Page 54 – Humble Student of the Markets

Why investors should look through trade tensions

Posted by Cam Hui - May 12, 2019

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

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

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

The latest signals of each model are as follows:

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

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

Looking through a trade war

Josh Brown made an astute comment last week that all investors should keep in mind.

Here is why I think investors should look through the effects of any trade tensions.

Imagine a trade war

Imagine a US-China trade war, what is the worst that could happen? Bloomberg reported that Citi estimates an initial 0.5% hit to GDP growth:

An increase of tariffs on $200 billion of Chinese goods would cut 0.5 percentage points off China’s growth over one to two years, and the impact could more than double if duties are slapped on all its shipments to the U.S.

That’s according to Citigroup Global Markets Inc economist Cesar Rojas, who also wrote in a May 8 note that raising tariffs on $200 billion of China’s goods to 25 percent from 10 percent on Friday would slice 0.2 percentage points off global growth over the same period. The impact on global expansion also would also double if duties of 25 percent are slapped on the remaining Chinese imports, he said.

In a full-blown and protracted trade war, the IMF projected that China would lose 1.6% of GDP growth, the US would slow by 1.0%, and the rest of Asia would get sideswiped.

Who think that it would actually last as much as a year? Calculated in economic terms, China would “lose” a trade war, but when calculated in political cost, America would lose as Trump does not have the same pain threshold as Xi.

In isolation, an addition 15% in tariffs on $200 billion of exports will not totally derail the Chinese economy. China has a number of policy levers to mitigate the effects of a trade war. First, it could resort to stimulating its economy with more targeted debt financing. I pointed out that China threw caution to the wind and raised total social financing (TSF) by roughly 9% of GDP in Q1 (see Sell in May? The bull and bear debate). The latest April update shows that TSF slowed to (only) 1.4 trillion yuan, or about 2% of GDP. To be sure, such a course of action increases its financial fragility, and China is already seeing rising defaults. But in a war, normal rules go out the window.

Keep an eye on the relative performance of China’s property developers. This group is highly sensitive to PBoC policy, and the effects of monetary stimulus or tightening will be immediately visible.

Another policy lever open to Beijing is a currency devaluation. While it would undoubtedly annoy Washington and create capital flight problems, a long stalemate will break the soft RMB peg.

Taken all together, these initiatives are likely to defer a hard landing, but they would not serve as the engine of global growth.

Now imagine the consequences of a trade war from Trump’s viewpoint. You are facing an election next year. Economic growth will decelerate because of the trade war, and you can’t order the Fed to cut interest rates. There is a little wiggle room in the timeline for further negotiations, as the tariffs are only payable for goods exported from China on or after May 10, 2019, and any exports in transit escape the higher rate. And despite Trump`s misguided perception, the tariffs are only paid by China in the same way Mexico was paying for the Wall. They are paid by American importers, and they are going to hurt. The damage will be felt in a number of Republican states such as TN, GA, KY, AR, and ID, and battleground states like MN, PA, and IN, and he will face pressure from his own party in those states.

Just remember the Newt Gingrich criteria that he outlined in the New York Times at the start of Trump’s presidency:

“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”

“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”

I am also old enough to remember Ronald Reagan’s 1980 campaign slogan, “Are you better off than you were 4 years ago?”

The Hill reported that Trump’s “Art of the Deal” trade tactics have alienated Republican legislators:

Senate Republicans feel that President Trump has once again pulled the rug out from under them on trade, leaving GOP lawmakers frustrated over their inability to influence the White House’s policy on an issue that could have major economic and electoral ramifications.

Days after a group of Republican senators relayed to Trump at a White House meeting their concerns about trade tensions with Canada, Mexico, Europe and China, Trump over the weekend threatened new tariffs on China, escalating a fight with Beijing and rattling markets.

The President will not be able to chart as independent course as he did in the last election cycle. He needs the support of his party, as he is reverting to a traditional style of fundraising. Tanking the economy and the stock market will not endear him to big money donors (via The New York Times):

About 200 bundlers from across the country are expected to gather Tuesday at the Trump International Hotel for a series of meetings and workshops about the campaign’s new fund-raising program. Vice President Mike Pence will address the group. Brad Parscale, President Trump’s campaign manager, will play host. Stephen A. Schwarzman, the Wall Street billionaire, has R.S.V.P.’d yes.

The group will be divided into tiers, based on success in raising money. The “Trump Train” donors, or those who raise $25,000, will be given a lapel pin and access to a national retreat and leadership dinners. “Club 45” members, or those who raise $45,000, will get all of that, as well as monthly conference calls with Republican Party leaders. And the “Builders Club,” or those bundlers who raise $100,000 or more, will be given access to national campaign events.

It is the kind of traditional campaign fund-raising apparatus that Mr. Trump thumbed his nose at during his 2016 run. And it involves some donors who only grudgingly accepted him once he was the Republican presidential nominee.

Playing the investing odds

To summarize, the suite of possible Chinese policy response is nothing more than band-aid solutions, but in a war, no one questions band-aids. On the other hand, it doesn’t seem that Trump has a Plan B, and he is going to face increasing political pressure from traditional Republican supporters as the trade war goes on.

Both sides need a deal, or at a minimum, a truce. It is only a question of how long it takes to arrive to an agreement. Sino-American trade frictions will continue to be a feature of the next decade, and the details of any deal in 2019 is unimportant as I fully expect that its provisions will be broken within a year. The Economist made the case that the fundamental problem is a clash of two different economic systems:

Any deal will also include promises to limit the [Chinese] government’s role in the economy.

The trouble is that it is unlikely—whatever the Oval Office claims—that a signed piece of paper will do much to shift China’s model away from state capitalism. Its vast subsidies for producers will survive. Promises that state-owned companies will be curbed should be taken with a pinch of salt. In any case the government will continue to allocate capital through a state-run banking system with $38trn of assets. Attempts to bind China by requiring it to enact market-friendly legislation are unlikely to work given that the Communist Party is above the law. Almost all companies, including the privately owned tech stars, will continue to have party cells that wield back-room influence. And as China Inc becomes even more technologically sophisticated and expands abroad, tensions over its motives will intensify.

Bottom line, be skeptical about the longevity of any agreement:

At some point this year Mr Trump and Xi Jinping, his Chinese counterpart, could well proclaim a new era in superpower relations from the White House lawn. If so, don’t believe what you hear. The lesson of the past decade is that stable trade relations between countries require them to have much in common—including a shared sense of how commerce should work and a commitment to enforcing rules. The world now features two superpowers with opposing economic visions, growing geopolitical rivalry and deep mutual suspicion. Regardless of whether today’s trade war is settled, that is not about to change.

This view of a clash of economic systems is becoming mainstream, and it was advocated by China hawk and now trade negotiator Robert Lightizer in his 2010 testimony to the US China Economic and Security Review Commission:

There are several reasons by China’s political system is fundamentally at odds with the American conception of the “rule of law.” At the national level, the Communist Party is willing to ignore international commitments to maintain power. Moreover, the Communist Party owns and operates, or is tied to, private enterprises in key sectors such as transportation, energy, and banking. China also suffers inadequate governance at the provincial level – a result of many factors including corruption, a lack of uniformity among rules, and arbitrary abuse of power. Finally, China suffers from a culture of noncompliance “where bad actors set the norm, where laws and regulations are often ignored or unevenly enforced, and where many citizens and market actors don’t know or can’t obtain their rights under the law.”

However, from a tactical perspective, it is evident from the market action that even a ceasefire that eliminates near-term tail-risk will spark a risk-on rally. The market is on the verge of a significant and extremely effective buy signal on the long-term monthly chart, even with the recent pullback.

How far can stock prices rise?

Now imagine that in the absence of trade tensions, how far can stock prices rise? While this is not a forecast, it is a projection of upside potential if everything goes right.

The US economy was on track for steady non-inflationary growth of 2-3%, with the Fed on hold. Such an environment represents a sweet spot for equities. According to FactSet, the forward P/E of the market is 16.5, which is equal to its 5-year average but above its 10-year average. Imagine it is now December 2019, and the forward P/E ratio has risen to its recent high of 18.5. Pure P/E expansion would add 12% in capital appreciation. On top of that, forward earnings grows at 3-5%, and the market could be 15-17% higher by year-end.

In conclusion, while the trade negotiation headlines are dire, there are many incentives for both sides to conclude a deal. Trading is a marathon, not a sprint. I therefore believe these trade tensions are temporary. Should the threat of a trade war recede, the market is poised for a significant rally with upside potential of 15-17% to year-end.

The week ahead

The market action last week was one of the most unusual weeks of my investing career. The market had been rising steadily, and the downdraft came out of nowhere. While the news flow had extremely bearish implications, the market wasn’t responding to bad news. The S&P 500 only fell -2.2% in the week, and the intra-day peak-to-trough drawdown came to only -4.5%.

The bear case is easy to make. The surprise imposition of the new round of tariffs had severe negative implications. Bloomberg reported that some trade groups were projecting job losses of as much as 400,000.

President Donald Trump’s higher tariffs on Chinese imports will have “dire consequences” for U.S. equipment manufacturers and worsen prospects for American farmers and others already reeling from lower commodity prices, an industry trade group warned on Friday.

The tariffs will “drive down exports, and suppress job gains for the industry by as much as 400,000 over 10 years. It will also invite China to hit back at American businesses, farmers, communities, and families,” said Kip Eideberg, vice president of government affairs for the Association of Equipment Manufacturers, which represents more than 1,000 U.S. makers of farm, construction and mining machinery.

“With producers already struggling with falling commodity prices, additional retaliatory tariffs on U.S. agricultural exports will have a chilling effect on equipment manufacturers,” Eideberg said in a statement after the penalties went into effect.

When the news of Trump’s about face on trade negotiations broke, I suggested waiting for the market reaction first before reacting, as the news flow was rapid, and headline risk was high. By Thursday, the technical condition of the market had dramatically deteriorated. The S&P 500 had broken down out of a rising uptrend, indicating the steady advance is over. The last episode of a broken uptrend saw the start of the mini-bear that culminated in the panic bottom on Christmas Eve. Could it happen again?

NASDAQ leadership has also broken down, which is another confirmation that the bulls were losing control of the tape.

Is it time to turn bearish?

Not just yet. As I pointed out, the magnitude of the downdraft on the trade news was remarkably mild. Monday’s market action was especially puzzling. The market gapped down -1.2% at the open, but rose the rest of the day to end with only a loss of -0.5%. The market was simply not responding to bad news. Friday’s market action was equally puzzling. After the news that the US had imposed another round of tariffs at one minute after midnight, the Shanghai Composite rose 3.1%. To be sure, Bloomberg reported that state owned firms were in the market buying stocks to support prices, but Hong Kong was up 0.8% and Korea was up 0.3%. All of the European markets were also green on the day. Was Beijing intervening in all those markets too?

When the US market opened, it gapped down, but rallied and ended the day in positive territory. The hourly chart shows that the S&P 500 rallied through a downtrend line, with possible gap fills as upside objectives. Is this how the market reacts to ugly news?

One explanation is the market had become washed out, which is an unusual condition in light of the shallow nature of the pullback. Rob Hanna of Quantifiable Edges reported that his Capitulative Breadth Indicator (CBI), which is a bottom-up count of stocks in the S&P 100 experiencing capitulative selling. Hanna found that CBI readings of 10 or more were indicative of market washouts. Even though these buy signals did not necessarily mark the exact bottom, stock prices have exhibited a strong upward bias upwards after such events.

A similar, but less rigorous, historical study by Urban Carmel based on Thursday’s closing price came to a similar conclusion. The market is oversold, and due for a bounce.

Signs of fear have broken out in the option market. The CBOE equity put/call ratio spike to levels seen in the market downdraft late last year, and the term structure of the VIX curve had inverted.

Similar signs of panic selling in the TRIN index are also appearing. The 10 day moving average of TRIN has spike to levels consistent with past market bottoms. With the exception of the capitulative selling episode last December, downside risk has been limited at these levels.

In view of the potentially Apocalyptic nature of these trade developments, how can we reconcile a market capitulation event with a shallow decline? A protracted and full-blown trade war has the potential to push the world economy into a synchronized global recession.

I can offer two explanations. One is the market is not taking Trump’s threats seriously. In that case, potential downside risk is high as further negative developments could crater prices.

The other explanation is most market players are already short beta, and there is little selling left to do (see A stampede you could front run). Both institutional investors and hedge funds are underweight equities. Retail investment accounts are at best neutrally positioned. In effect, cautious positioning is putting a floor on the market.

I had already pointed out that the BAML global fund manager survey shows institutions are underweight equities, and they have been slowing buying.

The semi-annual Barron’s Big Money poll shows domestic manager bullishness has been in retreat.

Jason Goepfert at SentimenTrader found that hedge funds have a low equity exposure.

The latest Commitment of Traders report shows that large speculators, which are mostly hedge funds, are short the high beta NASDAQ 100.

The combination of these readings, and the market’s inability to respond to bad news, are supportive of the thesis of exhausted sellers. Nevertheless, this raises a dilemma for both investors and traders. While the market may be poised for a reflex rally, what will happen afterwards?

Here is what I am watching, other than the news on trade negotiations. One of the most important questions is, what will happen to earnings expectations? Earnings estimates have been steadily rising, will we see wholesale estimate cuts because of tariffs? Q1 earnings results have been solid. The EPS beat rate is above average, and the sales beat rate is in line with historical experience.

Q2 guidance has so far been solid. Will it reverse course?

If the Street revises estimates downwards, we should see the effects in the next 2-4 weeks. That time frame also coincides with the window for a market bounce. If the stock market is rallying as estimates are being cut, then that is a signal to turn cautious. The 2-4 week window is also a negotiation window. The latest round of tariffs are applied to goods exported from China starting on May 10, not landing on US soil on that date. Within that period, all imports from China will be subject to the new tariffs as it takes that long for shiploads of goods to arrive. The US has made it clear that if there is no deal by late June, the new tariffs of 25% will be imposed on the remainder of goods coming from China.

Another item to watch is the message from the credit market. Despite last week’s near inversion of the 10-year to 3-month rate, the 2s10s yield curve has steepened during this episode, indicating better growth expectations. The 10s30s remain elevated, and it is not signaling a slowdown.

As well, I am watching New Deal democrat‘s monitor of coincident, short leading, and long leading economic indicators. Is there any sign of a slowdown? The current outlook is relatively upbeat.

Driven by the “flight to quality” in bonds, the long-term forecast improved to positive this week. The short-term forecast also remains slightly above neutral. The nowcast also is positive. The picture for 2020 looks increasingly positive. I’m watching initial claims, and will watch the regional Fed reports, particularly closely to see whether the recent improvement has been temporary or not.

My inner investor is giving the bull case the benefit of the doubt, and he is overweight equities. My inner trader is waiting for the inevitable bounce, but he is watching developments for what he will do next.

Disclosure: Long SPXL, TQQQ

Some lessons on trading market surprises

Posted by Cam Hui - May 8, 2019

Mid-week market update: When the news of the Trump tweets broke, I wrote:

When it comes to unexpected news, my tactical inclination is to stand aside and let the market tell the story, and then reassess once the dust is settled.

In a very short time, the market has gone to a full-blown panic.

The breadth of the decline has been astounding, and it is unusual to see this level of correlation in a sell-off, especially when the SPX is only -2.1% off its all-time highs as of Tuesday’s highs. This kind of behavior is evidence of a panicked stampede.

That said, the dust is starting to settle on this trade related downdraft. It is time to assess the situation.

The latest news

Reuters dropped a bombshell early this morning with a story of how the Chinese had backtracked on their commitments:

The diplomatic cable from Beijing arrived in Washington late on Friday night, with systematic edits to a nearly 150-page draft trade agreement that would blow up months of negotiations between the world’s two largest economies, according to three U.S. government sources and three private sector sources briefed on the talks.

The document was riddled with reversals by China that undermined core U.S. demands, the sources told Reuters.

In each of the seven chapters of the draft trade deal, China had deleted its commitments to change laws to resolve core complaints that caused the United States to launch a trade war: Theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation.

U.S. President Donald Trump responded in a tweet on Sunday vowing to raise tariffs on $200 billion worth of Chinese goods from 10 to 25 percent on Friday – timed to land in the middle of a scheduled visit by China’s Vice Premier Liu He to Washington to continue trade talks.

The straightforward interpretation of this story is the Chinese had reneged on past commitments, or had become overly aggressive in their negotiations. Another explanation is this was a calculated leak by the American side to spin their version of events, and to put more pressure on the Chinese.

Past analysis of the trade dispute had shown that the China had technical objections to changing their laws because it would mean a contradiction of previously published Party directives and Xi Jinping principles. Forcing them to backtrack would amount to an unacceptable level of humiliation. An LA Time article published two days ago highlighted the analysis of Derek Scissors of AEI, who explained the political nuance of the American demands [emphasis added]:

Trump did not elaborate on why he suddenly revived the threat to raise tariffs, fueling speculation that the president was posturing or employing last-minute pressure tactics to close a deal.

But Lighthizer and Treasury Secretary Steven T. Mnuchin, who were in Beijing last week, said at the briefing Monday in Washington that China was backpedaling on language in the text, with the potential of significantly altering the deal, according to Bloomberg News.

Analysts familiar with the development said that one key element of the U.S. complaint centered on China’s resistance to codifying in Chinese law an agreement that dealt with strengthening intellectual property protections.

Derek Scissors, a China expert at the American Enterprise Institute, said he regarded this matter as more to do with form than substance. At the crux of it, he said, the Chinese did not want to include in the deal anything that would be taken as a repudiation of Chinese President Xi Jinping’s leadership.

Soon after the Reuters story broke, Trump tweeted that Vice Premier Liu He was coming to Washington to “make a deal” and the futures market rallied. Of course Liu is visiting Washington “to make a deal”. What else was he planning to do? Visit the Smithsonian?

How did the market react to these news stories, which came out before the open? Stock prices are roughly flat on the day, despite the bearish overtones of the Reuters report. What is even more surprising is the market stabilized when the SPX is only about 2% off its highs.

The market’s reaction

From a sentiment perspective, a market that does not react to bad news is bullish. From a technical perspective, the market is turning up at just the right time. The SPX bounced off trendline support of a rising channel, and 14-day RSI is turning up just below neutral in a manner consistent with past minor pullbacks, while VIX flashed a market oversold reading by surging above its Bollinger Band.

The technical damage from the sell-off has been relatively minor. There are no signs of any serious breakdowns in the performance of the top five sectors that comprise over two-thirds of the index weight. The market cannot rise sustainably without the participation of these heavyweights, nor can they fall without serious technical breakdown of a majority of these sectors.

To be sure, there will likely more volatility ahead. I have no idea as to how the trade talks will be resolved this week. There are four possibilities:

No deal, one or both sides walk away
A deal is made
Both sides agree to continue talking, and the new tariffs are suspended
Both sides agree to continue talking, and the new tariffs remain in place

The consensus expectation is (1) will be very negative, stock prices will surge on outcome (2) and (3), and (4) will be mildly negative for prices, but not catastrophic. That said, it is unclear how much of (4) has already been discounted.

Oh, if you are bearish because of the record short in VIX futures and think the latest simmering trade news is going to spark a market crash, don’t get too excited. Fresh analysis from Goldman Sachs shows that the VIX shorts offset the long position dominated by ETP issuers. Waiting for VIXmageddon may be like Waiting for Godot.

