Correction ahead: Momentum is dying

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: Sell 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.
 

Momentum is dying

I have been cautious on the near-term equity market outlook for several weeks (see Here comes the growth scare and Still bullish, but time to reduce risk). I reiterate my point for being bullish and bearish over different time frames. While I believe stock prices will be higher by year-end, investors should be prepared for some turbulence over the next few months.

We are now seeing definitive technical evidence of a softer market in the near-term. Momentum is dying, and across a variety of dimensions. One key technique that I use to monitor momentum is the behavior of different moving averages. If the shorter moving average starts to roll over while the longer moving average continues to rise, that’s a sign of fading price momentum.

The chart below depicts the weekly S&P 500 chart, with a MACD histogram on the bottom panel. Note how MACD, while still strongly positive, is starting to roll over. I find that the weekly chart is useful for intermediate term price moves while filtering out the noise from daily fluctuations.
 

 

In the past, such episodes have resolved themselves with either a sideways consolidation or market downdraft. I expect that the most likely outcome is a correction that will last 1-3 months, followed by a resumption of the bull market.
 

Dying momentum everywhere

Evidence of fading price momentum can be found everywhere. The MACD rollover can be found in a variety of stock indices. Here is the NASDAQ Composite.
 

 

The small cap Russell 2000 is also rolling over.
 

 

The fading price momentum effect can be seen globally. Here are non-US developed market equities, as measured by EAFE.
 

 

Emerging market stocks started to fade several weeks ago, ahead of developed markets (see An EM warning).
 

 

Risk appetite indicators are also losing momentum. The stock/bond ratio is exhibiting a pattern of MACD histogram rollover.
 

 

High yield (junk) bond prices, net of interest rate effects, have been highly correlated with stock prices, and momentum is dying as well in this asset class.
 

 

Even more ominous is the analysis from John Murphy of Stockcharts, who concluded from waning momentum that the market may have peaked in late 2018 and it may be undergoing a topping process:

LONG-TERM MOMENTUM IS ALSO WEAKENING… The monthly bars in Chart 2 show the uptrend in the S&P 500 that started exactly ten years ago. And that uptrend is still intact. The sharp selloff that took place during the fourth quarter of 2018 stayed above the rising trendline drawn under its 2009, 2011, 2016 lows. That’s the good news. What may not be so good are signs that long-term momentum indicators are starting to weaken. The two lines in the upper box in Chart 2 plot the monthly Percent Price Oscillator (PPO). [The PPO is a variation of MACD and measures percentage changes between two moving averages]. The PPO lines turned negative during the second half of last year when the faster red line fell below the slower blue line. And they remain negative. [The red histogram bars plotting the difference between the two PPO lines also remain in negative territory below their zero line (red circle)]. Secondly, and maybe more importantly, the 2018 peak in PPO is lower than the earlier peak formed at the end of 2014. That’s the first time that’s happened since the bull market began. In technical terms, that creates a potential “negative divergence” between the PPO lines and the S&P 500 which hit a new high last year. That raises the possibility that the ten-year bull market may have peaked in the fourth quarter of 2018 and is now going through a major topping process. If the peaking process in stocks has already started, that could start the clock ticking on the nearly ten-year economic expansion that also started during 2009.

 

Weak fundamental momentum

In addition to evidence of fading price momentum, the market is also faced with the prospect of negative fundamental momentum. The latest update from Yardeni Research Inc. shows that forward 12-month large cap EPS estimates edged up last week, but within the context of a multi-week downtrend. The strength in large cap estimates was not confirmed by mid and small cap estimates, both of which continued to fall.
 

 

We can see the effects of price and fundamental momentum from two ETFs. The relative performance of MTUM (black line) represents the returns of a pure price momentum factor. By contrast, FFTY is the IBD 50, which relies on a composite of fundamental and price momentum factors to construct its portfolio. As the following chart shows, the relative performance of both factors have been highly correlated until last fall. Since then, price momentum has been flat to down during the latest rally, while IBD 50 momentum has begun to roll over in the last few days.
 

 

Recession scare ahead?

Last Friday’s shockingly weak Employment Report also raises some concerns of fading macro momentum. While the weak February headline Non-Farm Payroll figure could be attributable to a data blip, or mean reversion from the strong January report, the internals of the report show signs of economic weakness. Temporary employment, which has historically led NFP, is topping out. This suggests that employment will weaken further in the coming months.
 

 

Equally worrisome is the outright loss of 31K in construction jobs, Construction employment growth has either been coincident or led past recessions. That`s not a surprise, as housing is a highly cyclical industry and a key barometer of economic health.
 

 

The message from the commodity markets is equally downbeat. Despite an apparent recovery in industrial metal prices, the internals are less bright.
 

 

However, IHS Markit pointed out that global metal users PMI has been declining, which is indicative of a softening manufacturing environment.
 

 

Business Insider (paywall) reported that the UBS US recession had spiked. However, these readings have to be taken with a grain of salt. Note the past false positives, which are highlighted on the chart.
 

 

Still bullish to year-end

Despite these short-term negatives, I remain bullish on equities to year-end, and believe that any growth scare is only temporary in nature for several reasons.

The first reason is the existence of a Trump Put. Bloomberg reported that Trump believes his 2020 re-election prospects goes through the stock market:

President Donald Trump is pushing for U.S. negotiators to close a trade deal with China soon, concerned that he needs a big win on the international stage — and the stock market bump that would come with it — in advance of his re-election campaign.

As trade talks with China advance, Trump has noticed the market gains that followed each sign of progress and expressed concern that the lack an agreement could drag down stocks, according to people familiar with the matter. He watched U.S. and Asian equities rise on his decision to delay an increase in tariffs on Chinese goods scheduled for March 1, one of the people said.

Trump has become obsessed with stock prices as a metric of his administration’s success. Even if the much anticipated trade deal doesn’t produce a market pop, he may be tempted to take other means to boost stock prices.

Trump’s fixation on stock-market performance has shaped his assessments of his economic policies. Top White House staff know to be aware of how markets are performing when summoned to the Oval Office to speak with Trump because the president often asks: ‘‘What’s happening with the markets?’’

The second reason is the Powell Put. The minutes of the January FOMC meeting makes it clear that the Fed is monitoring the stock market [emphasis added]:

Following the briefing, participants raised a number of questions about market reports that the Federal Reserve’s balance sheet runoff and associated “quantitative tightening” had been an important factor contributing to the selloff in equity markets in the closing months of last year. While respondents assessed that the reduction of securities held in the SOMA would put some modest upward pressure on Treasury yields and agency mortgage-backed securities (MBS) yields over time, they generally placed little weight on balance sheet reduction as a prime factor spurring the deterioration in risk sentiment over that period. However, some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve’s securities holdings was a factor putting significant downward pressure on risky asset prices, and the investment decisions of these investors, particularly in thin market conditions around the year-end, might have had an outsized effect on market prices for a time. Participants also discussed the hypothesis that investors may have taken some signal about the future path of the federal funds rate based on perceptions that the Federal Reserve was unwilling to adjust the pace of balance sheet runoff in light of economic and financial developments.

In addition, both the BAML Fund Manager Survey and the compilation of State Street investor confidence from Callum Thomas of Topdown Charts shows that institutions are already defensively positioned. While other segments of the markets, such as retail investors, are not similarly cautious, these reading should put a floor on stock prices in the event of bearish news.
 

 

Lastly, investors should not ignore the powerful effects of a breadth thrust. If history is any guide, stock prices are almost invariably higher after a breadth thrust such as the one experienced in January, even though interim corrections may occur shortly after the event.
 

 

I had highlighted the results of my historical study in a past publication (see Still bullish, but time to reduce risk) which shows that excess return (bottom panel) weakens after two months, but rises thereafter. Moreover, three and six month maximum drawdowns are in the 11-13% range, indicating the possibility of a interim pullback.
 

 

I went back 20 years, and found very few instances like the one we are encountering today. There were not many episodes where the weekly MACD histogram had been deeply negative, rose strongly, and rolled over. In all cases (n=3), the market pulled back. In two of the three cases, the correction was relatively minor and the market did not re-test its previous low.
 

 

Buy the dip, or sell the rip?

My base case scenario calls for a correction of 1-3 months in length, but without a re-test of the December lows. The depth of the pullback will be a function of any growth scare, and the details of the US-China trade agreement. As always, I will be data dependent.

I have written before that I am both bullish and bearish on different time frames, and current circumstances suggest different positioning for traders and investors. Traders with time horizons of up to three months should be tilted bearishly, and be prepared to sell or short into market strength. On the other hand, longer term oriented investors should view any market weakness as an opportunity to deploy funds into equities in anticipation of higher prices later in the year.
 

The week ahead

I have been tactically cautious on the equity market outlook in these pages for the past few weeks, and it appears that the technical break has finally appeared. The S&P 500 ended the week with a bearish engulfing candle that erased two weeks of gains. Past instances of such formations have tended to be bearish, but traders should be prepared for a backtest rally in the upcoming week.
 

 

One of the bearish setups that I highlighted before was the unusual high correlation between stock and gold prices. In the past, such episodes have resolved themselves with a trend reversal in stock prices, which seems to be finally happening.
 

 

Too much technical damage has been done to believe that the market could just simply bounce and advance to test the old highs. One of my bearish tripwires was the violation of breadth support, as defined by the net 20 day highs-lows. In addition, the S&P 500 also breached its 200 dma last week, which is an important psychological level.
 

 

The technical damage is not just isolated to US equities. Chinese stocks had rallied through a key resistance zone on the excitement of stimulus, MSCI re-weighting of Chinese shares in its global indices, and a likely trade deal, only to see them crater late last week below support turned resistance when it became evident that growth was faltering. Moreover, the SCMP report that insiders are selling even as foreigners buy in did not help matters. In addition, US soybean prices, which are sensitive to the expectations of a trade truce, failed to stage an upside breakout through resistance, and they have weakened to test support.
 

 

In anticipation of the question, I have no idea how far down the correction might run. My working hypothesis is a 5-10% pullback, but that is only just a guesstimate. However, there are ways of spotting bottoms, but none of the signs are in place.

The Fear and Greed Index remains elevated, and I would like to see it fall to a minimum of 30 before declaring the possibility of a bottom are in place.
 

 

The VIX Index neared the top of its upper Bollinger Band (BB) last Friday, which can be a signal that a short-term bottom is near. However, past instances of VIX closes above its upper BB that was not accompanied by an S&P 500 close below its lower BB (light yellow shaded regions) have seen stock prices weaken further. By contrast, the combination of VIX closes above its upper BB and S&P 500 below its lower BB (grey shaded regions) have marked reasonable long entry points for traders.
 

 

To be sure, the market is oversold short-term, and a 1-2 day relief rally could happen at any time.
 

 

Next week is option expiry week. Rob Hanna at Quantifiable Edges pointed out that March OpEx is one of the more bullish OpEx weeks of the year.
 

 

These conditions argue for a short-term relief rally that begin early in the week, followed by either more choppiness or a resumption of the bear trend.

My inner investor is neutrally positioned with his asset allocation at roughly his target weights. Should stock prices correct further, he is prepared to raise his equity weight. My inner trader was short going into the decline, and he is getting ready to add to his shorts should the market rally. In other words, my inner investor is getting ready to buy the dip, while my inner trader will sell the rips.

Disclosure: Long SPXU

 

Consolidation or correction?

Posted by Cam Hui -

Mid-week market update: I have been cautious about the US equity market outlook for some time, and the market seems to be finally rolling over this week. The SPX violated an uptrend while failing to rally through resistance.
 

 

In the short rim, stock prices are likely to experience difficulty advancing. However, such episodes of trend line breaches can either resolve themselves through a sideways consolidation or a correction. What is the more likely scenario?
 

A mixed leadership message

An examination of sector market leadership doesn’t yield a lot of clues. The top four sectors, Technology, Healthcare, Financials, and Communication Services, make up roughly 60% of the weight of the index. However, their relative performance doesn’t give us many clues to the market direction. Financial stocks, whose relative performance is highly correlated to the shape of the yield curve, is performing roughly in line with the market. Technology is strong, but its strength is offset Healthcare weakness. Communications Services, which is dominated by FB, GOOGL, and NFLX, is not confirming Tech leadership, indicating mixed FAANG participation in this rally.

The picture from market cap leadership is a bit more worrisome. Mid and small cap stocks have been the leaders in the latest rally, and all metrics of market capitalization indicate small and mid cap strength are rolling over. However, this may only be a signal that stock prices are struggling at resistance. It does not necessarily mean they will correct.
 

 

The silver lining

There are, however, some silver linings in the dark cloud. Biotech stocks have led this market upwards, and the group staged an upside breakout through resistance when the major indices failed. So far, Biotechs have pulled back but they are still holding above resistance turned support. That’s a good sign.
 

 

The SPX breached its 10 dma today after a prolonged advance. Statistical analysis from Troy Bombardia indicates that such episodes tend to be short-term bullish, though the market is down 62% of the time after three months.
 

 

The bear case

On the other hand, there are plenty of ominous signals. The most worrisome has been the inability of stock prices to respond to good news. We have seen a couple of instances where Asian markets have risen on the news of an imminent US-China trade deal. US equity futures rise overnight, only to see the strength fade away during regular trading hours.

I pointed out before that stock and gold prices have been unusually correlated in the rally off the December bottom. Such instances of high correlation tended to be resolved with a stock price reversal, which we seem to be seeing the beginning of.
 

 

The strength of the USD is also a concern. Roughly 40% of SPX revenues are foreign, and USD strength creates an earnings headwind for multi-nationals. Past episodes of excessive USD strength have resolved themselves with stock market weakness.
 

 

As well, Mark Hulbert recently warned that his index of NASDAQ market timers are in their 96 percentile of bullishness, which is contrarian bearish:

The rally since Christmas Eve has indeed been sharp and powerful. Investors’ hopes have been rekindled in a big way. The Hulbert Nasdaq Newsletter Sentiment Index (HNNSI), which measures the average recommended exposure level among Nasdaq-oriented market timers, recently rose to one of its highest levels ever — higher than 96% of daily readings since 2000, in fact.

This does not bode well for the market’s near-term prospects, according to contrarian analysis. To repeat: none of this discussion automatically means we’re in a bear market. We won’t know for sure, one way or the other, until the market averages either surpass their bull market highs from last fall or break down below their Christmas Eve lows. But it definitely isn’t a good sign that so many bulls are prematurely declaring victory.

 

The last word

Where does that leave us? My inner trader is still tactically bearish, but he is keeping an open mind as to near-term market direction. While he is tilting towards the correction case, he is not ready to get wildly bearish until the SPX decisively breaks support on the hourly chart.
 

 

Disclosure: Long SPXU
 

An EM warning

Posted by Cam Hui -

avFor several months, the BAML Fund Manager Survey shows that global institutions have been piling into emerging market equities.

 

The purchase of EM equities has been a smart move, as they have been leading the market upwards. However, their time in a leadership role may be coming to an end owing to a series of disappointments. EM started to top out against the MSCI All-Country World Index (ACWI) in early February, and relative performance has been rolling over ever since.

 

Disappointment everywhere

A glance at the Economic Surprise Index (ESI) tells the story. EM ESI has been declining, indicating that economic releases are increasingly disappointing compared to market expectations.

 

Yardeni Research, Inc. (YRI) just published their monthly summary of consensus estimate revisions around the world. YRI calculates a 3-month average diffusion index of upward revisions less downward revisions, normalized as a percentage of the entire sample. EM estimate revisions are still highly negative, but they are “less bad” as the rate of deterioration has been improving.

 

Is that enough to be buying EM equities? I took a look at what countries could be causing the improvement. Only one, count them – one, actually showed a positive estimate revision in February. That country was Brazil.

 

Two other countries were in the honorable mentions category by showing strong improvements. Overall estimate revisions remained negative, but the indicator was nearly positive (remember this is a 3-month moving average). The runner-up was The Philippines.

 

The next one was Argentina.

 

What about China?

There have been many investment eyes on China owing to its economic slowdown and the outsized global effect of its trade discussions with the US. The Shanghai Composite rose Monday and broke through the 3000 level on the combination of “a trade deal is imminent” story, and the news of MSCI’s dramatic increase of China equity weights in its global indices.

Here is where hope may be running ahead of reality. Even as Chinese equity ETFs have decisively broken out through resistance, soybean prices have failed to rally above its resistance level.

 

The strength in Chinese shares was largely attributable to foreign buying. The latest statistics on the HK-Shanghai flows shows an enormous spike in northbound (HK to Shanghai) flows.

 

At the same time, the SCMP reported that insiders are selling even as foreigners buy in.

Take a look at who owns China’s US$6.4 trillion stock market. At 2.2 per cent, foreigners’ sway is tiny. And while local retail investors are blamed for the 2015 stock-market frenzy, they hold only 20 per cent. The majority of shares are still controlled by insiders: founders, management and parent holding companies.

As early as May 2017, China’s securities watchdog tightened regulation on stock sales by majority shareholders. The move was intended to protect retail investors and strengthen corporate governance.

But that hasn’t stopped insiders from selling, even at the risk of facing the regulator’s ire. In the three weeks ended February 23, such investors – concentrated among firms listed on the private-sector ChiNext board – were net sellers of more than 4 billion yuan of shares, according to data compiled by Sinolink Securities.

On Monday and Tuesday, when daily trading volume exceeded 1 trillion yuan, close to 80 companies filed insider-selling disclosures with the Shanghai and Shenzhen exchanges.

To be sure, the foreign buying frenzy is probably not over yet. The measured point and figure target on FXI is 53.45, which represents a potential upside of 20% from current levels.

 

I had highlighted a buying opportunity in Chinese stocks in January (see A buying opportunity in Chinese stocks?) and they are up between 6-20% in USD terms, depending on the chosen ETF. In light of the combination of technical relative deterioration in EM stocks, macro disappointment, narrow estimate revision leadership, and insider selling in China, this is not the time to committing new funds to EM or Chinese stocks. From a global perspective, since EM equities led the market up in this latest rally, the latest bout of relative weakness may be a warning that a prolonged risk-off episode is ahead in the weeks ahead.

 

The boom of 2021

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: Sell 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.

The Great MMT Experiment of 2021

As I watched last week`s CNBC interview with Stephanie Kelton, I became increasingly convinced that 2021 could see a great experiment in MMT. In that case, the market hiccup of late 1998 could serve as a template for the recent hiccup of late 2018. In that case, the best is yet to come!

