Page 54 – Humble Student of the Markets

An opportunity in EM stocks?

Posted by Cam Hui - January 22, 2019

The latest BAML Fund Manager Survey shows that institutional managers have been piling into emerging market equities while avoiding the other major developed market regions.

Indeed, there is good reasoning behind the bullish stampede. Callum Thomas showed a series of charts supportive of the EM equity bull case. For one, developed market M-PMIs have been falling while EM PMIs have been mostly steady.

On a relative basis, EM/DM equity performance are showing signs of a long-term double bottom consistent with the double bottom pattern of the last cycle.

The cyclical to defensive stock ratio in EM appear to be bottoming. This ratio led the downturn, could it be signaling a risk-on revival?

Should you follow suit into EM stocks?

What cyclical rebound?

There is some reason for caution. The EM cyclical/defensive revival is likely a reflection of the disparity of DM vs. EM M-PMIs. The chart below shows another way of measuring global cyclicality through the industrial metals to gold ratio (red line) against the US equity to Treasury ratio (grey bars). As the chart shows, both are correlated to each other, and the industrial metals to gold ratio is still falling.

In addition, the relative performance of global industrial stocks to MSCI All-Country World Index (ACWI) continues to roll over.

What cyclical rebound?

Some EMs are more equal than others

Investors also need to understand that not all EM equities behave in a uniform way. Major market leaders can be found in India and selected Latin American countries.

The markets of China and her major Asian trading partners (most of which are not classified as EM) are lagging, though they appear to be trying to bottom.

Similarly, commodity prices, as well as the stock markets of EM resource extraction countries, which are highly China sensitive, are also struggling.

In conclusion, a commitment into EM equities represents a high-beta bet on global growth. If you want to buy EM, be selective and focus on the countries and economies that have shown signs of renewed growth independent of the world economy. The jury is still out on a cyclical growth turnaround.

As always, China remains the elephant in the room. More on that topic later.

A different kind of America First

Posted by Cam Hui - January 20, 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: Sell equities
Trend Model signal: Neutral
Trading model: Bullish

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

A bright tomorrow

Mark Hulbert recently wrote a column which determined that the US equity market is overvalued based on five of six valuation metrics. He concluded “if you were concerned last fall about stock market overvaluation, you should be almost as concerned now”.

I beg to differ. I will show most of these valuation metrics are either not useful, distorted, or a product of the low interest environment that the market is operating under. I go on to sketch out a likely bright long and medium future for US equities, which argues for an America First approach to equity investing.

An overvalued market?

Hulbert’s six valuation metrics can be categorized as:

Price to asset value: Price/book, Q-Ratio (price to replacement cost)
Cash flow: Price to sales, CAPE, P/E ratio
Yield: Dividend yield

Many of these have their own special problems. The price to asset ratio is becoming less and less relevant for equity valuation in an environment where the competitive advantage of companies depend heavily on the value of their intellectual property. Jim O’Shaughnessy of OSAM pointed out that the price to book factor has become virtually useless as a stock picking technique. In that case, why should it be relevant for equity valuation? The same goes for the Q-Ratio, which measures price to replacement asset.

Let me next address the cash flow ratios. The price to sales factor has become distorted as a valuation metric. Recall that P/E = Price to Sales x Net Margin. Analysis from the Leuthold Group indicates that net margins have surged since about 2000. It is therefore no surprise that price to sales have also risen in sympathy.

Does that mean that net margins are due to mean revert? Not necessarily. The Leuthold Group also showed that EBIT margins, which is a proxy for operating margin, has remained fairly steady over the same time period. The rise in net margin was the result of two factors, corporate tax cuts that began with in the Bush II era, and falling interest rates which reduced interest expense.

The next cash flow valuation metric to consider is CAPE, or the Cyclically Adjusted P/E ratio. Bob Shiller has stated that CAPE should not be used as a market timing indicator, either short or long term. Consider this chart of CAPE, which has been above its 10-year average for most of the time since the start of the Tech Bubble. Does that mean you should have been out of stocks all this time? Even if you had sold out at the top of Tech Bubble, when would you have bought back in? Stock prices have more than doubled since that peak.