For the last word, I refer readers to some back of the envelope calculation from strategist Tom Lee. While any analysis from Lee should be taken with a grain of salt because of his permabull reputation, he does make a valid point. Do you think that a trade war will last as much as a year?

My inner trader remains bullishly positioned. While my inner investor is taking no action, more conservative investment oriented accounts may wish to sell covered calls against existing long positions in order to lock in the juicy option premiums from the spike in volatility.

Disclosure: Long SPXL, TQQQ

How to navigate Trump’s trade gambit

Posted by Cam Hui - May 6, 2019

President Trump surprised the market on Sunday with a tweeted threat:

Notwithstanding his misunderstanding that tariffs are not paid by the Chinese, but American importers, this tweet sounds like an effort to put pressure on China, just as Vice Premier Liu He is scheduled to arrive in Washington on Wednesday with a large (100+) trade delegation for detailed discussions. News reports indicate that both sides have given significant ground, and a deal may have been possible by Friday.

In response to Trump’s tweeted threat, the WSJ reported that the Chinese may reconsider making their trip to Washington because “China shouldn’t negotiate with a gun pointed at its head”. CNBC subsequently report indicated that the Chinese are preparing to visit Washington, but with the delegation size will be reduced, the timing of the visit is not known, and it is unclear whether Vice Premium Liu He will be in the group.

A Chinese delegation will come to the U.S. this week for trade talks after President Donald Trump upended negotiations by threatening new tariffs on Sunday, according to sources familiar with the matter.

One of the sources briefed on the status of talks said the Chinese would send a smaller delegation than the 100-person group originally planned. It is unclear whether Vice Premier Liu He would still helm this smaller group, an important detail if the team were traveling to Washington with an eye toward sealing a deal. Two senior administration officials described Liu as “the closer”, since he had been given authority to negotiate on President Xi Jinping’s behalf.

The team from Beijing was set to start talks with American negotiators on Wednesday as the world’s two largest economies push for a trade agreement. It is unclear whether the talks will still start Wednesday.

Another encouraging sign was the report that Chinese media censored Trump’s tweets, which could be interpreted as a signal that Beijing did not want to unnecessarily escalate the conflict. The front pages of the two major Chinese news portals had no mention of Trump’s threats.

US tariffs are already higher than most developed market economies. If implemented, the new levels would be higher than most EM economies, and have a devastating effect on global trade.

I spent Sunday responding to emails and social media inquiries about how to react to this news. In many ways, it was more exciting than watching the latest episode of the Game of Thrones.

Assessing both positions

Let us start by examining how strong a hand each side thinks it holds. China’s official and Caixin PMI softened in April, indicating that the effects of the last stimulus program may be petering out. On one hand, they may be waiting for a trade deal as another way of boosting their economy ahead of the October celebration of the 70th anniversary of the founding of the PRC.

On the other hand, Tom Orlik of Bloomberg Economics believes that the full effects of the stimulus program hasn’t fully filtered through to the economy yet.

Bloomberg also reported that the recent stimulus program may have bought China more time to address their financial stability problems:

Recent efforts have instead been directed at the government’s real goal: making the financial system safer. The China Banking and Insurance Regulatory Commission is focused on mitigating the risk of contagion along multiple fronts: rolling back lending between banks and other financial institutions; preventing the system from feeding credit into blatantly speculative activities; migrating risk from shadow lenders back to the formal banking system; and improving bank asset quality.

Recent efforts have instead been directed at the government’s real goal: making the financial system safer. The China Banking and Insurance Regulatory Commission is focusedon mitigating the risk of contagion along multiple fronts: rolling back lending between banks and other financial institutions; preventing the system from feeding credit into blatantly speculative activities; migrating risk from shadow lenders back to the formal banking system; and improving bank asset quality.

Judged on those terms, the results are promising. Shadow banking has contracted, as has interbank lending. Efforts by institutions to dispose of nonperforming loans more quickly are themselves a form of deleveraging. All of this has massively reduced the amount of complexity in the financial system and put the regulators in a better position to manage risk.

It’s also increased the system’s capacity to safely support higher levels of debt. That’s where the current stimulus comes in. Rather than a free-for-all where banks and shadow banks are given the freedom to shovel as much credit as possible into the economy — which broadly describes the approach pursued repeatedly between 2009 and 2016 — the current effort is targeted and limited only to banks (which have been chastened since their freewheeling days) and the bond market.

This time the stimulus is focused on tax cuts, local government bond issuance to support investment in public works, and providing banks with liquidity expressly for the purpose of lending to small firms.

Those measures have been designed specifically to avoid undoing regulators’ progress in reducing risk in the last two years. Indeed, rather than contradicting the deleveraging campaign, it represents a commitment to making that campaign successful.

Axios reported the Chinese were reported backing off some concessions, indicating Beijing believes it holds a strong hand. “A source familiar with the situation told me that the Chinese had been backing off of agreements the U.S. negotiating team believed they had already made.” If the Chinese delegation were to delay its scheduled trip to Washington, that would another signal that Beijing believes it holds a strong hand and it can wait out the Americans.

Push comes to shove, China has a Plan B of more stimulus, raising tensions in the South China Sea, and encouraging North Korea to make more missile or nuclear tests.

What’s Trump’s Plan B?

The same Axios report indicated that Trump thinks he holds a strong hand, “Trump’s view, the source said, is that he’s negotiating from a position of clear economic strength, especially with the latest strong U.S. jobs numbers.”

In addition, the latest Gallup poll ending April 30 shows Trump’s approval rating at 46%, an all-time high, which gives him political room to maneuver.

While both sides would like to make a deal to help their respective economies, I would characterize Trump’s hand as strong economically, but weak for political reasons:

Trump will own any market fallout. The market’s risk-off response is Trump’s Achilles Heel. Trump views the stock market as a scoreboard for the success of his Administration. If it were to crater because of a failed trade negotiation, he will own the market retreat. He won’t be able to blame the Fed, or anyone else.
Trump is being pressured by the Democrats to be tough on China. CNBC recently reported that Bernie Sanders unveiled a platform challenging Trump’s China policy. He will have to appear tough, but not too tough as to sink the trade deal. This tweet from Senate Minority Leader Chuck Schumer makes it clear that there is bipartisan support for a tough stand on China.

Trump needs a trade win. Senator Chuck Grassley has refused to even consider the NAFTA replacement without the repeal of the steel tariffs. Trump needs a trade win heading into the 2020 election. In farm country, where much of the Republican support can be found, grain prices have fallen to levels last seen in 1977, and the latest tweets are not helping.

Unsurprisingly, farm bankruptcies have been rising.

What’s Trump’s Plan B if the negotiations fail? Does he want a crashing stock market, a tanking economy, and soaring farm bankruptcies ahead of an election?

The market’s verdict

When it comes to unexpected news, my tactical inclination is to stand aside and let the market tell the story, and then reassess once the dust is settled. As the closing bell rang Monday, the market’s tone had changed considerably from the open. While volatility will undoubtedly rise in the week ahead as the market reacts to new headlines, it is clear that the bears had failed to seize control of the tape.

For the past few weeks, I had been writing about how the stock market had been advancing steadily while exhibiting a series of “good overbought” signals on the short-term 5-day RSI. Market pauses were marked by overbought readings on the 14-day RSI. Brief corrections were halted when the 14-day RSI returned to neutral, and the VIX Index spiked above its upper Bollinger Band.

To my surprise, this pattern remains intact. The SPX successfully tested its rising wedge support, and the 14-day RSI did not decline below neutral.

The small cap Russell 2000 staged an upside breakout on Friday. Not only did the breakout hold, the index rose further today, indicating further strength and momentum.

NASDAQ leadership also remains intact, which is another indication that the bulls remain in control of the tape.

What do we say to the bear-faced market god? Not today.

Disclosure: Long SPXL, TQQQ

Green shoots, rotten roots?

Posted by Cam Hui - May 5, 2019

here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:

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

Are the green shoots turning brown?

Just when you think the global economy is starting to spring green shoots, the skies have darkened and some of those shoots may be turning brown. In the US, ISM Manufacturing fell and missed expectations. And that’s not all. Analysis from Nordea Markets concluded that the internals are pointing to further weakness.

In China, both the official PMI, which is tilted towards larger SOEs, and the Caixin PMI, which measures SMEs, fell and missed expectations. These readings have cast doubt on the longevity of Beijing’s stimulus driven rebound.

On the other hand, the Non-Farm Payroll report came in ahead of expectations. In Europe, the PMIs for peripheral countries like Italy and Greece are outperforming Germany. In addition, exports from Korea and Taiwan, which are highly globally sensitive, have rebounded indicating recovery.

What’s going on? How do we interpret these cross-currents?

I agree with Rob Hanna’s insightful comment that “Tops Wobble Before Falling Over”. My review of the market’s technical conditions reveals the market is not wobbling yet. Any market wobble would be seen in NASDAQ and semiconductor stocks. Until Technology and NASDAQ leadership starts to falter, and if their leadership is not replaced by the reflation-sensitive cyclical groups, we remain bullish on equities.

Look for the market to wobble first

It can be useful during these periods of macro and fundamental uncertainty to turn to technical analysis. The market’s technical signals represent messages of how expectations are evolving, which investors should heed.

As stock prices have been on a tear since the Christmas Eve lows, there is some natural nervousness that the market has risen too far too fast. Rob Hanna at Quantifiable Edges made an insightful comment that “Tops Wobble Before Falling Over”, which he wrote on Thursday just after the post-FOMC market downdraft:

I’ve shown numerous studies in the past that suggest uptrends often become choppy before they ultimately end. It is highly unusual for an uptrend that is showing strong persistence to abruptly top out. The study below demonstrates this concept. The persistent uptrend of late has kept SPX above its short-term moving averages for an extended period. Tuesday, after 22 consecutive closes above the 10ma, SPX dipped down and closed below it. The study below looks at performance following other instances where SPX closed below its 10ma for the first time over 15 days.

Hanna continued:

The strong upslope serves as some confirmation of the bullish edge. As my friend and colleague, Tom McClellan says, “A spinning top does not just stop spinning and fall over. It wobbles first.” I saw a few bullish studies along these lines last night. Odds seem to suggest a good chance of a bounce arriving in the next few days.

My own review of sector leadership confirms that, so far, the market is not wobbling yet.

The message from sector analysis

A review of sector leadership came to the following conclusions:

FAANG stocks are still dominant
Cyclical stocks are showing signs of emerging leadership
Defensive sectors are lagging

Barring any “wobbles” from these themes, the strength of high beta, glamour, and cyclical sectors lead to the conclusion that the path of least resistance for stock prices is still up.

The primary tool for a sector review is the Relative Rotation Graphs. RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The RRG analysis of US large cap sectors shows the dominance of FAANG stocks. Technology stocks are in the top right quadrant, indicating strength. Other strong sectors include Consumer Discretionary (AMZN), and Communication Services (FB, GOOG, GOOGL). By contrast, defensive sectors such as Utilities, Real Estate, and Consumer Staples are all in the bottom half of the chart, which indicate weakness. While Healthcare stocks are often classified as defensive, their recent weakness are attributable to market jitters over a Democrat victory in 2020, and the negative implications of a Medicare for All program.

I have written about this before, but FAANG leadership is especially evident in the strong relative strength of NASDAQ 100 stocks, both on a capitalization weighted basis (middle panel), and on an equal-weighted basis (bottom panel).

An RRG analysis of small cap sectors reveals some common themes and notable differences. Tech stocks are still the market leaders, and defensive sectors are still the laggards. However, Consumer Discretionary stocks have moved from the top half of the chart to the bottom half, as small caps does not have AMZN to play a leadership role. I therefore interpret this sector as weaker than it actually is on the large cap chart.

Sometimes, a cross-border analysis can be revealing, as factor and sector returns are often correlated across different global regions. An RRG analysis of European sectors tells a similar story. Technology stocks are also the market leaders, and defensive sectors are mainly the laggards. One key difference is the cyclical sectors are more advanced in their leadership development than the US.

The following table of US large cap, small cap and European sector leadership summarizes the important leadership themes. Technology is consistently in the leading quadrant across all three groupings, and defensive sectors are laggards. In the US, late cyclicals such as Energy and Materials are starting to show some life,

Limitations of RRG analysis

I would, however, like to highlight some of the limitations of RRG analysis. One problem with this technique arises because of the quirks of the arbitrary boundaries of RRG charting. American large and small cap Financial stocks are in the bottom left “lagging” sector, but on the verge of rising into the top left “improving” quadrant, while European Financials have already risen to “improving”. The relative performance of US and European Financials are roughly the same. The chart below depicts the market relative returns of US Financials (black line) and European Financials (green line). In the past, the relative strength of this sector has been highly correlated to the shape of the yield curve, and the current steepening trend should be supportive of this sector.

The other sectors that may be doubtful as emerging US market leaders are the deep cyclical resource extraction sectors of Energy and Materials. The relative performance of these sectors is highly sensitive to the USD, and the recent strength of the greenback will be headwinds for these sectors.

By contrast, the relative performance of other cyclical sectors and groups seems more constructive.

Investment implications

It is not enough for a market analyst to analyze the market from a purely technical perspective, and then come to a conclusion based purely on the charts. Risk and return exist in many dimensions, and my review would be incomplete without a review of the macro backdrop.

To recap, our review of sector leadership came to the following conclusions:

FAANG stocks are still dominant
Cyclical stocks are showing signs of emerging leadership
Defensive sectors are lagging

Let’s start with the cyclical stocks. The roots of the cyclical upturn comes from China. It was evident last year that the Chinese economy was slowing. In response, the authorities abandoned their previously stated objective of deleveraging, and rebalancing growth, to a highly targeted program of credit driven stimulus, as well as fiscal stimulus in the form of tax cuts. Evidence of a turnaround was shown in Q1, which provided the impetus for renewed optimism for global growth.

The latest round of economic statistics from Asia suggest that the recovery may be stalling. To be sure, a nascent export recovery is taking hold in highly China sensitive economies such as Korea and Taiwan. Based on these readings, I do not expect China to save the world with another stimulus growth leg, but Beijing has managed to stabilize Asian economies. Everything else being equal, the recovery is starting to look L-shaped.

That said, the Chinese leadership will not allow the economy to tank ahead of the October celebration of the founding of the PRC. Undoubtedly, they are counting on a US-China trade deal to provide the next round of stimulus for the economy. US Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin went to in Beijing last week for a round of talks which were described as “productive”. Vice Premier Liu He is expected to lead a delegation of Chinese officials to Washington in the coming week for further discussions. It is evident that both sides want an agreement, and official sources of hinted that we could see the outline of a deal by this coming Friday. The market has anticipated the prospect of a trade agreement before, and successive cries of “wolf” are being increasingly discounted or ignored. Nevertheless, press reports indicate that both sides appear to have given ground on substantive issues, and a positive announcement may be at hand. Should the discussions fall apart, I would expect the Chinese authorities would resort to Plan B, which is another round of stimulus so that growth holds up until Q4.

A Xi Put is firmly in the market. Expect the cyclical and reflation trade to keep working, at least until later this year.

In the US, the Powell Fed adjusted market expectations of a rate cut this year by stating that it doesn’t know whether the next move will be up or down. “Patience” has changed to “transitory”:

We expect that some transitory factors may be at work. Thus, our baseline view remains that with a strong job market and continued growth, inflation will return to 2 percent over time, and then be roughly symmetric around our long-term objective.

In a November 28, 2018 speech, Jerome Powell made it clear that one key focus of the Powell Fed is to avoid ad hoc responses to financial crises, and to develop a more systematic approach to ensure financial stability:

Outside of these crisis responses, however, systemic issues were not a central focus of policy.

The Global Financial Crisis demonstrated, in the clearest way, the limits of this approach. Highly inventive and courageous improvisation amid scenes of great drama helped avoid another Great Depression, but failed to prevent the most severe recession in 75 years. The crisis made clear that there can be no macroeconomic stability without financial stability, and that systemic stability risks often take root and blossom in good times.3 Thus, as the emergency phase of the crisis subsided, Congress, the Fed, and the other financial regulators began developing a fundamentally different approach to financial stability. Instead of relying on improvised responses after crises strike, policymakers now constantly monitor vulnerabilities and require firms to plan in advance for financial distress, in a framework that lays out solutions in advance during good times.

Even though the Fed has signaled that it doesn’t know whether it will cut rates this year, the Powell Financial Stability Put remains in place. The lagging relative strength of defensive sectors is testament to the floor that the Fed is likely to put on stock prices.

At the same time, with the cyclical and reflation trade in doubt, the market has gravitated to the only source of consistent growth, which are the FAANG and Technology stocks.

Keep an eye on the semiconductor group, which has both Tech and cyclical qualities. The group was a strong market leader, but became over-extended and was rejected a relative resistance. Despite the pullback, the relative uptrend remains intact.

Any market wobble would be seen in NASDAQ and semiconductor stocks. Until Technology, and NASDAQ leadership starts to falter, and if their leadership is not replaced by the reflation sensitive cyclical groups, I remain bullish on equities.

The week ahead

Looking to the week ahead, the stock market appears to be resuming its orderly advance after a brief post-FOMC downdraft. Subscribers received an alert early Thursday indicating that short-term indicators had flashed buy signals, based on the assumption that the market would continue its slow grind upwards. The SPX was testing its wedge support, the VIX Index had breached its upper Bollinger Band indicating a short-term overbought condition, and the 14-day RSI was near levels where it had bottomed in the past during this advance. I was fortunate in that call, when stock prices staged a strong turnaround on Friday after the April Jobs Report printed a positive surprise.

Long-term sentiment is supportive of further market strength. Mark Hulbert highlighted an academic study by Malcolm Baker and Jeffrey Wurgler, Investor Sentiment and the Cross-Section of Stock Returns. The latest readings from the Baker-Wurgler model indicate no signs of market froth indicative of a major market top.

The analysis of equity fund flows came to a similar conclusion. Enthusiasm for stocks is nothing compared to the 1999-2000 NASDAQ top, or the 2005-07 top (via Urban Carmel).

As well, the Conference Board`s measure of long-term equity sentiment is neutral, and not excessively bullish.

Intermediate-term sentiment models like the Fear and Greed Index reset and recycled after last week’s brief scare. The index closed at 60 on Friday, which is well below the 80-100 target zone where past rallies have topped out.

At the same time, Q1 earnings season is providing positive fundamental momentum support for stock prices. Both earnings and sales beat rates are above their historical averages, and forward 12-month EPS estimates continue their trend upwards. At the current rate of improvement, the market may be able to avoid the dreaded “earnings recession” of a YoY quarterly earnings decline that was feared by many investors several weeks ago.

As well, FactSet reported that the rate of quarterly estimate cuts for Q2 is lower than the historical average, indicating a better than average fundamental outlook.

From a technical perspective, NASDAQ 100 leadership remains intact.

Another encouraging sign is the upside breakout by the small cap Russell 2000. While this index is still well below its all-time high, the breakout is likely to spark some animal spirits and increased risk appetite among traders.

The combination of benign intermediate and long-term sentiment readings and positive price and fundamental momentum is bullish. My inner investor is overweight equities. My inner trader added to his long positions late last week, and he is strapping himself in for the ride to further highs.

Disclosure: Long TQQQ, SPXL

A resilient advance

Posted by Cam Hui - May 1, 2019

Mid-week market update: It is always a challenge to make a technical market comment on an FOMC announcement day. Market signals are unreliable. The initial market reaction can be deceptive, and any move reversed the next day after some somber second thought. In addition, today is May Day, and a number of foreign markets are closed, which deprive traders of additional signals from overseas.

