates continue to rise, indicating positive fundamental momentum. This should be supportive of stock prices, in the absence of a renewed trade war.
 

 

The macro outlook is best summarized by New Deal democrat as a dilemma of two time frames:

It boils down to: the short term forecast — over the next 4 to 8 months — looks flat at best, and could develop into an actual downturn. The longer term — over one year out — looks more positive…

In short, short leading indicators have been going basically sideways. And as I’ve noted repeatedly in the last few months, the leading employment sectors of manufacturing, residential construction, and temp jobs have all turned flat or downward since January. Whether there’s a recession or not in the short term probably depends on the intensity of Trump’s trade wars, and how much businesses, and business planning, suffers for them.

In the absence of trade war risk, the intermediate-term equity outlook is bullish. There is no signs of a recession on the horizon. The Fed has signaled that it stands ready to “act as appropriate to sustain the expansion”. There is little more that the bulls could ask for.
 

The week ahead

Up until now, all of the technical analysis and sentiment analysis leading up to the G-20 summit had only marginal value, because of the binary nature of the meeting outcome. I would expect that the stock market would adopt a risk-on tone on Monday and gap up.

How far up? Here is where technical and fundamental  analysis can provide some guidance. Assuming that the S&P 500 breaks out to new all-time highs on Monday, here is what I would watch for signs of a possible stall.
 

 

  • An overbought signal on the 14-day RSI would provide the first warning sign, though overbought markets can become even more overbought.
  • A VIX close below its lower Bollinger Bnd can be another signal that the market may be losing momentum. A high degree of caution is warranted.

I made a study of all non-overlapping signals when the VIX fell below its lower BB, and the market returns have historically been poor in the first week after the signal, but began to climb again afterwards.
 

 

The same study of the success rate told roughly the same story. Returns were subpar in the first week and then recovered afterwards.
 

 

Aggressive traders could choose to buy the initial surge, but be prepared for a pullback. The market is likely to become overbought and stall within the first week. In addition, there may be bearish triggers in mid-July.

Robert Mueller is scheduled to testify before the House Intelligence and Judiciary committees on July 17, and those events are likely to unnerve Trump. President Trump is a master of the media, and he has shown a pattern of reverting to the unexpected exercise of powers in border security and trade to deflect attention from political threats. The last example was his directive to slap a 5% tariff on Mexico if the migrant problem was not solved. Don’t be surprised if Trump lashes out at European autos, or uses either of his NAFTA partners as punching bags again around the time of the Mueller testimony.

Once the rally starts to roll, I would monitor the performance of cyclical stocks for a market signal to the sustainability of the move. Undoubtedly, semiconductors will perform well in light of Huawei’s temporary reprieve, but what about the other cyclical groups?
 

 

Another way of measuring a cyclical reflationary effect is the ratio of industrial metals to gold. While both are commodities and both have inflation hedge characteristics, industrial metals are more sensitive to global growth, and the industrial metals to gold ratio is historically correlated to the stock to bond ratio, which is an indicator of risk appetite.
 

 

That said, how far can stock prices rise under a best case scenario of no trade war, a supportive Fed, and continued growth?

Let us begin with the growth outlook. FactSet reports that expected year/year quarterly EPS growth is expected to be soft until Q4. Should we sail past this window of vulnerability without a trade war, the outlook should begin to turn up late in the year.
 

 

Analysis from Nordea Markets tells a similar story. Surveys like ISM and PMI are short leading indicators, and the yield curve is a long leading indicator. It is therefore no surprise that the yield curve leads ISM readings. Based on this analysis, the economy should bottom out and turn up either Q4 2019 or Q1 2020.
 

 

So where does that leave equity investors? Let us try some rough back of the envelope calculations. The forward P/E of the market stands at 16.6. Supposing exuberance took over because of the lack of trade war tail-risk, and forward P/E rises to 18.0. Add another 3% to increase to forward earnings to year-end. The combination of P/E expansion and rising earnings gives us an approximate year-end target of 3280, or 11.4% plus dividends from Friday’s close.
 

 

From a technical perspective, the outlook appears even more bullish. The market is likely to stage a decisive upside breakout next week, and the upside target on the point and figure chart ranges from 3750 to 4100, depending how the parameters are defined. I would caution, however, that the time frame for point and figure target is likely to be longer than the fundamentally derived target in the previous exercise.
 

 

In conclusion, the intermediate-term outlook equity outlook appears bullish, and may be poised for a melt-up. Be prepared for short-term pullbacks. Since the US and China only agreed to restart talks, an agreement is no slam dunk, and setbacks will be inevitable. Given what is at stake for both sides, weakness should be regarded as buying opportunities as long as recession risk is low.

My inner investor was neutrally positioned at roughly his asset allocation target weights coming into the weekend. He will be opportunistically raising his equity weight in the days and weeks to come.