Hulbert did allow that the market appears reasonably priced based on the P/E ratio. Indeed, the market is trading at 15x forward earnings, which is roughly the 10-year historical average, indicating an undemanding P/E valuation.

Lastly, Hulbert pointed out that the dividend yield is high compared to its own history. But what should you compare the dividend yield to? The chart below shows the yield on 3-month and 10-year Treasury paper. You need to go all the way back to the early 1960’s to find a similar interest rate environment. If stocks are expensive based on dividend yield, so is the fixed income market. In that case, what is the alternative?

A demographic dividend ahead

Looking forward for the next 10 years, I would argue that the US is about to reap a demographic dividend. By 2021, the Millennials will be the biggest age cohort of the American population. Moreover, they are moving into their prime earnings and child bearing years.

While history doesn’t repeat but rhymes, we can see a similar age demographic profile for the Baby Boomers in 1991. To be sure, the Baby Boomer population bulge was more pronounced that the Millenials are today, but remember what happened to stock prices during the 1990’s.

In 2011, researchers at the San Francisco Fed presented some results that related age demographics to market P/E ratios. They found that there was a strong correlation between the middle aged to old cohort ratio to market P/Es, based on the savings behavior of different age cohorts. Their forecast was for market P/Es to bottom out at about 2020-2021.

A follow-up study published in 2018 found that the P/E ratio did not behave as expected. However, that could be attributable to the unusual monetary policy regime which encouraged risk-taking during that era.

Nevertheless, expect rising demand for equities as Millenials become middle-aged and enter their prime earnings and savings years.

The 2020s may turn out to be a golden age for US equity returns, which should be an advantage for the US economy compared to others. Europe, by contrast, has an aging population and it does not have a Millennial “echo boom” in the American manner.

China is undergoing the height of its demographic boom now, but its population is aging rapidly, and the availability of cheap workers will grow scarcer as time goes on.

In short, demographic patterns argue for an America First strategy for long-term equity investing.

America First, medium term

There is also a case to be made for an America First approach over a medium term (6-12 months) time horizon. I wrote before that US recession odds are receding. However, the global economy remains fragile. The Ned Davis Research (NDR) Global Recession Model shows the chances of a global recession has rapidly risen.

By contrast, the NDR US Recession Model shows recession risk is still low, which concurs with my own analysis.

If a non-US recession were to develop, current positioning would favor the outperformance of US stocks. The latest BAML Fund Manager Survey shows that institutional managers have sold their US equity position down to neutral, eurozone zone equities to an underweight position (not shown), and they are avoiding the UK (not shown).

However, they have gone risk-on by pouring money into emerging market stocks.

The chart below depicts annual global real M1 growth compared to US equity returns. Global real M1 growth usually leads equity prices by about 10 months. However, should the US decouple from the rest of the world in a slowdown, a possible template of this scenario would be the Asian and Russian Crises of 1997-98. In that case, look for a reversal of fund flows as managers pile into the US market as a safe haven. While the US was not totally insulated from the Russia Crisis because of financial contagion from the collapse of LTCM, the Fed managed to stabilize and rescue the financial system in short order. Blink and you missed the market downdraft.

Under a scenario of a non-US slowdown, investors would flock into USD assets as a safe haven, and US equities as the only source of growth left standing. However, FactSet reports that 37% of the revenues of the S&P 500 come from foreign sources, companies with international operations will be vulnerable because of a combination of declining foreign sales and unfavorable currency effects from a rising USD. Under these circumstances, investors should tilt their exposure to domestically oriented companies among large cap stocks, or mid and small caps which tend to have fewer foreign operations.

Key long-term risks

There are a number of key risks to the bullish outlook for US equities, both in the long and medium term. While the demographics research from the San Francisco Fed was highly intriguing, the same researchers turned their sights to foreign markets in 2014, and they found they could not reproduced the same results in non-US markets.

I believe that the differences in research results can be attributable to the strong equity culture in the US compared to the other markets, and the size of the US market which produces a strong home bias where American investors generally do not venture outside its borders.

As an example, the World Bank reported that the 2017 US market cap to GDP ratio, which can be thought of as a proxy for the strength of the equity culture, is 165.7%. By contrast, the market to GDP ratio is 61.5% for Germany, 106.5% in France, and 77.9% for the eurozone.