Stephanie Kelton is one of the leading academic proponents of Modern Monetary Theory (MMT). I wrote about MMT before, so I won’t repeat myself (see Peering into 2020 and beyond). MMT postulates that a government which borrows in its own currency is only constrained by the inflationary effects of excessive debt, and until it hits that point, a government does not have to worry about deficits (for further background, see this Barron’s interview with Stephanie Kelton).

There are a number of myths about MMT. It does not mean that deficits doesn’t matter, deficits don’t matter until the bond market decides it matters. There is no free lunch. It does not mean that government doesn’t have to tax. Taxes are and remain a tool of fiscal policy. It is not Keynesian economics. Keynes believed that governments should try run deficits in bad times and surpluses in good times. MMT says that debt, by itself, is not a constraining factor.

With that introduction, I can sketch out a scenario in which MMT becomes the dominant ideology after the 2020 election, which could unleash a powerful fiscal stimulus on the American economy for the following reasons:

  • The rise of millennial political power;
  • A growing acceptance of government debt; and
  • Stimulus will occur, regardless of who wins the 2020 election.

Fiscal stimulus will be reflationary and equity bullish. I have no idea if the implementation of MMT will be a boon, or if Kelton will become the Arthur Laffer of the Left. The bill will be payable much later. In the meantime, investors should be prepared to party. If the results were to turn out to be catastrophic, investors can then opportunistically position themselves to profit from the cleanup.

The rise of the millennials

I wrote about the demographic effects of the aging millennial generation could have on investment flows (see Demographics isn’t destiny = History rhymes), but that analysis only focused on investment demand. It is clear from age demographics that a new age cohort is going to have an outsized effect on America, and in many dimensions.

One of those dimensions is politics. The rising young star of the Democrats is Alexandria Ocasio-Cortez (AOC), and she is already the main character of a comic book that features her as the new super-hero. AOC has championed an ambitious program called the Green New Deal (GND) featuring an array of programs to fight climate change, and other popular progressive initiatives such as medicare for all, and free college. All of this will be financed by MMT.

Former Bill Clinton economic advisor Brad DeLong implicitly recognized the rise of the millennials, and concede that his own time had passed.

I don’t know how far the progressives within the Democratic Party will get, but their ambitious agenda is likely to push the Overton Window, or the range of acceptable political discourse, to the left. The Overton Window had been drifting to the right for a generation, and some mean reversion is to be expected. A recent academic paper by Gabriel Zucman found that wealth inequality is at levels last seen during the last Gilded Age, before the Great Depression.

A growing acceptance of deficits

There is also another growing acceptance that government debt is not the source of evil from a number of respected sources. Warren Buffett, in his latest letter to Berkshire Hathaway shareholders, emphasized the productive use of government since 1942:

Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%! Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To “protect” yourself, you might have eschewed stocks and opted instead to buy 31⁄4 ounces of gold with your $114.75.

And what would that supposed protection have delivered? You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle.

Our country’s almost unbelievable prosperity has been gained in a bipartisan manner. Since 1942, we have had seven Republican presidents and seven Democrats. In the years they served, the country contended at various times with a long period of viral inflation, a 21% prime rate, several controversial and costly wars, the resignation of a president, a pervasive collapse in home values, a paralyzing financial panic and a host of other problems. All engendered scary headlines; all are now history.

The New York Times highlighted comments by former IMF chief economist Olivier Blanchard, who stated that US debt levels are not necessarily worrisome because rates are low, and growth is higher than the cost of debt:

Mr. Blanchard, the former I.M.F. chief economist, emphasizes that interest rates are comfortably below the rate at which the economy is growing. That means that, despite high debt levels in the United States, it shouldn’t matter if the nation keeps borrowing money because its capacity to pay is growing faster than interest costs.

That was also the approach embraced by Canadian prime minister Justin Trudeau in his last election. He reasoned that debt levels were low, and so were rates. If the market is going to lend to you cheaply for infrastructure spending, then why shouldn’t you take advantage of that opportunity. (As it turns out, the Trudeau Liberals’ infrastructure program was much slower than advertised, but that’s another story.)

Across the Atlantic, Handelsblatt reported that some German economists are starting to doubt Germany’s propensity towards austerity and fiscal discipline:

Germany’s debt constraint amendment, introduced in 2009 and known as the “debt brake”, sets a tight limit on structural deficits and only permits exceptions in natural disasters or severe recessions.

It’s been sacrosanct, with even the powerful International Monetary Fund not daring to question the rule, at least not in public, even though IMF experts regularly exhort the German government to invest more and abandon its strict balanced-budget policy.

But an open debate about its merits has erupted, and it’s been triggered not by Anglo-Saxon economists long critical of German austerity but by German economist Michael Hüther, the head of the industry-friendly IW German Economic Institute.

Hüther told Handelsblatt that the debt brake has turned into an obstacle to tax cuts and investment. “We’ve walled ourselves in,” he said.

The amendment served its purpose and exerted budget discipline on governments, he said. But it’s gone too far, and now bedeviling debt at a time of low interest rates and a huge need for public investment is bad policy.

“Times have changed,” he said. It’s time to “open the windows.”

Other economists agree, such as Jens Südekum of Düsseldorf University. The debt brake contributed to budget consolidation, he said. “But it has over-fulfilled its purpose.” It now stands in the way of much-needed modernization and growth. “That’s why we should get rid of it again.”

The theme is the same. More debt can enhance growth because the returns are greater than the cost:

The IMF has pointed out that in the current low-interest environment, debt-funded investments end up paying for themselves because they increase Germany’s potential growth.

So what should be done? Hüther of the IW proposed having a special budget just for investment. Fratzscher of the DIW said the debt brake should be replaced by a rule that links spending to economic performance.

“In addition, the government should introduce an investment rule that makes sure the state doesn’t squander public assets and instead invests enough in public infrastructure,” he said.

Indeed, Bloomberg reported that Germany is turning to fiscal stimulus in the face of continuing budget surpluses. Brad Setser of the Council on Foreign Relations pointed out that if Germany were to run stimulus of 0.3% to 0.4% of GDP for the next 4 or 5 years, its budget surplus would disappear.

Finance Minister Olaf Scholz has set aside more than 150 billion euros ($170 billion) for infrastructure, education, housing and digital technology over the next four years. The push on infrastructure is helping construction, which grew at an annual pace of more than 3 percent in the second half of 2018.

At the same time, changes to social-security contributions and taxation are putting more money in consumers’ pockets, which should help domestic demand. Unemployment figures on Friday showed another drop in the number of jobless.

“Slowly but surely, Germany is delivering the boost to government spending that observers have asked for many years,” said Holger Schmieding, chief economist at Berenberg Bank.

The argument for less frugality has been espoused by everyone from U.S. President Donald Trump to Nobel laureate Paul Krugman, and with German growth cooling, calls from outside Germany for more have grown louder recently. “There is basically no downside” to more spending, according to Brad Setser, a senior fellow for international economics at the Council on Foreign Relations in New York.

A very Republican MMT

While we have no idea who the Democrats will nominate to be their presidential candidate in 2020, we do know that their policies are likely to be progressive, and call for a high degree of fiscal expansion. In other words, higher deficits.

What about the Republicans? In this case, we do know who the probable nominee will be. Kevin Muir at The Macro Tourist characterized Trump as an MMT adherent:

Now, we all know that governments rarely balance budgets, but before Trump, the Republicans at least used to give lip-service to the idea.

But the Trump tax cut was unprecedented at this stage of the business cycle. And I know Trump isn’t actually embracing MMT as a new sect of economic religion, but let’s face it – the idea that deficits don’t matter has him on the same page as the MMT’ers.

Then let’s examine the next tenet of MMT – that which government spending doesn’t actually need to be borrowed, but instead can be financed through credit creation (once again, only up to the point where the economy becomes constrained in real terms – not financial terms).

Well, what is Trump saying about quantitative tightening?

Why, that it’s terrible of course and should be stopped immediately.

So let’s think about this. If Trump is pushing for the Federal Reserve to not wind down their previous quantitative easing (balance sheet expansion) then isn’t he advocating for a permanent expansion of the balance sheet? And if so, isn’t this the same as the government spending while monetizing it?

Again, it sure sounds an awful lot like MMT.

The implementation of MMT would require a higher than usual degree of cooperation and coordination between the fiscal and monetary authorities. Despite Jay Powell’s pushback against MMT in his latest Senate testimony, the ideas are not totally foreign in central banking circles. The enactment of such a program sounds a lot like helicopter money. These ideas are also reminiscent of Nomura chief economist Richard Koo’s prescriptions for Japan, which called for the government to spend until it hurts, and then spend some more, while the BoJ supports the fiscal expansion.

Who wins in 2020?

The only question is who wins the elections in 2020. A victory by the Democrats would see spending in the form of their priorities, namely fighting climate change, free medical care and university education. A Republican victory would see more tax cuts. Either way, we are likely to see more fiscal stimulus.

Political scientist Rachel Bitecofer called the scale of the Democrats landslide victory in 2018 well before anyone else. Here is her latest analysis. The Democrats should easily beat Trump in a head-to-head contest, but it becomes a toss-up if an independent like Schulz were to enter the race. That’s because an independent is 5 to 1 times more likely to draw votes from Democrats than from Republicans.

In either case, we are likely to see a great MMT experiment in 2021. That will mean fiscal stimulus, which will be reflationary and equity bullish. I have no idea if the implementation of MMT will be a boon, and Kelton will become the Arthur Laffer of the Left. The bill will be payable much later.

In the meantime, investors should be prepared to party! If the results were to turn out to be catastrophic, investors can then opportunistically position themselves to profit from the cleanup.

The week ahead

A reader recently asked me if I was still tactically bearish. If so, what was my downside objective, and what would turn me bullish.

I replied that I would turn bullish if earnings estimates showed a consistent turnaround for two consecutive weeks, and across all market cap bands. In addition, the recent breadth thrust off the December bottom had been breathtaking, and I would be surprised to see a correction that is more than 5-10%.

The latest update of earnings estimates from FactSet showed some mixed results. The good news is forward 12-month estimates had stopped falling in the latest week, though in the context of a multi-week downtrend.

The bad news is the market is experiencing the worst cut in quarterly estimates since Q1 2016.

The weak earnings outlook is consistent with the analysis from New Deal democrat, who monitors high frequency economic data and segments them into coincident, short leading, and long leading indicators:

The coincident nowcast is neutral. The short-term forecast is negative. The long-term forecast is neutral, just slightly above negative.

By next week the effects of the government shutdown in the weekly data should be gone. The monthly data may be temporarily skewed to the downside in December and January, with a compensating skew to the upside in February. The base case remains a continuing slowdown all this year, with the possibility of recession (due in large part to poor or haphazard public policy) increasing during the second half.

The technical outlook is not overly encouraging for the bull case either. The S&P 500 advance failed at a key 2800 resistance level while violating and uptrend line. In addition, the recent rally had been accompanied by a series of “good overbought” conditions as measured by RSI-5, but past rallies had been halted by an overbought signal on RSI-14, which the market flashed in the last couple of weeks. These are all signs of a struggling bull.

The picture from market cap leadership is also somewhat disconcerting. Mid and small cap stocks had been the relative strength leaders in the latest advance, and both groups have violated relative uptrends (circled) indicating a loss of momentum.

The relative performance of defensive sectors have been behaving in an unusual fashion since the onset of the rally. Normally, you would expect defensive stocks to lag as the market undergoes a strong momentum driven V-shaped rally. While Consumer Staples stocks have underperformed, which is expected, Utilities are beginning to form a broad based relative bottom, and REITS remain range-bound on a relative basis.

It is also a puzzle that high beta flat against low volatility stocks and price momentum slightly negative since the market rally?

In addition, the long-term normalized equity-only put/call ratio is depressed, indicating a high level of complacency. With the exception of the late 2017 market melt-up, stock prices have either stalled or retreated when readings reached these levels in the past three years.

To be sure, the bull case is not entirely dead. Credit market risk appetite indicators are showing no signs of negative divergence and confirming the latest stock market advance.

I have also been watching Biotech stocks as a key tactical indicator. These stocks staged an upside breakout through resistance even as the S&P 500 stalled at resistance. So far, Biotechs are holding up well above resistance turned support, which is a bullish sign.

I am also monitoring the net 20-day highs-lows as a key tactical indicator. The bulls have so far successfully defended support, while the bears will have to weaken the market sufficiently to break support.

Just to be clear, I am not forecasting a bearish scenario where the market corrects back to test its December lows. Even if the market were to experience an earnings recession, analysis from Goldman Sachs reveals that 13 of the last 22 earnings recessions were not followed by actual economic recessions, which were the real bull market killers.

My inner investor has taken partial profits by trimming equity positions that drifted upwards because of the two month market rally, and he is back at a neutral asset allocation. My inner trader continues to lean bearish.

Disclosure: Long SPXU

A tale of two treaties

Posted by Cam Hui -

Mid-week market update: Posting will be lighter than usual, I was hit by a nasty flu bug this week and I am barely recovering.

It was the best of times, it was the worst of times. Two treaties (actually one of them isn’t a treaty but an MOU despite Trump’s objections to the term) have either been signed or about to be signed.

The lessor known agreement is the Treaty of Aachen, signed Macron and Merkel, to revive the EU, and as update to the Franco-German friendship pact the Élysée Treaty signed by de Gaulle and Adenauer in 1963. The Élysée Treaty was one of the key foundations of the European Union. No sooner than the treaty was signed, Der Spiegel wrote about the bickering than nearly scuttled the agreement:

Indeed, despite all the ceremony and pomp in Aachen, fundamental differences between the Germans and the French very nearly prevented them from reaching an agreement. To make matters worse, the two countries have trouble seeing eye to eye in an area that is particularly vital to Europe’s future: forging a joint defense and common policies on arms exports. German and French negotiators only barely managed to save the deal thanks to a secret supplementary agreement.

To be sure, the Élysée Treaty needed an update as the challenges for Europe have changed since 1963:

Throughout the history of the European Union, Germany and France have always served as both the leaders and the driving force of the European project. Close cooperation between the two countries is today more important than ever to counter everything from attacks by right-wing populists, to Russian subversion and American threats to impose import tariffs on European goods — not to mention the looming Brexit chaos that threatens to engulf Europe.

Then the squabbles began:

The crisis began more than a year ago, when Macron unveiled his vision for Europe in a speech at Sorbonne University in Paris — and received nothing but silence in response from Berlin. Since then, the two partners have quarreled like an old married couple nearly every chance they get, bickering over everything from a joint budget for the eurozone to the details of the digital services tax on major tech companies like Google and Apple and emission limits for nitrous oxide. In addition, Germany’s aspirations to become a permanent member of the United Nations Security Council are only halfheartedly supported by France. “I’m afraid there are a ton of issues where we have to get our act together,” a government official in Berlin complained.

One of the points of contention was over Nord Stream 2:

But their differences rarely surface as openly as they did in last week’s conflict over the Nord Stream 2 natural gas pipeline. The French had long embraced a neutralité politique, as they call it, to avoid sabotaging the German-Russian plans. But only a few weeks after the declarations of mutual devotion in Aachen, the two countries came within a hair’s breadth of a major diplomatic spat.

The evening before a vote on a contentious EU directive that would have severely impeded the gas project, the French Foreign Ministry released a statement that left officials in Berlin completely taken aback.

“France intends to support the adoption of such a directive,” it said in the press release. The Foreign Ministry showed little sympathy for the shocked reaction in Berlin, adding that the Germans were well aware of French reservations concerning the project, “but perhaps didn’t want to hear them.”

Both sides have differing views of defense policy:

There’s been much talk recently of Europe’s “strategic autonomy,” which is the official objective of EU defense policy. If the importance of NATO is likely to wane, Germany and France have no choice but to cooperate with each other, as officials in Paris and Berlin know perfectly well.

There is no lack of lofty intentions, but the reality of the relationship is an entirely different matter. “Germany and France have completely different traditions in some areas,” says Michael Roth, state minister at the Foreign Ministry in Berlin.

When it comes to security issues, the Germans always initially react with restraint, and military missions by the German armed forces, the Bundeswehr, are viewed as a last resort. By contrast, France sees itself as a global power capable of restoring order around the world, and Paris views its military as a natural instrument of foreign policy.

…and on it goes.

The other “treaty” is the upcoming US-China trade agreement, which was announced by Presidential tweet on Sunday. Despite Trump’s objections over terminology, it is being negotiated as a Memorandum of Understanding (MOU) rather than as a treaty. That’s because treaties are subject to Congressional ratification, whereas MOUs are not.

Soon after Trump tweet, doubts began to surface. Bloomberg outlined a series of analyst reactions summarized as “Trump Tariff Delay Doesn’t Mean Trade War Is Over, Analysts Say“. Bloomberg also reported that much of the objection related to how credibly the Chinese could commit to maintaining a stable exchange rate, and what that precisely means:

The U.S. and China haven’t yet agreed on the critical issue of enforcement in a proposed currency deal that would ensure Beijing lives up to its promise to not depreciate the yuan, four people familiar with the matter said.

Treasury Secretary Steven Mnuchin on Friday touted the currency pact as the strongest ever, though he offered no details, following two days of high-level talks in Washington between U.S. and Chinese officials. The discussions were extended into the weekend in search of a broad trade deal to prevent the U.S. from increasing tariffs on Chinese goods next week.

President Donald Trump has previously accused China of gaming its currency to gain a competitive advantage, though his Treasury Department has repeatedly declined to name the Asian nation a manipulator in its semi-annual reports on foreign-exchange markets.

Still, the U.S. asked China to keep the value of its currency, the yuan, stable as part of trade negotiations between the world’s two largest economies. If successful, that would neutralize any effort by Beijing to devalue its currency and make its exports cheaper to help counter American tariffs, people familiar with the ongoing talks said this week.

In addition, James Politi of the Financial Times noted that ending forced technology transfer would make China a more attractive place to invest, and therefore have the perverse effect of raising the trade deficit.

International agreements tend to be well-intentioned, but the devil is in the details of their implementation. More importantly for investors, here are the investment implications of these agreements.

Defining intention

Instead of getting lost in the weeds of the difficulties with each agreement, the critical question to ask is, “What is the intention of the agreement?”

In the case of the Treaty of Aachen, it is a re-affirmation of Franco-German leadership of the European Union. Both France and Germany are committed to the idea of a united Europe. Outsiders may be dismayed by the squabbles, but it is nothing more than the bickering of an old married couple committed to the relationship.

The choice of Aachen as the site to sign the treaty is highly symbolic. Aachen was the seat of Charlemagne`s Holy Roman Empire, which united central Europe during the Early Middle Age.