My inner trader was in all cash coming into the weekend as he did not want to flip a coin on the summit outcome. He expect to take an initial long position on Monday.

 

What’s up with gold?

Posted by Cam Hui -

Mid-week market update: Gold staged an upside breakout from a multi-year base, which got a lot of technicians excited. The point and figure chart upside targets range from about 1630 to the mid-1700s, depending on how the parameters are set.
 

 

Before you pile in and buy, let me educate you on the causes of this move, so that you can make a reasoned decision. Think of this as the case of a dog and his tail. Gold is the tail, and it is wagging very rapidly. Figure out why before taking action.
 

What inflation?

Gold bugs have pointed to gold as an inflation hedge, but this chart showing gold prices and inflationary expectations disprove that theory. Even as gold prices rose, inflationary expectations have been falling.
 

 

Don’t buy gold if you are using it as an inflation hedge.
 

A weak USD

One of the drivers of strong gold prices is a weak US Dollar. Historically, gold has seen a rough inverse correlation with the trade weighted dollar (inverted on chart).
 

 

That’s where the Fed comes in. When the market started to discount three rate cuts in 2019, and the Fed did nothing to correct that perception at its June FOMC meeting, the greenback weakened and gold soared.

Even though the US 10-year yield hovers around 2%, its spread against Bunds is historically high. Should the Fed embark on a rate cut cycle, there is lots of room for the spread to fall, and for the USD to weaken against EUR. A similar condition holds true for the USD against most other major currencies.
 

 

Gold bulls and dollar bears beware! Recent Fedspeak has tempered the market’s aggressive rate cut expectations. Powell’s speech on Tuesday was less equivocal as he made the “on one hand” and “on the other hand” cases:

The question my colleagues and I are grappling with is whether these uncertainties will continue to weigh on the outlook and thus call for additional policy accommodation. Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened. But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty to the outlook. We will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.

St. Louis Fed President James Bullard is one of the most dovish voting members of the FOMC. He broke with the consensus and dissented at the most recent June meeting by calling for a rate cut. He appeared to moderate some of his dovish position in a Bloomberg interview when he stated that he believed a 50 basis point cut would be overdone, and a 25 basis point insurance cut would be more appropriate.

Maybe a July rate cut is not a certainty after all.
 

Gold loves falling real rates

Another bullish driver of gold prices is falling real rates. The following chart shows the price of gold with the inverse of real rates.
 

 

Indeed, as global central banks have pushed bond yields into negative territory, their actions have put upward pressure on gold prices.
 

 

Needless to say, Fed policy and falling real rates are inter-related. It is interesting that a minor divide has opened up between senior members of the Fed and the more dovish regional Fed presidents. Fed chair Powell and vice chair Clarida have focused mainly on trade and global growth uncertainties as the reasoning behind a possible insurance rate cut. By contrast, the more dovish regional presidents like Bullard and Kashkari have put far more emphasis on the disappointing realized inflation and falling inflationary expectations to justify rate cuts. Just as revealing was Powell’s hint that the dovish dot plot was attributable to the non-voters, namely the regional presidents, on the FOMC, rather than the Fed governors, who are permanent voters.

Will the global viewpoint of the governors prevail, or will the domestic concerns of the regional presidents gain the upper hand? Should the latter group dominate the discussion, it will mean that the Fed will be focusing on the evolution of real interest rates, which is a key driver of gold prices.

In the short term, gold is wildly overbought. The DSI stands at 93, which is a level that has not been seen since the 2011 peak. Now is not the time to be buying.
 

 

Even if you are bullish, be well advised to wait for the pullback, and watch how the other factors and drivers are evolving. Know why you are buying before making the decision.
 

 

What about the stock market?

As for the stock market, there isn’t much to say, other than it is marking time ahead of the Trump-Xi summit at the G-20 this weekend. I continue to be concerned that sentiment is a little too relaxed ahead of the meeting, which has the potential to be a high volatility inducing event.

Sentiment surveys, such as II sentiment, has normalized as % Bulls are recovering to pre-pullback levels.
 

 

Short-term option sentiment is exhibiting minor levels of anxiety. 9-day VIX (VXST) has spiked above 1-month VIX. Since the G-20 meeting is within the VXST window, this development is entirely to be expected, though I would have thought that the degree of term structure inversion would have been more pronounced.
 

 

My inner trader continues to stand aside in cash. He doesn’t need to roll the dice ahead of an event that he doesn’t have a trading edge.

Personal note: Publications will be lighter than usual in the next couple of weeks as I am still recovering from cataract surgery, which makes seeing the computer screen somewhat of a challenge. I will continue to publish a weekend and mid-week update, and the regular service will resume as soon as possible.