With those caveats, I can make a general observation that the advance off the Christmas Eve low has been remarkable and resilient. A historical analysis from Steve Deppe shows that years that have begun with four consecutive monthly advances since 1950 have resolved bullishly, with only one single exception (N=14).

Oddstats also pointed out that 2019 was the fifth best start to the year.

If these small samples of history are any guide, the stock market should be considerably higher by year-end, unless you believe this is a repeat of 1971, based on Steve Deppe’s analysis, or 1987, based on Oddstats’ data.

Intermediate term bullish

I continue to believe that the outlook is intermediate term bullish. The analysis of the market relative performance of the top five sectors, which comprise just over two-thirds of index weight, shows a healthy rotation in leadership. Technology stocks are still strong, and Healthcare has made a relative bottom. The steepening yield curve, which is closely correlated with the relative strength of Financial stocks, has pulled that sector out of the doldrums. Consumer Discretionary and Communication Services staged a brief relative breakout, but pulled back.

The important takeaway is these top sectors are strong. Even in cases when they have faltered, another heavyweight sector has stepped up to take up the baton.

Here is another case in point. Cyclical sectors faced a brief setback on a brief growth scare. In particular, the high flying semiconductor stocks were hit hard, but everything except the Transportation sector has recovered and regained their mojo.

I recently highlighted the NASDAQ leadership as a source of market strength. The equal-weighted relative performance ratio (bottom panel) is especially important indicator of NASDAQ price momentum.

The NDX took a hit on Tuesday when heavyweight Alphabet disappointed, but the relative uptrend remained intact, and the index recovered the next day after Apple reported. As this table from BAML shows, the market has been rewarding earnings and sales beats while punishing misses during earnings season. Q1 Earnings Season has featured an above average level of beats. That’s market resilience, which is intermediate term bullish.

Brief pullback ahead?

Still, this advance appears extended and a brief and shallow pullback can happen at any time. NYSE 52-week highs began to spiked on Tuesday and continued today. While a surge in new highs is considered intermediate term bullish, such market action could be a short-term sign of bullish exhaustion. In only four of the last 12 instances (33%) in the last three years saw the market continue to rise. In the other two-thirds of the occasions, stock prices have either stalled and consolidated, or pulled back, usually in a shallow fashion.

My inner investor is bullishly positioned. My inner trader remains cautiously bullish, and he is waiting for market weakness so that he can buy the dip.

Disclosure: Long SPXL

A stampede you could front run

Posted by Cam Hui - April 29, 2019

You may think that institutional money managers run in herds, but that is not necessarily true. Different managers have different mandates that color their views. As well, their geographical base can also create differences in opinions in how their view their world and markets. I analyze institutional sentiment by segmenting them into four distinct groups, each with their own data sources:

US institutions, whose sentiment can be measured by Barron’s semi-annual Big Money Poll
Foreign and global institutions, as measured by the BAML Fund Manager Survey (FMS), which is conducted on a monthly basis;
RIAs, as measured by the NAAIM survey, conducted weekly; and
Hedge funds, as measured by option data and the CFTC futures Commitment of Traders data, though hedge funds are partly represented in the BAML FMS sample, and other sources.

While “institutions” do not always agree, current conditions are pointing an unusual consensus of opinion, and traders can profit by front running the institutional stampede.

An unusual agreement

Barron’s just published their semi-annual Big Money poll, and a comparison of the Barron’s poll with the BAML Fund Manager Survey (FMS) reveals a group of managers who de-risked their portfolios in conjunction with the stock market weakness in late 2018, but they are starting to buy again.

One of the weaknesses of the Barron`s poll is it only asks managers views of the market, but it does not ask how they are positioned. The BAML FMS does ask about manager positioning, and it shows that their equity positions are low compared to their historical average, but they are just beginning to buy again.

We can see this in the biggest changes in monthly positions, where equities went up the most, and cash levels fell the most.

This was in slight contrast to the Barron’s poll, which indicated that US managers plan on raising both equity and cash levels, at the expense of their commodity exposure.

A history of over and under valuation from Barron’s shows that manager bullishness peaked in H2 2016, while neutral opinions rose. US manager bullishness is not extreme.

At the same time, growth expectations are bottoming. The combination of a manager short beta position and a growth turnaround is likely to spark a bullish stampede, which is just starting.

Sector preferences are also similar. The BAML FMS of global managers favor Technology and Healthcare (pharma), while avoiding Materials and Utilities.

The Barron’s US sample shows a similar view, of Technology, Healthcare, and FAANG flavored sectors like Communications Services (FB, GOOG, GOOGL) and Consumer Discretionary (AMZN), while Materials and Utilities are out of favor.

In short, both US and global managers are buying equities, and their portfolios are tilted towards high beta sectors.

RIAs are already bullish

I have seen a number of analysts refer to the NAAIM Exposure Index as representative of institutional activity. This is a misunderstanding. NAAIM stands for National Association of Active Investor Managers consisting mainly of RIAs.

For some perspective, the assets under management (AUM) of a seasoned RIA might be around $100 million. A successful team of several RIAs might be around $1 billion. By contrast, a typical institutional manager’s AUM would range from $10 billion to over $100 billion.

Another shortcoming of the NAAIM Exposure Index, which is taken weekly, is it asks the views of its members, rather than their positioning. Opinions can swing much more wildly than portfolio positions. An investor who entrusted his funds with a manager who moved the portfolio beta as quickly as the NAAIM Exposure Index pictured below would see turnover over 500% a year, and it would raise red flags and risk that manager getting fired for churning the portfolio.

Instead, I have found that NAAIM Exposure Index to be useful at extremes. In particular, it has flashed good contrarian buy signals when the index has fallen below its 26-week Bollinger Band (grey shaded regions), though readings above the upper BB (yellow shaded regions) have not been as effective as sell signals.

Current readings indicate that RIAs have turned bullish, and they are buying, just like the large institutions.

Hedge funds still cautious

Traders also spend a lot of time trying to discern hedge fund activity. While hedge fund assets are lower than large institutions, their turnover rate can be an order of magnitude higher, and their activity can dramatically affect tape action.

At this point, it is important to understand how hedge funds work. Large multi-strategy hedge funds like a D.E. Shaw or a Renaissance with billions in assets is really a portfolio of traders and managers each running their own strategies. Even though there are a lot of smart people under the same roof, there is little or no incentive for cooperation or collaboration. They all compete against each other for capital, and therefore they are highly secretive about their approaches and portfolios. The only thing you might only know that the team in the next desk or office trades currencies, and that would be the only extent of your knowledge.

In addition, different strategies will have different tilts, and a long position is usually offset by a short position (hence the “hedge” fund label). Some of the more well-known categories that trade equities are global macro funds, long/short funds, equity market neutral, CTA trend following strategies, and convertible arbitrage. The list goes on, and there is no monolithic “hedge fund” position.

Nevertheless, Jason Goepfert at SentimenTrader recently highlighted an unusual condition. In aggregate, hedge fund equity betas are at historic lows. As these strategies tend to be drawdown sensitive, continued equity strength will force HF traders to cover and increase their beta.

I wrote yesterday (see Sell in May? The bull and bear debate) that NASDAQ stocks have been the leadership throughout this rally. Leadership is even more evident when you look at the equal weighted ratios (bottom panel). Moreover, NASDAQ stocks turned up even before the broad market turn. A meaningful correction is therefore unlikely until this group shows significant signs of relative weakness.

The analysis of the CoT data from Hedgopia reveals that large speculators, which are mostly hedge funds, are still short the NASDAQ 100. This sets up a situation for an explosive upside should these traders capitulate and go long.

To be sure, hedge funds may have already expressed their equity bullishness in other ways. There has been growing concern about the record crowded short in VIX futures. Some analysts have interpreted these readings as a potential VIXmageddon, where volatility explodes and stock prices fall. From a cross-asset analytical viewpoint, the VIX short may be another way that traders are positioned for rising equities.

Orderly advance, or blow-off top?

From a tactical perspective, the stock market has been staging an orderly advance, while respecting the rising trend line pictured in the chart below. My base case scenario calls for a continuation of this pattern, which consists of a rally, followed by market consolidates and minor corrections, and then further strength. On the other hand, should the index stage an upside breakout through the rising trend line, it would be the signal for a blow-off top, much like the one we saw in late 2017 and early 2018.

In addition, a decisive upside breakout by the small cap Russell 2000 might provide another reason for a risk-on stampede.

Stay tuned.

Disclosure: Long SPXL

Sell in May? The bull and bear debate

Posted by Cam Hui - April 28, 2019

The latest signals of each model are as follows:

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

Sell in May and go away?

The stock market has made a strong V-shaped recovery since the Christmas Eve bottom. The SPX, NASDAQ 100, and NASDAQ Composite have all rallied to all-time highs last week. As we approach the seasonally weak six months of the year, should you sell in May and go away?

Here are the bull and bear cases.

Weak seasonality

Let us first begin with examining the negative seasonality case, which cannot be characterized as wildly bearish. In the last 20 years, the May-October period has been weak for equity returns.

A statistical review of monthly returns from 1990 shows that the May-October period shows lower median returns, and higher risk levels than the November-April period.

That said, the returns of the seasonally weak May-October period remain positive, and investors would have been disadvantaged by moving to cash during those six months. A limited test of a switch switching strategy, where an investors holds SPY during November-April and switches to a buy-write ETF (which was only available since 2007) also underperformed the simple buy-and-hold benchmark. (For the uninitiated, a buy-write strategy consists of buying the underlying stock or index, and the selling a call option against the long position. That way, the holder trades off potential upside for some immediate cash for income and partial downside protection.)

Don’t expect China to rescue global growth

Notwithstanding the fact that the market is entering a seasonally higher risk period, there are a few other reasons to be cautious on equities.

The first reason relates to Chinese stimulus. Should the world expect China to save the world again? It seems that the Chinese authorities reached a Mario Draghi-like “whatever it takes” moment in Q3 or Q4 2018. They abandoned all of their rhetoric about deleveraging and undertook a massive stimulus program. As a result, total social financing (TSF) rose an astounding 8.2 trillion yuan in Q1, which amounts to roughly 9% of GDP (see Can the market advance continue? Watch China!).

It was therefore no surprise to see a surge in upside surprises in China’s economic statistics.

A rising tide lifts all boats, and the effects of the stimulus program was seen globally. The latest BAML Fund Manager Survey saw a turnaround in global growth expectations.

Can this continue? Caixin reported that there has been a shift in rhetoric:

China’s top decision-makers are shifting focus away from more stimulus and back towards structural reform after positive economic performance in the first three months of 2019, say analysts.

Though the domestic economy was still “under downward pressure,” activity in the first quarter of the year was “better than expected,” said a meeting of the 25-member Politburo chaired by President Xi Jinping, according to the official Xinhua News Agency.

We can see the effects of this shift in policy in real-time. The shares of Chinese real estate companies, which are highly levered and therefore very sensitive to shifts in monetary policy, began to surge in October, and they have now begun to pull back.

To be sure, the stimulus program is not about to come to a dead stop. CNBC reported that Beijing will continue to support the economy, even though more shock-and-awe debt tactics are off the table:

China will implement counter-cyclical adjustments “in a timely and appropriate manner,” while the pro-active fiscal policy will become more forceful and effective, and the prudent monetary policy will be neither too tight nor too loose, it said.

For this year, the government has unveiled tax and fee cuts amounting to 2 trillion yuan ($298.35 billion) to ease burdens on firms, while the central bank has cut banks’ reserve requirement ratios (RRR) five times since early 2018 to spur lending.

Further policy easing is widely expected.

On Friday, the politburo reiterated that the government will effectively support the private economy and the development of small- and medium-sized firms.

Authorities will strike a balance between stabilizing economic growth, promoting reforms, controlling risks and improving people’s livelihoods, the politburo said.

The key question for investors is whether the global cyclical rebound can continue now that China has taken its foot off the stimulus accelerator. The next phase in China’s growth recovery will depend in a large degree on the details and success of the US-China trade talks. While there are hopeful signs that a signing ceremony may be scheduled for late May, the market has gone down this road before and it has been disappointed.

Margin headwinds ahead?

Another threat to equity prices is the prospect of a margin squeeze. Bridgewater Associates recently published a paper detailing the long-term risks to US equity prices from margin compression.

Over the last two decades, US corporate profit margins have surged and have contributed more than half of the excess return of equities relative to cash. Without that consistent expansion of margins, US equities would be 40% lower than they are today. Margins have been rising for 25 years, and when we look at market pricing, it appears to us that the market is extrapolating further margin gains. The long-term valuation of equities hinges heavily on what happens to margins going forward: if margin gains can be extrapolated, then valuations look reasonable; if margins stagnate, then valuations are a bit expensive but not terrible; if margins revert toward historical averages, then equities are highly overvalued.

Over the last few decades, almost every major driver of profit margins has improved. Labor’s bargaining power fell, corporate taxes fell, tariffs fell, globalization increased, technology allowed for greater scale and lower marginal costs, anti-trust enforcement fell, and interest rates fell. These factors have produced the most pro-corporate environment in history. Many of these drivers of high profit margins are now under threat. Before we get to analyzing each, the following panel shows how everything moved in the same direction, in favor of corporates.

Bridgewater believes that the low hanging fruit is gone, and the outlook is less rosy:

Looking ahead, some of the forces that supported margins over the last 20 years are unlikely to provide a continued boost. Incentives for offshore production have been reduced as global labor costs have moved closer to equilibrium, with domestic costs and rising trade conflict increasing the risk of offshoring, while the potential tax rate arbitrage from moving abroad is now much smaller…

At the same time, we have seen popular sentiment begin to sour against the forces that have driven margin expansion, as well as against the companies that have benefited most from them. As we have discussed at length in prior research papers, we are in the midst of a populist backlash against rising inequality and increasingly seeing a move toward more protectionism. Recent surveys show increasing animosity toward globalization and the power of companies more broadly and a bit more welcoming attitudes toward government regulation of firms.

While Bridgewater’s concerns are long-term in nature, cyclical pressures are starting to appear. Morgan Stanley pointed out that sales growth is slowing, while wage growth is rising. This will start to put pressure on operating margins, and earnings growth expectations.

Bullish momentum supportive of further gains

The bull case rests mainly on a combination of fundamental and price momentum. Can momentum be stopped?

Consider the interim results of Q1 earnings season as a measure of fundamental momentum. The earnings beat rates have been coming in above their historical averages, and forward 12-month EPS estimates have troughed and they are rising again. Can this optimism, once began, be stopped dead in its tracks?

From a technical perspective, US equities, as measured by the broad Wilshire 5000, are on the verge of a bullish MACD crossover buy signal in the next month or two. Past buy signals have led to strong gains in the past, and the subsequent bull phase has lasted at least a year. While I am not in the habit of anticipating model readings, the market would have to really crash to avoid the buy signal. The current bearish episode that ended on December 24, 2018 is reminiscent of two instances when central bankers stepped in to rescue the market. In 1998, the Fed halted the panic resulting from the Russia default and subsequent LTCM crisis; in 2011, the ECB backstopped the eurozone banking system with its LTRO program. In both instances, stock prices recovered and went on to new highs.

Non-US developed market equities, as measured by the MSCI EAFE Index, is also on the verge of a MACD buy signal.

The MSCI Emerging Market Free Index is also nearing a similar buy signal, though past buy signals have not been as effective for EM equities.

Putting it all together, the technical picture of global equities is showing a similar bullish potential. Can this momentum be stopped?

The price momentum effect can partly be explained by a stampede into equities by market participants. The latest BAML Global Fund Manager Survey shows that global institutions had de-risked ahead of the late 2018 market sell-off, and they are now scrambling to add risk as the economic outlook normalized.

Bloomberg also reported that hedge funds are short beta. How long can these short-term return sensitive players resist the siren of price momentum?

Individual investor sentiment readings are mixed. Long-term investors, as measured by the monthly AAII asset allocation survey, are roughly neutral in their risk appetite. Both equity and bond allocations are slightly above median, but readings are not excessive.

The TD-Ameritrade Investor Movement Index, which measures what TD-Ameritrade clients are doing with their money, shows a defensive tilt that is more consistent with market bottoms, not market tops.

The weekly AAII sentiment survey, which consists of a greater sample of traders, shows a bull-bear spread of 13%, but readings are not excessive.

What is unusual about the AAII sentiment survey is the spike in neutral opinions to 46.3%, which is an indication of confusion and uncertainty. Such readings are relatively rare, and they have tended to be either neutral or bullish for stock prices.

To be sure, there have been positive flows into equity funds in the past few weeks, but a longer term time scale shows that the magnitude of the flows is only a blip compared to its history.

In general, the Street can be described as underweight risk and short equity beta. These conditions suggest that as long as macro and fundamental momentum are lasting, the bullish stampede can continue.

The Powell and Xi puts

Another bullish consideration are the Fed’s dovish turn, and the implicit Xi Put from China.

The Federal Reserve made a dovish pivot in Q1 and changed to a “patient” stance on monetary policy. Fed watcher Tim Duy outlined the internal discussions about the Fed’s prolonged inability to hit its 2% inflation target:

The failure of the Fed to meet its self-defined inflation objective yields a number of both short- and long-term negative outcomes. At a most basic level, the continuing suboptimal inflation outcomes suggest policy has been too tight throughout the expansion that followed the Great Recession. Unemployment could have been reduced more quickly and could possibly still be held sustainably lower than current Federal Reserve forecasts anticipate. Another concern is that persistently low inflation is eroding inflation expectations which, though little understood (see Tarullo (2017)), anchor the Fed’s inflation forecast. The Fed would need to provide even easier policy should they want to firm up those expectations.

Over the longer-run, policy makers increasingly focus on how they should respond to the next recession. In addition to lower interest rates, quantitative easing, and forward guidance, Fed speakers also increasingly anticipate tweaking the policy framework to make up past inflation shortfalls. A version of such a policy is the temporary price-level targeting scheme suggested by former Federal Reserve Chairman Ben Bernanke.

As a reminder, here is how Ben Bernanke explained his temporary price-level targeting proposal:

In a previous blog post and paper, I proposed one variation of this kind of commitment, called “temporary price-level targeting” (TPLT). In brief, under TPLT, following adverse shocks to the economy that force short-term rates to zero, the Fed would commit in advance to avoid raising rates at least until any shortfalls of inflation from target during the ZLB period had been fully offset. So for example, if the Fed has a 2 percent inflation target in normal times, under TPLT it would commit not to begin raising rates from zero until average inflation since the beginning of the ZLB period was at least 2 percent. (Once rates have lifted from zero, policy is guided by a conventional rule such as a Taylor rule.) Since inflation early in the ZLB period would likely be below 2 percent, meeting this condition would typically involve some overshoot of the inflation target before rates were raised. Some willingness to accept temporary overshoots of the inflation target is typical of lower-for-longer strategies.

Duy concluded that it all adds up to a dovish direction on monetary policy:

Taken together, the above suggests a high likelihood that policy will at least err on the dovish side. In reality, I think the Fed should not just err on the dovish side, but should instead pursue an explicitly dovish strategy. Arguably it would be foolish if not downright irresponsible to enter the next recession without at least convincingly anchoring inflation expectations at 2%; an effort to do so might entail not just accepting above 2% inflation ahead of the next recession, but actually targeting a higher level to ensure that average inflation prior to the next recession is 2%.