The choice of Annegret Kramp-Karrenbauer (AKK) to succeed Angela Merkel as the head of the CDU is equally significant for European unity. AKK hails from Saarland, which The Economist described as “a hilly federal state of only 1m inhabitants abutting Luxembourg and France”. The grandmother of Heiko Maas, Germany’s foreign minister and also a Saarlander, held three passports in her life without moving, Saarlanders are therefore have a high historical sensitivity to European conflict:

“Saarland was always marked or threatened by war,” adds Oliver Schwambach, an editor at the Saarbrücker Zeitung, the state’s most-read newspaper. He notes that Mr Maas’s grandmother never moved but held three passports during her lifetime: “So people here hate conflict of any sort. Elections here are less angry, politics is more mild than elsewhere.”

To be sure, this treaty will not fix everything that`s wrong with Europe, but Europe cannot exist without the foundation of a strong Franco-German relationship, and the Treaty of Aachen re-affirms that commitment. All the squabbling, and everything else is European Theatre.

Despite all of the hand wringing about a growth slowdown in Europe, and Germany barely avoiding a technical recession, major European stock indices are bottoming and turning up. I interpret this reaction as the market has already priced in much of the bad news.

In addition, the fragile European banking system, which did not entirely fix their problems from the last crisis, is not showing significant signs of stress. The relative performance of European financials are not very different from the relative performance of US financials. This is a sensitive barometer of possible trouble in Europe, and no alarms are ringing.

US-China: Cold War 2.0

By contrast, the intentions behind the US-China trade deal are very different. Its purpose is only to tone down and manage the trade tensions between the two countries, while other sources of friction remain unresolved. I warned about this over a year ago (see Sleep walking towards a possible trade war) when the US branded China as a “strategic competitor” in its National Security Strategy of 2017 (NSS). I had also highlighted a New Yorker article that the competition is occurring in the military dimension as well:

The Defense Department is trying to change that, an effort reflected in its latest National Defense Strategy. Syntactically, the document is fairly straightforward: the Pentagon wants more money to buy more stuff. But the type of war it plans to fight is novel. In short, the Pentagon is trying to move on from the war on terror. “Inter-state strategic competition, not terrorism, is now the primary concern in U.S. national security,” the strategy, which is being released later today, reads. China and Russia are now America’s “principal priorities.”

Even as the US and China negotiate on trade, the SCMP reported the US Navy is sending two ships through the Taiwan Straits, which exacerbates tensions with Beijing. In this context, trade frictions will remain under control as long as US-China relations remain calm in other dimensions.

As well, the US demand for exchange rate stability has the potential to increase future volatility. Supposing that in the not too distant future, China hits the debt wall and the economy hard lands, which results in and a depreciation of the RMB beyond Beijing`s control. Would the US interpret such a development as a breach of the MOU, retaliate with trade sanctions, and exacerbate China’s downturn? Notwithstanding the catastrophic scenario of a hard landing, the Caixin editorial “The Unbearable Lightness of a Stable Yuan” raises some practical problems with a demand for exchange rate stability:

But there are two key structural sources of downward pressure on the yuan that will continue in 2019 and beyond. First, China’s economic growth will likely continue to slow, which may make investing in yuan-denominated assets less attractive. Second, the country may run its first full-year current account deficit in more than 25 years after its surplus plummeted in 2018. Large surpluses have meant there’s been a steady flow of capital into China, and have given the country a war chest of foreign-exchange reserves with which to support the yuan. The end of surpluses erodes this important backstop, and deficits mean net outflows, which will reduce demand for the yuan.

Under these conditions, a demand from the U.S. that China’s currency remains strong seems a big ask.

Meanwhile, back in the financial world, we have the contrast of two markets. Chinese stock indices surged on Monday between 5-6% on a combination of favorable trade news, and the news of the Politburo meeting confirming push for growth, and end of deleveraging. On the other hand, the SPX rose a mealy 0.1% on the news. Similarly, we saw China equity ETFs surge and decisively broke above resistance, while it has pulled back, current price levels remains above resistance turned support. By contrast, US-centric prices like soybeans failed at resistance and weakened.

Over the next couple of quarters, the Chinese and Asian outlook will be underpinned by another round of stimulus. The latest figures show that infrastructure investment went vertical in January. While the pace is not sustainable, Beijing is pulling out all stops once again to dress up growth ahead of the October celebration of Mao`s revolution

Investment implications

What does this mean for investors? The US market is at or near “peak good news”. The Fed has turned dovish, and news of the upcoming trade deal has taken off the tail-risk of a full-blown trade war. What other good news could lie ahead?

I have pointed out before that the stock market rally off the December lows was accompanied by declining EPS estimates, which translates into P/E expansion.

But the market is no longer cheap based on a forward P/E ratio, but roughly fairly valued. This makes US equity prices vulnerable to a setback on bad news, now that most of the good news is out.

From a technical perspective, this analysis from Chris Verrone of Strategas tells a similar story. Small cap price momentum has been powerful, and such episodes are typical characteristics of strong rallies off market bottoms. While this kind of market action is bullish longer term, short-term setbacks are very common.

At a minimum, US stocks are likely to underperform over the next few months. Relative to the MSCI All-Country World Index (ACWI), US equities are rolling over, while non-US equities are bottoming and turning up.

My inner trader remains short the US market.

Disclosure: Long SPXU

Still bullish, but time to reduce risk

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: Sell 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.
 

Take some chips off the table

Don’t get me wrong. I haven’t turned bearish. The US equity market is no longer wildly cheap. The current forward P/E is now 16.2, which is between its 5-year average of 16.4 and 10-year average of 14.6. It is a far cry from the sub-14 multiple seen at the December lows.
 

 

When I turned bullish in mid-January 2019 (see A rare “what’s my credit card limit” buy signal and Ursus Interruptus), my model portfolio became overweight equities in the snapback rally. Its equity weight would have drifted to either the top or above its asset allocation range. Now that the market is no longer cheap, it is time to trim equity weights back to a more neutral position.

This is not a bearish call. The US stock market is not going to crash, and it should be higher a year from now. This is just a call to reduce risk, and near-term risk levels are rising. Looking to the next few months, a number of risks have appeared.

  • Rising financial stress
  • Weak market internals and negative divergences
  • US-China trade deal blowback
  • USD strength is a threat to stock prices

 

Rising financial stress

Most notably, signs of systemic financial risk are showing up all over the place. In the past, stock prices have stumbled after the relative performance of bank stocks have breached technical support. Will this time be any different?

 

An equally worrisome sign is the bifurcation of the paths taken by the stock and credit markets. As global stock prices have rebounded from their December lows, the credit market is marching to a different drummer. A BAML survey of investment grade bond managers reveals their biggest worry is a global recession.
 

 

Stock prices staged a strong rally since the Christmas Eve low, but bond yields have been declining and continue to decline since early November. In addition, the 2s10s yield curve began to steepen slightly in December prior to the stock market low, and flattened again in January. These are all signs that the bond market expects slower growth, both in the US and globally. So why are stock prices rising?
 

 

The WSJ reported that the percentage of negative yielding bonds have actually risen since mid-January, and most of the rise has come from Europe. Does this look like the picture of a global growth revival?

Negative-yielding government bonds outstanding through mid-January have risen 21% since October, reversing a steady decline that took place over the course of 2017 and much of last year, according to data from Bank of America Merrill Lynch. While the stock of negative-yielding debt still remains below its 2016 high, the proliferation of these bonds—which guarantee that a purchaser at issuance will receive less in repayment and periodic interest than they paid—underscores the uncertainty over the growth prospects in much of the developed world.

As for China, the latest round of stimulus is starting to kick in, and the authorities are pulling out all stops to ensure that growth doesn’t tank ahead of the 70th anniversary of the founding of the People’s Republic of China on October 1, 2019. However, stimulus is going to be front-end loaded this year, and further analysis reveals that about interest payments amount to roughly 70% of new financing, as measured by total social financing (TSF).
 

 

Weak market internals

Even as stock prices have rallied, the behavior of some market internals are unconvincing. In particular, the relative performance of high beta groups has been mixed, which is not a bullish signal for equity market risk appetite.
 

 

Cyclical indicators are still weak, indicating expectations of decelerating global growth. Global industrial stocks have rebounded strongly, but the rally looks like a dead-cat bounce in the context of a slowing global economy.
 

 

The industrial metals to gold ratio is another indicator of global cyclical growth and correlates well with risk appetite. This ratio remains in a downtrend.
 

 

The commodity markets are flashing other cautionary signals.  Copper prices is indicating a slowdown in global growth.
 

 

Trade deal blowback

One key component of any US-China agreement is the reduction of the trade deficit. China will have to divert imports from other regions of the world to the US. Analysis from Barclays shows that the EU will be the biggest loser in such an arrangement.
 

 

The latest release of Eurozone PMI shows a rebound in Composite PMI, led by services, but manufacturing has been slow, and exports have been especially weak. A US-China trade deal will serve to further weaken European manufacturing, The German economy, which has been the growth locomotive of Europe, narrowly avoided a technical recession in Q4. Further reduction of German exports could push Germany and Europe into recession, which would expose more cracks in the European banking system.
 

 

So far, the relative performance of European financial stocks has been roughly in line with American financials, but investors should keep an eye on any possible negative developments on this front.
 

 

What about the US Dollar?

Another effect of a possible US-China trade deal is a widening growth differential between the US and other non-Chinese economies, and that would serve to put upward pressure on the USD. Moreover, the Fed’s neutral monetary policy stance, in contrast to the easy nature of other major central banks, will also serve to buoy the greenback. In the past, sustained USD strength has seen equity prices take a tumble.
 

 

A rising USD would also put downward pressure on earnings growth, as 38% of S&P 500 sales come from non-US sources.
 

 

Why I remain bullish

Despite all these concerns, I remain constructive on the outlook for stock prices. I do not believe the bounce off the December low is a bear market rally for two reasons.

The first is the Fed policy. The minutes of the January FOMC meeting makes it clear that a Powell Put is in place. There was a great deal of concern about “market stability”, and “volatility” [emphasis added].

Among those participants who commented on financial stability, a number expressed concerns about the elevated financial market volatility and the apparent decline in investors’ willingness to bear risk that occurred toward the end of last year. Although these conditions had eased somewhat in recent weeks, a couple of participants noted that the strain in financial markets might have persisted or spread if it had occurred during a period of less favorable macroeconomic conditions. A couple of participants highlighted the role that decreased liquidity at the end of the year appeared to play in exacerbating changes in financial market conditions. They emphasized the need to monitor financial market structures or practices that may contribute to strained liquidity conditions. A few participants highlighted the importance of ensuring that financial institutions were able to withstand adverse financial market events–for instance, by maintaining adequate levels of capital.

Remember how the market took fright at Powell’s comment about balance sheet normalization being on autopilot? Here is how they changed their tune at the January meeting:

Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year. Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet.

Here is the key passage which indicates that some members of the FOMC are closely watching the stock market [emphasis added]:

Following the briefing, participants raised a number of questions about market reports that the Federal Reserve’s balance sheet runoff and associated “quantitative tightening” had been an important factor contributing to the selloff in equity markets in the closing months of last year. While respondents assessed that the reduction of securities held in the SOMA would put some modest upward pressure on Treasury yields and agency mortgage-backed securities (MBS) yields over time, they generally placed little weight on balance sheet reduction as a prime factor spurring the deterioration in risk sentiment over that period. However, some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve’s securities holdings was a factor putting significant downward pressure on risky asset prices, and the investment decisions of these investors, particularly in thin market conditions around the year-end, might have had an outsized effect on market prices for a time. Participants also discussed the hypothesis that investors may have taken some signal about the future path of the federal funds rate based on perceptions that the Federal Reserve was unwilling to adjust the pace of balance sheet runoff in light of economic and financial developments.

The markets throw a tantrum, the Fed responds. The Powell Put is firmly in place.

The late 2018 market dip, coupled with the dovish shift in Fed policy, is somewhat reminiscent of Fed policy in 1998, when the Fed eased in response to the Russia Crisis. Stock prices recovered, and then bubbled up to the NASDAQ top about 1 1/2 years later. This monetary backdrop argues for a strong market into 2020.

History doesn’t repeat, but rhymes, and I am neither forecasting a bubbly rise in stock prices, nor am I forecasting the timing of the ultimate equity market top. Further, I am not implying that the Powell Fed is becoming a carbon copy of the Greenspan Fed of 1998-2000. This rather frank Brookings Institute podcast interview with Janet Yellen reveals that the former Fed chair was highly sensitive to foreign economic developments. Reading between the lines, a Yellen Fed today would probably behave in the same way as the Powell Fed did. Nevertheless, the 1998-2000 period can serve as a useful template for thinking about how stock prices might behave in the future.

Indeed, the market’s recent recovery was accompanied by a strong breadth thrust, with the percentage of stocks above their 50 day moving average rising to about 90%. While the market is overbought, past episodes have tended to resolve bullishly over a one-year time horizon.
 

 

I studied the period from 2001 to the present, and found 12 instances with non-overlapping periods where this indicator exceed 90%. The market performed very well over a one-year time horizon, but that does not preclude a corrective period within a shorter two month period.
 

 

Another analysis of strong market momentum illustrates my point of near-term weakness. The chart below depicts the ratio of stocks above their 50 dma to stocks above their 200 dma as a measure of momentum. Past episodes have seen the market advance either stall or correct when momentum starts to peter out, but prices are generally higher a year later.
 

 

In conclusion, the US equity market has moved from being cheap to roughly fair value in a very short time, while a number of near-term risks are appearing on the horizon. While I do not believe any of these risks pose an existential threat to the bull market, they do have the potential to cause some dislocation over the next few months. Investors should therefore adjust their asset allocations accordingly to a more neutral position should a corrective episode manifest itself.
 

The week ahead: Vulnerable to a setback

Looking to the week ahead, the US equity market appears vulnerable to a setback. Traders can often discern the tone of a market by the way it responds to news. The stock market only ground out a marginal recovery high and stalled at resistance in the face of bullish trade news and FOMC minutes. The stall occurred just as RSI-14 neared 70, which is a level that past advances ran out of steam in the past year.
 

 

Short-term breadth readings are also suggesting a downward bias to stock prices, as the percentage of stocks above the 5 dma is rolling over after hitting overbought territory.
 

 

At times like this, a useful question traders can ask is what could go right, and what could go wrong. One scenario could see the US-China trade discussions fall apart, which would be catastrophic for risk appetite. On the other hand, the upside from a deal appears limited, as much has already been discounted. This WSJ report seems to suggest that Trump is eager for a deal, but the market reaction so far has been tepid:

President Trump, citing progress in U.S.-China trade talks, said he is looking at extending a deadline to raise tariffs and hoping to meet next month with Chinese leader Xi Jinping to complete a broad trade agreement.

His comments in the Oval Office followed four days of talks between U.S and Chinese negotiators, which Mr. Trump extended through the weekend. “We’re having good talks, and there’s a chance that something very exciting can happen,” he said.

Among the accomplishments that Mr. Trump cited was a pact with Beijing to curb currency manipulation, which Treasury Secretary Steven Mnuchin called “one of the strongest agreements ever on currency.”

More importantly, Trump sounds ready to throw the China hawks like Robert Lightizer under the bus:

China hawks in the business community, the administration and in Congress say they are troubled by what they see as Mr. Trump’s growing impatience for a deal, and are urging him to stand firm and insist China make fundamental changes in its industrial policies…

The prospective deal also reflects a growing divide between Mr. Trump and Mr. Lighthizer, say people familiar with the administration deliberations. During the past year, Mr. Lighthizer has successfully recommended to Mr. Trump that he impose tariffs on Chinese goods over the objections of Mr. Mnuchin.

But after the stock market nose-dived late last fall, Mr. Trump’s appetite for a tariff battle with China diminished, say administration officials. Recently, the U.S. Trade Representative’s office has been making thank-you calls to those who appear on television or in the press calling for the administration to take a tougher stance on China.

“Lighthizer had previously been getting his way by mastering the inside game,” said Gene Sperling, a former senior economic official in the Clinton and Obama administrations, who has negotiated China trade deals. “As Trump gets more eager for any deal, he is now being forced to play an outside game to keep the pressure on.”

Should the US and China conclude an agreement, attention will turn next to the US trade negotiations with the EU with a particular focus on autos. In addition, greater scrutiny will be given to China’s import diversions in order to satisfy their agreement with the US, and one of the biggest losers will be Europe. This would be a bearish development for European stocks, and neutral to bearish for US equities.

One little known source of geopolitical risk, at least to the residents of Europe and North America, is the growing tension between India and Pakistan. This article from The Economist summarized the situation well:

A huge car bomb struck a convoy of paramilitary police in Indian-administered Kashmir on February 14th, killing at least 40 paramilitary police. The suicide attack, claimed by a Pakistan-based Islamist terror group, was the deadliest single blow to Indian security forces since the start of unrest in Kashmir 30 years ago.

Amid public outrage in India, and with national elections approaching in April, Narendra Modi, India’s prime minister, has promised a “jaw-breaking response”. Having boosted his nationalist credentials by ordering retaliatory “surgical strikes” across the Pakistani border following a similar attack in 2016, Mr Modi will be pressed to react even more harshly this time. Chronically tense relations between India and Pakistan, both nuclear-armed states, appear headed towards a dangerous showdown.

Indian officials were quick to underline Pakistan’s links to Jaish-e-Muhammad (JeM), the group that claimed responsibility for the attack. Its leader, Masood Azhar, “has been given full freedom by the government of Pakistan…to carry out attacks in India and elsewhere with impunity,” declared a statement from India’s foreign ministry. Many Indians have also expressed anger with China, which has repeatedly blocked Indian efforts to get Mr Azhar included on the UN Security Council’s list of designated terrorists. Pakistan, a close ally of China, condemned the attack but in the same breath rejected “insinuations” of any link to the Pakistani state.

So far, only South Asian specialists appear to be paying any attention to this story, but events have the potential to spiral out of control very quickly. A conflict between two nuclear-armed neighbors is never a welcome development for market risk appetite.

A conflict could serve to spike risk premiums, and gold prices. However, gold has been behaving in an unusual manner, as it has been rising in line with stock prices. In the past, gold has acted as a safe haven during periods of stock market turmoil, and the long-term correlation of stocks and gold has been slightly negative. However, recent episodes of high stock and gold correlations have tended to resolve themselves in a stock price trend reversal. A near-term decline in equities may be on the horizon.
 

