Page 54 – Humble Student of the Markets

Home in the range

Posted by Cam Hui - August 28, 2019

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

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

Buy the dips

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

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

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

Still range-bound

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

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

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

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

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

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

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

Disclosure: Long SPXL

How not to push back against Trump

Posted by Cam Hui - August 27, 2019

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

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

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

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

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

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

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

We’ve down this road before

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

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

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

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

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

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

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

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

Hong Kong: The next financial domino?

Posted by Cam Hui - August 26, 2019

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

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

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

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

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

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

…and GDP growth expectations are tanking.

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

Hong Kong’s protests in context

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

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

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

That was then, this is now.

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

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

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

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

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

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

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

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

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

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

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

China’s likely response

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

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

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

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

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

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

A contrarian buy?

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

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

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

How worried should you be about a recession?

Posted by Cam Hui - August 25, 2019

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

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

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

The latest signals of each model are as follows:

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

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

Recession fears are rising

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

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

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

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

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

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

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

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

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

The yield curve signal

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

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

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

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

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

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

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

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

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

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

New Deal democrat’s “recession watch”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What are you so worried about?

Beware of USD strength

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

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

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

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

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

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

Risk levels are rising. Stay tuned.

2020 Election risks

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

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

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

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

Risks and red herrings

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

Buy the dips, sell the rips

Posted by Cam Hui - August 21, 2019

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

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

Retest of lows ahead?

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

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

Powell’s Jackson Hole speech

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

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

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

San Francisco Fed president Mary Daly (via Quora):

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

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

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

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

The G7 wildcard

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

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

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

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

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

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

Disclosure: Long SPXL

Peak Brexit panic?

Posted by Cam Hui - August 19, 2019

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

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

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

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

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

Dire scenarios

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

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

Brexit exhaustion?

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

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

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

How to buy Brexit panic

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

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

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

Peering into 2020: New decade, new paradigm

Posted by Cam Hui - August 18, 2019

The latest signals of each model are as follows:

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

The remarkable FAANG run

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

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

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

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

Paradigm shift ahead

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

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

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

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

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

He went on to forecast the next paradigm this way:

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

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

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

Watch for leadership reversal

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

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

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

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

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

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

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

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

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

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

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

Timing the paradigm shift

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

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

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

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

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

Audit your trading the way pros do it

Posted by Cam Hui - August 13, 2019

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

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

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

Philosophy

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

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

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

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

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

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

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

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

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

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

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

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

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

My inner trader’s philosophy

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

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

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

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

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

Investment process

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

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

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

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

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

Evaluating my inner trader’s process

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

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

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

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

I recently came upon a saying among traders:

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

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

A White Swan market

Posted by Cam Hui - August 13, 2019

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

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

A short-term bottom ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

The markets need to adjust to that new reality:

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

The short and intermediate term outlook

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

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

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

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

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

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

Disclosure: Long SPXL

A correction, or a trade war meltdown?

Posted by Cam Hui - August 11, 2019

The latest signals of each model are as follows:

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

Welcome to the Q3 tantrum

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

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

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

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

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

Trade War + Currency War?

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

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

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

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

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

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

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

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

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

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

There are three problems with devaluing the currency, however.

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

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

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

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

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

The bear case

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

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

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

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

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

The bull case

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

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

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

Unemployment is low, and wage growth is strong.

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

What are you so worried about?

How much does the trade war matter?

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

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

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

A recent Bloomberg study came to a more optimistic conclusion.

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

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

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

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

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

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

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

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

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

Peterson Institute 2016 trade war study

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

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

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

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

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

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

Just a hiccup

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

Ripe for a counter-trend rally

Posted by Cam Hui - August 7, 2019

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

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

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

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

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

Unfinished downside potential

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

USDCNY at 7? It’s not you, it’s me

Posted by Cam Hui - August 5, 2019

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

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

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

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

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

Addressing USD strength

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

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

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

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

Dollar strength = Rising stress

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

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

Trump’s options are limited

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

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

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

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

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

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

What’s the cost?

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

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

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

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

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

There is a price to be paid for everything.

Powell’s dilemma (and why it matters)

Posted by Cam Hui - August 4, 2019

The latest signals of each model are as follows:

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

What Powell couldn’t say

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

What is going on?

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

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

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

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

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

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

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

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

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

Rising risks

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

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

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

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

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

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

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

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

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

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

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

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

Fading business confidence

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

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

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

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

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

China’s surprising response

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

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

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

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

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

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

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

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

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

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

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

China Evergrande (3333.HK)

China Vanke (2202.HK)

Greentown China Holdings (3900.HK)

Country Garden Holdings (2007.HK)

Estimating downside risk

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

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

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

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

A (deceptive) long-term buy signal

Posted by Cam Hui - July 31, 2019

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

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

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

Looking for confirmation

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

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

The Fed disappoints

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

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

Short-term outlook

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

A hawkish cut ahead?

Posted by Cam Hui - July 29, 2019

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

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

Signs of economic strength

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

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

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

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

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

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

Do you feel lucky?

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

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

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

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

Do you feel lucky?

Is this how currency wars begin?

Posted by Cam Hui - July 28, 2019

The latest signals of each model are as follows:

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

Sleepwalking into a currency war?

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

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

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

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

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

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

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

Europe: Desperate for stimulus

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

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

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

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

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

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

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

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

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

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

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

China: Stimulus or devaluation?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

America: The last island of growth

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

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

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

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

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

Investment implications

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

Caution: Upside potential limited

Posted by Cam Hui - July 24, 2019

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

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

USD strength warning

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

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

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

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

Nervous internals

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

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

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

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

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

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

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

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

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

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

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

A tactical call

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

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

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

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

Disclosure: Long SPXU

Will stock prices surge on a Fed rate cut?

Posted by Cam Hui - July 21, 2019

The latest signals of each model are as follows:

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

A well-telegraphed rate cut

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

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

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

Many reasons to cut

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

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

China said Wednesday that further levies would complicate the negotiations.

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

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

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

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

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

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

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

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

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

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

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

How far will the Fed ease?

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

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

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

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

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

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

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

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

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

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

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

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

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

A technical warning

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

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

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

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

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

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

Policy uncertainty ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Earnings, earnings, earnings!

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

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

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

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

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

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

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

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

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

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

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

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

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

Stay tuned.

The week ahead

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

A market on a knife edge

Posted by Cam Hui - July 17, 2019

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

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

Waiting for confirmation

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

Global stocks have also not confirmed the buy signal either.

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

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

Tactical hurdles

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

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

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

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

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

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

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

Disclosure: SPXU

Questions for Judy Shelton and gold standard supporters

Posted by Cam Hui - July 16, 2019

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

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

A gold standard supporter

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

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

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

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

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

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

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

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

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

No, we need to fix the money. Literally.

Evaluating t gold standard within a monetary framework

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

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

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

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

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

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

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

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

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

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

What about the fractional banking system?

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

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

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

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

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

Monetary policy implications

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

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

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

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

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

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

UGRB would be a global central bank:

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

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