One of the key assumptions of the demographics study is domestic investors are largely responsible for changes in their own market. That is only true if investors have a strong home bias, and foreign investors have minimal participation in a country’s equity market. The US equity market comprise slightly over half of the global market cap, which can encourage a home bias for American investors. By contrast, an MSCI report indicated that UK investors, who also have a fairly strong equity culture, only put 25% to 45% of their equity allocation into UK stocks. How many Americans do you know only allocate that little to domestic equities?

U.K. institutional and retail investors, respectively, held more than 25% and 45% of their stock holdings in U.K. companies, according to industry research.1 To illustrate U.K. investors’ relative concentration in their home market, U.K. stocks made up only 5.2% of the free-float market capitalization of the MSCI ACWI Index as of the end of December 2018.

The San Francisco Fed research only addressed the demographics effects on Wall Street, the demographics of the aging of the Millennials on Main Street is equally important. Unlike their parents, the Millennial generation is facing a number of economic headwinds as they enter their prime earnings years. One of their key problems is wage stagnation, and labor’s falling share of the GDP pie.

Another headwind can be found on the liability side of the Millennial cohort’s balance sheet. A recent Fed study concluded that the burden of student loans has prevented about 400,000 young Americans from buying homes between 2005 and 2014.

The authors of the study also pointed out that student loan debt has broader implications for consumers:

This finding has implications well beyond homeownership, as credit scores impact consumers’ access to and cost of nearly all kinds of credit, including auto loans and credit cards. While investing in postsecondary education continues to yield, on average, positive and substantial returns, burdensome student loan debt levels may be lessening these benefits.

Despite the tailwinds of a rising work force over the next decade, the size of the demographic dividend will be dependent on policy decisions made in Washington. A recent Pew Research Center poll indicates that the Millennial and Gen Z cohorts are more liberal than their elders, and look for government for solutions. This may create greater political pressure to alleviate problems such as income inequality and student debt in the coming years, and unleash a demographic driven spending boom over the next couple of decades.

Key medium-term risks

In the medium term, there are two key risks to the bullish forecast. If the American economy were to sidestep a recession while non-US economies slow, financial contagion risk will have to be contained. Last week, we saw two Chinese HK-listed developers mysteriously plunge without warning because of a rumored default and the cross-shareholdings and cross-collateralization of shares pledged in loans:

Jiayuan International Group Ltd., Sunshine 100 China Holdings Ltd. and Rentian Technology Holdings Ltd. fell over 75 percent in a matter of minutes and at least 10 companies were 20 percent lower or more by the close, wiping out HK$37.4 billion ($4.8 billion) in market value. Most of that came from Jiayuan, which lost HK$26.3 billion on record volume.

“Some of these companies might have cross-shareholdings in each other and when one of those starts to tumble, it brings down other related stocks,” said Hao Hong, chief strategist with Bocom International Holdings Co. “It’s likely more similar stock crashes could happen this year. A lot of share pledges in Hong Kong are underwater, and as soon as the positions are liquidated it triggers an avalanche.”

So far, so good. The sell-off was isolated to a small group of companies, and the damage contained. This is something that investors will have to keep an eye on.

From a domestic viewpoint, the partial government shutdown is starting to raise concerns on Wall Street about economic growth. The latest estimates call for a cut of 0.1% in GDP growth per week, but the damage could begin to escalate. Politico reported that Wall Street is starting to get worried that a prolonged stalemate could push the economy into recession[emphasis added]:

Recessions don’t just happen, after all. They are usually triggered by largely unforeseen shocks to the system, like the tech over-investment and dot-com crash of the late 1990s or the credit crisis of 2008. The government shutdown is not there yet. But the longer it drags on, the closer it gets.

“You can take the ruler out right now and calculate the exact impact from missed paychecks and contracts and you don’t have to go many months to get to zero growth,” said Torsten Slok, chief international economist at Deutsche Bank. “But this is not just some linear event. It can get exponentially worse in very unpredictable ways, from government workers quitting, to strikes, to companies not going public. It’s no longer just a political sideshow, it’s a real recession risk.”