 

Another source of vulnerability comes from fundamentals. The latest update from FactSet shows that Q4 is nearly over. While sales and EPS beat rates are roughly in line with historical averages, forward EPS are being revised downwards, and Q1 guidance is below average. The recent market advance in implies that price gains are the result of multiple expansion in the face of a deterioration in fundamentals.
 

 

While I would not discount the possibility of further upside next week on the news of a definitive US-China trade deal, risk/reward is not favorable for the bulls, at least in the short run.

My inner investor is trimming back his equity exposure, which has drifted upward as the market rallied. He is targeting a neutral asset allocation position, as specified by his investment policy. My inner trader began dipping a toe on the short side last week, and he is prepared to add to his shorts should the market advance further.

Disclosure: Long SPXU
 

Defying gravity

Posted by Cam Hui -

Mid-week market update: For the last few weeks, I have been writing about a possible market stall ahead (see Peering into 2020 and beyond). So far, the pullback has yet to materialize, though risk levels continue to rise as the SPX approaches its resistance zone at 2800-2810.
 

 

Here are some reasons why the market might be defying gravity.
 

The bull case

From a technical analysis viewpoint, the bull case can be summarized by healthy positive breadth, and strong price momentum, as evidenced by a breadth thrust.

As the chart below shows, while the SPX has rebounded and it is below its all-time high, both the NYSE and SPX Advance-Decline Lines have made new all-time highs. This is generally interpreted as a bullish development.
 

 

In addition, the % of stocks above their 50 day moving averages surged above 90% in this latest rally. Such conditions are indicative of strong price momentum, otherwise known as breadth thrusts. Analysis from Ned David Research shows that past episodes have tended to resolve in a bullish fashion.
 

 

The bear case

On the other hand, I have documented how consensus EPS estimates have been steadily falling for the last few weeks, and Q1 guidance has been worse than average, indicating a deterioration in fundamental momentum.
 

 

Market internals have also been weakening. The VIX Index, which is inversely correlated with stock prices, continue to exhibit a positive RSI divergence. Should the VIX spike, stock prices are likely to fall.
 

 

Dipping my toe in on the short side

Subscribers received an email alert today that my inner trader took profits in his long positions and he is dipping his toe into the short side of the pool.

The market is becoming overbought, and risk/reward is tilted to the downside. (Chart readings are based on Tuesday nights close.)
 

 

The Daily Sentiment Index (DSI) for stocks stands at 88, which is also an overbought condition.
 

 

In addition, I had highlighted that while the market continued to grind upward on a series of “good overbought” conditions on RSI-5, it has stalled when RSI-14 reached 70, which is an overbought reading.
 

 

One of the key technical tests may be the behavior of the biotech stocks. Biotechs have already broken out to the upside, while the broad market averages haven’t yet. The question of whether this group can hold its breakout could be a key barometer to the short-term bull/bear outlook for this market.
 

 

My inner trader has taken a small initial short position, though it is not a high conviction trade. The market is sufficiently extended that he is prepared to add to it should the market rise on the news of a trade deal, or truce.

Disclosure: Long SPXU

 

China is healing

Posted by Cam Hui -

Recent top-down data out of China has been weak (see How worried should you be about China?), but there are some signs of healing as the latest round of stimulus kicks in.
 

 

Real-time signs of recovery

While Chinese economic statistics can be fudged, real-time indicators are pointing to signs of recovery. Firstly, the stock market indices of China and her major Asian trading partners are all exhibiting constructive patterns of bottoming. Not reflected in this chart is the 2.7% surge in Shanghai, 1.6% rise in Hong Kong, amid a broad based rally in Asian risk assets Monday based on trade talks optimism.
 

 

What about the Chinese consumer? My pair trades of long new consumer China and short old finance and infrastructure China are signaling better times ahead for the Chinese household sector.
 

 

There are also signs of stabilization on the infrastructure front. The relative performance of Chinese material stocks relative to global materials has broken up through a relative downtrend. Chinese materials are now range-bound against global materials, which is a signal of stabilization.
 

 

Trade peace ahead?

What about the trade negotiations? As we await the news on the US-China trade talks, Reuters reported that Chinese negotiators will arrive in Washington this week for the next round of talks, while both sides made encouraging sounds about the discussions:

The United States and China will resume trade talks next week in Washington with time running short to ease their bruising trade war, but U.S. President Donald Trump repeated on Friday that he may extend a March 1 deadline for a deal and keep tariffs on Chinese goods from rising.

Both the United States and China reported progress in five days of negotiations in Beijing this week.

Trump, speaking at a White House news conference, said the United States was closer than ever before to “having a real trade deal” with China and said he would be “honored” to remove tariffs if an agreement can be reached.

The real-time indicators of trade negotiations, namely iShares China (FXI) and soybean prices, are testing key resistance levels after undergoing a bottoming process.
 

 

Another possible bullish factor is the upcoming MSCI decision to possibly raise the weight of Chinese A-shares in its global indices (via CNBC):

Chinese A-shares — or yuan-denominated stocks traded on the mainland — were included in the MSCI Emerging Markets Index for the first time last year, allowing investors to access the Chinese equity market more easily. Now, MSCI is considering whether to further increase the weighting of A-shares in its indexes, and could announce its decision by the end of this month.

Should we see a positive resolution to the talks, a Potemkin trade deal, or even a delay of the tariffs that take a full-blown trade war off the table, expect upside breakouts on these instruments, and a trading opportunity for further profits ahead.

Chinese weakness? That’s so 2018.
 

Peering into 2020 and beyond

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: Sell equities
  • Trend Model signal: Neutral
  • Trading model: Bullish

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

Gazing into the crystal ball

In the past year, I have been fortunate to be right on the major turning points in the US equity market. I was steadfastly bullish in early 2018 after the correction (see Five reasons not to worry, plus two concerns). I turned cautious in early August because of the early technical warning, which was accompanied by deterioration in top-down data (see Market top ahead? My inner investor turns cautious). Finally, I turned bullish on stocks in mid-January 2019 (see Ursus Interruptus).
 

 

What’s next, as I gaze into the crystal ball for 2020 and beyond?
 

Short and long-term outlook

I pointed out last week that I am both bullish and bearish, but on different time frames (see Here comes the growth scare). Here is my base case scenario:

  • Short-term growth scare (next 1-4 months)
  • Recovery (remainder of 2019)
  • Two themes for 2020:
    1. Resumption of Sino-American Cold War 2.0
    2. Prepare for the Modern Monetary Theory (MMT) experiment

     

    Near term growth scare

    I have been writing about a possible near-term growth scare, and there is no point repeating myself (see Here comes the growth scare). The most visible sign of a growth slowdown is the continual downward revisions of forward 12-month EPS, indicating a loss of fundamental momentum, and the above average rate of negative guidance for Q1 earnings.
     

     

    In addition, the deterioration in initial claims is concerning, as initial claims have historically been inversely correlated with stock prices. However, there may be an anomaly in the data because of a possible spike that attributable to the federal government shutdown.
     

     

    Another worrisome sign of weakness is the diving NFIB small business confidence.
     

     

    Globally, bond yields are also plunging, which is a real-time market signal of slowing growth.
     

     

    New Deal democrat, who monitors high frequency economic figures and categories them into coincident, short leading, and long leading indicators, indicated this week that the short-term outlook is deteriorating, though with an important caveat:

    The big news this week is that the short-term forecast has turned sharply negative, while the coincident nowcast also turned negative. The long-term forecast remains essentially neutral.

    A special note of caution this week: In the past several weeks a whole variety of both weekly and monthly indicators in several time frames have abruptly cratered. Part of that may be due to the “polar vortex” giving rise to 30-year low temperatures in part of the country, but I suspect that the effects of the government shutdown have been more pronounced than almost everybody thought. A similar pattern happened during the 2011 “debt ceiling debacle.” If so, the coincident indicators in particular should begin to bounce in the next several weeks.

     

    No 2019 recessionary bear

    Should stock prices retreat and test the December lows on a growth scare, I believe such an event would represent a gift from the market gods. I had pointed out that the equity valuations in December 2018 were discounting a mild recession (see Ursus Interruptus), which represents a contrarian buying opportunity, unless you believed that a catastrophic global meltdown was about to happen.

    Today, the Fed has become much more accommodative, and it has signaled that rate hikes are on hold until mid-year. A recent CNBC interview with Fed governor Lael Brainard revealed a even more dovish tilt. The Fed is now more attuned to downside risk from abroad [emphasis added]:

    STEVE LIESMAN: How does it fit in with your general view of the economy? Did you believe the economy is decelerating? Is that part of that framework that you have?

    LAEL BRAINARD: So I think going into this year we would have expected a solid growth figure, but a slower growth figure than the very strong growth we were getting last year. But downside risks have definitely increased relative to that modal outlook of continued solid growth.

    STEVE LIESMAN: Let’s talk about some of those risks that are out there. First overall question: do you see an elevated risk of recession this year or next?

    LAEL BRAINARD: I would certainly say there are a variety of downside risks. And, of course, I’m very attend I have to all the recession indicators that people look at, including the slope of the yield curve. But in terms of the other kinds of downside risks, foreign growth has slowed. It was first very apparent in China, but now we’re seeing those numbers coming in below expectations in Europe. Policy uncertainty still high whether, you know, we look at trade conflict with China or whether we look at Brexit, and financial conditions have tightened, so I want to take those on board as I think about the year ahead.

    In addition, the market had been concerned about the Fed’s program of steadily shrinking its balance sheet, which represents a form of monetary tightening. Brainard stated that she is in favor of ending the program of balance sheet normalization later this year:

    So I think on the balance sheet, it’s really important to distinguish between the overall technical factors and monetary policy. With regard to just the general size of our balance sheet, ultimately, you know, we said last time that we’re going to stay in an ample reserve system. My own view is that balance sheet normalization process should probably come to an end later this year. We know that liquidity demand on the part of financial institutions is much higher than it was pre-crisis so we want to make sure that there’s an ample supply of reserves to guard against volatility.

    The Powell Put is firmly in place.

    In addition, there is sentiment support in place that will put a floor on stock prices. Simply put, the slow moving institutions are bearish, which is contrarian bullish. Callum Thomas reported that the State Street Confidence Index, which measures the equity allocation of fund managers by the State Street custodian bank, is at an extreme indicating high levels of defensiveness.
     

     

    The latest BAML Global Fund Manager Survey confirms these observations. Equity allocations are at the lowest level since September 2016, despite rising stock prices. This indicates that managers are increasingly defensive and they are actively selling their equity positions.
     

     

    The defensive posture can also be seen in cash allocations, which have risen to levels not seen since 2009.
     

     

    Analysis from Goldman Sachs shows that past equity bears with recessions tend to continue to fall, while bear markets without recessions tend to recover quickly. I believe the current episode falls into the latter category, and if history is any guide, expect a pullback over the next few months, followed by a recovery.
     

     

    Once the market moves past any growth scare and realizes that recession risk is only a mirage, the market should stage a relief rally, which I believe should last until year-end.
     

    Cold War 2.0

    The year 2020 is another story altogether. While my crystal ball starts to get cloudy beyond six months, there are two themes that investors should consider in 2020. The first is the resumption of the Sino-American Cold War 2.0.

    The friction between America and China is not just restricted to trade. I wrote in early 2018 that the US had branded China a strategic competitor in its National Security Strategy 2017 (see Sleepwalking towards a possible trade war). Regardless of what understanding both sides may come to before the March 1 deadline, those tensions are not going away.

    Leland Miller of China Beige Book summarized the most likely scenario in a recent CNBC appearance.

    • The short time frame of 90 days between the G20 summit and March 1 prevents meaningful negotiation between the parties on comprehensive structural reform.
    • The only way a deal that can be done if a Trump-Xi meeting can be finalized.
    • Both sides want a deal, so there will be a deal, but it will be a superficial one at best.
    • The provisions of a deal will include commitment to reduce the trade deficit, and shallow efforts on IP protection, but those provisions can be reversed easily if relations deteriorate.
    • Robert Lightizer recognizes that Trump wants a deal, and his mandate is to strike the best deal he can. Therefore his primary focus has turned to enforcement. The intent of the latest round of negotiations is set up a process to document possible non-compliance by China so that they can retaliate with higher tariffs in the future.

    In a separate CNBC appearance, Miller stated that there is a growing consensus on both sides of the aisle in Washington that China is becoming a problem for America. As the US approaches the 2020 election, he expects that both Trump and the Democratic nominee to posture and demonstrate how tough he or she is on China. This outcome will not be bullish for US-China relations, the global trade outlook, or equity prices.

    Look for a resumption of Cold War 2.0 in 2020, not just in trade, but in other dimensions as well.
     

    The Great MMT experiment

    The dominant event of 2020 for the stock market will be the election. While there will be a huge gulf between Trump and the Democratic nominee, there will be some commonalities. Donald Trump is a self-professed “debt guy”. The ambitious provisions of the Democrats’ Green New Deal (GND) suggests that Modern Monetary Theory (MMT) will become a major topic of conversation in 2020. Whoever wins, MMT is likely gain greater traction and become a serious theory for government finance in the post-electoral landscape.

    What is MMT?

    Kevin Muir at The Macro Tourist had a terrific layman’s explanation:

    MMT’ers believe that government’s red ink is someone else’s black ink. Sure, the government owes dollars, but they have a monopoly of creating those dollars, and not only that, the creation of more and more dollars is essential to the functioning of the economy.

    Here are the policy implications of accepting MMT:

    • governments cannot go bankrupt as long as it doesn’t borrow in another currency
    • it can issue more dollars through a simple keystroke in the ledger (much like the Fed did in the Great Financial Crisis)
    • it can always make all payments
    • the government can always afford to buy anything for sale
    • the government can always afford to get people jobs and pay wages
    • government only faces two different kinds of limitations; political restraint and full employment (which causes inflation)

    The government can keep spending until they begin to crowd out the private sector and compete for resources.

    And in fact, Stephanie Kelton [a leading academic proponent of MMT] argues it is immoral to not utilize this power to fix problems in our society. From an interview she gave,

    “if you think you can’t repair crumbling infrastructure or feed hungry kids, unless and until you find some money somewhere, it’s actually pretty cruel because you leave people who are struggling in a position where there are still struggling and they are hurting, and they are not properly taken care of…”

    This may sound like sacrilege to Austrian economists, but MMT adherents believe the government can keep on spending, and printing money with inflation being the only constraint on its actions. Before descending down the rabbit hole of whether the MMT effects are benign, like Japan, or hyper-inflationary, like Zimbabwe, here is some perspective. FT Alphaville published an insightful article detailing how the US financed its deficit during the Second World War. Ultimately, how an initiative is financed is a political question [emphasis added]:

    In a resolution this week, in interviews and even in an oped for The Financial Times, Democrats have either hinted or said outright that they would pay to fight climate change by borrowing — the same way the country paid to fight fascists. It’s not an absurd comparison. During the war, the US borrowed more than 100 per cent of its gross domestic product and did not subsequently collapse.

    Also, though: finance in the US was different in the 1940s.

    • The Federal Reserve explicitly supported the goals of the war, and expanded its balance sheet to keep Treasury yields down.
    • Domestic institutional investors were trapped in the US, with few options for assets other than Treasuries. There weren’t really any foreign investors.
    • Within a decade after the war, two runs of inflation — the first of which reached 20 per cent — got the US debt to GDP ratio down to 50 per cent.

    We have always been underwhelmed by the argument “you can’t do x, because x is politically infeasible.” You argue a policy on its merits, then you convince the people you need to convince. And shocks can redefine “feasible,” the way hurricanes and wildfires have in the US.

    But: to borrow at the scale of the second world war is not just a political question for Congress. It’s a political question for the Fed, which during the war provided quantitative warfighting to keep yields down on Treasuries. It’s a political question for US capital at home, which has spent the last 40 years getting used to buying assets wherever it wants in the world. And it’s a question for foreign capital in US markets, which didn’t exist during the war, and may not feel compliant now.

    Twenty per cent inflation in 2030 wouldn’t hurt, either. But it’d be, you know, a political adjustment.

    The US raised taxes on capital from 44 to 60 per cent during the second world war. Labour taxes doubled, from 9 to 18 per cent. The numbers come from a 1997 paper by Lee Ohanian for the American Economic Review. The US financed just over 40 per cent of the war through direct taxes, comparable to what the Union did during the Civil War. It was a far greater percentage than during the Revolutionary War, the War of 1812 or the first world war:

     

    The Fed cooperated to keep rates down, with a technique otherwise known as financial repression:

    We don’t have a historical record of what happens to Treasury yields as debt climbs above 100 per cent of GDP, because the Fed was part of the war effort. In 1942, the Fed began intervening in Treasury auctions, keeping 90-day bills at 3/8 of a per cent, with a ceiling for all debt on 2.5 per cent.

    After the war, inflation eroded the debt away:

    In a paper for the National Bureau of Economic Research in 2009, Joshua Aizenman of the University of California, Santa Cruz and Nancy Marion of Dartmouth College point out that within 10 years of the end of the war, two bouts of inflation dropped US debt by 40 per cent. (They also note that the US, unlike other countries, tends to extend the maturity of its debt when it borrows more. Maturity peaked at 113 months in 1947. It reached a low of 31 months in 1976, and is now back at 69 months.)

    But developed-economy central banks can’t create inflation now even when they’re desperate to. So a 29-year nonmarketable bond at 2 3/4 per cent, like the one Treasury offered as a swap in 1951, might not be the same good deal for Treasury anymore. Maybe it can’t be inflated away. Again: we just don’t know.

    Here is the key conclusion [emphasis added]:

    Democrats have proposed to finance a new program the way the US financed the second world war. They are correct that when Americans really want something, they find a way to pay for it. But a lot of things — including the entire structure and movement of US and global capital —were very, very different during the war. There’s consequently no guarantee what worked in the past will work again today.

    Today, the US has a dovish and compliant Federal Reserve. The President is a self-professed “debt guy” who is not afraid to stimulate the economy by running deficits. His likely opponent in 2020 will likely come from the left wing of the party who is sympathetic to similar ideas about government finance. What they differ on are the government’s priorities.

    This is a perfect political environment to experiment with MMT. At best, MMT represents a new theory that turns macro-economics and government finance upside down. At worst, Stephanie Kelton, who is the academic face of MMT, is the Left’s version of Arthur Laffer.

    Whoever wins, expect a round of reflationary fiscal stimulus in 2021. The result will be bullish for growth, and equity prices.

    I leave the theorists to argue how the piper will be paid. The answer to that question is well beyond my pay grade.
     

    The outlook for 2020″sl

    In conclusion, as we peer into 2020, I expect the competition between the US and China to heat up again into a new Cold War 2.0. This development will be bearish for equity prices.