A WSJ article discussed the inflation undershoot problem, and revealed that Chicago Fed President Charlie Evans actually proposed an “insurance rate cut”:

If inflation runs too far below 2% for a while, it would show “our setting of monetary policy is actually restrictive, and we need to make an adjustment down in the funds rate,” Chicago Fed President Charles Evans said Monday, referring to the central bank’s benchmark federal-funds rate.

Mr. Evans said his forecast was for inflation to rise over the coming year, justifying a rate increase in late 2020 and possibly again in 2021 to keep price pressures under control.

But if it turns out that core inflation, which excludes volatile food and energy categories, falls and stays near 1.5% for several months, “I would be extremely nervous about that, and I would definitely be thinking about taking out insurance in that regard” by cutting rates, he said.

At a minimum, the Fed has investors’ back for the rest of the year. Don’t be afraid to take risk.

As for China, one of the reasons behind the Draghi-like “whatever it takes moment” last year was undoubtedly in anticipation of the October celebration of the 70th anniversary of the founding of the Peoples’ Republic of China. The Chinese leadership from Xi Jinping down would pull out all stops to avoid a tanking economy just as the anniversary begins. Despite all of the rhetoric about a policy shift to a more measured and targeted stimulus program, Beijing is likely to resort to more debt driven stimulus should growth falter.

Don’t worry, world. Xi has your back, at least until Q4. Then all bets are off.

What I am watching

Bull or Bear? Here is what I am watching to resolve the debate.

Let’s begin with the yield curve. The 2s10s yield curve has been steepening, which is a signal from the bond market that it is anticipating better growth. Can that continue?

If the market were to take a tumble, financial distress risk is likely to rise. So far, the relative performance of credit has roughly tracked stock prices.

Last week, the market seems to have hit the pause button on the relative performance of cyclical stocks. The disappointing earnings reports from cyclical companies like 3M, FedEx, and UPS have hurt these stocks. Watch if their relative performance recovers, or lags.

Lastly, monitor the progress of major market indices like the S&P 500. Will it flash a MACD buy signal on the monthly chart?

Even if the market were to falter, don’t panic. Jeff Hirsch at Almanac Trader pointed out that it is not unusual for the market to pause and consolidate its gains in May in a pre-election year.

In conclusion, while the combination of weak seasonality, fading stimulus from China, and a possible margin squeeze could prove to be headwinds for stock prices, strong momentum, and the presence of both a Fed Put and Xi Put are positives for risk appetite. Given the current conditions, I am inclined to give the bull case the benefit of the doubt, though investors should be prepared for minor pullbacks.

The week ahead

Looking to the week ahead, the market may be poised for a minor pullback. The S&P 500 has been staging a “good overbought” advance, as it becomes overbought on short-term 5-day RSI, while pausing when the 14-day RSI gets overbought. Past pullbacks during such advances have been halted when RSI-14 at or near neutral, and when the VIX Index breaches its upper Bollinger Band. As the index has become overbought on RSI-14, and it is testing a rising trend line that has proven to be upper limit for its rally for 2019, it may be time for another pause and pullback. Should history repeat itself, the corrective episode should not be very serious, with downside risk limited to about 2%, which is about the level of the 50 day moving average at about 2850-2860.

The analysis of intermediate-term breadth, as measured by the net 20-day highs-lows, reveals a similar pattern. Advancing phases has seen breadth declines halt at support, but past minor corrections were marked by only minor breaches of support and quick bounce backs. Current conditions are setting up for another one of these pullbacks, as breadth has been trending down with a series of lower highs.

Option sentiment is also ripe for market weakness. The CBOE equity-only put/call ratio has been falling to levels that has historically signaled complacency. That said, this indicator has not flashed immediate actionable sell signals in the past. Instead, it has only warned of sentiment conditions where the market has either stalled or pulled back.

The FOMC meeting in the coming week is also a source of event risk. The market is discounting a quarter-point rate cut by December, according to the CME’s Fedwatch Tool.

At the same time, evidence of strong Q1 GDP growth and a global reflationary rebound might give Fed policymakers some pause. If the Fed wanted to lean against the expectations of a rate cut by downgrading downside risks and upgrading growth and inflation, the FOMC statement may be the perfect venue for such a statement. Stay tuned.

That said, overbought markets can become more overbought, and the market can continue to despite overbought conditions. However, such a scenario would call for a unsustainable parabolic blow-off which ultimately resolves itself with a collapse.

Instead, my base case scenario would see the S&P 500 consolidate and pullback by 2% or less within the next two weeks, and the rally to resume soon afterwards. Should stock prices weaken from these levels, I would discount the possibility of a deeper correction as those signs of weakness are not present.

Simply put, the market is insufficiently overbought and insufficiently frothy for this to be an intermediate term top. The Fear and Greed Index stands at 72, and it has not reached my target level of 80, which would be the minimum level for a minor top.

Other risk appetite indicators are nowhere near the frothy levels that warn of a top. High beta stocks have barely begun to beat low volatility stocks, and IPOs are underperforming the market. Sentiment does not look like this at market tops.

In addition, there are no signs of a change in leadership. NASDAQ stocks have been the market leaders even before the Christmas Eve bottom. The relative performance of the NASDAQ 100 (middle panel) has been dramatically outperforming since mid-February. This relationship is even more clear in the bottom panel, which shows the Equal Weighted NASDAQ 100 to Equal Weighted S&P 500. NASDAQ ratio rising in a well-defined channel. It is difficult to believe that stock prices would falter and top out without signs of a technical breakdown in NASDAQ stocks.

There have also not been any warnings from the option market. The 9-day to one-month VIX term structure (bottom panel) has been a sensitive barometer of market uneasiness compared to the more conventional 1-month to 3-month VIX ratio (middle panel) that is a measure of VIX term structure. We saw a negative divergence warning in December when the short-term term structure inverted sharply, while the longer term term structure flattened. There is no similar divergence today.

My inner investor is bullishly positioned and overweight equities. My inner trader is also bullish, but he is keeping some dry powder ready. Should the market weaken, he will see that as an opportunity to add to his long positions.

Disclosure: Long SPXL

Buy, or fade the breakout?

Posted by Cam Hui - April 24, 2019

Mid-week market update: The market strength this week was no surprise to me based on my seasonal analysis I published on the weekend (see Will a volatility collapse lead to a market collapse?). Last week was option expiry (OpEx) week, and OpEx weeks have historically been bullish for stocks. In particular, Rob Hanna at Quantifiable Edges found that April OpEx week was one of the most bullish ones of the year.

However, last week saw the SPX edge down -0.1%, and my own analysis found that April post-OpEx weeks that saw market declines tended to experience strong rallies (red bars). By contrast, the market had a bearish tilt after strong April OpEx weeks (green bars).

This historical study was conducted from 1990, and the sample size of losing April OpEx weeks was relatively small (N=8). Here is the same analysis for all post-OpEx weeks. The conclusion is the same. Strong OpEx weeks were followed by market weakness, and vice versa, though the magnitude of the effect was not as strong.

Could this week’s upside breakouts of the major indices be attributable to an OpEx effect? If so, could the breakout be a fake-out?

Cautionary signals

A number of cautionary signals are appearing. The Daily Sentiment Index (DSI) is highly elevated, indicating an overbought market (but you knew that).

Mark Hulbert’s Stock Newsletter Sentiment Index (HSNSI) is also flashing a crowded long reading.

I would highlight a caveat for traders. Sentiment models tend to behave very differently at market bottoms and tops. While sentiment signals are good actionable at bottoms because bottoms tend to be panic driven, they don’t behave in a similar fashion at market tops as overbought markets can stay overbought for a long time.

Momentum, momentum!

In fact, turning cautious as the market makes all-time highs feels like standing in front of a freight train. It is said that there is nothing more bullish than a market making a fresh high.

Here is a different take on market breadth that is supportive of the bull case. Conventional breadth analysis uses the generals and troops analogy. If the large cap indices (generals) are leading the charge, but the equal weighted or small cap indices (troops) are not following, then that is a negative divergence which warrants caution. However, divergences can take a long time to play out, and signals have historically not been actionable.

I can turn that around in a different way. In the short run, I am watching the performance top five sectors in the index, which represent just under 70% of index weight, for clues to market direction. If these heavyweights (generals) are all performing well, it doesn’t matter what the smaller weights (troops) do, the market is going higher.

As the chart show, two of the top five (Technology and Consumer Discretionary) have staged relative performance upside breakouts. The relative performance of Financial stocks has historically been correlated with the 2s10s yield curve, and they should improve as the yield curve has steepened. Communications Services are performing in line with the market, but the sector is improving. Healthcare, which had been dragging down the market, has stabilized and appears to be trying to find a bottom.

In short, the top five sectors are either strong, or showing signs of strength. None are laggards, which should be supportive of further gains.

In the short run, the US equity market should continue to grind up as long as sentiment doesn’t become overly exuberant. The market has been rising on a series of “good overbought” conditions on short-term RSI-5 momentum (top panel). It has paused or staged minor corrections whenever it became overbought on intermediate term RSI-14 momentum, or tested the top of its rising uptrend line. If this behavior can continue, stock prices can rally to further new highs.

I would be more concerned if it were to stage an upside breakout through the rising uptrend, and RSI-14 becomes more overbought. That would be a signal of excessive giddiness to sell into.

My inner investor remains overweight equities. My inner trader is also bullish. He took some partial profits on his long positions when the market hit the rising resistance line yesterday, and he is prepared to buy more on a pullback.

Disclosure: Long SPXL

A Healthcare rebirth? And broader market implications

Posted by Cam Hui - April 22, 2019

It is Easter Monday, a day when Christians focus on the theme of rebirth and resurrection, Healthcare stocks just underwent a near-death experience when the market panicked over the prospect of a Democrat victory in 2020, and the potential negative effects of the implementation of a Medicare-For-All policy.

To be sure, there are costs to be taken out of the system. The US spends more than any other industrialized country on health care, with a lower life expectancy.

Indeed, the political winds are starting to shift. Axios reported that Republicans are becoming more open to the idea of passing a bill that will lower drug prices:

The White House and top lawmakers from both parties think a bill to lower drug prices has a better chance of becoming law before the 2020 election than any other controversial legislation.

Between the lines: Republican politics on drug prices have changed rapidly. The White House has told Democrats it has no red lines on the substance of drug pricing — a position that should leave pharma quaking.

We have seen these kinds of scares before. An examination of the relative performance of the sector gives some hope for a rebirth. If history is any guide, such an oversold condition on RSI of the relative performance of the XLV to SPY ratio in the last 20 years have been signals of a recovery ahead for the sector. Downside potential is limited with readings this oversold.

There are broader market implications as well.

Healthcare the only Big 5 laggard

An analysis of the relative performance of the top five sectors reveals a picture of strong price momentum. These sectors consist of roughly 68% of index weight, shows two sectors (Tech and Consumer Discretionary) staging upside relative breakouts, one (Communication Services) which is range-bound, one (Financials) which is starting to turn up. Financial sector relative returns are highly correlated to the shape of the yield curve, which appears to be steepening. The worst sector is Healthcare.

Here is another view of sector breadth from Urban Carmel. If it were not for the weakness in Healthcare, most of the major market indices would be a fresh highs.

This analysis of the sectors of the index show a pattern of market strength. Everything is strong, or a worst, neutral, except for Healthcare. If the Healthcare stocks bottom, or stabilize, and upward momentum continues, we can expect further gains from the major market indices.

Disclosure: Long SPXL

Will a volatility collapse lead to a market collapse?

Posted by Cam Hui - April 21, 2019

The latest signals of each model are as follows:

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

The calm before the volatility storm?

In the past week, there have been a lot of hand wringing about the collapse in volatility across all asset classes. Equity investors know that the VIX Index has fallen to a 12-handle, and past episodes of low VIX readings have resolved themselves with market corrections.

The MOVE Index, which measures bond market volatility, has also fallen to historic lows.

Low volatility has also migrated to the foreign exchange (FX) market.

As a sign of the times, Bloomberg reported that Europe will soon see a new short-volatility corporate debt ETF.

The 50 million euros ($56 million) product, ticker TVOL, aims to deliver steady gains so long as markets demand a higher cushion for price swings on speculative-grade debt compared with what comes to pass, or the volatility-risk premium.

This dynamic — selling volatility when it’s high and waiting for it to deflate — has spurred the post-crisis boom in financial instruments tied to shorting equity swings. Now it offers ETF traders income in the potentially more-stable world of fixed-income options.

“The premium available has been relatively persistent over the last 10 years,” Michael John Lytle, chief executive of Tabula, said in an email. “Most of the time it has also been larger in credit than in equity.”

The Tabula product tracks a JPMorgan Chase index that simulates the returns of selling a so-called options strangle on a pair of credit-default-swap indexes referencing high-yield markets. The underlying index has returned an average 2.9 percent over the past five years but has posted losses over the past 12 months, a period that coincided with the fourth-quarter meltdown in risk assets.

This ETF launch is a classic case of investment bankers feeding the ducks when they’re quacking. What could possibly go wrong?

Is this the calm before the volatility storm? What’s next? The answer was rather surprising.

Some volatility can be ignored

While it is true that low volatility periods are eventually followed by high volatility periods, the mere existence of a low vol state is not an actionable sell signal. For example, OddStats showed what happened to the market after the VIX Index fell from over 20 to 12 within 60 trading days.

Bloomberg reported that Harley Bassman, who invented the MOVE Index, voiced some concerns about the low MOVE Index readings, but they were only cautionary signals.

“Low volatility, by itself, is not a sign of bad things to come,” Bassman said in an interview. “But together with low rates and a flat curve, all three send the same message:
Volatility is going to rise as things become problematic with the economy.” A recession isn’t imminent, but mid-2020 “would be a fine time for historical indicators to reprise their prescience,” he added…

Low implied volatility doesn’t cause market disruptions, but it’s often “found loitering near the scene of the crime,” Bassman says. It’s associated with negative convexity, a sort of accessory after the fact that can accelerate a market move in progress.

But a flattening yield curve followed by tightening credit spreads usually precede it, and are the usual suspects when the economy winds up in the tank.

You can also think of low volatility as fuel, Bassman says. As a sign of ebbing demand for risk-management products and overexposure to risky assets such as triple-B-rated bonds (thus the tightening credit spreads), it’s necessary for the explosion, but “is not the match, it’s the gasoline.”

Another reason for the low level of MOVE is lower term premium, according to Variant Perception. As long as the market’s view of uncertainty for holding longer dated fixed income securities persists, bond market volatility will stay low.

Low FX volatility is a bit more worrisome. In the past, extremely low FX volatility has been followed by a large move in the USD, though the direction is unclear. Investors need to understand the potential of the move, work through the implications, and prepare accordingly.

A mean reversion in FX volatility may be the most important driver of asset returns over the next 12-24 months.

Which way the greenback?

Which way is the USD likely to move, up or down? Different techniques yield different results.

The classic method of purchasing power parity (PPP) points to an overvalued greenback, according to The Economist’s Big Mac Index.

The Big Mac index is based on the theory of purchasing-power parity (PPP), which states that currencies should adjust until the price of an identical basket of goods—or in this case, a Big Mac—costs the same everywhere. By this metric most exchange rates are well off the mark. In Russia, for example, a Big Mac costs 110 roubles ($1.65), compared with $5.58 in America. That suggests the rouble is undervalued by 70% against the greenback. In Switzerland McDonald’s customers have to fork out SFr6.50 ($6.62), which implies that the Swiss franc is overvalued by 19%.

According to the index most currencies are even more undervalued against the dollar than they were six months ago, when the greenback was already strong. In some places this has been driven by shifts in exchange rates. The dollar buys 35% more Argentinian pesos and 14% more Turkish liras than it did in July. In others changes in burger prices were mostly to blame. In Russia the local price of a Big Mac fell by 15%.

The chart below shows the raw Big Mac Index on the top panel, and the GDP-adjusted index on the bottom. As the top panel shows, very few currencies are overvalued against the USD, and most are on the left of the chart, indicating undervaluation. The GDP-adjusted index was developed to address “the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower”, and it shows the USD to be more fairly valued.

While PPP-style techniques like the Big Mac Index does offer some insight into equilibrium exchange rate levels over a 10-year period, The Economist offered the following caveat for the shorter term:

Such deviations from burger parity may persist in 2019. Exchange rates can depart from fundamentals owing to monetary policy or changes in investors’ appetite for risk. In 2018 higher interest rates and tax cuts made American assets more attractive, boosting the greenback’s value. That was bad news for emerging-market economies with dollar-denominated debts. Their currencies weakened as investors grew jittery. At the end of the year American yields began to fall as the global economy decelerated and investors anticipated a more dovish Federal Reserve. But the dollar has so far remained strong.

On the other hand, other analytical techniques indicate a bullish outcome. From a technical perspective, the USD Index may be forming a bullish cup and handle formation.

Currency strategist Marc Chandler also made the case that the greenback is about to enter another significant bull leg:

In the big picture, we argue that the dollar’s appreciation is part of the third significant dollar rally since the end of Bretton Woods. The first was the Reagan-Volcker dollar rally, spurred by a policy mix of tight monetary and loose fiscal policies. The rally ended with G7 intervention to knock it down in September 1985. After a ten-year bear market, a second dollar rally took place. It can be linked to the tech bubble and the shift to a strong dollar policy.

Chandler identified three phases of the USD rally. The first phase began Reagan-Volcker era, followed by the Clinton era and tech bubble, which drew foreigners into Dollar assets, and the third phase was the Obama rally, as the US economy recovered faster than its major trading partners in the wake of the Great Financial Crisis. Chandler believes that the US is about to take the global lead in growth again, which would put upward pressure on the USD.

With the fiscal stimulus winding down, the dollar may enter the third phase of its super-cycle: a return to divergence. Recall that the global slowdown began in H2 18, but the fiscal stimulus that is saddling the US with more a trillion dollar a year deficit helped mitigate the pressure. It grew at an average pace of 3.8% in the middle two-quarters last year. The German and Japanese contracted in Q3 and Q4 was only a little better. The Italian economy contracted in both quarters.

Historically, USD strength has been correlated with GDP growth. Renewed growth in the US economy would put upward pressure on the greenback.

Viewed from this perspective, the technical cup and handle formation makes perfect sense.

Untangling the macro and investment implications

For investors, even knowing the USD is poised to strengthen will be tricky to navigate. There are many moving parts to currency appreciate. Here are some first order effects:

Dollar strength means commodity weakness, which could spark a manufacturing renaissance as the price of inputs fall in the US.
A rising USD will put downward pressure on imported inflation, which gives the Fed more room to ease, but
Rising USD will put pressure on vulnerable EM economies with Dollar debt, and raise financial stability concerns, and
The flip side of the rising USD coin are depreciating foreign currencies, which will increase trade tensions.
In the short run, the earnings of large cap multi-nationals would face headwinds, as roughly 40% of the revenues of the companies in the S&P 500 are non-US, but
Domestic earnings would be boosted by better US growth.

There are many moving parts whose second order effects are not known. What will the policy response be to these developments? From the Fed? From major trading partners? How will US trade policy change as its currency rises?

These are all very good questions with no answers.

For equity investors, I can make the assurance that while the short-term effects of USD strength is negative on earnings and margins, the historical experience shows that stock prices are not correlated in any form to currency movements.

Timing the dollar rally

The timing of a Dollar bull move may not be immediate. There are a number of factors working to suppress the USD, and a breakout in asset volatility.

Firstly, large speculators are already bullish on the USD, and they are adding to their aggregate long positions.