Now some are slashing their estimates even further. Ian Shepherdson of Pantheon Macroeconomics this week said if the shutdown lasts through March it could push first-quarter growth below zero, a sentiment echoed by J.P. Morgan Chase CEO Jamie Dimon on the bank’s earnings call on Tuesday in which he implored Trump and Congress to make a deal.

While some of the economic damage will be reversed once the shutdown is ended, when government employees receive back pay, workers will nevertheless have to deal with the degradation of their credit ratings. The real damage comes from the contractor sector, especially when contract employees will not be paid for the shutdown period. There has been a significant shift in federal government employment since 2000 as more services were outsourced. The number of contractors has grown while the count of full-time employees have stagnated.

US economic growth is already slowing from an annualized pace of 3-4% growth in H2 2018 to about 2% in 2019. Should the budget impasse and the partial government shutdown continue, growth could slow sufficiently to spook the markets that a recession is about to start. In addition, should the US-China trade talks end without a deal and a renewed trade war, the global growth outlook is also likely to darken.

In conclusion, the market may be setting up for an America First era of U.S. equity outperformance, both in the medium and long term. The long-term outlook is favourable because of an anticipated demographic dividend. U.S. equities with a domestic focus may outperform over the next 6–-12 months because of stronger economic growth prospects compared to the rest of the world. However, investors should be aware that demographics is are not necessarily destiny, and there are other factors affecting long-term equity returns. In the medium term, the U.S. is not immune to financial contagion from abroad, and it is also at risk of policy error that could tank economic growth.

The week ahead: Waiting for direction

Looking to the week ahead, short-term direction is uncertain after several weeks of strong gains. The market’s behavior during the early part of Q4 earnings season also give little clue to future price direction. Results are roughly in-line with historical norms. The EPS beat rate is slightly above average, while the sales beat rate is slightly below, but results are highly preliminary. Forward 12-month EPS edged down only -0.01% last week, which is in stark contrast to the more recent history of downgrades. Is this the end of falling forward EPS estimates? It is too soon to tell.

On the other hand, Leigh Drogen of Estimize indicated that an earnings recession is ahead based on crowd-sourced earnings estimates (click this link if the video is not visible).

In addition, the bullish signal from insiders has turned neutral. The quick price recovery has tempered the enthusiasm of insiders. This group of “smart investors” bought heavily in past dips, but they have reverted to their normal pattern of selling as the market recovered.

The technical perspective is also mixed. On one hand, recent bullish market action is typical of past episodes of Zweig Breadth Thrusts (see A rare “What’s my credit card limit” buy signal) and what Walter Deemer calls breakaway momentum. If history is any guide, expect the market to continue to grind upwards.

But the market is obvious quite overbought. What is less clear is whether current readings represent a series of good overbought conditions that accompany strong advances, or just an extended market ready for a pullback. The chart below shows RSI-5 and RSI-14 to illustrate the difference between short and medium term momentum. RSI-5 is overbought at 85, but RSI-14 has not risen above 70 indicating an overbought condition. The 10-year history of past episodes give little guidance. The market went on to rise further in half of similar instances (blue vertical line), and retreat in the other half (red vertical line).

In the very short run, the SPX is likely to encounter overhead trend line resistance at 2680-2685, with initial support at 2635, and secondary support at 2575. Watch these levels and keep an open mind.

The upcoming week may turn out to be a make or break period for market direction. Internals such as market cap leadership is not yielding any definitive clues. Mid and small cap stocks remain in relative downtrends, and NASDAQ names are mired in a relative trading range.

My inner investor is adopting a neutral position on the market. Stock prices have recovered sufficiently that they represent value, but they are no longer screaming buys. He has moved his asset allocation back to a neutral weight from an underweight position in equities.

My inner trader is leaning slightly bullish, but only slightly. The market is overbought on short-term breadth, but an examination of the last ZBT (warning, N=1) shows that prices reached a similar overbought condition, pulled back briefly, and went on to more gains. Should the market weaken early next week, he is prepared to buy the dip, but a strong risk control discipline is required should the pullback turn into a deeper correction.