    On the other hand, we are likely to see an experiment with MMT in the post-electoral landscape in 2021. Should such a scenario unfold, it would provide a fiscal boost to the economy, and equity prices.

    I suggest that investors prepare for these themes to become more dominant in the future. It is impossible to forecast the magnitude of these effects, as my crystal ball gets very cloudy when I look that far ahead, but my best advice is to be aware of these themes, and stay data dependent.
     

    The week ahead: A market stall ahead

    Looking to the week ahead, the US equity market is nearing an inflection point. Risk/reward is starting to tilt towards the downside, though there may be some minor upside potential left.

    Mark Hulbert observed that his NASDAQ Newsletter Sentiment Index (HNNSI) is highly elevated and he described sentiment as climbing a “slope of hope”, which is contrarian bearish.
     

     

    Hulbert qualified his remarks that sentiment models are inexact in their market timing. In the past, he has stated that these signals tend to work best on a one-month time horizon. I would also point out that overbought markets can become more overbought, and HNNSI readings are not at the extreme levels seen at past market tops.

    The usual qualifications apply, of course. Contrarian analysis doesn’t always work. And, even when it does, the market doesn’t always immediately respond to the contrarian signals. This past summer, for example, as you can see from the chart, the HNNSI hit its high about six weeks prior to the market’s. That’s a longer lead time than usual, but not unprecedented. But when the market finally did succumb to the extreme optimism, the Nasdaq fell by more than 20%.

    Another qualification about the HNNSI as a contrarian indicator: It works only as a very short-term timing indicator, providing insight about the market’s trend over perhaps the next few months at most. So it’s not inconsistent with the contrarian analysis of current market sentiment that the stock market could be headed to major new all-time market highs later this year.

    The Fear and Greed Index is also flashing a warning, though the indicator has not reached levels seen at past tops either.
     

     

    The market action of the VIX Index, which is inversely correlated with stock prices, is also flashing another warning. RSI-5 momentum flashed a bullish divergence for the VIX, indicating that volatility is about to spike, which conversely means a decline in stock prices.
     

     

    However, positive momentum still holds the short-term upper hand, and there may be more upside potential over the next few days. Small cap stocks, as measured by the Russell 2000, have broken up through its channel, and they have also rallied through a relative downtrend (bottom panel).
     

     

    We can also see a similar pattern in midcap stocks, both on an absolute and market relative basis.
     

     

    These signs of positive momentum still have to be respected. For the time being, the market continues to flash a series of “good overbought” RSI-5 conditions indicating strong momentum. The market has not triggered any of my bearish tripwires, such as the Fear and Greed Index above 80, the VIX Index falling below its lower Bollinger Band, or RSI-14 rising to an overbought reading of 70.
     

     

    On the other hand, short-term breadth indicators are sufficiently overbought that the market could pull back at any time.
     

     

    My inner investor is neutrally positioned at his target asset allocation levels. Equity returns should be positive over the next year from current, though he does not expect them to be spectacular.

    My inner trader remains long equities, but he has been taking partial profits as the market rallied last week. He is waiting for either an overbought extreme reading or a downside break as a signal to reverse to the short side.

    Disclosure: Long SPXL

     

    Nearing peak good news?

    Posted by Cam Hui -

    Mid-week market update: Stock prices have been rallying as it hit a trifecta of good news. First, a compromise seems to have been made on the avoidance of another government shutdown. As well, Trump has been making encouraging noises about a US-China trade agreement. Either both sides could come to an understanding on or before the March 1 deadline, or the deadline will be extended, which is a sign of progress. Should the announcement of a definitive time and date of a Trump-Xi meeting, that would be an encouraging signal that an agreement has been made, and the formal signing ceremony would occur at the summit.

    Lastly, Reuters reported that the Cleveland Fed President Loretta Mester stated the Fed is finalizing plans on scaling back or completely eliminating its program to reduce its balance sheet, otherwise known as quantitative easing:

    The Federal Reserve will chart plans to stop letting its bond holdings roll off “at coming meetings,” Cleveland Fed President Loretta Mester said on Tuesday, signaling another major policy shift for the Fed after pausing interest rate hikes.

    “At coming meetings, we will be finalizing our plans for ending the balance-sheet runoff and completing balance-sheet normalization,” Mester said in remarks prepared for delivery in Cincinnati. “As we have done throughout the process of normalization, we will make these plans and the rationale for them known to the public in a timely way because transparency and accountability are basic tenets of appropriate monetary policymaking.”

    As a consequence, the SPX is breaking out above its 200 day moving average (dma) and approaching resistance at about the 2800 level.
     

     

    I have been bullish about the likely prospect for a Sino-American trade deal (see Why there will be a US-China trade deal March 1 and The Art of the Deal meets the Art of the Possible). Should we see news of a trade deal, but that event may represent the short-term peak of good news. After all this, what other bullish developments can you think of that could propel stock prices to further highs?
     

    Fade the news

    A recent Bloomberg article outlined veteran investor Shawn Matthews’ case for fading a trade deal rally. In particular Matthews cited the signal from the bond market as a sign that any stock market rally from a potential trade deal is not sustainable.

    “Right now, it’s a risk-on mentality — you want to be long riskier assets until you get a deal with China,” Matthews, who headed Cantor Fitzgerald LP’s broker-dealer unit from 2009 until last year and now runs his own hedge fund, told Bloomberg TV in New York. “When that happens you certainly want to be looking to scale back.”

    Despite Matthews’ recommendation to stay invested in equities for now, the bond market is showing signs of caution, he said. The 13 percent surge in global stocks since Christmas is beginning to reflect some kind of a U.S.-China deal, so a classic case of “buy the rumor, sell the fact” may eventuate, said Matthews.

    “The bond market is not seeing the follow through,” said Matthews, whose career began in 1990 and saw him rise to lead one of Wall Street’s biggest brokerages until he left to start Hondius Capital, a macro fund. “If it was truly a risk-on world and people believed it and it was an extended trade, then you would see the 10-year start to back up. That’s a clear sign there’s some concern about what’s going on out there.”

    If the stock market rally that bottomed on Christmas Eve was a growth driven surge, why has neither the 10-year yield nor the 2s10s yield curve moved?
     

     

    Bearish tripwires

    In all likelihood, the rebound from late December is on its last legs. However, none of my bearish tripwires have been triggered, and I am not ready to turn tactically bearish just yet.

    The Fear and Greed Index has rebounded strongly, but it has not risen into the target zone of 80-100. At a minimum, I would like this reading in the high 70s before turning bearish.
     

     

    In addition, neither RSI-14 has reached an overbought condition of above 70, nor has the VIX Index fallen below its lower Bollinger Band, which is a signal that the market is about to stall.
     

     

    I am not tactically turning bearish just yet. Expect further upside as the FOMO crowd pile in over the next few days. Bespoke pointed out that the market performs well following a 200 dma breakout preceded by eight weeks below it.
     

     

    In addition, past breadth thrusts from deeply oversold positions have been long-term bullish, and that will be another form of encouragement for the bulls.
     

     

    My inner trader remains bullishly positioned, though he has taken partial profits as stock prices rallied.

    Disclosure: Long SPXL

     

    The Art of the Deal meets the Art of the Possible

    Posted by Cam Hui -

    In his 2019 State of the Union address, President Trump said he was seeking “real structural change” to China’s economy:

    I have great respect for President Xi, and we are now working on a new trade deal with China. But it must include real, structural change to end unfair trade practices, reduce our chronic trade deficit, and protect American jobs.

    In the next breath, he referred to the reboot of NAFTA, which only yielded minor changes:

    Another historic trade blunder was the catastrophe known as NAFTA. I have met the men and women of Michigan, Ohio, Pennsylvania, Indiana, New Hampshire, and many other states whose dreams were shattered by the signing of NAFTA. For years, politicians promised them they would renegotiate for a better deal, but no one ever tried, until now.

    Our new U.S.-Mexico-Canada Agreement, the USMCA, will replace NAFTA and deliver for American workers like they haven’t had delivered to for a long time. I hope you can pass the USMCA into law so that we can bring back our manufacturing jobs in even greater numbers, expand American agriculture, protect intellectual property, and ensure that more cars are proudly stamped with our four beautiful words: “Made in the USA.

    While Trump positions himself as a master dealmaker in his book The Art of the Deal, it is said that politics is the art of the possible. Let us consider what is actually possible during these rounds of US-China trade negotiations.
     

    Intellectual property rights

    In addition to the growing trade deficit with China, one complaint the West has with China is the protection of intellectual property. Analysis from the St. Louis Fed shows that the situation is improving. Chinese payment for the use of US IP has been steadily rising over the years, and the rate of increase has been higher than China’s GDP.
     

     

    On the other hand, there are still cases like the one involving the Chinese scientist charged with the theft of Philips 66 IP worth over $1 billion:

    Phillips 66 spokesman Dennis Nuff confirmed Monday that the company is cooperating with the Federal Bureau of Investigation in an case involving a former Bartlesville employee.

    A Chinese national, Hongjin Tan, who is a legal permanent resident of the United States, was charged last week in Tulsa federal court on a theft of trade secrets complaint, according to federal court documents. Tan is being detained, and preliminary and detention hearing are scheduled Wednesday.

    In a separate incident, Bloomberg reported on the FBI sting of Huawei:

    The sample looked like an ordinary piece of glass, 4 inches square and transparent on both sides. It’d been packed like the precious specimen its inventor, Adam Khan, believed it to be—placed on wax paper, nestled in a tray lined with silicon gel, enclosed in a plastic case, surrounded by air bags, sealed in a cardboard box—and then sent for testing to a laboratory in San Diego owned by Huawei Technologies Co. But when the sample came back last August, months late and badly damaged, Khan knew something was terribly wrong. Was the Chinese company trying to steal his technology?

    […]

    Like all inventors, Khan was paranoid about knockoffs. Even so, he was caught by surprise when Huawei, a potential customer, began to behave suspiciously after receiving the meticulously packed sample. Khan was more surprised when the U.S. Federal Bureau of Investigation drafted him and Akhan’s chief operations officer, Carl Shurboff, as participants in its investigation of Huawei. The FBI asked them to travel to Las Vegas and conduct a meeting with Huawei representatives at last month’s Consumer Electronics Show. Shurboff was outfitted with surveillance devices and recorded the conversation while a Bloomberg Businessweek reporter watched from safe distance.

    This investigation, which hasn’t previously been made public, is separate from the recently announced grand jury indictments against Huawei. On Jan. 28, federal prosecutors in Brooklyn charged the company and its chief financial officer, Meng Wanzhou, with multiple counts of fraud and conspiracy. In a separate case, prosecutors in Seattle charged Huawei with theft of trade secrets, conspiracy, and obstruction of justice, claiming that one of its employees stole a part from a robot, known as Tappy, at a T-Mobile US Inc. facility in Bellevue, Wash. “These charges lay bare Huawei’s alleged blatant disregard for the laws of our country and standard global business practices,” Christopher Wray, the FBI director, said in a press release accompanying the Jan. 28 indictments. “Today should serve as a warning that we will not tolerate businesses that violate our laws, obstruct justice, or jeopardize national and economic well-being.” Huawei has denied the charges.

    For Americans, how do they resolve these differences, and what should the proper policy response be?

    This conundrum is reminiscent of debates over Fed policy. If an excessively easy monetary policy designed to cushion the economy from the effects of the Great Financial Crisis raises the risk of creating an asset price bubble, what should the Fed do? One option is to raise rates, which chokes off growth, but minimizes bubbles. In the last few years, the Fed has chosen to eschew the use of interest rate policy, which it believes to be an overly blunt instrument, and rely on macro prudential lending policy as a way of combating asset bubbles.

    Here is how the Art of the Deal meets the Art of the Possible. These cases of intellectual property theft are specific in nature, and occur on American soil, rather than in China. Trade policy is an overly blunt instrument, and these cases can be dealt with by existing agencies, such as the FBI.
     

    Structural reform

    Trump also raised the issue of “real structural reform” in his State of the Union address. What does that actually mean, and can these problems be addressed by the March 1 deadline?

    Currency strategist Marc Chandler framed the problem this way:

    China cannot commit to the kind of structural reforms the US demands. It is pursued policies in direct contradiction of the IMF and Washington Consensus, and it has literally lifted hundreds of millions of people out of poverty. The US wants the Chinese state to withdraw from the economy. While there is an intuitive appeal but the closer it is examined, the less insightful it becomes.

    Imagine Chinese officials demand that the US government withdraws from the housing market, where through its ownership of Fannie Mae and Freddie Mac, it nationalized America’s mortgage lending. Imagine Chinese officials complained when the US injected capital into all the large banks whether they asked for it or not.

    If the size of the state is measured as expenditures as a percentage of GDP than it is the US state that is the outlier for how small it is rather than the size of the Chinese state. Many critics see the US government as having encroached on the markets to an unprecedented extent, and now the US is insisting the Chinese state withdraws. It is an unrealistic demand that is tantamount to unilateral disarmament.

    In other words, if the US is demanding the kinds of structural reforms that it proposes by March 1 deadline, it is in effect making an ultimatum that cannot be met, and the demands represent a fig leaf for what amounts to the declaration of a full-blown trade war.

    Why bother negotiating when you know the other side cannot yield to your terms?

    The WSJ reported that a wave of farm bankruptcies is already sweeping America’s farm country. To be sure, the bankruptcies cannot be all attributable to the trade war, as commodity prices have been depressed. The Midwest represents the heartland of Republican support. and both Trump and Congressional Republicans will have to face the voters next year. Are these demands about structural reforms a form of posturing, or is Trump serious enough to go over the cliff if they are not met?

    Moreover, Trump has made it clear he is enthusiastic about a summit with Kim Jong-Un of North Korea, which is a country that China has considerable leverage over. How susceptible is he to Xi Jinping playing the North Korea card?

    Here is another instance where the Art of the Deal meets the art of the possible. Expect either the March 1 deadline to be extended, or a deal to be made where both sides commit to further discussions on intellectual property protection and structural reforms.

    Despite all of the rhetoric about how the two sides are still far apart, and no Trump-Xi meeting is scheduled, a sliver of daylight is appearing in the negotiations. Axios reported Sunday that the US side has floated a trial balloon of a Mar-A-Lago location for a summit instead of China`s proposal of a Chinese location.

    Xi may soon come to Mar-a-Lago. President Trump’s advisers have informally discussed holding a summit there next month with Chinese President Xi Jinping to try to end the U.S.-China trade war, according to two administration officials with direct knowledge of the internal discussions.

    Both officials, who are not authorized to discuss the deliberations, described Trump’s club in Palm Beach, Florida, as the “likely” location for the leaders’ next meeting, but stressed that nothing is set. The meeting could come as soon as mid-March, these sources said.

    A third official cautioned that the team has discussed other locations, including Beijing, and that it’s premature to say where they’ll meet or even whether a meeting is certain to happen.

    Everybody wins. The Trump administration demonstrates a mastery of the Art of the Deal. China can temporarily take the tail-risk of additional tariffs and trade war off the table.

     

    Here comes the growth scare

    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: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Bullish

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

    Bullish and bearish over different time frames

    I was recently asked to clarify my market views, as they appear to have been contradictory. Let me make this clear, I am both bullish and bearish, but over different time horizons.

    I expect that the U.S. equity market should perform well into the end of 2019. The recent Zweig Breadth Thrust signal on January 7 (see A Rare “What’s My Credit Card Limit” Buy Signal) has historically seen higher prices over longer time frames. Exhibitions of powerful price momentum have historically been very bullish.

    Troy Bombardia recently pointed out that the NYSE McClellan Summation Index (NYSI) recently exceeded 850, and past episodes have resolved bullishly. My own shorter-term study shows that the market was higher 75% of the time after one month with an average return of 1.8%, and higher 83.3% of the time after three months with an average return of 3.9%.
     

     

    However, I do have some concerns about the possibility of stock price weakness over the next few months. As we pointed out last week (see Recession Ahead? Fuggedaboutit!), the market is likely to be spooked by growth slowdown as we approach Q2. Evidence of a growth scare is already emerging.
     

    The growth scare in Europe

    The most visible portion of the growth scare is appearing in Europe. German industrial production is tanking, and the country is in a technical recession. In addition, the European Commission cut its 2019 eurozone growth forecast from 1.9% to 1.3%.
     

     

    As Germany has been the growth locomotive of the eurozone, worries are spreading. Even The Economist published an article entitled, It is Time to Worry About Germany’s Economy — A Sputtering Engine”.

    Germany is getting both the short and the long term wrong. Start with the business cycle. Many policymakers think the economy is close to overheating, pointing to accelerating wages and forecasts of higher inflation. In their view, slower growth was expected, necessary even. That is complacent. Even before the slowdown, the IMF predicted that in 2023 core inflation will be only 2.5%—hardly a sign of runaway prices. In any case, higher German inflation would be welcome, as a way to resolve imbalances in competitiveness within the euro zone that would elsewhere adjust through exchange rates. The risk is not of overheating but of Europe slipping into a low-growth trap as countries that need to gain competitiveness face an inflation ceiling set too low by Germany.

    The slowdown also portends deeper problems for Germany’s globalized economic model. Weakness in part reflects the fallout from the trade war between China and America, two of Germany’s biggest trading partners. Both are increasingly keen on bringing supply chains home. America is due soon to decide whether to raise tariffs on European cars. Trade is already becoming more regionalised as uncertainty grows. If global commerce splits into separate trading and regulatory blocs, Germany will find it harder to sell its goods to customers around the world.

    The possibility of a no-deal and disorderly Brexit is also worrisome. This New York Times graphic shows that while the British economy will bear most of the pain of a no-deal Brexit, both the French and German economies will also be vulnerable too. In addition, Bloomberg reported that a study by Halle IWH concluded that 100,000 German jobs would be at risk in the event of a no-deal Brexit.
     

     

    Another possible but less noticed development is bearish implications of a U.S.-China trade agreement. China has promised to import more from the U.S. in order to reduce or eliminate the trade deficit over time. However, if China were to import more American goods in the short run, demand will have to be shifted from somewhere else. More imports from America such as Boeing aircraft, and fewer from Airbus. Europe would bear the brunt of falling Chinese demand under such a scenario.
     

    A US slowdown ahead?

    Over on this side of the Atlantic, slowdown fears are also rising. Yelp recently unveiled a business survey called the Yelp Economic Average (YEA), and it is uncovering broad-based signs of a business downturn.