In addition, the USD is unlikely to break upwards until we see some definitive signs of economic strength. The market just underwent a global growth scare. While expectations are starting to turn up, as evidenced by the latest results from the BAML Fund Manager Survey, a consensus about renewed economic momentum is not evident among market participants or policy makers.

To be sure, economic growth is recovering. The Atlanta Fed’s GDPNow, or nowcast of Q1 GDP growth, has recovered to 2.8% from a low of 0.3% on March 1, the New York Fed’s nowcast is 1.4%, and the St. Louis Fed’s nowcast is 1.9%. The real test for Fed officials will come later this year when the growth outlook recovers and stabilizes. When will policy start to tilt more hawkish and when will they signal likely rate hikes, and how will the market respond to the resulting clash between the White House and the Fed?

In conclusion, the market may be setting up for a major currency market move either later this year or early next year. Investors should be aware of such a development, and be prepared for a return of market volatility. At this time, too many unknown variables exist to reliably forecast the direction of stock prices, but history shows that equity returns have not been significantly correlated with the USD. Nevertheless, a mean reversion in FX volatility may be the most important driver of asset returns over the next 12-24 months.

The week ahead

Peering into the crystal ball for the week ahead is a case of fun with technical analysis. It is easy to arrive at both bullish and cautious views of the market, even when analyzing the same chart.

The bulls can point to a pattern of a market that has been grinding upwards as it has exhibited a series of “good overbought” readings on RSI-5, while testing overhead resistance at an uptrend channel, only to pull back and consolidate whenever RSI-14 reaches or nears an overbought level of 70. At the current rate of advance, the market could potentially test its all-time highs in late April, though that is not a specific forecast.

The bear case is based on a market caught in an ever tightening wedge pattern. If the index were to break down through wedge support, it would signal the start of a corrective phase. It is unclear, however, whether the market is rising in an orderly channel, which is market by the solid blue lines, or a wedge. If it is a wedge, how is the underside of the wedge defined? Wedge support could be defined by the dotted blue line, or the dotted red line.

Jason Goepfert at SentimenTrader also highlighted an ominous signal last week. He observed that “Dumb Money Confidence” has reached its highest level in a decade. He added, “Every date that saw this high of a reading in the past 20 years sported a negative return in the S&P 500 at some point between the next 2-8 weeks.”

I analyzed the Dumb Money Confidence indicator and came to the conclusion that this is not an actionable sell signal. The chart below depicts the indicator shown by Goepfert, overlaid with the S&P 500 in the bottom panel. There were two instances when the indicator reached similar levels as it is today, which are shown in black, and four others that were close, shown in grey. I further marked the maximum peak-to-trough drawdown on a closing basis. In some cases, the signal occurred after the market peak, and those instances were marked by “L”.

In half of the cases, the market continued to climb, and the drawdown was minimal. In others, the maximum drawdown varied between -4% and -8%, though the decline measured at the peak of the signal tended to vary between -2% and -6%. While I am always open to new trading system ideas, I conclude that this signal is at best noisy, and at worse no better than a coin toss. The drawdowns do not appear significant compared to an investor who is assuming normal equity risk.

My inclination is to tilt towards the bull case. Q1 Earnings Season is proceeding more or less as expected. While it is still early in the reporting period (15% of the index reported) the EPS beat rate is above average, and the sales beat rate is below average. EPS estimates have shaken off the recent growth scare and they are growing again, indicating fundamental momentum.

Equally important is the market reaction to earnings reports. Beats are rising more than average, and misses are declining in line with historical averages. This is what we would expect in a “normal” market.

The NASDAQ 100 broke out to an all-time high last week, and the most bullish thing any stock or index can do is to rise to a fresh high. If the breakout holds, the point and figure measured target is 9349, which represents an upside potential of 22% from current levels.

One data point that is supportive of further gains in the NASDAQ 100 is the behavior of large futures speculators. Even as the index tested and eventually broke out to new highs, large speculators (read: hedge funds) sold and moved to a net short position in NDX futures (via Hedgopia).

Last week, I highlighted a study by Rob Hanna of Quantifiable Edges indicating positive seasonal tailwinds from option expiry (OpEx) week. In the past, April OpEx week has been one of the most bullish OpEx weeks of the year. Unfortunately, the market did not follow the script and the S&P 500 fell -0.1% on the week.

My own study of April post-OpEx week since 1990 revealed a strong mean reversion effect. If the previous OpEx week was positive (green bars), the market tended to struggle the week after, but if OpEx week was negative (red bars), cumulative returns were strong. (Note that the chart depicts median cumulative returns and not individual daily returns).

Here is the analysis for % positive during April post-OpEx week. While Monday tended to be weak, the market was 100% by Thursday and Friday, though the sample size is relatively small (N=8).

As the sample size for April post-OpEx was small, here is the same study for all post-OpEx weeks. The pattern is similar, with weak Mondays and a strong mean reversion effect for the remainder of the week.

The statistics for % positive tell a similar story.

From a tactical perspective the hourly chart looks constructive for the bulls into next week. The market has exhibited a pattern of slowly rising with a series of tests of the ascending trend line. It filled a gap at 2890-2900, but the bulls were able to rally market and the index closed above the upper gap at 2900. Should the market weaken, the gap at 2835-2850 would likely get filled.

My inner investor is bullish and overweight equities relative to his target equity weight. My inner trader is also long and bullish.

Disclosure: Long SPXL

Debunking VIXmageddon and other bear myths

Posted by Cam Hui - April 17, 2019

Mid-week market update: I would like to address a number of bearish themes floating around the internet in the past few weeks, they consist of:

A low volume stock market rally
Extreme low volatility (remember the VIXmageddon of early 2018)
The closing stock buyback window during Earnings Season, which removes buyback support for stocks

None of these factors are likely to sink stock prices. Here are some reasons why.

VIXmageddon ahead?

Traders remember the VIXmageddon event of early 2018. Everybody and his brother had shorted the VIX index, and it was easy money until the music stopped. It’s happening again. Zero Hedge, which is our favorite supermarket tabloid for the perma-bear set, pointed out that the Commitment of Futures report shows an extremely crowded short position in VIX futures.

The short position stampede was sparked by a momentum trade. The VIX Index has collapsed from over 20 to 12 within 60 trading days. OddStats showed what happened to the market after such events.

Here is another study that goes back further using the DJIA and low volatility.

Do you feel better now?

I can suggest a more sensible way of analyzing volatility. In the past, the VIX has flashed early warning signs of an impending market retreat. First, the VIX Index trading below its lower Bollinger Band was a sure sign of an overbought market, and the advance was not sustainable. While the VIX did approach its lower BB last week, it did not close below that critical level. In addition, the term structure of VIX futures also foreshadowed market declines. The inversion of the 9-day to 1-month ratio (VXST to VIX), or a spiked above 1, preceded the market collapse in January 2018, and in December 2019. This time, the VXST to VIX ratio has started to rise from a historically low and complacent level, but readings are far from an inversion. In addition, the 1-month to 3-month ratio (bottom panel) never fell to levels indicating excess bullishness.

In short, I am monitoring volatility indicators for signs of possible market weakness. Those indicators are not flashing any warning signs yet.

Anemic volume

One of the adages of technical analysis is price follows volume. The current advance on low volume has raised concerns about a negative divergence. Joe Granville codified volume measures with his On Balance Volume Indicator.

The theory is that traders should be able to spot patterns of accumulation and distribution with OBV. Watch for positive or negative divergences, they said.

Here is the OBV pattern of SPY. Did the negative divergence in 2017 lead to a correction, or the positive divergence after the VIXmageddon collapse in February 2018 lead to market recovery?

Here is the OBV pattern of the index. The latest episode of advance on low volume, as measured by OBV, is less pronounced. However, the negative divergence in 2017 did not lead to market weakness.

There is a lesson to be learned here. Market structure has changed from the days that Granville formulated his OBV Indicator. Volume statistics are less reliable today. More trades are reported off the NYSE tape, or the consolidated tape. Trades are done off exchange in crossing networks. The presence of HFT algos are also polluting the volume data.

Not all indicators work forever.

Buyback blackout

Another reason to be bearish is the buyback blackout as we enter Earnings Season.

Matthew Bartolini at Alpha Architect studied the October 2018 correction, and he thoroughly debunked the theory that buybacks are supporting the stock market:

If buybacks were the cause of the market correction, we would expect to see poor performance before earnings announcements. Looking at the dates surrounding releases, there is no evidence of worse performance around earnings season. Broadening our scope, the regressions show residual alpha in each time period. The residual alpha should be taken with a big grain of salt since the regressions do not show significance across any time period.

Bottom line: The market isn’t going to fall because of a buyback blackout.

Reasons to be hopeful, and cautious

From a trading perspective, there are some reasons to be hopeful, and to be cautious. The market’s sideways action this week is supportive of its slow grind upwards. The hourly chart shows that the market’s weakness halted just short of a gap at 2900, but capped by a rising resistance trend line at about 2915. Moreover, the index may be caught between a wedge, which should be resolved with a breakout within the next week.

On the other hand, positive seasonality has only just begun. Ryan Detrick at LPL Financial pointed out that the market is just entering its most favorable period of April seasonality. The market tends to make most of its gains in the second half of the month.

My inner trader remains bullishly positioned.

Disclosure: Long SPXL

Can the market advance continue? Watch China!

Posted by Cam Hui - April 15, 2019

The US equity market has risen more or less in a straight line since the Zweig Breadth Thrust buy signal of January 7, 2019 (see A rare “what’s my credit card limit” buy signal). Technically, breadth thrusts are extremely rarely long-term bullish signals. How far can stock price rise from here?

Chris Ciovacco made a recent video which studied the market behavior of breadth thrusts that came to a bullish conclusion. He defined a breadth thrust as % of stocks above their 200 dma rising from 10% to over 70% in a short period. This has happened only twice in the last 15 years. The first time was the rally off the Lehman Crisis bottom of 2009, and the next time was the eurozone Greek Crisis of 2011.

Ciovacco pointed out that the current breadth thrust occurred more rapidly than either 2009 or 2011, which is a sign of bullish price momentum.

He went on to outline the bullish market performance in the wake of these breadth thrusts (warning, N=2).

Can history repeat itself? Do current fundamentals support further market strength?

Here is an “out of the box” answer to the question of further market strength: Watch China.

A cyclical recovery

I have been writing in these pages about a global cyclical recovery for several weeks. The market became excessively cautious in Q4, and it was surprised by the combination of Fed dovishness, and wide ranging effects of Chinese stimulus.

In particular, the market underestimate the degree of Chinese stimulus. A examination of the performance of cyclical vs. defensive stocks by region shows that it was EM that turned first, followed by the US, and now by the other regions in the world.

This chart from Tom Orlik of Bloomberg Economics on Total Social Financing (TSF) tells the story of stimulus. Is it any wonder why we are seeing a global cyclical recovery?

For some perspective, the TSF ramp came to about 9% of GDP.

What next?

The key question for investors is, “Can this stimulus program continue?”

Leland Miller of China Beige Book explained what happened and his prognosis in a Yahoo Finance interview. Beijing did not want a repeat of the slowdown panic of 2015, so they pulled out all stops and flooded the system with liquidity. Anyone who wanted a loan got it – the local authorities, the stressed SMEs, anyone. What was different about this stimulus program was the cost of debt did not go down as it did with previous programs. Instead, interest rates rose. If Beijing wants to continue its stimulus into Q2 and Q3, then it will have to subsidize financing costs. At some point, the subsidies will be untenable. Miller believes that China is hoping that a trade deal will alleviate some of the growth pressures, and they can take their foot off the accelerator on their stimulus initiative.

Keep in mind that China will be celebrating its 70th anniversary of Mao’s victory in October, and the leadership will not want to be embarrassed by a tanking economy. My personal guess is they will pull out all stops to continue their stimulus until Q3. Then all bets are off.

What to watch

The first sector to feel the effects of a shift in policy is the highly leveraged property developers. Regular readers will recall that I was closely monitoring large developers like China Evergrande (3333.HK) last October for signs of cracks in the Chinese economy. The share prices of property developers tested their lows in October, but the market did not break.

I had highlighted the China real estate ETF (TAO) as a possible speculative buy candidate last week (see Selections for a new bullish impulse). The performance of this sector may be more useful as a market indicator than a long candidate, as the fortunes of this sector is highly dependent on the Beijing’s whims. While the fit is not perfect, the relative performance of TAO to the Chinese market can be a useful canary in the coalmine of the PBoC’s policy intentions, particularly at relative price performance extremes. As the chart below shows, the relative returns of TAO (bottom panel) roughly coincided with the growth scare in 2015, and in late 2018.

Similarly, we can see how the shares of China Evergrande reacted during the Panic of 2015, and during the eurozone and Greek crisis of 2011.

My inclination is to give the bull case the benefit of the doubt. Technical momentum has historically been a powerful bullish signal. At the same time, keep an eye on the Chinese property sector for signs of fading stimulus.

Disclosure: Long SPXL

How “patient” can the Fed be?

Posted by Cam Hui - April 14, 2019

The latest signals of each model are as follows:

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

What are the limits to “patience”?

The credit market may be setting up for an unpleasant surprise. According to the CME’s Fedwatch Tool, the market mainly expects no change in the Fed Funds rate for the rest of this year, with the possibility of a cut later in the year. It is not expecting a rate hike. Politico reported that Trump’s economic advisor Larry Kudlow went even further: “I don’t think rates will rise in the foreseeable future, maybe never again in my lifetime.”

The minutes of the March FOMC meeting tells a different story. Since the Fed made the U-turn and adopted the policy of “patience”, the Committee is not expecting any changes in rates for the rest of 2019:

A majority of participants expected that the evolution of the economic outlook and risks to the outlook would likely warrant leaving the target range unchanged for the remainder of the year.

However, some members would not rule out another increase in interest rates this year. The strength in the labor market could raise economic growth in the months ahead, though not as rapidly as last year.

Underlying economic fundamentals continued to support sustained expansion, and most participants indicated that they did not expect the recent weakness in spending to persist beyond the first quarter. Nevertheless, participants generally expected the growth rate of real GDP this year to step down from the pace seen over 2018 to a rate at or modestly above their estimates of longer-run growth.

There was also some uneasiness over the use of the word “patient” as it could be viewed as handcuffing future actions if the time came to raise rates:

Several participants observed that the characterization of the Committee’s approach to monetary policy as “patient” would need to be reviewed regularly as the economic outlook and uncertainties surrounding the outlook evolve. A couple of participants noted that the “patient” characterization should not be seen as limiting the Committee’s options for making policy adjustments when they are deemed appropriate.

Who is right? The market or the Fed? If the bond yields start to rise, what does that mean for stock prices?

Mixed signals from the labor market

Let’s start with an analysis of the labor market, as that is one of the Fed’s key indicators of the economy. Some concerns were raised by the release of the JOLTS report last week, as the headline job openings figure plunged.

I tend to discount the job openings number as noisy and unreliable because employers have advertised job openings when there are no jobs available in order to troll for resumes. The actual hires and quits figures from the same JOLTS report did not show a rapidly deteriorating job market. Hires made a new cycle high last October, and quits made a new high in January. Neither have fallen as dramatically as job openings. Does this look like the picture of a labor market falling off a cliff?

To be sure, there are some signs of wobbles in the labor market. Historically, temporary jobs (blue line) have led the headline Non-Farm Payroll figure (black line) by several months, and the March Jobs Report shows that temp job growth is stalling. However, a BLS study found a similar leading/lag relationship between the quits to layoffs ratio (red line) and NFP. The latest JOLTS report shows is not confirming the weakness in temp jobs. There is no need to panic, but we will have to keep an eye on these indicators.

In addition, initial jobless claims fell below 200K last week, which is another cycle low. This does not look like the picture of labor market weakness. As a reminder, initial claims have been highly inversely correlated to stock prices.

A warning from small business?

Another worrisome sign appeared with the latest monthly NFIB small business survey. Small businesses can be regarded as sensitive economic barometers and the canaries in the coalmine because of their lack of bargaining power. Joe Wiesenthal at Bloomberg pointed out that small businesses who cite “poor sales” as their biggest problem (white line) has been ticking up, while businesses who cite “quality of labor” as their biggest problem (cyan line) has been falling. The bottom panel of the chart below shows the spread between the two series. While NFIB data can be noisy, and this indicator has flash false positive signals of economic weakness (red circles) in the past, this is something to keep an eye on.

NFIB data can be very noisy and contradictory. Other analysis reveals that NFIB selling prices lead core CPI by about 11 months. How soft can the economy be if leading indicators of inflation are accelerating?

Financial stability risk

Ultimately, what matters to the Fed is the “balance of risks”. Is the economy weakening, or is the softness only temporary? What are the risks to financial stability, as this Fed chair has made this unspoken “third mandate” a key plank of monetary policy. Since financial stability was the root cause of the last two recessions, he wants to ensure that financial risks do not destabilize the economy.

Here, the picture is mixed. The Chicago Fed’s National Conditions Leverage Subindex shows that while financial conditions for banks (blue line) are relatively tame, the level of stress for non-financials (red line) is rising.

There was good news and bad news from the quarterly senior loan officers survey. The bad news is banks tightened credit in Q4 for both small businesses (blue line) and on individuals’ credit cards (red line). The good news is conditions are not alarming and there are no signs of an outright credit crunch.

None of these readings are in red alert territory, but they do serve to underline the financial stability risks.

Green shoots of recovery
The FOMC minutes cited foreign weakness as a source of downside risk:

A number of participants judged that economic growth in the remaining quarters of 2019 and in the subsequent couple of years would likely be a little lower, on balance, than they had previously forecast. Reasons cited for these downward revisions included disappointing news on global growth and less of a boost from fiscal policy than had previously been anticipated.

However, a number of global “green shoots” are appearing. Tony Dwyer of Canaccord Genuity observed that while global PMIs are falling, PMI breadth (middle panel) is starting to improve.

Callum Thomas also pointed out that the relative performance of cyclical to defensive stocks are rebounding all around the world.

As well, the PMI of the users of cyclically sensitive commodities, namely copper, steel, and aluminum, are all turning up.

Bullish or bearish?

How do we interpret these signals? How patient can the Fed be under these circumstances?

Much depends on the Fed’s view of the balance of risks. While the balance of risks are current even, the current trajectory of economic growth suggests that growth risks will start tilting toward the upside as the year progresses, which will pressure the Fed to raise rates later this year.

In the past, the industrial metals to gold ratio has been a reliable barometer of global growth expectations, and bond yields. Industrial metals to gold has been highly correlated to the 10-year Treasury yield in the last 20 years. Growing evidence of renewed growth should start to put upward pressure on yields in the near future.

However, rising bond yields are not necessarily fatal to stock prices. One possible template for today’s market may be the late 1990’s. The 2s10s yield curve inverted during the summer of 1998, but it was unconfirmed by the 10s30s yield curve. Today, the 3m10y yield curve inverted, but the 2s10s did not, and the 10s30s had been steepening, instead of flattening. While the 2s10s spread is about 15bp, the 10s30s is over 40bp, which is a highly definitive repudiation of the yield curve inversion or flattening message. In both instances, the Fed stepped in. In 1998, it was in response to the Russia/LTCM Crisis. Today, the Fed made an abrupt policy U-turn to become “patient”. What’s more, global monetary policy has also begun to turn away from tightening.