Disclosure: Long SPXL

There is no magic black box to profits

Posted by Cam Hui - January 16, 2019

Mid-week market update: Since my publication detailing the Zweig Breadth Thrust buy signal (see A rare “what’s my credit card limit” buy signal), I have been inundated with questions about the possible twists and turns of the market after such a signal. I discussed this issue extensively in 2015 (see The Zweig Breadth Thrust as a case study in quantitative analysis), my conclusion was:

What can we conclude from examining the data? Perturbing the data can yield different ZBT signals, Even discounting the different versions of the ZBT buy signals, I think that everyone can conclude that we saw a bona fide ZBT buy signal last week.

The question then becomes one of what subsequent returns were and how much can we rely on ZBT to take action in our portfolios. My conclusion, which agrees with Rob Hanna, is that the stock market tends to rise after ZBT buy signals. At worse, stocks didn’t go up, so a long position really doesn’t hurt you very much. The poor ZBT returns from the 1930’s represent a market environment from a long-ago era that may not be applicable today and therefore those results should be discounted.

Investors and traders should not treat these models and indicators so literally. History doesn’t repeat, it rhymes.

This is another reason why I am not a big fan of analogs. I recently referred to the 1962 Kennedy Slide as a possible template for the stock market, though I was thinking in terms of the bottoming pattern. From a different perspective, Global Macro Monitor highlighted a 1962-2019 analog for the stock market, which was picked up by Zero Hedge (bless their bearish hearts).

Does this look scary? Does this mean that the stock market is about to fall off a cliff, or is this just click bait?

Market implications

While I would never say “never”, but consider what happened in 1962. The so-called Kennedy Slide was the result of Kennedy going after the steel companies. He ultimately prevailed by sending in the FBI into steel company offices, and the homes of steel executives. The market panicked because it was anticipating what industries JFK would go after next.

What would be the catalyst for such a sell-off today? Here are a few possible candidates that I can think of:

A full-blown trade war with China because negotiations have broken down
Trump crosses the a State of Emergency Rubicon (see A State of Emergency for the markets too?)

In other words, you would be betting on some catastrophic event like this as the base case scenario. While we recognize that such outcomes are risks, it is difficult to see how they represent the central tendency.

The risk of small sample sizes

Traders need to avoid the mindset that there is some magic black box that gives them 100% certainty. Here is one example from OddStats of how a historical study (N=17) with 100% certainty isn’t really a sure fire bet..

If you torture the data hard enough, it will talk, but should you believe everything it tells you, especially with a small sample size? Here is another historical analog of the 1982 market compared to the 2019 market from OddStats. How much should you trust the historical pattern?

A more sensible approach to an event like a ZBT is to recognize that it represents an unusual price momentum surge using historical analysis like this one from Troy Bombardia. Even then, traders should be wary of torturing the data until it talks.

So far, the market has paused its advance earlier this week, and we may continue to see some near-term pullback or consolidation. If history is any guide, weakness should be viewed as buying opportunities, barring any unexpected cataclysmic news.

No free lunch

I pointed out before (see A 2018 report card) that, regardless of how good the historical record of a trading system, you are making a bet somewhere. It is a truism in finance theory that you have to take on risk to be rewarded with higher returns, and if you don’t want to take a risk, then you earn the risk-free rate. All trading systems have vulnerabilities, and those vulnerabilities will fail at some point. That’s a feature, not a bug.

There is no certainty in the markets. You can only profit by playing the odds in an intelligent and sensible fashion.

Disclosure: Long SPXL

A State of Emergency for the markets too?

Posted by Cam Hui - January 14, 2019

President Trump has threatened to impose a State of Emergency in order to get his Wall built. Can he do that? Analysis from The Economist indicates that there is historical precedence for such actions:

Presidents do have wide discretion to declare national emergencies and take unilateral action for which they ordinarily need legislative approval. A “latitude”, John Locke wrote in 1689 (and his writings influenced the US constitution), must be “left to the executive power, to do many things of choice which the laws do not prescribe” since the legislature is often “too slow” in an emergency. American presidents have, for example, suspended the constitutional guarantee of habeas corpus (Abraham Lincoln during the Civil War), forced people of Japanese descent into internment camps (Franklin Delano Roosevelt during the second world war) and imposed warrantless surveillance on Americans (George W. Bush after the September 11th attacks). With some notable exceptions, including when the Supreme Court baulked at Harry Truman’s seizure of steel mills during the Korean War, the judiciary has usually blessed these actions. In addition, Congress has passed dozens of laws—New York University law school’s Brennan Centre for Justice has catalogued 123—giving presidents specific powers during emergencies.