    Over the past quarter, YEA fell by more than two points, due in large part to declines in the professional services, shopping, and other categories. Slumps in core business sectors may be early signs of an economic downturn. A second successive fourth-quarter slump isn’t a result of seasonality; we’ve normalized the data so that it is seasonally adjusted.

    Of the 30 business sectors represented by the Yelp Economic Average (YEA), only one—gas stations—saw an increase in the fourth quarter of 2018, resulting in a national decline to 98.5 from 100.7 in the third quarter. All YEA scores are calculated relative to the fourth quarter of 2016, for which the score was set to 100.

    The downturn left few business sectors untouched. Everything from high-end retail such as jewelry stores and antique shops to pricey professional services such as private eyes and architects were hit hard in the fourth quarter, in a trend extending to sectors beyond our core 30. So were more routine discretionary offerings, such as burger places, bars, and coffee shops.

    In addition, Georg Vrba’s unemployment rate recession model is on the cusp of a recession call (see The Unemployment Rate May Soon Signal A Recession: Update – February 1, 2018): “If unemployment rate rises to 4.1% in the coming months the model would then signal recession”.

    I am skeptical that a recession is in the cards. The recession model is based on a rising unemployment rate, which has signaled slowdowns in the past. However, the rise in unemployment is the result of the labor force participation rate rising faster than job growth, which are signs of a strong economy not a weak one.

    As well, the blogger New Deal democrat went on “Recession Watch” for Q4 last week because of tightening credit conditions from the Senior Loan Officer survey. Credit has tightened across the board for firms of all sizes.
     

     

    Analysis from Citi Research confirms NDD’s concerns. Changes in credit standards leads industrial production by three quarters.
     

     

     

    I would also add that credit conditions have also tightened on the consumer side as well.
     

     

    The deterioration in credit conditions was enough to put NDD on “Recession Watch”:

    We have 3 negatives: interest rates, housing, and credit conditions
    We have 2 positives: corporate profits and real retail sales per capita
    We have 2 mixed indicators: money supply and the yield curve

    There has been enough further deterioration in the long leading indicators — metrics I have followed and updated over and over again for years — during the second half of 2018 that a plurality are negative. It had already appeared that the more likely outcome would be that in the second half of 2019, left to its own devices, the economy would just barely escape recession, although poor government policy choices this year could easily tip the balance. The further deterioration described above warrants going on Recession Watch one year out — i.e., beginning Q4 2019.

    However, NDD was careful to distinguish this as a “Recession Watch” warning, and not an actual recession forecast.

    It isn’t a “Recession Warning,” where a downturn looks certain, but more on the order of the warning given to Scrooge by the Ghost of Christmas Future: what is likely to happen if there is no intervening change for the good.

     

    Why I am bullish

    Here is why I remain bullish on equities longer term. It is true that recessions are bull market killers, I am skeptical of these recession warnings
     

     

    Recessions don’t occur spontaneously, but occur as part of a process. Past recessions have been the result of either tight Fed policy cooling growth into recession (1973, 1980, 1982, 1990) or the unwinding of financial excesses that led to an accident (2000, 2008). The same conditions are not in place. Fed policy can hardly be described as overly hawkish. A financial accident is always possible (China, the European banking system), but the American economy is largely insulated from the worst of any implosion. Should a U.S. recession occur, we expect it to be mild.
     

    Traversing the valley of weak growth

    Nevertheless, NDD’s short leading indicators are pointing to Q2 weakness, and the market will have to traverse this valley of weak growth. The latest update from FactSet shows that while Q4 earnings season beat rates are slightly ahead of historical averages, Estimate revisions are falling and the Q1 negative guidance rate is higher than average, but stock prices haven’t responded to the downgrades.
     

     

    In addition, the old market leaders of 2018 have not stepped up in the reflex rally off the December 24 bottom, and many of the old FAANG stocks are likely to face regulatory headwinds in 2019. Business Insider reported that Facebook is facing an existential threat to its business model in Europe. Other companies that rely on Big Data like Google and Amazon are likely to get caught up in the dragnet soon.

    Germany’s antitrust regulator, the Bundeskartellamt, or Federal Cartel Office, on Thursday issued Facebook with an ultimatum: Stop hoarding people’s data.

    Following an unprecedented three-year investigation involving extensive conversations with Facebook, the Bundeskartellamt issued a press statement declaring that it had “imposed on Facebook far-reaching restrictions in the processing of user data.”

    It demands that Facebook — which has 32 million monthly users in Germany — change its terms and conditions so that people can explicitly stop it from hoarding data from different sources, including Facebook-owned apps like WhatsApp and Instagram as well as third-party websites with embedded Facebook tools such as “like” or “share” buttons.

    If FAANG falters, where’s the leadership? The market will have to spend a little time to sort these issues out before it can rise further.
     

    What could go right

    Still, there are some silver linings in the dark cloud of bearish factors. Even the perennially bearish Zero Hedge conceded that market positioning is supportive of stock prices in the short run. Analysis from Nomura shows that Commodity Trading Advisors are responding to the change in price trend and adding to their equity positions.
     

     

    As well, risk parity funds are unwinding their underweight position in equities and they are starting to buy again.
     

     

    In addition, the team of Steve Mnuchin and Robert Lighthizer are headed to China for another round of trade negotiations on February 14-15, though the timing of a Trump-Xi meeting has not been finalized yet. Asia Nikkei reported that while China is making trade concessions, it is also playing the North Korea card. A trade agreement, regardless of how incomplete the provisions are, combined with a de-escalation of tensions with North Korea, will be a positive surprise for the markets.

    As things stand, Xi’s side appears to be making concessions to Trump — announcing increased purchases of American goods and hinting at some structural reforms — in a bid to stabilize bilateral economic relations. China’s economic slowdown has made it difficult for Xi to take a combative stance.

    But things are not that simple. What is also happening is that China is playing the “North Korea card” and shrewdly weighing in on the second U.S.-North Korean summit, as a way to gain leverage in the trade talks with Washington.

    Xi was in effect offering a big win to Trump, not just on trade, but on North Korea as well:

    China’s strategy was clear from the composition of the delegation that accompanied Liu on his trip to Washington. Although labeled as “ministerial-level talks,” Liu took no cabinet members with him. The only other high-profile figure on the delegation was Yi Gang, the governor of the People’s Bank of China, the country’s central bank.

    Sitting opposite a full line-up of Trump administration heavyweights such as U.S. Trade Representative Robert Lighthizer, Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross was a group of Chinese vice-ministers.

    The unequal and bizarre lineup of the Chinese side said it all. The main purpose of Liu’s U.S. trip was to meet Trump and personally convey in polite terms Xi’s request for a summit.

    China knew that if it could arrange a meeting with Trump before the March 1 trade negotiation deadline, it could finalize the details of a possible deal in the days after this week’s Chinese New Year holiday.

    This is where the North Korea issue comes into play. A source involved in Sino-North Korean relations says the really big issue between the U.S. and China is not trade, but national security.

    I believe that the recent statements on the American side about “a sizable difference” between the two sides and no Trump-Xi summit has been scheduled is posturing (see Why there will be a US-China trade deal March 1). Both sides desperately need a deal for their own domestic reasons. Negotiators on both sides will undoubtedly be closed-mouthed after the Beijing round of talks, but statements by both sides will give some clues. Barring a complete breakdown, any decision to keep talking should be seen as a sign of progress. Expect negotiations to go right down to the wire, much like the NAFTA negotiations, which yielded only cosmetic changes, but all sides were able to claim victory. Trump’s Friday night tweet about a meeting with Kim Jong-Un is a tantalizing clue that he has taken Xi’s bait of a trade-North Korea linkage in the discussions.
     

     

    The Chinese stock market was closed last week, but the U.S.-listed ETF was not. The U.S.-listed ETF (FXI) and soybean prices are exhibited constructive technical patterns that bear watching. FXI (top panel) made a double bottom and is now testing a key resistance zone. Soybean prices have been trending up and also testing key resistance.
     

     

    These will be key indicators to watch in the days to come.
     

    Bullish tripwires

    Should the market correct, or retrace and test the December lows, we stand by our belief that a re-test would represent a buying opportunity because the market was discounting a mild recession at the December 2018 year-end (see Ursus Interruptus).

    Should stock prices weaken and re-test the previous lows, here are the signs we would watch to see if the same buying opportunity is still presenting itself.

    How are insiders behaving? This group of “smart investors” bought the last two rounds of market weakness. Would they continue to do so if stock prices re-visit the December lows?
     

     

    One concern that will undoubtedly face the markets in the event of a widespread growth scare is financial stress, and contagion risk from abroad. In the past, technical breakdowns of the relative performance of bank stocks have been warnings of equity bear markets.
     

     

    Since a key stress point is the European banking system, how are the European financial stocks performing? Is the relative performance of the sector significantly worse than US financials?
     

     

    As well, watch for signs of stress in the canaries in the Chinese coal mine. How are Chinese property developers like China Evergrande (3333.HK) behaving? Are they holding long-term support?
     

     

    What about the AUD/CAD exchange rate? Both Australia and Canada are commodity-sensitive economies, but Australia is more sensitive to China while Canada is more levered to American growth. Is AUD/CAD holding support?
     

     

    If these tripwires were to flash the all-clear sign should stock prices correct, that would be the signal to step up and buy.
     

    The week ahead

    Looking to the week ahead, I am also bullish and bearish over different time frames. In the very short run, the SPX successfully tested support while exhibiting positive RSI divergences and an unfilled gap above current levels. This suggests a bullish tone to the early part of the coming week.
     

     

    There is precedence for the pattern of breadth thrust, overbought and pullback before rallying to new highs. Exhibit A is the Zweig Breadth Thrust signal of 2015.
     

     

    Looking at the bigger picture, the SPX rally was halted at the 200 dma resistance. Another run at the 200 dma while flashing another overbought reading on RSI-5 would be no surprise, with additional resistance at 2800. Should such a rally occur, watch to see if the VIX Index breaches its lower Bollinger Band, which is a sign of a stalling rally.
     

     

    The Fear and Greed Index has rebounded strongly and ended on Friday at 61. It may need to rise up into the 80-100 target zone before this rally is over.
     

     

    Longer term, a glance at the history of % of stocks above the 200 dma became wildly oversold shows that past V-shaped bounces off deeply oversold conditions has seen the market rally stall at current readings. This is consistent with my view of a growth scare induced correction over the next few weeks.
     

     

    Tactically, it may be a little early to get overly defensive. The NYSE McClellan Summation Index (NYSI) is extended, but the stochastic has not rolled over yet. A rollover of the weekly stochastic has historically been a more timely sell signal for the market.
     

     

    My inner investor is neutrally positioned at his investment policy asset weights. My inner trader remains bullishly positioned for a rally into early next week.

    Disclosure: Long SPXL

     

    Why there will be a US-China trade deal by March 1

    Posted by Cam Hui -

    Stock prices began on a sour note this morning (Thursday) on the fears of a European growth slowdown. They slid further when Trump advisor Larry Kudlow appeared on Fox Business News and said that there’s “a sizable difference” between the US and China’s positions in the trade negotiations. The White House went on to pour cold water on the idea of an imminent Trump-Xi summit and said that the two may not meet before the March 1 deadline.

    The two most trade deal sensitive vehicles, Chinese equity ETFs and soybean prices, weakened as a consequence. However, their technical patterns remain constructive. FXI (top panel) remains in an uptrend as it tested a resistance zone after exhibiting a double bottom. Soybean prices are also in an uptrend and they are also testing resistance.

     

    My inclination is to shrug off the negative headlines as posturing by American negotiators. There will be a trade deal. Here is why.

    The necessity of a trade deal

    Both sides desperately need a deal.

    For the Chinese, their economy is weakening. Since official economic statistics can be dubious, a scan of the Q4 earnings reports of listed US companies show that most are showing sales are down roughly -5% (h/t The Long View).

     

    Even the sales at BABA shows that sales growth was attributable to user growth, and not organic growth by user. These figures do not support the narrative of real GDP growth of over 6%.

     

    On the American side, Trump has shown himself to be highly sensitive to falling stock prices. It is difficult to conceive that he would tank the trade talks and the stock market, except as a temporary negotiating tactic. In addition, the WSJ reported that a wave of bankruptcies is sweeping the farm belt.

    Throughout much of the Midwest, U.S. farmers are filing for chapter 12 bankruptcy protection at levels not seen for at least a decade, a Wall Street Journal review of federal data shows.

    Bankruptcies in three regions covering major farm states last year rose to the highest level in at least 10 years. The Seventh Circuit Court of Appeals, which includes Illinois, Indiana and Wisconsin, had double the bankruptcies in 2018 compared with 2008. In the Eighth Circuit, which includes states from North Dakota to Arkansas, bankruptcies swelled 96%. The 10th Circuit, which covers Kansas and other states, last year had 59% more bankruptcies than a decade earlier.

     

    To be sure, the bankruptcies are not all attributable to trade tensions. Low commodity prices and rising farm debt also contributed to the mounting distress, but the trade war did not help matters.

     

    As Trump and the Republicans look ahead to the elections in 2020, a loss of support in this key region which forms the backbone of their support would amount to political suicide.

    That said, I would not expect any more than the market consensus on the details of a trade agreement. It will be little more than a face-saving deal that leaves key issues of whether China can reshape its industrial policy, which favors its SOEs, and intellectual property protection. Leland Miller of China Beige Book stated on CNBC that while he believes there will be a mini-deal, friction will rise again in 2020. A consensus has developed in Washington on both sides of the aisle that China is becoming a strategic competitor. Both Trump and the Democrat’s nominee will both position themselves as being “tough on China”.

    In conclusion, there will be a phony trade deal by the March 1 deadline. Both sides will declare victory, but they won’t go home. The war will resume next year.

     

    What gold tells us about stock prices

    Posted by Cam Hui -

    Mid-week market comment: The SPX has risen roughly 400 handles since the December 24 bottom, and it is approaching its 200 dma. Can the market stage a sustainable rally above this key hurdle?

     

    Golden clues

    For some clues, we can turn to the price of gold. The top panel of the chart below shows that gold prices tend to have an inverse correlation with stock prices, and that relationship is especially true now. When stocks rise, gold falls, and vice versa.

     

    Here are some clues to the likely direction of stocks from gold prices. First, the long-term outlook for gold prices looks impressive. It is formed a multi–year saucer shaped base. The objective on an upside breakout is about 1560 based on point and figure charting.

     

    In the short run, however, the golden rally looks exhausted and due for a pullback. Gold prices are testing the underside of uptrend resistance. Similarly, the inflation expectations ETF (RINF) is displaying a similar technical pattern of approaching trend line resistance.

    When I turn to gold equities (GDX), the silver/gold ratio is exhibiting a negative divergence that is not supportive of further strength. Silver is the poor man’s gold, and it tends to have a higher beta than gold. The underperformance of the silver/gold ratio is therefore another short-term cautionary sign for gold bugs.

     

    In addition, Mark Hulbert pointed out that the sentiment of short-term gold timers is an off-the-charts bullish reading, which is contrarian bearish.

     

    Contrast those sentiment readings with Callum Thomas’ weekly (unscientific) Twitter poll conducted on weekends, which still shows respondents to be net bearish even after last week’s advance. Stock prices are climbing the proverbial Wall of Worry.

     

    In conclusion, while the longer term outlook for gold prices is bullish, this precious metal appears overextended in the short-term. The inverse relationship between gold and stock prices implies a bullish outlook for US equities.

    Cautionary tripwires for equities

    However, this does not mean that traders should pile into stocks with abandon. The stock market is highly overbought, and it can either consolidate or correct at any time. Here are a couple of cautionary signs that I am watching for.

     

    1. RSI-14: While the series of overbought readings flashed by the RSI-5 indicator could be signals of “good overbought” conditions, an overbought reading by the longer term RSI-14 indicator has historically been a cautionary sign of an extended market.
    2. VIX below lower BB: In the past, the VIX Index falling below its lower Bollinger Band has also been another cautionary signal for the stock market. Intra-day dips below the lower BB isn’t enough, it’s the closing price that raises the red flag. Watch for it.

    My inner trader went long the market earlier this week. He is bullishly positioned, but he is watching these triggers as signals to exit his long positions.

    Disclosure: Long SPXL

     

    Demographics isn’t destiny = History rhymes

    Posted by Cam Hui -

    As new data has crosses my desk, I thought I would write a follow-up to my bullish demographic analysis published two weeks ago (see A different kind of America First). To recap, I observed that America is about to enter another echo demographic boom as the Millennial generation enters its prime earnings years.
     

     

    A study by San Francisco Fed researchers pointed out that this should raise demand for equities from Millennials. This is especially important as the Baby Boomers reduce their equity holdings as they retire.
     

     

    I then postulated that rising savings from Millennial should usher in another golden age in US equities.

    This is the part where history doesn’t repeat itself, but rhymes.
     

    A generation of slackers?

    I had some pushback from readers to the effect that the new generation is a bunch of slackers living in their parents’ basement. But please be reminded that Baby Boomers in the youth popularized the practice of smoking pot, and once believed in “free love”. They eventually grew up, got jobs, and became responsible citizens.

    A recent study by FINRA and the CFA Institute found that the approach that the Millennial generation has adopted to their personal finances are not very different from older cohorts. The study was based on eight focus groups and a 2018 online survey of nearly 3,000 Millennials, Baby Boomers, and Gen Xers. This is an important issue for the financial services industry. Forbes reported that Millennals are poised to inherit $30 trillion over the next 30 years.

    When it comes to financial goals, the assumed overconfidence and ambition of millennials should translate into expectations of early retirement. But the data does not bear this out: Only 3% of millennials with taxable retirement accounts anticipate retiring before age 50, and a sizeable proportion of millennials don’t expect to retire at all. Moreover, the goals of non-investing millennials are exceptionally modest, with 40% of this group saying that their top goal is simply not living paycheck to paycheck. The goals of millennials with taxable accounts line up fairly well with those of Gen Xers and baby boomers who also have such accounts.

    Despite their greater comfort with technology, Millennails are not embracing robo-advisors.

    Indeed, notwithstanding their presumed tech savvy, millennials are not especially well informed or curious about robo-advisors. Of those surveyed, 37% had never heard of robo-advisors, and only 16% said they were very or extremely interested in them. Moreover, when working with a financial professional, more than half of the millennials studied said they’d prefer to do so face to face. They were similarly unimpressed with cryptocurrencies.

    Their trust in Wall Street is not especially high.