Here is what happened next in 1998. Growth began to recover, and the 10-year yield rose as a consequence, but stock prices also rose in response to the growth recovery and the Fed’s easy monetary policy, until the ultimate NASDAQ Bubble Top in early 2000.

History doesn’t repeat itself, but rhymes. While I am not forecasting a similar blow-off top, there is still considerable upside potential in stock prices even if growth were to rebound and 10-year yields rise.

In conclusion, the market has likely misjudged the degree of the Fed’s patience. I expect a growth revival later this year will put pressure on the Fed to raise rates, and bond yields will rise. However, this is not necessarily bearish for stock prices, as long as the bullish effects of rising growth expectations outweigh the negatives of rising rates.

The week ahead: Earnings Season ahead

Looking to the week ahead, much of the short-term outlook for stock prices will depend on the reports from Q1 Earnings Season. So far, there are some hopeful signs for the bulls.

FactSet pointed out that the market is entering Earnings Season with diminished expectations: “For Q1 2019, the blended earnings decline for the S&P 500 is -4.3%.” However, with only 6% of the index reporting, the earnings beat rate is 83%, which is above the 5-year average of 72%. Earnings estimates are also coming at 7.5% above expectations, which is above the 5-year average of 4.8%.

If we were to combine the expected EPS growth decline of -4.3% with the 5-year average earnings beat of 4.8%, the market might just manage to avoid the earnings recession, a positive surprise.

In addition, the forward outlook remains positive. FactSet reports that forward 12-month EPS have been recovering and they are rising again, indicating positive fundamental momentum.

To be sure, companies are citing concerns over FX, labor costs, and materials as earnings headwinds. While these factors have not negatively affected the trend of upward estimate revisions, we will have to watch how this affects margins and inflation expectations in the weeks ahead.

Another possible bullish signal comes from insider activity. While this signal is not as strong as it has been in the past, the latest report from Open Insider shows that insider selling has virtually dried up while the level of buys remain about the same. Recent definitive buy signals occurred during period of market weakness, and the latest mini cluster of insider buying in the face of rising stock prices is constructive for the bull case.

From a technical perspective, the market continues to grind up while exhibiting a series of “good overbought” readings on RSI-5, only to see the rally stall and consolidate as RSI-14 reaches overbought territory at 70, tests the rising trend line, and see the VIX test its lower Bollinger Band (bottom panel).

As of Friday’s close, the market stands at a near overbought condition, and it would only take a minor one-day rally for it to flash cautionary signals.

A variety of sentiment models are also supportive of further intermediate term gains. The AAII Bull-Bear spread, which measures individual investor opinion, has reached 20, but the past history of such readings has been a mixed bag. In some cases, the market has reversed course and corrected, but it has continued to grind upwards in other cases.

Similarly, the TD-Ameritrade Investor Movement Index, which measures how the firm’s clients are acting in their accounts, shows that bullishness is recovering, but readings can hardly be described as a crowded long.

The NAAIM Exposure Index, which measures the opinions of RIAs, saw a minor retreat in bullishness last week. While readings are a little elevated, they are not at a bullish extreme, which would be contrarian bearish.

Similarly, Investors Intelligence sentiment, as measured by the bull-bear spread, is firmly in neutral.

Estimates of hedge fund equity exposure do not indicate excessive bullishness either. The Commitment of Traders data of NASDAQ 100 futures, which is usually the high beta vehicle of choice for hedge funds, indicate that large speculators covered their shorts from a crowded short to a neutral position (via Hedgopia).

Long-short hedge funds market exposure estimates have fallen to lows not seen since 2013.

Finally, the market is likely to see some seasonal tailwinds in the coming week. It is option expiry week, and Rob Hanna at Quantifiable Edges found that April OpEx is one of the strongest OpEx weeks of the year.

My inner investor is bullish, and he is slightly overweight equities in his portfolio. My inner trader is also bullish. He is prepared for a week marked by some choppiness, but with a bullish bias.

Disclosure: Long SPXL

Selections for a new bullish impulse

Posted by Cam Hui - April 10, 2019

-week market update: Numerous signs of a new bullish impulse are appearing.

The American economy has sidestepped a recession;
Sentiment is not excessively bullish; and
Price momentum is strong.

It is a truism in investing that you should buy when blood is running in the streets. The latest update of NDR’s Global Recession Model shows the probability of a global recession, which is defined as sub-3% growth, at 96.63%.

One application of that rule is to buy risky assets when a recession is evident to the public. It seems that we have reached that point, what should we buy?

Dodging the recession

Let’s start with the good news. Greg Ip at the WSJ wrote that “The World Seems to Have Dodged Recession, for Now”:

If the world was at risk of sliding into recession, policy makers appear to have pivoted in time to prevent it.

In the U.S., the slowdown never got started. March capped a quarter in which jobs grew as fast as they did in the fourth quarter. Growth in private hours worked, a better gauge of business labor demand, actually accelerated.

In the rest of the world, a rise in China’s purchasing managers index in March suggests its slowdown may be ending and a modest improvement in German industrial production in February sparked hopes for the same there. In sum, while recession fears haven’t entirely receded, the panic that gripped financial markets last year now looks misplaced.

Josh Brown, otherwise known as The Reformed Broker, thinks that the recession panic was overdone. He stated on CNBC that the US has never imported a recession from abroad:

Recession fears have been reignited amid weakening global conditions, but recessions have never been contagious and the U.S. is doing just fine, according to Josh Brown, CEO of Ritholtz Wealth Management.

“The consumer is on fire. The small business owner is on fire. Financial conditions have not been easier in 13 years. Money is flowing and businesses are growing,” Brown, also a CNBC contributor, told CNBC’s “Halftime Report.”

“Can you think of a recession from anywhere international that we’ve imported over here? It’s never happened. Even in 1998 when every country in Asia melted down, devaluation of the Ruble, complete banking fiasco all over the place in Latin America, we didn’t have a recession as a result to that,” he added.

The economic stresses that have been manifesting in Europe, China, and Japan are worrying many of a global slowdown. Adding to the fears is the deteriorating U.S. data including durable goods, Markit PMI and manufacturing survey, but Brown said the data is skewed by the government shutdown and will soon recover.

“The first quarter is always disappointment,” Brown said, referring to a phenomenon called residual seasonality. “In some years, we had that because of major northeastern snowstorms. In other years, we had that because of the falling price of the oil. It happens every single year.”

“You will see a bounce back in the data when we get deeper into Q2 right on schedule,” he said.

Jurrien Timmer at Fidelity pointed out that US equities is following roughly the same path as the non-recessionary drawdowns of 1994, 1998, and 2011 (via Callum Thomas).

Supporting sentiment

Add to the equation a backdrop of supportive sentiment. The University of Michigan survey of the public’s believe that the stock market will rise has pulled back from a high of 66.7% to 57.1%, While that reading is still a little elevated, there is room for sentiment to become more bullish.

Momentum returns

The turnaround from excessive caution about an economic slowdown is showing up in rising price momentum. Brett Steenbarger at TraderFeed wrote on Monday:

I noticed an interesting event at the Friday close. Over 80% of all SPX stocks closed above their 3, 5, 10, 20, 50, and 100-day moving averages. (Data from the excellent IndexIndicators.com site). That is very broad strength. Going back to 2006, we’ve only seen 23 similar occurrences–and none since 2013! Many of those occurrences were seen in 2009 and 2010 and then again in 2012 and 2013 during protracted rises following market weakness. Indeed, if we examine those 23 occurrences over the next 20 and 50 days, we find 17 occasions up and 6 down for both time frames. The average 20-day gain was about 1.5%.

What this says to me is that we’re seeing significant upside momentum in stocks. Historically, such momentum has led the market higher, though not necessarily at the same rate previously seen. The main takeaway is that we can’t conclude that we’re heading lower simply because we’re “overbought”. Whether we think the valuations are justified or not, whether we like macroeconomic forecasts or not, equities have found meaningful demand. Perhaps that’s not so surprising in a world of low interest rates and tepid growth: U.S. stocks may offer some of the few havens for yield and growth. It may also be the case that the stock market, which has been kindly disposed to the current U.S. administration ever since the 2016 election, could display similar behavior should odds of re-election increase.

In any case, we’re seeing broad strength and few signs of weakness. A normal correction, given low levels of volatility and volume and the fact that stocks making new 52-week highs are not expanding, is clearly a possibility. If the mood of participants that I speak with is indicative of a more general mood, any such pullback may find interest from frustrated traders late to the party.

In other words, get ready for the dip buyers to stop waiting for the dip and pile in on the long side.

What to buy?

If global stock prices are poised for another bull leg, what should you buy? I have a number of suggestions, both in the US and internationally.

Let’s start in the US. The macro backdrop is a cyclical rebound, and cyclical stocks appear to be the emerging leadership. Industrial stocks (XLI), semiconductors, (SMH) and transportation (IYT) are all turning up relative to the market.

Across the Atlantic, it may be a little too early to be buying cyclicals, especially in light of the latest Trump tariff threat. The following chart shows performance of core and peripheral Europe against the MSCI All-Country World Index (ACWI). Surprisingly, Germany, which is the growth locomotive of the eurozone and its export leader, is underperforming. On the other hand, the pattern is the more “peripheral” the country, the greater the outperformance. The countries exhibiting the broadest based relative bottoms are Italy and Greece.

Yes, that Italy. That Greece. For some perspective of how much Greece has recovered, just take a look at this chart of the yield on 10-year Greek debt. In Europe, it seems that the dominant theme is contrarianism and financial healing.

The ACWI relative charts of China and her major Asian trading partners tell another story. The country showing the best momentum is Hong Kong. Despite all the excitement over a US-China trade truce, and China’s stimulus program, the Shanghai market has been range-bound against ACWI for 2019. The other Asian markets are also range-bound relative to ACWI, though two (Singapore and South Korea) are tracing constructive double bottom patterns.

In Asia, you might want to bet on momentum. A really speculative choice might be the Chinese real estate stocks (TAO). I am indebted to my former Merrill Lynch colleague Fred Meissner of The Fred Report for bring this to my attention, though he does not explicitly recommend a position. The relative performance of TAO to both China (FXI) and ACWI has been astounding. Though TAO is a little extended, it is an aggressive way of gaining exposure to Beijing’s stimulus programs, whose effects appear quickly in the highly leveraged real estate sector.

There you have it. Bullish investors can position themselves with a diversified selection of investment themes and factors around the world, with exposure to a cyclical rebound in the US, beaten up contrarian exposure in Europe, and momentum in Asia.

Disclosure: Long EWI

Making sense of Trump’s pressure on the Fed

Posted by Cam Hui - April 8, 2019

I am somewhat at a loss of why Trump is putting so much pressure on the Federal Reserve. In a recent CNBC interview, CEA chair Kevin Hassett projected that growth would rise again to 3% later this year. “Everything we see right now is teeing us up to have a year like last year – Q1 around 1.5% or 2%, then Q2 goes way north, carries you into a 3% year.”

After the BLS reported a strong than expected March Jobs Report last Friday, Donald Trump repeated his assertion that the Fed should shift to an easier monetary policy (via CNBC):

President Donald Trump said Friday the U.S. economy would climb like “a rocket ship” if the Federal Reserve cut interest rates.

Commenting after a strong jobs report for March, Trump said the Fed “really slowed us down” in terms of economic growth, and that “there’s no inflation.”

“I think they should drop rates and get rid of quantitative tightening,” Trump told reporters, referring to the Fed’s policy of selling securities to unwind its balance sheet, a stimulus put in place during the financial crisis. “You would see a rocket ship. Despite that we’re doing very well.”

A “hot” economy

Robin Brooks of the Institute of International Finance believes that if economic growth remains on the current trajectory, the unemployment rate is destined to fall a lot lower.

With unemployment at 3.8% (yellow) and participation at 63.0% (vertical), break-even jobs growth – the monthly pace needed to keep unemployment at 3.8% for participation at 63.0% – is only 120k (horizontal). We’re averaging 200k, so U-3 unemployment is likely headed a lot lower.

Do a 3% growth rate and a strong jobs market constitute good reasons for the Fed needs to ease in a dramatic fashion?

Counterweights to Powell

In addition, Trump announced that he is nominating economic commentator Stephen Moore and former pizza chain executive Herman Cain as governors of the Federal Reserve. The White House hopes that the additions would act as counterweights to the perceived hawkishness of Fed chair Jerome Powell.

While many market participants and economists are in an uproar over the nomination of Moore and Cain (see the CNBC Wall Street survey which showed that 60% of respondents were against Moore’s confirmation, and 53% against Cain’s confirmation), their confirmation in the Senate is no slam dunk. The current verdict on PredictIt for both Moore and Cain’s confirmations are highly unfavorable.

As well, the WSJ reported that Cain cast doubt as to whether he would actually be confirmed by the Senate:

Herman Cain, President Trump’s latest choice for the Federal Reserve Board, expressed caution about his chances of making it through the vetting process that precedes a formal nomination.

In a video posted Friday evening to Facebook , Mr. Cain dwelled on the arduous nature of the background check conducted before the White House submits nominations to the Senate for confirmation.

“They have to collect an inordinate amount of information on you, your background, your family, your friends, your animals, your pets, for the last 50 years,” Mr. Cain said. He added that the endeavor would likely be “more cumbersome” in his case because he has held a large number of roles throughout his career.

“Whether or not I make it through this process, time will tell,” Mr. Cain said. “Would I be disappointed if I don’t make it through this process? No. Would I be thrilled and honored if I do make it through this process? Yes.”

Why is Trump putting so much pressure on the Fed?

Trump’s economic report card

Soon after Trump’s inauguration, I laid out a series of criteria for the economic success of Trump’s presidency (see Forget politics! Here are 5 key macro indicators of Trump’s political fortunes). By those yardsticks, Trump is performing quite well.

The economic success of the Trump presidency is based on the criteria as outlined by Newt Gingrich in a New York Times interview:

“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”

“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”

Trump has performed reasonably well based on the Gingrich criteria. First, there have been no major incidents of terrorism within US borders, at least the ones that matter in a political sense. As an example, the casualty count of the mass shooting in Las Vegas was much higher than that of the Boston Marathon bombing, but the prevailing political view is the latter poses a much bigger than to the safety of Americans.

I had created five economic yardsticks for the Trump administration based on the Bloomberg Intelligence economic criteria. Here is how he is performing a little over two years later.

The prime age labor force participation rate has been improving steadily.

Trump promised good jobs. That means full-time jobs. Full time workers as a % of the labor force has been trending upwards.

What about manufacturing? The intent of Trump’s trade policy is to bring back manufacturing jobs. The bad news is manufacturing jobs as a % of the economy has been flat. The good news is the multi-decade declining trade trend has been arrested.

Trump promised a program of tax cut and deregulation would revitalize the economy and induce companies to repatriate offshore profits, and raise capital expenditures. Did it? Not really. The capex to GDP ratio has been flat.

Finally, Bloomberg Intelligence suggested net business births as another economic criteria of Trump’s success. While there is no timely way of measuring net business births, I did turn to NFIB small business confidence as a proxy. Small business confidence did surge after Trump’s election, but they have fallen in the last few months.

We saw a similar pattern in small business sales and expectations.

While I recognize that Donald Trump is a highly polarizing figure. In an alternate universe, if this was the record of any other Republican occupant of the White House, such as Marco Rubio, Jeb Bush, Mitt Romney, just to name a few, the administration’s economic record would be judged to be a success. While there are some inevitable hits and misses, the grade would be, at a minimum, a solid B.

Political insurance?

It is with that report card in mind that I pose the following puzzle. The jobs are coming back. The economy is growing at a reasonable pace. Why is Trump squeezing the Fed so hard?

He is already winning on the economy. Stock prices are up about 33% on an un-annualized total return basis since his inauguration.

Is he just trying to run up the score as a form of insurance?

If so, the insurance will costing him a lot of political capital.

An unusual sweet spot for equities

Posted by Cam Hui - April 7, 2019

The latest signals of each model are as follows:

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

Opportunities from uncertainty

Now that stock prices have recovered to within 2% of their all-time highs, what’s next for the stock market? To be sure, stock prices are no longer cheap. FactSet reports that the market is trading at a forward P/E ratio of 16.7, which is just above its 5-year average of 16.3 and well above its 10-year average of 14.7.

Should investors throw in the towel? Not yet. While valuations are not compelling, equities remain in a sweet spot as cautious long-term sentiment readings can drive prices higher.

Strategas published a terrific analysis showing how forward US equity returns have historically been higher when global policy uncertainty is high. While the sample size for this study is small, it is consistent with the contrarian principle of buying when blood is running in the streets.

Indeed, the latest reading of global policy uncertainty shows that it remains at an elevated level.

Despite the elevated valuation, equities find themselves in an unexpected sweet spot. There is still room for stock prices to rise as tensions and risk levels fade.

The Mexico border climb-down

The good news is, risk levels are fading. President Trump threatened to immediately close the border with Mexico if the Mexican government didn’t act, or if Congress didn’t act to control illegal border crossings. This week, he climbed down from his threat to close the border right away by giving Mexico a year to mitigate border crossings, or he would either close the border or put tariffs on autos crossing the border.

Fed nomination controversies

At the same time, Trump had been pressuring the Fed to pursue an easier monetary policy and cut rates.

That tweet was followed by a CNBC interview with economic advisor Larry Kudlow, who called for the Fed to immediately cut by 50bp.

Top White House economic advisor Larry Kudlow wants the Federal Reserve to “immediately” cut interest rates by 50 basis points.

“I am echoing the president’s view — he’s not been bashful about that view — he would also like the Fed to cease shrinking its balance sheet. And I concur with that view,” Kudlow told CNBC on Friday.

“Looking at some of the indicators — I mean the economy looks fundamentally quite healthy, we just don’t want that threat,” he added. “There’s no inflation out there, so I think the Fed’s actions were probably overdone.”

After Friday’s better than expected March Jobs Report, Trump repeated his call for the Fed to cut interest rates. He went further and said the Fed should stop its quantitative tightening program and begin quantitative easing.

Trump nominated Stephen Moore and Herman Cain to fill the two open seats on the Board of Governors of the Federal Reserve. The only common element between the two candidates is they have been strong supporters of Trump policies in the past, as well as past hard money advocates.

Moore penned a recent WSJ Op-Ed entitled “The Fed Is a Threat to Growth”, subtitled “The real economy is ready to reignite, but Powell’s tight-money policy is acting like a wet blanket”, which summarizes his views well, However, his views on low interest rates appears to be a function of what year it is (and presumably the party in control of the White House at the time).

From the New York Sun, April 24, 2016: “A second reason for the business investment slump is monetary policy. While this may not be the right time for rate hikes, ultra-low interest rates have led to financial engineering rather than the deployment of excess corporate cash for productivity enhancing investments.”

From an interview with Brian Lehrer, April 3, 2019: “On balance I think low interest rates are a good thing. They mean that businesses can invest and borrow at low prices. It means that if you want to buy a home – I always tell people my gosh this is the golden age to buy a home, Brian…So I don’t have a problem with low interest rates”.

Establishment economists have been aghast at Moore’s nomination. He was not trained as an economist, Instead, he spent most of his professional life as an economic commentator on tax policy. Even Greg Mankiw, who was Bush 43’s CEA chair, took the unusual position of publicly opposing Moore’s confirmation due to his lack of qualification and partisanship.

A couple of weeks ago, I gave a talk at the Federal Reserve Bank of Dallas. I said that, although I am not a fan of President Trump, I have to give him credit for making good appointments to the Fed. I was thinking about people like Jay Powell, Rich Clarida, and Randy Quarles.