    So what about trust? Millennials have had to navigate the most difficult economic landscape of any generation since the Great Depression. The financial crisis has defined their world and shaped their expectations. Surely advisers can expect to have a more difficult time convincing them to take a chance and entrust them with their money, right? Apparently not. Contrary to popular wisdom, the difficult economic times have not made millennials overly skeptical of finance professionals or the finance industry. According to the study, 41% of millennials with retirement or taxable accounts work with an adviser and 72% of these are either very or extremely satisfied with them. Finally, only 15% of those millennials not using an investment professional said it was due to a lack of trust.

    In that respect, demographics does look like destiny.
     

    How history only rhymes

    On the other hand, the Millennial cohort is maturity in an economic environment that is less friendly than the one experienced by Baby Boomers. The competitive environment is more challenging, and they are less likely to out-earn their parents than the Baby Boomers.
     

     

    In addition, I had pointed out a Fed study which concluded student loans are creating headwinds in the rate of home ownership. The same financial burdens are likely to restrain the savings capacity of this generation, which will affect their demand for equity investments.
     

     

    On the other hand, don’t be too surprised if American political discussion shifts to the left over the next decade, just as the 1960’s and 1970’s was a period of leftward drift and political turmoil in the US. As Millennials age and flex their political muscle, the likes of Alexandria Ocasio-Cortes, who is already a Millennial political star, expect economic theories like Modern Monetary Theory to assume a more prominent role in policy discussions. While I have no strong believes as to whether MMT is the correct approach, I do expect a greater fiscal boost should it become adopted. At worse, MMT would be no worse than Arthur Laffer’s supply-side theory which underpinned much of fiscal policy starting with the Reagan years.

    In short, demographics isn’t destiny. Expect some headwinds for Millennials from a tougher competitive environment and higher debt burdens. On the other hand, don’t be surprised at a political blowback as this generation flexes its political muscle.

    History doesn’t repeat, but it does rhyme.
     

    Recession ahead? Fuggedaboutit!

    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: Sell 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.
     

    Confident about a slowdown?

    Recently, a number of prominent investors and analysts, including Jeff Gundlach, David Rosenberg, and Ed Yardeni, have warned about an ominous recession signal from the Conference Board’s consumer confidence survey. Ed Yardeni’s analysis of the present situation to expectations spread was especially ominous for equity investors.
     

     

    Fuggedaboutit! The American economy isn’t going into recession. Call me bullish, but with a caveat.
     

    A false signal

    To be sure, there are numerous signs that confidence indices of all stripes are rolling over, starting with the University of Michigan consumer confidence index.
     

     

    NFIB small business confidence is coming off its highs.
     

     

    However, Renaissance Macro pointed out the recession probability signal based on present conditions to expectations spread recession indicator is at 100%, but it has been elevated since mid-2014. This is not a reliable and actionable indicator.
     

     

    The consumer revival

    If you are worried about the American consumer, then ask yourself why real retail sales are continuing to make new highs? Past recessions have usually been preceded by a peak in real retail sales.
     

     

    Over on Wall Street, the relative performance of consumer discretionary stocks have been rising. Most notably, the turnaround even as stock prices plunged in December and continued as the market rallied.
     

     

    In addition, the housing sector, which is the ultimate form of cyclical consumer durable, is showing signs of a turnaround. November new home sales surged and handily beat Street expectations last week. In addition, the relative performance of homebuilding stocks have begun to turn up as long rates have fallen. Similar the pattern of consumer discretionary stocks, this group’s relative uptrend occurred ahead of the stock market selloff last December.
     

     

    Do these charts look the market signals of a weak consumer to you?
     

    Possible growth scare ahead

    This doesn’t mean that equity investors should entirely shrug off downside risk and the bulls won’t have clear path up to all-time highs. Prepare for some volatility as there may be a growth scare ahead.

    I am indebted to the work of New Deal democrat, who has been monitoring high frequency economic data and categorizing them into coincident, short leading, and long leading indicators. This framework is highly useful for understanding the growth outlook in different time frames. His latest update has pointed to persistent readings of short-term weakness that will become evident mid-year, but a long-term (one-year) strength indicating low recession risk.

    The long-term forecast and the nowcast are slightly to the positive side, while the short term forecast is slightly negative for the fourth week in a row. Some of this is due to the government shutdown, so we will have to wait several more weeks to see is the changes are real.

    The signs of short-term weakness into mid-2019 could be mistaken by analysts as the basis for a possible recession. Cue the growth scare going into Q2. Troy Bombardia also observed that the ECRI Weekly Leading Indicator has been consistently negative, which is another worrisome sign.
     

     

    Another warning sign for equity investors is the continuing downgrade in forward 12-month EPS estimates. To be sure, stock prices have held up well during a Q4 earnings season whose beat rates are roughly in line with long-term averages, but how long can stock prices defy the gravity of negative fundamental momentum?
     

     

    The chart below depicts quarterly actual and estimated earnings. If New Deal democrat is right about economic weakness in Q2, then equity investors should be prepared for either downward revisions in Q2 EPS estimates, or downside reporting surprises.
     

     

    Waiting for the “you won’t want to buy” moment

    For now, the current newsflow of a dovish Fed and a likely US-China trade deal is tilting sentiment and price momentum bullishly.
     

     

    However, I am concerned that the late December bottom seemed too easy. II sentiment has normalized, and % bears spiked only briefly above % bulls. These readings are inconsistent with past durable intermediate term bottoms.
     

     

    Another worrisome sign evident during this rebound rally is the lack of apparent leadership. The relative performance of NASDAQ and small caps are not showing signs of sustainable leadership. If this rally were to carry itself further, what’s going to lead the way?
     

     

    There is a trader’s adage on Wall Street that when it’s time to buy, you won’t want to. There are too many investors and traders who are too eager to buy the dip.

    It is difficult to see how the market could fall without some bearish catalysts. We have to wait for the “you won’t want to buy moment”, which may occur when the market hits the growth scare speed bump in the coming weeks.

    In conclusion, the US economy is unlikely to enter a recession based on long leading indicators, barring a full-blown trade war. However, investors should expect a growth scare going into Q2. In light of the powerful short-term price momentum in stock prices, timing the inflection point between rebounding optimism and a growth scare will be a tricky task.

    I remain cautiously intermediate term bullish on equities. However, should the growth scare become the dominant narrative in the coming days and weeks, it could become the trigger for a re-test of the December lows. If that were to occur, investors should look through the “you won’t want to buy” fears to step up and load up on equities.
     

    The week ahead

    Looking to the week ahead, the market may be nearing a key technical inflection point. Rather than make a decision on the likely direction, my inner trader believes it would be more prudent to allow the market action tell us the likely short-term direction.

    The intermediate term bull case rests with the continuation of positive price momentum. The SPX exhibited a positive MACD crossover on the weekly chart. The 10-year record of past signals have been mostly bullish (blue vertical lines) with only a small minority that resolved bearishly (red lines).
     

     

    On the other hand, I remain open to the possibility of a W-shaped bottom, especially in light of the likely economic softness starting Q2. A study of market history by Andrew Thrasher concluded that the market needs to clear the 100 and 200 dma in order to reduce the risk of a re-test of the December lows.

    Going back to 1960, after a 15+% decline while the market has remained below its 100-day and 200-day Moving Average, the risk of a retest or a lower high were high. But once we cleared these intermediate and long-term MAs then the risk diminished.

    Troy Bomardia’s historical studies came to a similar conclusion.  Most retracements of “crash and rally” patterns stall either at the 50% retracement or 200 dma. However, they can turn back higher, and strength can persist all the way to all-time highs before retreating.

    So where does that leave us? The SPX rallied through a key downtrend last week, indicating persistent strength, which is bullish. However, the index ended the week just below its 100 dma, as well as the 61.8% Fibonacci retracement level. In addition, the VIX Index (bottom panel) closed Friday just shy of its lower Bollinger Band, which are levels where past stock market rallies have begun a pullback.
     

     

    Breadth indicators offer little clue to direction. On one hand, the market is overbought, but one of the most bullish things a stock market can do is become overbought and stay overbought. On the other hand, readings have pulled back from an extreme overbought condition that is reminiscent of the pattern displayed after the last Zweig Breadth Thrust buy signal in 2015 when the rally stalled and prices pulled back.
     

     

    My inner investor is neutrally positioned at roughly his policy asset weights. My inner trader is stepping aside until the market can flash further clues to market direction.

     

    Dismounting from the market rodeo

    Posted by Cam Hui -

    Mid-week market update: I am publishing the mid-week market update early ahead of the FOMC meeting Wednesday, which can create a high degree of volatility.

    It has been over a month since the December 24 market bottom, and stock prices have rallied strongly since that bottom. Indeed, price momentum has continued to lift prices even after the Zweig Breadth Thrust buy signal of January 7 (see A rare “what’s my credit card limit” buy signal).
     

     

    Marketwatch reported that Morgan Stanley strategist Mike Wilson thinks it’s time to dismount from this stock market rodeo:

    Employing a rodeo metaphor, Wilson on Monday urged his clients to “dismount” as the market’s rally since late 2018 is starting to look precarious.

    “Maybe the bull ride since Dec. 24 has not gone a full ‘8 seconds’ but we’d look to dismount anyway—we’re close enough and bulls can be dangerous animals,” he said in a report, referring to the number of seconds a bull rider is required to stay on to earn a score for a ride…

    “We struggle to see the upside in hanging on just to see how long we can. We think it is better to hop off now and rest up for the next rodeo,” said Wilson.

    I would tend to agree. At a minimum, investors and traders face a number of potential landmines this week.
     

    FOMC surprise?

    The FOMC began a two-day meeting today, and we will see the statement Wednesday. Expectations are building for a dovish tone, with a pause in rate hikes, and a possible taper of the central bank’s balance sheet runoff.

    Bloomberg commentator John Authers quoted TS Lombard U.S. economist Steven Blitz as an example of how market expectations have turned dovish:

    Fed Chairman Powell’s grace note was to float the possibility of tapering the pace of balance sheet reduction (QT). The market grabbed it, took it as gospel, and next week we will see whether the Fed delivers. If they do not, they will probably wish they had, and then taper at the March meeting. They could, of course, skip the QT adjustment half-step entirely and go right to a clean 25bp cut in the funds rate, but the data-dependents on the FOMC would not take kindly to such a leap.

    Authers believes that expectations becoming a little too unrealistic:

    In other words, Powell will enter Wednesday with the market braced for him to make a U-turn for the ages, a complete 180-degree turn from his views on the balance sheet as expressed only last month. There is substantial risk of disappointment, but whatever he says after the FOMC meeting, it will matter more than Ross’s admission that trade peace with China remains “miles and miles” away.

    Kevin Muir, or The Macro Tourist, thinks that Powell is ready to cave on the question of balance sheet adjustment, or quantitative tightening, in the wake of the recent WSJ article entitled “Fed Officials Weight Earlier Than Expected End to Bond Portfolio Runoff”:

    Which leads me to three different possibilities:

    1. Powell somehow believes that surprises are bad and that it is important for the information to be eased out into the market. I guess that might be the case if you are talking about bad news, but it seems to me that good news should be ripped off like a band-aid. But hey – I don’t have an army of PhD economists telling me the optimal method of communicating my waffling, so I don’t know. Maybe this is just messed-up Fed thinking at work.
    2. Maybe the WSJ has gone rogue and this story is not a leak but merely the “connecting of dots” from previous Fed communication. If you look carefully, there is little new information.
    3. Someone – either another faction at the Fed or maybe even the White House – planted the story in an attempt to force the Fed to change QT policy.

    I know the last two options seem a little extreme.

    Here is the more sober interpretation of the Fed’s likely actions this week from Tim Duy:

    The Fed will hold steady this week. I anticipate that barring any evident inflationary pressures, the Fed will be content to stay on the sidelines through at least the middle of the year. I think the underlying data will still prove too strong for central bankers to signal that they are at the end of the rate cycle. They will though want to communicate that regardless of their expectations, actual policy will be made with patience and flexibility. They will also want to communicate that the ultimate size of the balance sheet remains a technical issue at this point.

    If the market expectations have built up for an abrupt dovish shift from the FOMC, then prepare for disappointment from the market. For what it’s worth, Rob Hanna at Quantifiable Edges highlighted the historical record of positive equity market returns on FOMC days between the Powell Fed and his predecessors.
     

     

    Trade talks wildcard

    The second potential market landmine that the market faces are the upcoming US-China trade talks. A senior Chinese delegation is arriving in Washington on Wednesday to meet with American officials for two days of scheduled talks. Treasury Secretary Steve Mnuchin stated that the main issues are market access, making sure there aren’t forced ventures, not forced transfers of technology, and a monitoring mechanism if and when they reach an agreement.

    The WSJ highlighted the really difficult issue of the domination of China’s SOEs in key industries:

    China’s state firms dominate industries that U.S. firms want to enter, including telecommunications, energy, banking and insurance, and have made inroads into industries Mr. Xi is staking out as top priorities for the future. Beijing and local governments, for instance, have announced more than $100 billion in financing, mainly to state-owned firms, to develop a domestic semiconductor industry.

    State-owned construction firms are building Mr. Xi’s ambitious Belt-and-Road infrastructure projects across Asia and Africa, while state-owned banks are often called on to ramp up credit to keep the Chinese economy from slowing too rapidly.

    One Chinese economist calls state businesses “the legs of the Communist party.”

    In effect, the Americans are asking the Chinese to abandon their industrial strategy. It would be the equivalent of asking the US to abandon English style system of jurisprudence and adopt the Napoleonic Code.

    The Trump administration insists that Beijing cut tariffs and regulations that benefit state firms and block U.S. competition. It also wants China to reduce subsidies, preferential loans and other help that give state-owned firms an added advantage.

    Mr. Xi and his allies see state firms as a source of employment and thus social stability and a way for China to compete internationally through national champions in steel, aluminum, construction and other fields. They are also an important lever to manage the economy, in part because the Communist Party plays a big role in selecting top managers.

    In addition, the official US request for the extradition of Huawei CFO Meng Wanzhou is likely to put a damper on negotiations. CNN summarized the key points of the US indictments in the extraction request:

    1. Huawei’s founder lied to the FBI: Huawei founder Ren Zhengfei, who has played a prominent role in defending the company in recent weeks, repeatedly lied about its business dealings in Iran, US prosecutors say.
    2. Bonuses for employees who stole trade secrets: US prosecutors say Huawei had a policy in place that gave bonuses to employees who successfully stole confidential information from competitors.
    3. The ‘home’ team pressured colleagues to steal: Aside from a cash incentive, Huawei employees were allegedly under enormous pressure to obtain trade secrets.
    4. US investigators accessed Meng Wanzhou’s electronic device: Prosecutors allege that Meng, the Huawei CFO, was part of a decade-long conspiracy to evade American sanctions on Iran and dupe Congress and US investigators.

    Despite all the soothing American talk about the Huawei case being separate from the trade discussions, it really is not. The indictments are part of a broader effort of economic warfare against emergent Chinese 5G technology. The belligerent tone will make it difficult for both sides to back down during the trade talks.

    Ultimately, the decision on whether to cut a deal will be political. Is Trump sufficiently pressured by stock market instability to sweep these bigger issues under the rug for another day? The best case that we can hope for out of these meetings is an agreement for an ongoing process to keep talking. The worst case is the talks break down.

    Even though my base case scenario still calls for a deal to be made, the risks are asymmetric and tilted to the downside.
     

    Earning season volatility

    In addition, there is the earnings season wildcard. There are a lot of large cap bellwethers reporting this week, and the market reaction is likely to add volatility.
     

     

    Subscribers received an email alert this morning (Tuesday) that my inner trader had taken profits on his long positions and reversed to the short side. Just don’t ask me what the downside target is, I have no idea. All I know is risk/reward is tilted to the downside. One thing at a time.

    Disclosure: Long SPXU
     

    A buying opportunity for Chinese stocks?

    Posted by Cam Hui -

    I had a number of bullish comments on China in the wake of my last post (see How worried should you be about China?). Jeroen Blokland pointed out that the market is discounting a lot of weakness in the Chinese economy.
     

     

    On the other hand, Caterpillar shares cratered today on jitters of a China slowdown. This brings up the question, “Are Chinese stocks a contrarian buy opportunity?”
     

    Valuation support

    Indeed, there is valuation support for Chinese stocks. Callum Thomas highlighted the low P/E ratios of the China A-Share market. Historically, such valuations have been good low-risk entry points.
     

     

    Near-term fundamental momentum

    Another reader (thank you, Ken) pointed out that the OECD leading economic indicators are bottoming for China, while they are still falling for the US and eurozone. These are signals that worst of the slowdown in China has already been seen.
     

     

    I also outlined my tactical view of China was “Apocalypse Not Yet” (see How worried should you be about China?). The latest stimulus package is likely going to buy them another 2-3 quarters of growth, and my base case scenario calls for a trade agreement to be made:

    My base case scenario is no crash in 2019. The limited stimulus package announced by Beijing will have some effect, and it will likely buy the country another two or three quarters of growth. At the same time, China is desperate to reach a trade agreement with the US.

    The Trump administration has also shown that it is highly sensitive to stock market movement, and it is also eager to reach an agreement. As one simple example, after stock prices weakened on Tuesday, January 22, National Economic Council director Larry Kudlow appeared on CNBC to sooth markets and deny reports that a planned meeting between Chinese and American negotiators had been canceled. This is a signal that American negotiators are sensitive to pressure from Wall Street to make an agreement.

    Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to be signed. But that will not be the end of the story. The next battle will be over review, enforcement, and verification of reform initiatives.

    However, expect trade tensions to rise again in 2020:

    The fundamental nature of the Sino-American relationship is changing. Years of negotiation with past administrations have led to a sense of promise fatigue from both sides of the aisle. A consensus is emerging that China is becoming a strategic competitor. Cold War 2.0 has begun, and 2020 will be a difficult year for US-China relations as aspiring candidates will try to show how tough they are on China.

    In conclusion, current levels present a relatively low-risk entry point into Chinese equities. The outlook should be positive until late 2019, but don’t overstay the party.
     

    How worried should you be about China?

    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: Sell equities
    • Trend Model signal: Neutral
    • Trading model: Bullish

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

    The elephant in the room

    I pointed out recently that the latest BAML Fund Manager Survey shows that institutional managers have been stampeding into emerging market (EM) stocks exclusive of the other equity markets around the world (see An opportunity in EM stocks?). However, some EM countries are more equal than others. The chart below shows that while EM stocks have begun to outperform global equities (bottom panel), China continues to lag compared to other major markets like Brazil and India.
     

     

    For investors, China is becoming the elephant in the room. The country accounts for roughly one-third of global GDP growth, and its economic growth rate is decelerating. Ken Rogoff stated in Davos that he thinks China is hitting the debt wall:

    Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

    “People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

    “China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

    “There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

    How worried should you be about China?
     