Then today the president nominates Stephen Moore to be a Fed governor. Steve is a perfectly amiable guy, but he does not have the intellectual gravitas for this important job. If you doubt it, read his latest book Trumponomics (or my review of it).

It is time for Senators to do their job. Mr. Moore should not be confirmed.

In an interview with Bloomberg TV, Moore was asked about his view on the correct size of the Fed’s balance sheet (starts at about 11:00). Moore replied, “To be honest, I’m going to have to study up on this one”. In reality, he had authored a 2014 Heritage Foundation paper, Quantitative Easing, The Fed’s Balance Sheet, and Central Bank Insolvency addressing this very issue.

Another common element between Moore and Cain is both are hard money advocates. In September 2015, Moore voiced his support for getting rid of the Federal Reserve and returning to a gold standard (click this link if the video is not visible).

Herman Moore’s credentials are a little bit more mainstream. He was on the board of directors of the Kansas City Fed from 1992 to 1996, eventually becoming the chair, though his role had little to do with monetary policy. Like Moore, Cain is a strong Trump supporter. He co-founded the America Fighting Back PAC. The home page tells the story of the PAC’s political leanings.

It is puzzling that Trump would choose to nominate Herman Cain to be a Fed governor, because the entire history of Cain’s approach is contrary to Trump’s favor of low interest rates. Cain has always been a hard money advocate, and he has strongly believed in a gold standard. He penned a WSJ Op-Ed in 2012 calling for its adoption:

Article I, Section 8 of the Constitution grants power to Congress “to coin Money, [and] regulate the Value thereof.” But for the last 40 years in Washington, regulate has meant manipulate, with the Federal Reserve raising and lowering interest rates and buying and selling assets at its own discretion. All of this manipulates the value of the dollar. We regulate time by making sure an hour is always a fixed quantity of minutes and a foot is always a fixed quantity of inches. The more complex a society, the more it depends on fixed and rigorously reliable standards. A dollar should be defined—as it was prior to 1971 under the postwar Bretton Woods system—as a fixed quantity of gold.

Paul Krugman cited just one recent example of the dire effects of a gold standard straitjacket.

To be sure, Herman Cain was never the sort of “low interest guy” that Trump favors. In a recent editorial, while Cain was supportive of Trump’s policies, he also justified rising rates that accompanies higher economic growth as “a good thing”.

The main thing to understand is that economic activity is picking up, and that’s what’s driving the rise in interest rates. Retail activity has turned out much stronger this holiday season than economists were predicting. Jobless claims are down. Business investment is up. And a tax cut is coming within days.

The first year of the Trump Administration has not produced everything we wanted, but the overall economic performance has been triumphant, and we’re just getting started. That’s why interest rates are rising, and that’s why you should understand it’s very good news.

While many market participants may find Trump’s attempt to politicize the Fed to be disturbing, the purpose of these pages is not to discuss what should happen, but the market implications of likely events and policies. While Trump may believe that Moore and Cain could act as counterweights to Powell’s hawkishness, Moore will likely become a conditional dove (when a Republican occupies the White House) and Cain is an uber-hawk and anti-inflation fighter. If both are confirmed, their views will offset each other.

Reflationary surprise ahead?

In the meantime, global central bankers have all gone on pause as the risk of a global slowdown is rising. The Fed has turn to “patience” as a mantra, citing the combination of slower growth and uncertainties from abroad. The NDR Global Recession Model shows a high likelihood of recession, which is defined as sub-3% growth, and not the same way as US recessions.

However, the world may be in for a rebound. The better than expected PMI from China, upbeat ISM, and better than expected March Employment Report, which I forecasted (see A March Jobs Report preview) are foreshadowing a possible global reflationary surprise.

The behavior of global stock prices is supportive of the global reflationary thesis. Callum Thomas recently observed that the incidence of “golden crosses”, a condition where the 50 dma rises above the 200 dma as signals of improving stock indices trends, is rising all around the world.

As well, analysis from Yardeni Research indicates that forward 12-month estimates have bottomed and they are rising across all market cap bands, indicating positive fundamental momentum.

Even the Atlanta Fed’s GDPNow nowcast of Q1 GDP growth has recovered to 2.1% from a near zero reading in March.

The ECRI’s Weekly Leading Index is also turning up, though readings remain in negative territory.

Investment implications

I have written before about the excessively defensive posture of institutional managers. State Street sentiment, which is derived from the actual holdings of US managers and what they do with their money, shows a high degree of cautiousness.

The BAML Fund Manager Survey of global institutional managers also indicate a historically low weighting in equities.

There are other indicators of sentiment, each measuring a different constituency. The Commitment of Traders measures futures traders and fast money hedge funds, NAAIM measures RIAs serving retail investors, and AAII weekly sentiment measures mostly individual day and swing traders. What matters the most to long-term sentiment is institutional investor positioning. While these behemoths move at a glacial pace, their big money flows, once started, can persist for months and quarters, and therefore they are best when forecasting the long-term outlook. Right now, institutions are very cautious. At a minimum, that should put a floor on any corrections as the breadth of any selling should be limited.

In short, the combination of overly defensive institutions in an environment that is coming out of a growth scare, and falling policy uncertainty puts equities in an unusual sweet spot. A turnaround after a period of excessive pessimism creates the conditions for a FOMO rally of risky assets. I expect equity prices will be considerably higher by year-end.

The week ahead: “Good overbought” advances

Looking to the week ahead, the stock market appears to be repeating the pattern of grinding up while flashing a series of “good overbought” readings on RSI-5, only to see the advance stall when RSI-14 reaches the overbought level of 70. The Index is now testing the upper end of a rising channel, while RSI-14 is overbought, indicating a high likelihood of a minor pullback early in the week.

Breadth indicators are generally constructive for the bull case. The S&P 500 Advance-Decline Line made another all-time high Friday, which is a positive sign of bullish breadth. Two of the other three breadth indicators are bullish, with % bullish and % above the 200 dma advancing to fresh recovery highs as stock prices rallied. Only the % above the 50 dma flashed a negative divergence. I interpret these conditions as long-term bullish, but a pullback can happen at any time.

The breadth indicators for the NASDAQ 100 are also exhibiting a similar constructive pattern. The NASDAQ 100 Advance-Decline Line made a fresh all-time high, and both the % bullish and % above the 200 dma rose to new highs as the index rose.

An analysis of market cap leadership is also constructive for the bull case. The performance of both mid and small cap stocks made double bottoms relative to large caps (troops leading the generals). As well, NASDAQ 100 stocks remain in a constructive relative uptrend.

Credit markets are also confirming the equity market advance. The price performance of high yield (junk), investment grade, and EM bonds relative to their duration-adjusted Treasury benchmarks are not diverging from stock prices.

Although the weekend Barron’s cover did flash a “magazine cover” contrarian cautionary signal.

However, SentimenTrader pointed out that Barron’s does not function well as a good contrarian magazine cover indicator.

A survey of sentiment indicators are not at extreme levels, which gives room for the market to rise further. AAII weekly sentiment is neutral, despite the recent market rally.

The NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investors’ funds, spiked last week. Readings are not yet at bullish extremes, and the spike could be indicative of a FOMO rally as advisors pile into stocks.

Option market sentiment is not at a crowded long either. The term structure of the VIX Index (middle panel) is below average, but readings cannot be considered to be a crowded long. The VIX Index (bottom panel) has also not breached below its Bollinger Band, which is a signal of an overbought stock market.

The 30 day moving average of the equity-only put/call ratio is in the middle of its 10-year historical range. Sentiment, as measured by the put/call ratio, can hardly be described as either panic or euphoria, but meh!

Short-term breadth indicators are also showing the similar pattern of rising prices while flashing a series of “good overbought” signals. However, readings are overbought, indicating a high likelihood of a pause or pullback early in the week.

My inner investor is bullishly positioned. He is slightly overweight equities compared to his target equity weights. My inner trader is also bullish and long the market. He is prepared to buy more should the market pull back next week.

Disclosure: Long SPXL

A “green shoots” rally ahead?

Posted by Cam Hui - April 3, 2019

Mid-week market update: Even as the slowdown gloom overtook the market in the past few weeks, stock prices did not break down. Now, the storm seems to be passing as green shoots of growth are starting to appear.

For equity investors, the most notable change was the reversal in forward 12-month EPS estimates, which bottomed and begun to rise again. This is an indication of the return of bullish fundamental momentum.

The combination of an unexpected growth turnaround and excessively cautious positioning is sparking a “green shoots” risk-on rally.

The turnaround

Joe Wiesenthal at Bloomberg summarized the current situation well in his Tuesday morning commentary:

Thanks to weakness from abroad, and the briefly inverted yield curve, there’s a lot of anxiety about recession risk. So it was not surprising to see stocks surge on a day like yesterday [Monday], when we got decent Chinese data, and a U.S. ISM report that was solid all around.

Amidst all of the gloom about a deceleration in Chinese growth, Beijing’s stimulus efforts began to pay off when both China’s official PMI and Caixin PMI prints rose and beat expectations.

The strength was not just isolated to China. ASEAN PMI rose as well, which reflects strength across the entire region.

Combine those upbeat releases with an upside surprise in ISM Manufacturing, and the “green shoots” thesis is complete.

Short equities is the pain trade

On top of that , surveys of institutional positioning shows that managers have been overly defensive going into this turnaround, and you have the ingredients for a pain trade. The latest BAML Fund Manager Survey shows that global managers’ equity weights are historically low.

Similarly, the State Street survey of manager holdings shows that US domestic managers are also defensively positioned.

For some perspective of the differences in sentiment and market positioning, compare the recent surge in global bond prices…

…to global stock prices, and you get the idea.

Notwithstanding the fact that bonds have rallied harder than stocks, analysis from JPM shows that implied recession risk has fallen considerably across most asset classes, which is another bullish sign.

If we were to see evidence of a sustained turnaround in fundamentals, there is a distinct possibility of a FOMO rally that could take the major market indices to fresh highs.

Key risks

There are, however, a number of key risks to my bull case. Large speculators are in a crowded short in VIX futures. Short positioning is more extreme than it was just prior to the market selloff in Q4 2018. This sets up the potential for a VIX rally, and stock market drop.

The market is also subject to the event risk of Trump’s threat to close the Mexican border. Notwithstanding the fact that America would run out of avocados in 2-3 weeks, US-Mexico trade amounts to about $1 million per minute per day, 365 days a year. Closing the border would devastate GDP growth, and stock prices. This story may turn out to have the ups and downs of the China-US trade negotiations, or the impasse that eventually led to the partial government shutdown.

The market has become overbought from a short-term tactical perspective. Hourly RSI-5 recently exceeded 90. If the past is any guide, the market will either consolidate sideways or pull back for a couple of days. If the index were to correct, a logical downside target would a gap fill at about 2835-2848.

My inner investor is bullish and slightly overweight equities. My inner trader is also bullish, and he is prepared to take advantage of any weakness to buy.

Disclosure: Long SPXL

A March Jobs Report preview

Posted by Cam Hui - April 2, 2019

I have two thoughts ahead of the March Jobs Report that investors should consider. Let’s start with the tactical picture of what Friday’s reports might bring.

Recent jobs data has been distorted by the effects of the federal government shutdown, which can make the reported figures nonsensical. Now that the effects of the shutdown are mostly over, we can get a better idea of the overall trend.

One clue comes from the weekly initial jobless claims data, which is reported on a timely basis. As the chart below shows, the week of the February Jobs Report survey coincided with an unusually strong initial claims print, which may have contributed to the shocking miss in the February NFP report of 20K jobs. Initial claims for the March survey week weakened to a level consistent with January’s. In light of the strong January NFP print of 304K jobs, which was later revised to 311K, this suggests that an in line or beat result for March headline NFP estimate of 175K.

Notwithstanding the tactical trading considerations of the March Jobs Report, a new development is likely to affect how the Fed views employment data, which could affect thinking on future policy.

Job market measurement error (and what it means)

A new research paper by Ahn and Hamilton found a number of internal inconsistencies in the job survey data is mis-stating the unemployment rate, and participating rate. These errors can have important policy implications. Here is the abstract:

The underlying data from which the U.S. unemployment rate, labor-force participation rate, and duration of unemployment are calculated contain numerous internal contradictions. This paper catalogs these inconsistencies and proposes a reconciliation. We find that the usual statistics understate the unemployment rate and the labor-force participation rate by about two percentage points on average and that the bias in the latter has increased since the Great Recession. The BLS estimate of the average duration of unemployment overstates by 50% the true duration of uninterrupted spells of unemployment and misrepresents what happened to average durations during the Great Recession and its recovery.

Hamilton summarized the research results at his blog Econobrower. Here is the first inconsistency:

One of the well-known inconsistencies in these data is referred to in the literature as “rotation-group bias;” see Krueger, Mas, and Niu (2017) for a recent discussion. One would hope that in a given month, the numbers collected from different rotation groups should be telling the same story. But we find in fact that the numbers are vastly different. In our sample (July 2001 to April 2018), the average unemployment rate among those being interviewed for the first time is 6.8%, whereas the average unemployment rate for the eighth rotation is 5.9%. Even more dramatic is the rotation-group bias in the labor-force participation rate. This averages 66.0% for rotation 1 and 64.3% for rotation 8.

The second problem has to do with systematic errors when people who responded to one survey but do not respond in a subsequent survey:

A second problem in the data, originally noted by Abowd and Zellner (1986), is that observations are missing in a systematic way. The surveyors often find when they go back to a given household in February that some of the people for whom they collected data in January no longer live there or won’t answer. The standard approach is to base statistics for February only on the people for whom data is collected in February. But it turns out that people missing in February are more likely than the general population to have been unemployed in January. If the people dropped from the sample are more likely to be unemployed than those who are included, we would again underestimate the unemployment rate.

There were also inconsistency problems with the reports of the length of unemployment:

A third inconsistency in the underlying data comes from comparing the reported labor-force status with how long people who are unemployed say they have been looking for a job. Consider for example people who were counted as N the previous month but this month are counted as U. The histogram below shows the percentage of these individuals who say they have been actively looking for work for an indicated number of weeks. Two-thirds of these people say they have been looking for 5 weeks or longer, even though the previous month they were counted as not in the labor force. Eight percent say they have been looking for one year, and another 8% say they have been looking for two years.

Here is what happened when the authors adjusted for these errors. The unemployment rate is higher than reported. The policy implication is there may be more slack in the labor market than what is in the Fed’s original models, which argues for an easier monetary policy than what is being currently pursued.

Another effect is the length of unemployment is much lower than reported. More importantly, the bars in the bottom panel show the differences between the reported and adjusted numbers. The takeaway is the rate of improvement in the jobs market is actually not as strong as previously reported (annotation is mine). This result also gives greater ammunition for the doves within the Fed.

The Federal Reserve is a slow moving institution, and I do not expect any immediate policy changes as a result of this paper. Nevertheless, this is an important paper by two well respected researchers. Ahn is a Fed economist, and Hamilton is well-known for his work on oil prices and recessions. This kind of research result can move the needle, over time, and change the analytical framework, and shift Fed policy towards an easier path.

Could a unicorn cull tank the US economy?

Posted by Cam Hui - March 31, 2019

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The ”

Ultimate Market Timing Model

” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

My inner trader uses a

trading model

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

The latest signals of each model are as follows:

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

Unicorn cull ahead?

As we bid adieu to the Q1 2019, there has been increasing angst about the possibility of a recession, though I have expressed my view that a number of internals cast doubt about the usefulness of the inverted yield curve signal (see How the market could melt up and Why the yield curve panic is a buying opportunity). Notwithstanding my skepticism, I would like to explore what happens in a recession.

Recessions are cathartic processes that unwind the excesses of the past expansion cycle. The most obvious excess in this cycle has been the rise of Silicon Valley unicorns, private companies with valuations in excess of $1 billion.

The enthusiasm that greeted the Lyft IPO has raised angst among some investors about the herd of unicorns stampeding towards the IPO door, Bloomberg sounded a warning about a possible unicorn IPO mania:

Should these and others make it to the stock exchange, 2019 could prove to be one of the biggest years on record for the amount of money raised in U.S.-listed IPOs. The total will reach $80 billion this year, double the yearly average since 1999, Goldman Sachs Group Inc. predicted in November—an estimate that may prove low. And there’s no arguing that peaks in IPOs have occurred near major tops in the stock market and close to the onset of recessions. Both 1999 and 2007 were unusually strong years for IPOs that were swiftly followed by nasty bear markets in stocks and downturns in the economy.

Could a stampede of unicorns mark a market top, and their subsequent cull sink the American economy?

Private value excesses

Jawad Mian, the founder of Stray Reflections, recently warned about how private market valuations have gotten ahead of public market valuations, and how these excesses are about to unwind in a Twitter thread.

1) In 2015, venture capitalist Bill Gurley predicted “dead unicorns” and that all these private valuations are “fake.” Now he has reconsidered his view, “You have to adjust to the reality and play the game on the field.” There are no more disbelievers, except @chamath.
2) The value of the Nasdaq grew from around 1,000 points in 1995 to more than 5,000 in 2000 at the bubble peak, which mirrors the extreme jump in US unicorn valuations from $100 billion to about $500 billion in the past five years.
3) China is now home to 168 unicorns, worth a total $628 billion. It now takes just four years, on average, in China for a new company to achieve unicorn status compared to seven years in the US. In fact, nearly half of the Chinese unicorns became so just two years after launch.
4) The median global VC deal size for late-stage companies was around $11 million in 2017, but now mega-rounds of $100 million-plus are more common. So much so that CB Insights is considering lifting its threshold of a mega-round to $200 million or more.
5) VCs raising ever-larger funds at an increasing pace, despite a lack of viable opportunities. Sequoia raised $8bn, largest ever by US venture firm. “It’s easier to raise money than anytime I’ve been in the business,” said David Rubenstein. Does not bode well for future returns.
6) Gulf money is notoriously late to the party, purchasing Carlye Group in 2007 at the peak of the credit bubble, and anchor investors in Glencore IPO in 2011 at the peak of the commodity bubble. Now they are “all in” on Uber and opened offices in Silicon Valley to do more.
7) Discipline is loosening considerably. @bfeld noted, “A number of companies, often times with nothing more than a team and a Powerpoint presentation, have had great success raising capital north of that $10 million level… I view this as a significant negative indicator.”
8) Bird is fastest company to unicorn valuation, raising four rounds in less than 12 months. In less than six months, DoorDash’s valuation nearly tripled to $4 billion. Robinhood went to $5.6 billion from $1.3 billion. Coinbase to $8 billion from $1.6 billon.
9) There has been a 10-fold increase in VC-stage investment by mutual funds in just three years, with more than 250 funds now holding positions in private tech companies.
10) After the new SEC chairman, Jay Clayton, “pledged” to look after ordinary investors upon taking the job, he said he wants to make it easier for small mom-and-pop investors to invest in private companies.
11) Stanford professor Strebulaev examined 135 unicorns and found nearly half would lose unicorn status after taking into account the complicated structure of multiple funding rounds and generous promises to their preferred shareholders.
12) Because of QE, capital was abundant, but had nowhere to go and be productive because the world was still in a downturn. The scarce asset was “growth” and so have created a bubble in the riskiest long-duration asset—venture backed companies.
13) As @lessin puts it, technology was a “bubble of last resort”… soaring tech valuations are really more a commentary on the plummeting value of capital than the value of tech companies themselves. This is now changing, money is becoming scarcer and cost of capital is rising.
14) Uber’s new CEO said, “We suffer from having too much opportunity right now as a company.” Uber addresses this ailment by burning money some $20 billion since it’s founding a decade ago and now accessing public markets as private capital is tapped out.

Mian followed up with tales of past excesses and their subsequent collapses, which may or may not be relevant in the current circumstances:

15) A century ago, railroad entrepreneurs found a ready market to fund their massive expansion plans based on an extreme overestimation of the market opportunity. This ended badly, of course, and holds more parallels to today’s ride-sharing companies than we might like.
16) On seeing the announcement of a new issue of stock by the Northern Pacific and Great Northern roads, Jesse Livermore said, “The time to sell is right now… If money already was that scarce and the railroads needed it desperately. What was the answer? Sell ’em! Of course!”
17) Saudi Arabia is the single largest funding source for US startups, funneling at least $15 billion since mid-2016. As @karaswisher said, “If you remove the Saudis from the worldwide network, everything collapses.” By comparison, China has invested $11 billion since 2000.
18) Masa announced a second $100 billion Vision Fund last year. Saudis committed another $45 billion. But after the Khashoggi murder, Softbank raised doubts over its plans. Without a second Vision Fund and with tighter scrutiny on China investing in US, party coming to an end.
19) Just as churches once raised the highest towers of the city, wealthy individuals use skyscrapers as egotistical personal and corporate symbols at the peak of every cycle. Salesforce Tower, the new tallest structure in San Francisco, is the church of our time.
20) At the opening last May, the building was christened as a symbol of “transformational optimism” that “courageously reaches up to the clouds” and creates a “seamless connection between heaven and earth.”
21) Transamerica Building became the city’s tallest in 1972. What followed was a collapse in the high-flying Nifty Fifty growth stocks and the vicious 1973-74 bear market, the worst ever since the Great Depression. Same story with Woolworth in 1913 and Chrysler in 1929.
22) When the leading company in the hottest sector goes public, it reflects a peak in social mood and usually presents an important inflection point in financial markets. As a rule, insiders sell at the top.
23) The AOL Time Warner merger in 2000 culminated in the tech crash, the Blackstone IPO in 2007 presaged the 2008 meltdown, and the Glencore listing in 2011 marked the peak in the commodity super-cycle. Uber, we believe, will mark the peak in Silicon Valley and tech valuations.
24) Let us not forget the consequences of humans’ compulsive greed and hubris. Uber—and many other Silicon Valley unicorns—could be worth multiples of their current value over the long run but not without first facing a reality check from public markets. The time to worry is now.

He closed with a contrarian warning about the IPO of Lyft, to be followed by Uber’s IPO:

25) We believe Lyft’s IPO will be successful, allowing Uber to easily cross the $100 billion valuation mark. This inevitably makes the public markets test more difficult after the initial euphoria and lock up period is over.

In short, the recent surge of unicorns has been fueled by a FOMO stampede of too much VC money chasing too few deals.

A New Era?

The mania is creating a wave of “new era” accounting and valuation metrics reminiscent of the giddiness of the NASDAQ Bubble. Even Harvard Business Review chimed in with an article entitled “Why We Need to Update Financial Reporting for the Digital Era”. Finance theory is now turned upside down. Instead of demanding payment for risk, it is now to be embraced because of the lottery-like value of its payoffs:

Risk is now considered a feature, not a bug.

Traditional valuation models consider risk to be an undesirable feature. Digital companies, in contrast, chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside. In light of this, an employee is evaluated not based on what she contributed to the company’s bottom line, but whether she identified a new, breakthrough idea.

This notion, that risk is a desirable feature, can seem like sacrilege to anyone who’s taken an introductory finance course. It’s unlikely that investors’ risk aversion has fundamentally changed. However, many investors seem to have concluded that the most successful companies with tens of billions of dollars of valuation today could never have justified their valuation at the start of their operation based on discounted cash flow. So, investors, and therefore managers, might be adjusting their approach to risk accordingly.

Earnings and cash flow matter less than the option value of the enterprise:

Investors are paying more attention to ideas and options than to earnings.

Business students are taught to value a company based on the discounted amounts of future cash flows or earnings. That concept is becoming almost impossible to apply to emerging companies that are run as a portfolio of ideas and projects, each with uncertain lottery-like payoffs. CFOs of these companies themselves admit that they cannot justify their market capitalizations based on traditional metrics. They conjecture that their market values might be the sum of the option values of the projects undertaken, a sum of best-case scenario payoffs. One CFO said that her valuation should be considered on a per idea basis instead of a per earnings multiple.

In theory, options valuation should be able to handle this problem of valuing firms with lottery-like payoffs. In practice, we have yet to see a model that can justify, for instance, Amazon’s market capitalization. It’s possible that companies like those are overvalued. It’s also possible that we simply don’t know how to estimate the right parameters to make an options-based valuation work.

As digital technology becomes more pervasive, more and more companies will present this sort of valuation challenge. Given that even sophisticated investors cannot estimate the value of these companies, CFOs question the ability of a day trader to value a digital company. Therefore, companies see little value in disclosing the details of their current and planned projects in their financial disclosures, even if those disclosures can reduce the information asymmetry between investors and managers. Given the bull market in digital stocks, CFOs believe that they have no incentives to provide any additional information beyond mandatory SEC disclosures, which they consider excessive, tedious, and uninformative and might invite unnecessary scrutiny and litigation.

FT Alphaville made a similar point. In this era of a “winner take all” competitive environment, the goal of market dominance is now the holy grail of many start-ups [emphasis added]:

To recap, a few weeks ago we made the argument that the rise of mystic job titles like “chief vision officer” — especially in the trendy start-up sphere — was indicative of corporates having lost their purpose. By that we meant that it used to be the purpose of corporates to make or provide stuff people wanted so much they were prepared to pay for it. This therefore loosely translated into a profit-generating operation.

In the modern corporate sphere the desire to make profits, however, has been replaced with the desire to achieve growth at any cost. Often this means the adoption of loss-leading strategies where products or services are given away for free or subsidised — because people are unlikely to want to pay for them — for the purpose of capturing customers.

This is justified by two notions. First, these products and services are so visionary and forward thinking that we the customers can’t yet understand, or imagine, what they will mean to us. Hence, while we may not be prepared to pay for them today, one day in the future — perhaps once we have fully lost the skills to make our own food, drive, write lists or interact with people face-to-face — we will eventually be prepared to pay top dollar for them.

The second justification is that if you hook enough customers to your brand you will eventually be able to sell them something they will be prepared to pay for. What that thing is doesn’t necessarily have to be determined yet, and may or may not be determined in countless corporate pivots that follow onwards.

This is why the mystic vision officer is so important. Establishing a vision of what tomorrow’s needs may be, rather than what today’s needs actually are, is essential to keeping the investment case alive. It has little to do with the practical realities of operating a profitable and successful business on the ground in the here and now.

And it’s all very believable because this is exactly how a selection of today’s most profitable technology stocks have made it.

The problem is, it’s a strategy closely linked to monopoly and not one that every single corporate can make work.

The Lyft IPO was oversubscribed, and its reception suggests that there is a voracious appetite for unicorn IPOs. But private market values, as determined by VC funding, now exceed public market values, which is determined by the stock market. What happens when these valuations adjust?

Who gets hurt? Assessing the possible damage

If one of the economic roles of recessions is to unwind the excesses of the previous expansion cycle, there are two questions that need to be answered. Who gets hurt, and how widespread is the damage?

While there are similarities between today’s surge of unicorns and the NASDAQ Bubble of the late 1990’s, there are a number of key differences that serve to cushion the economic effects of a unicorn cull, should it occur. First, the NASDAQ Bubble was a mania with widespread public participation. Today’s rise of unicorns was fueled by VCs, which represents well capitalized institutional money.

The recession of 2000 was caused by the collapse of NASDAQ Bubble, which had widespread public participation. The roots of the recession of 2007 were subprime mortgages, which drive housing prices to bubbly levels and exacerbated by excessive financial leverage. Neither of those elements are in place today. We have neither widespread public participation nor levered investments in venture capital. Therefore a demise of unicorns will only inflicted limited economic damage.

To be sure, Jawad Mian pointed out that Gulf money has historically been late to the party, and may represent a major group of players holding the bag. Oil prices are still relatively low and below the budget break-even levels of GCC oil producers, and GCC states are continuing to see capital outflows. The demise of their VC investments could put strains on their budgets and raise political uncertainty in that region, but that is at worse a second or third order effect.

What about the effects of a rush by unicorns out the IPO door? Could that tank the stock market? There is little evidence of an IPO bubble. To be sure, the quality of IPOs is deteriorating.

The bigger question is the market reception for such issues. The relative performance of IPO stocks cratered in line with the late 2018 market swoon but they have recovered, but their level is not out of line with their longer term experience. If the likes of Lyft, Uber, and other unicorns create a stampede for unicorn IPOs, the potential for a unicorn driven market top exists. But the market has to go up first before it can fall.

From a valuation perspective, stock prices are elevated, but not a bubbly levels. FactSet reported that the market is currently trading at a forward P/E of 16.3, which is just below its 5 average of 16.4 but above its 10 year average of 14.7.

Ed Yardeni’s Rule of 20 confirms my view of stock market valuations. His Rule of 20 adds the market’s forward P/E to the inflation rate. A sum of 20 or more is a valuation warning for the stock market. The market is not there yet, but here are some back of the envelope projections. Let us assume that forward 12-month S&P 500 EPS estimates rise by between 2% and 4% real, with an inflation rate of 1.5%. Apply a forward P/E of 19x to those earnings, add in 1.5% inflation, which would exceed the Rule of 20 tripwire. That translates to an S&P 500 level of 3400-3450, or a return of 20-22% to year-end. I would emphasize that this is not a forecast, but scenario analysis of what might happen should the market become bubbly.

In short, if we were to assume that VC investments have become excessively bubbly, and a unicorn cull is in the near future, such an event is unlikely to have much economic or market effect.
While a unicorn cull could hurt some investors, these investors are well capitalized and losses are unlikely to be catastrophic for their portfolio. Unicorn investments are funded by VC money, which is not subject to little financial leverage, and the lack of leverage should be a mitigating factor in cushioning the economy from the worst of these effects.

In addition, stock market valuations are elevated, but not at danger levels and there is no sign of a valuation bubble. The risk of a unicorn IPO crash dragging down stock prices is low. However, scenario of a IPO FOMO stampede that causes stock price surge, followed by a crash, is remains on the table, but the market has to go up before it goes down. Risk on!

Where are the excesses?

If a unicorn cull will not sink the American economy, then what could? I have long argued that the excesses in this expansion cycle can be found outside US borders. The most obvious is China. This China bears’ favorite chart of excess financial leverage tells the story.

China has long been a “this will not end well” story with no obvious bearish catalyst. In the short run, Beijing is pulling out all stops with another stimulus program to ensure their economy remains robust ahead of the October celebration of Mao Zedong’s victory and founding of the People’s Republic of China.

Already, there are some preliminary signs of a growth turnaround in China’s economy. Korean exports for March 1-20 are starting to turn up, which is a positive sign.

Chinese real estate is one of the most sensitive barometers of economic stress. Yuan Talks reported the property market is starting to warm up again, with notable price increases in Tier 1 and Tier 2 cities:

Chinese property developers are having a warmer-than-usual spring season this year as more and more signs are indicating a recovery in the housing market and many expect a bottom-out in top-tier cities this year.

According to a report released by China Academy of Social Sciences (CASS) on Thursday, the country’s top state think tank, the average home prices in the 142 sample cities tracked by the academy rose 0.36 per cent in February from the previous month, 0.494 percentage point faster than the previous month.

My real-time canaries in the Chinese coalmine are also behaving well. The AUDCAD exchange rate is healthy. This is an important indicator as both Australia and Canada are resource producing economies of similar size, but Australian exports are more sensitive to China while Canadian exports are more sensitive to the US.

The relative performance of Chinese Materials stocks to Global Materials is turning up, indicating a more constructive outlook for this cyclically sensitive sector in China.

In addition, the stock price of Chinese property developers like China Evergrande (3333.HK) are behaving well and well above key support levels.

In short, the near-term risk of a global recession is relatively low. Moreover, the latest update from New Deal democrat’s monitor of high frequency economic indicators shows that US recession risk is receding.

The long-term forecast improved from neutral to positive based on a major decline in long-term interest rates, despite Q4 corporate profits being reported down. The short-term forecast also changed from negative to neutral. The nowcast remains slightly positive. Generally speaking, while the outlook for the rest of 2019 is a continued slowdown and possibly worse, 2020 is initially beginning to shape up as a recovery.

Investors should be able to sleep well, and stay with a risk-on profile in their portfolios.

The week ahead: Rational caution

If you are looking for a “tell” on the tone of the stock market, the performance of the unicorn IPO of Lyft on its first day of trading is a demonstration of rational caution, not irrational exuberance. The issue was universally panned on my social media feed. The IPO was priced at the top of its range at 72 per share, and the stock ended the day up 8.8% in an atmosphere of universal caution (mildly NSFW example here). Major market tops simply don’t look like this.

Similarly, the Citi Panic/Euphoria Model shows that sentiment remains in neutral territory despite the Q1 stock market rally. No signs of any excess extremes yet.

Callum Thomas‘ update of the State Street Confidence Index of North American institutional investors confirms the lack of bullishness.

As well, BAML’s funds flow monitor shows that money has been pouring into fixed income and out of equities. This is hardly the picture of out of control market enthusiasm.

In the past year, the S&P 500 has experienced a series of “good overbought” conditions on RSI-5 even as the index advanced, and past declines have been halted when RSI-14 reached neutral. We may be seeing the start of another series of “good overbought” advances again, as the index is about to achieve a golden cross, which is intermediate term bullish.

The market ended the first quarter on a positive note. Ryan Detrick of LPL Financial found the historical experience shows that strong first quarters has led to strong stock markets for the rest of the year. The only outlier was the market crash of 1987.

If you are too impatient to wait until year-end, OddStats compiled the historical record of what stocks did in April after strong first quarters. He added, “The pattern is obvious – if you can’t spot it immediately, you should close your trading account.”

However, the market is overbought on a 1-2 day time horizon, and some consolidation or pullback is to be expected early next week.

The bulls will face a test of whether they can continue to maintain the positive momentum. Past “good overbought” conditions indicating strong momentum has carried prices higher in the last year.

The market is not without its headwinds. President Trump threatened to close the border with Mexico in the coming week in a series of tweets if Mexico does not control the flow of illegal immigrants headed north.

The DEMOCRATS have given us the weakest immigration laws anywhere in the World. Mexico has the strongest, & they make more than $100 Billion a year on the U.S. Therefore, CONGRESS MUST CHANGE OUR WEAK IMMIGRATION LAWS NOW, & Mexico must stop illegals from entering the U.S….
….through their country and our Southern Border. Mexico has for many years made a fortune off of the U.S., far greater than Border Costs. If Mexico doesn’t immediately stop ALL illegal immigration coming into the United States through our Southern Border, I will be CLOSING…..
….the Border, or large sections of the Border, next week. This would be so easy for Mexico to do, but they just take our money and “talk.” Besides, we lose so much money with them, especially when you add in drug trafficking etc.), that the Border closing would be a good thing!

The market has so far shrugged of these threats, as an unexpected border shutdown would crater stock prices. As a reminder, US-Mexico trade amounts to roughly $1 million per minute, 365 days out of the year. Closing the border would have a catastrophic effect on the economy.

Trump is known to closely watch the stock market as a barometer of his own performance. In his very next tweet, he berated the Federal Reserve for its interest rate policy, and blamed it for low stock prices.

That tweet does not represent just some off-the-cuff remark, but a coordinated White House effort to support the economy and boost stock prices. National Economic Council Director Larry Kudlow was on CNBC last Friday and urged the Fed to cut rates by 50bp.

Top White House economic advisor Larry Kudlow wants the Federal Reserve to “immediately” cut interest rates by 50 basis points.

“I am echoing the president’s view — he’s not been bashful about that view — he would also like the Fed to cease shrinking its balance sheet. And I concur with that view,” Kudlow told CNBC on Friday.

“Looking at some of the indicators — I mean the economy looks fundamentally quite healthy, we just don’t want that threat,” he added. “There’s no inflation out there, so I think the Fed’s actions were probably overdone.”

In that context, a threat to close the Mexican border is simply not credible.

I will be watching several important economic releases next week that could be major market movers. ISM Manufacturing will be reported on Monday, and Non-Manufacturing on Wednesday. Friday’s Jobs Report will also serve as an important test of the economy’s health. While most market observers will be focused on whether Non-Farm Payroll can beat the consensus estimate of 170K, my focus will be on temporary jobs as leading NFP indicator. Temp job growth has been topping out in the last two months, but the weakness was not confirmed by the quits to layoffs ratio from the JOLTS report. Which indicator is right? Was the weakness in temp jobs just a blip?

My inner investor was neutrally positioned at his asset allocation targets, but he is allowing his equity weight to drift upwards as stock prices rally. My inner trader is also bullish, and he may add to his long positions should the market pull back early next week.

Disclosure: Long SPXL

Some clarity from a “show me” week

Posted by Cam Hui - March 27, 2019

Mid-week market update: I had characterized this week as a “show me” week for the market, though I had a slight bullish bias (see How the market could melt up). While I remained tactically bullish, a number of unanswered questions remained in light of the yield curve related sell-off that began late last week.

Some of those questions are getting answered. The bulls are still have control of the tape, though the control remains tenuous. The most positive sign is the SPX is holding a resistance turned support zone at about 2800. The market advance last summer was characterized by a series of “good overbought” readings on RSI-5, and pullbacks were halted when RSI-14 reached the neutral zone. The same pattern seems to be occurring today, which is constructive.

Supportive internals

One of the challenges for the bulls has been the lackluster display of risk appetite. Risk appetite factor performance were range-bound for the last few weeks. However, price momentum, as measured by MTUM, staged a minor upside breakout from its range, which is a hopeful sign for the bulls.

Other market internals are also normalizing. I had expressed some concerns about the relative performance of mid and small cap stocks. These groups bounced off key relative support lines this week and turned up. By contrast, the NASDAQ 100, which had been the past market leaders, started to turn down. NASDAQ stocks appeared a little extended on a relative basis, and the rotation is a sign of a healthy advance.

I was also watching the performance of the Transports. Fortunately for the bulls, the DJ Transportation Average held its support, both on an absolute and relative basis. This is another sign that the bulls still have control of the tape.

Confirmation from RRG analysis

We have a confirmation of the market’s bullish tilt from RRG analysis. As a reminder, Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The leadership sectors in the top half of the chart constitute 55.8% of the weight of the index.

By contrast, the lagging sectors in the bottom half of the chart constitute 44.2% of index weight.

A more detailed analysis of some of the key sectors reveals further support for the bull case. Financial stocks recently fell from the improving quadrant into the lagging quadrant, but as the chart below shows, the relative performance of this sector is closely correlated to the shape of the 2s10s yield curve. As the yield curve has begun to steepen again, this should create a bullish tailwind for this sector, which comprises 13.3% of index weight. In addition, the relative performance of two leading sectors, Consumer Discretionary and Communication Services, shows a pattern of sideways consolidation. Until they actually break down, the bull case remains intact.

I interpret these conditions as the bulls still have control of the tape, though the control may appear a little bit tenuous at times. My inner trader remains cautiously bullish.

Disclosure: Long SPXL