    China weakness everywhere

    For global investors, the only question that matters for global growth is China. Right now, all signs point to a slowdown. I won’t bore you with Chinese economic statistics, which can be made up. However, we can consider other China-related free market indicators:

    • Commodity prices
    • Australian property market
    • Korean exports
    • German industrial production, whose capital goods are exported to China
    • Chinese auto sales

    China has shown itself to be a voracious consumer of raw commodities. For commodity prices, the industrial metal to gold ratio is a cyclically sensitive indicator of industrial demand, net of commodity price inflation (red line). This indicator has also shown itself to be highly correlated to risk appetite, as measured by the US equity to UST ratio (grey bars). Current readings indicator continued demand deceleration.
     

     

    We have all heard about how China’s great big ball of liquidity leaked out and went into real estate in Australia, Canada, the US, and other places with golden visa programs, like Portugal. Property prices in Australia, which has been an outsized recipient of Chinese hot money, has been tanking. I can also personally attest to similar conditions in Vancouver, and Toronto.
     

     

    South Korea is one of China’s closest trading partners. The latest figures show that its exports, which are also correlated with global EPS growth, have collapsed.
     

     

    The same could be said of German industrial production, and M-PMI.
     

     

    What about the Chinese consumer? Hasn’t Beijing been trying to rebalance growth away from credit driven infrastructure spending to China’s household sector? The weakness in Chinese auto sales tell a story of a stressed out consumer.
     

     

    In addition to these signs of short-term weakness, another source of concern is the Sino-American trade war, which remains unresolved.
     

    China’s long-term challenges

    While these short-term worries are spooking the markets, it is impossible to understand China without first analyzing her long-term challenges before drilling down to the shorter term policy responses to those problems. As I see it, China’s long-term challenges are:

    • A looming middle-income trap
    • An overleveraged economy
    • The rising tension between Xi Jinping’s desire to retain tight political control and the urgency to address the challenges of excess leverage and slowing growth

    A fast growing EM country hits the middle-income trap when its growth slows after reaching middle- income levels as they encounter developmental roadblocks to achieving high-income status. According to World Bank estimates, only 13 of 101 middle-income economies have achieved the transition to high income for the period from 1960 to 2008. Antonio Fatás of INSEAD summarized China’s challenge with falling growth rates using South Korea’s development path as an example.
     

     

    Fatás added the following caveat:

    In summary, the deceleration of GDP growth rates in China can be seen as a natural evolution of the economy as it follows its convergence path, in particular if we use recent decades in South Korea as a benchmark. Let’s not forget that South Korea is one of the best performer for countries in the range below 50% of the US GDP per capita. So using South Korea as a benchmark we might be providing an optimistic benchmark for Chinese growth.

    China is following the well-trodden development path followed by South Korea, Taiwan, and other Asian Tiger economies. China is running out of cheap labor fast, and its import substitution strategy of producing cheap imitation goods has also near the end of its useful life. Beijing’s policy response is to raise development by migrating up the value-added chain with an industrial strategy intended to achieve dominance in STEM research (see How China could dominate science from The Economist). One major leg of this is the China 2025 initiative, which is running into US and other Western objections about intellectual property theft and market access by Western companies (more on that later).

    In addition, as the China bears’ favorite chart shows, China’s policy response in the wake of the GFC of a shock-and-awe campaign of credit driven infrastructure stimulus has left in its wake a risky debt buildup.
     

     

    Additional efforts at credit driven stimulus are becoming less and less effective. Additional credit creation is resulting in less and less GDP growth.
     

     

    Beijing’s policy response is to try and gradually let the air out of the credit balloon through a deleveraging initiative. The idea isn’t to crash the economy, but to slow credit growth to manageable levels, to the unregulated shadow banking credit market back under the formal banking umbrella so that credit can be more easily controlled, and to use specialized tools to target stimulus when necessary.
     

    The shrinking private sector

    The rise of Xi Jinping as Party Secretary has given rise to a number of difficult policy trade-offs. Xi ascension was followed by an anti-corruption campaign, which was done to both root out corruption, and to consolidate power. Slowly but surely, Xi has consolidated power and control of the economy with the Party. That’s where the policy trade-offs come in. Xi’s power concentration is creating headwinds for the growth engines of the Chinese economy.

    First, the change in regime has given greater power to the State Owned Enterprises (SOEs) at the expense of Small and Medium Enterprises (SMEs). The government recognizes that SMEs represent the engine of economic growth, but a desire for Party control is stifling their growth outlook.
     

     

    Xi’s power consolidation is squeezing out the private sector to the benefit of the SOEs. A recent Forbes article entitled “Friends Don’t Let Friends Become Chinese Billionaires” tells the story:

    China Daily reported Friday that unnatural deaths have taken the lives of 72 mainland billionaires over the past eight years. (Do the math.)

    Which means that if you’re one of China’s 115 current billionaires, as listed on the 2011 Forbes Billionaires List, you should be more than a little nervous.

    Mortality rate notwithstanding, what’s more disturbing is how these mega wealthy souls met their demise. According to China Daily, 15 were murdered, 17 committed suicide, seven died from accidents and 19 died from illness. Oh, yes, and 14 were executed. (Welcome to China.)

    I don’t know about you but I find it somewhat improbable that among such a small population there could be so many “suicides,” “accidents” and “death by disease” (the average age of those who died from illness was only 48). I’m only speculating but the homicide toll could really be much higher.

    Is it any surprise that a recent Barron’s article reported that about half of high net-worth Chinese individuals have either emigrated or want to emigrate?

    About 53% of high-net-worth individuals surveyed said they had no plans to emigrate to other countries, while 38% said they were considering a move abroad. Nearly 9% said they had non-Chinese citizenship or were in the process of application.

    The top destination for rich Chinese to emigrate was Europe, with 30% of respondents picking the region. Australia and the U.S. tied on the second spot (28%), followed by Canada (27%) and Singapore (11%).

    At the same time, the PBOC’s efforts to slow credit growth are also hitting SMEs much harder than SOEs. In general, SOEs are more creditworthy because they have the implicit backing of the government, while SMEs have to survive on their own, which is creating a credit crunch for smaller Chinese businesses. Bloomberg reported that some companies have resorted to creative financing techniques to tap credit markets:

    The practice is one of several strategies for debtors to enhance their appeal to creditors, including one where borrowers guarantee each others’ debt. Use of stock as collateral for loans has also sown the seeds for volatility in stocks.

    Another even more imaginative technique is to use the structured finance tactic which sparked the GFC of slicing up a bond into different credit tranches, where the issuer buys the most junior “equity” tranche in order to secure financing. With all this inventiveness at work in Chinese finance, what could possibly go wrong?

    Lower rated private companies and local government financing vehicles, or LGFVs, have been the main users of structured issuance, observers say. One popular method is for the borrower to put up the money for the subordinated tranche — the first to absorb losses — of the asset-management vehicle that buys the bonds.

    Another key plank of Beijing’s policy response is to refocus growth towards the Chinese consumer. As Michael Pettis has pointed out in many past occasions, the success of such an initiative requires the redistribution of income away from the entrenched interests of Party cadres in the large SOEs to the household sector, which is a difficult task in the best of times.

    This cannot be said to be the best of times for the Chinese consumer. A weak job market is pointing to weak income growth.
     

     

    At the same time, households have been raising their debt levels in order to consumer, and to invest (mostly in property). Bloomberg highlighted how Chinese consumers have been piling on debt, and their debt capacity is well on its way to reaching their limits.
     

     

    In short, don’t expect too much help from the Chinese consumer.
     

    Short-term policy response

    In response to the latest slowdown, Beijing has responded with a small stimulus package of tax cuts, and targeted top-down credit growth aimed at SMEs. However, don’t expect the latest round of stimulus to have the same effect as previous efforts. China’s total tax intake is relatively low, which puts a limit on the effects of a tax cut.
     

     

    On the credit front, banks are caught between top-down directives of lending to small businesses and maintaining the credit quality of their loan portfolios. Reports are emerging that many SMEs simply do not qualify for bank loans, and they must turn to the shadow banking system for loans at much higher rates. Instead, banks are instead lending money to subsidiaries of SOEs incorporated to qualify as small businesses.
     

    The trade war wildcard

    In addition, China is trying to conclude a trade deal in order to alleviate the negative effects of the trade war. The latest Bloomberg report the discussions as recounted by Wilbur Ross indicates that both sides are talking, but they are “miles and miles” from reaching a resolution. China has reportedly offered to eliminate the trade deficit within several years, but the issue of China’s industrial strategy and intellectual property protection remains a sticking point. The WSJ reported that American businesses raised the China 2025 strategy as a concern:

    In a joint report to the U.S. Trade Representative, the U.S. Chamber of Commerce and the American Chamber of Commerce in China say Beijing’s ambitious plan to become a global technology leader is being widely implemented, casting doubt on efforts by Chinese officials to play down its significance.

    There is evidence of “a deep, concerted and continuing effort” by provincial officials to pursue the central government’s Made in China 2025 plan, which seeks to make China a leader in electric vehicles, aerospace, robotics and other frontiers of manufacturing, the two business groups say.

    Reuters reported that American negotiators have demanded regular reviews of Chinese trade reform practices, much in the manner of an arms control treaty:

    The United States is pushing for regular reviews of China’s progress on pledged trade reforms as a condition for a trade deal – and could again resort to tariffs if it deems Beijing has violated the agreement, according to sources briefed on negotiations to end the trade war between the two nations.

    A continuing threat of tariffs hanging over commerce between the world’s two largest economies would mean a deal would not end the risk of investing in businesses or assets that have been impacted by the trade war.

    “The threat of tariffs is not going away, even if there is a deal,” said one of three sources briefed on the talks who spoke with Reuters on condition of anonymity.

    CNBC reported that George Soros went even further and labeled Xi Jinping the “most dangerous enemy” of open societies. He went on to warn that the US and China are in a “cold war that could turn into a hot one”.
     

    Apocalypse Not Yet?

    For investors, the critical question is what happens next in China. The biggest issue China faces is that it is running out of bullets. FT Alphaville characterized China’s dilemma as “cakeism”, or the desire to have your cake and eat it too.

    Alphaville sat down with economist George Magnus, a former senior adviser to UBS Investment Bank and the recent author of “Red Flags: Why Xi’s China is in Jeopardy.” He describes what’s happening in China this way: “At the moment, we’ve got an incoherence of policy. It’s confusing to us looking at it from the outside. It must be incredibly confusing if you are an entrepreneur or small business on the inside.”

    China’s version of “cakeism,” he says, centers around the leadership’s conflicting commitments to de-risking the financial system on one hand and on the other, hitting elevated growth targets north of 6 per cent. “You can’t really have a determined effort to deleverage the economy and not expect it to have a material impact on economic growth,” points out Magnus.

    Its debt-driven growth model is reaching the limits of usefulness. Tightening put the brakes on growth. Without large scale credit growth, which will exacerbate their real estate bubble, the economy will crash. The tools available to tinker at the margins, such as rebalancing to household consumption, and an industrial policy to escape the middle-income trap may have long-term benefits, but will not help in the short run.

    Will China crash? The current policy response is another effort to kick the can down the road yet one more time, though this round of stimulus will be less effective than past efforts.

    So Chinese officials have been presented with a choice: play the long game and work towards shifting the economy towards a more sustainable path, or sidestep short-term pain and prop up growth now.

    Of course, China wants its cake. And just like the Brits, it wants to eat it, too.

    So blame “cakeism” for why the stimulus measures that China has rolled out since the summer have done little to boost the economy. Rather than a full-scale stimulus programme, China has favoured a more piecemeal approach this time around, including liquidity injections into the financial system, cuts to the amount of cash banks have to hold as reserves and infrastructure spending.

    But by asking banks to lend more to private and small companies (by cutting the reserve requirement ratio), and simultaneously urging banks to raise more capital and pay attention to their bad debts, officials are “not speaking with the same tongue,” says Magnus. Ultimately, this could lead China to fail on both fronts.

    My base case scenario is no crash in 2019. The limited stimulus package announced by Beijing will have some effect, and it will likely buy the country another two or three quarters of growth. At the same time, China is desperate to reach a trade agreement with the US.

    The Trump administration has also shown that it is highly sensitive to stock market movement, and it is also eager to reach an agreement. As one simple example, after stock prices weakened on Tuesday, January 22, National Economic Council director Larry Kudlow appeared on CNBC to sooth markets and deny reports that a planned meeting between Chinese and American negotiators had been canceled. This is a signal that American negotiators are sensitive to pressure from Wall Street to make an agreement.

    Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to be signed. But that will not be the end of the story. The next battle will be over review, enforcement, and verification of reform initiatives.

    The fundamental nature of the Sino-American relationship is changing. Years of negotiation with past administrations have led to a sense of promise fatigue from both sides of the aisle. A consensus is emerging that China is becoming a strategic competitor. Cold War 2.0 has begun, and 2020 will be a difficult year for US-China relations as aspiring candidates will try to show how tough they are on China.

    Apocalypse Not Yet. Though the short-term policy solutions doesn’t address the longer term problems.

    While this is my base case scenario, other more bearish outcomes are possible, I can offer two sensitive real-time barometers that can warn of an impending crash in China. The first is the AUDCAD exchange rate. Both Australia and Canada are similar sized economies with high exposure to resource extraction industries with some key differences. Australia is more sensitive to China, and its exports are mainly in bulk commodities such as coal and iron ore. The Canadian economy is more sensitive to the US, and its exports are tilted towards energy. A disorderly breakdown in the AUDCAD exchange rate would be an early warning signal that something is breaking in China.
     

     

    In addition, the stability of the Chinese financial system is highly sensitive to the health of its property market. Should highly levered property developers such as China Evergrande (3333.HK) break long-term support, it may be a signal of a Lehman-like moment in China’s banking system.
     

     

    The share price of Alibaba, which is a key barometer of Chinese consumer spending, is also performing well relative to the Chinese market.
     

     

    Should any of these key real-time indicators weaken significantly, it would be time to run for the hills.
     

    The week ahead

    Looking to the week ahead, the bulls can celebrate as the market seems to be sailing through earnings season well. The latest update from FactSet shows that the EPS and sales beat rates are coming at roughly their historical averages, though forward 12-month EPS are still being revised downwards.
     

     

    That said, the market is not reacting to bad news. The stock price of companies that beat are being rewarded, but misses are not being punished.
     

     

    The partial government shutdown has hampered the release of many key economic statistics. However, much was made about the sub-200,000 print last week of initial jobless claims representing a 50-year low, I would remind readers that the population adjusted initial claims has already been making fresh lows for quite some time.
     

     

    In the very short run, stock prices may be due for a pause. The market is nearing key resistance levels while exhibiting a negative divergence in RSI-5. Friday’s lack of bullish reaction to the news of a legislature truce which re-opened government is another warning sign that the market may be about to stall.
     

     

    Short-term breadth is back at or near overbought levels. While the market could stage a minor advance early next week, the combination of near overbought readings, negative divergence, and the proximity of key resistance levels argue for a pullback of unknown magnitude.
     

     

    My inner investor is neutrally positioned at about target asset weight levels. My inner trader is long the market, but he is getting ready to reverse course next week.

    Disclosure: Long SPXL
     

    How far can this pullback run?

    Posted by Cam Hui -

    Mid-week market update: The Zweig Breadth Thrust buy signal occurred a little two weeks ago. For those who jump onto the bullish bandwagon, it has been an exhilarating ride. This week, the inevitable pullback has arrived. The SPX breached a key uptrend on the hourly chart yesterday (Tuesday), and it could not hold the morning good news rally induced by the positive earnings reports from Comcast, IBM, and United Technologies.

     

    How far can this pullback run?

    The bear case

    There is a case to be made for a deeper correction, perhaps all the way to test the December lows. OddStats posted some bear porn, based on the historical behavior of the VIX. The forward returns look downright ugly.

     

    Andrew Thrasher also made the case for a re-test of the December lows, based on the extreme overbought condition flashed by the % of stocks above their 20 dma.

     

    A “good overbought” condition?

    On the other hand, a market doesn’t go down just because it is overbought. The stock market has historically experienced “good overbought” conditions when it continued to grind upwards.

    This chart of stocks above their net 20-day highs-lows shows the market recently reached an off-the-charts overbought extreme. Further examination of the historical experience shows that similar past episodes has seen prices rise further before topping out. The ZBT signal of 2015 was one such example.

     

    Market internals unhelpful

    If the market were to blast off to new highs or weaken to re-test the old lows, we should see some evidence from market internals. However, many of the internals are flashing ambiguous signals.

    As an example, this chart of market cap and group relative performance is unhelpful to determining leadership. Mid and small cap stocks remain in relative downtrends and cannot be considered market leaders. NASDAQ stocks, which had been the high beta leaders, remain mired in a relative trading range.

     

    The behavior of price momentum is equally puzzling. While it is constructive that price momentum did not break down during December downdraft, but they did not recover and lead the market as prices rebounded.

     

    Mixed sentiment

    Sentiment models are also flashing mixed signals. On one hand, Callum Thomas has been conducting a weekly (unscientific) Twitter poll, and sentiment remains bearish despite the powerful stock market rebound since the December 24 bottom, These readings should be seen as contrarian bullish, and as a sign that the market is climbing the proverbial wall of worry.

     

    On the other hand, the latest Investors Intelligence poll shows that the spike in bearish sentiment has normalized after the December panic. I would interpret this as long-term complacency and contrarian bearish.

     

    A re-test, but not yet

    Trading the market with these cross-currents can be treacherous. Moreover, the market has been moving on fundamental and macro news, which are inherently unpredictable. Under these circumstances, technical analysis is likely to have diminished importance.

    However, sentiment analysis does give us some clues, and my working hypothesis is the market is likely to see a re-test of its December lows, but not yet. Short-term sentiment such as the Callum Thomas Twitter poll is too bearish and likely a signal that the market is climbing a wall of worry. As well, the strong price momentum displayed by the ZBT suggests that the market is likely to see further near-term upside. On the other hand, long-term sentiment from the II survey indicates complacency, and points to a re-test of the December lows in the next few months.

    Tactically, the SPX is pulling back after a two-week rally, and initial support is at the current levels coinciding with the 50 dma and 61.8% Fibonacci retracement. Further support can be found at the 50% retracement of about 2580.

     

    My inner trader is still bullish. He is opportunistically adding to his long positions at current levels, He plans to add more should the index decline to 2580, with a tight stop set just below that level.

    Disclosure: Long SPXL