Once Trump has opened has opened the door to a State of Emergency, what happens next? What does that mean for the markets?

Few limits on emergency powers

The question of the wisdom of these decisions is beyond my pay grade, but I can shed some light on the constitutional, legal, and market implications of the declaration of a State of Emergency. Elizabeth Goitein wrote in an article in The Atlantic and concluded there are surprising few constraints on the President to declare a State of Emergency:

Unlike the modern constitutions of many other countries, which specify when and how a state of emergency may be declared and which rights may be suspended, the U.S. Constitution itself includes no comprehensive separate regime for emergencies. Those few powers it does contain for dealing with certain urgent threats, it assigns to Congress, not the president. For instance, it lets Congress suspend the writ of habeas corpus—that is, allow government officials to imprison people without judicial review—“when in Cases of Rebellion or Invasion the public Safety may require it” and “provide for calling forth the Militia to execute the Laws of the Union, suppress Insurrections and repel Invasions.”

Nonetheless, some legal scholars believe that the Constitution gives the president inherent emergency powers by making him commander in chief of the armed forces, or by vesting in him a broad, undefined “executive Power.” At key points in American history, presidents have cited inherent constitutional powers when taking drastic actions that were not authorized—or, in some cases, were explicitly prohibited—by Congress. Notorious examples include Franklin D. Roosevelt’s internment of U.S. citizens and residents of Japanese descent during World War II and George W. Bush’s programs of warrantless wiretapping and torture after the 9/11 terrorist attacks. Abraham Lincoln conceded that his unilateral suspension of habeas corpus during the Civil War was constitutionally questionable, but defended it as necessary to preserve the Union.

Congress passed the National Emergencies Act in 1976, but that law has largely failed in reining in Presidential powers:

Under this law, the president still has complete discretion to issue an emergency declaration—but he must specify in the declaration which powers he intends to use, issue public updates if he decides to invoke additional powers, and report to Congress on the government’s emergency-related expenditures every six months. The state of emergency expires after a year unless the president renews it, and the Senate and the House must meet every six months while the emergency is in effect “to consider a vote” on termination.

By any objective measure, the law has failed. Thirty states of emergency are in effect today—several times more than when the act was passed. Most have been renewed for years on end. And during the 40 years the law has been in place, Congress has not met even once, let alone every six months, to vote on whether to end them.

As a result, the president has access to emergency powers contained in 123 statutory provisions, as recently calculated by the Brennan Center for Justice at NYU School of Law, where I work. These laws address a broad range of matters, from military composition to agricultural exports to public contracts. For the most part, the president is free to use any of them; the National Emergencies Act doesn’t require that the powers invoked relate to the nature of the emergency. Even if the crisis at hand is, say, a nationwide crop blight, the president may activate the law that allows the secretary of transportation to requisition any privately owned vessel at sea. Many other laws permit the executive branch to take extraordinary action under specified conditions, such as war and domestic upheaval, regardless of whether a national emergency has been declared.

In addition to the well-known examples of Lincoln’s suspension of habeas corpus, FDR’s imprisonment of Japanese citizens, and George W. Bush’s warrantless wiretapping and torture, the government can in effect destroy an individual’s livelihood under these provisions:
President George W. Bush took matters a giant step further after 9/11. His Executive Order 13224 prohibited transactions not just with any suspected foreign terrorists, but with any foreigner or any U.S. citizen suspected of providing them with support. Once a person is “designated” under the order, no American can legally give him a job, rent him an apartment, provide him with medical services, or even sell him a loaf of bread unless the government grants a license to allow the transaction. The patriot Act gave the order more muscle, allowing the government to trigger these consequences merely by opening an investigation into whether a person or group should be designated.

Designations under Executive Order 13224 are opaque and extremely difficult to challenge. The government needs only a “reasonable basis” for believing that someone is involved with or supports terrorism in order to designate him. The target is generally given no advance notice and no hearing. He may request reconsideration and submit evidence on his behalf, but the government faces no deadline to respond. Moreover, the evidence against the target is typically classified, which means he is not allowed to see it. He can try to challenge the action in court, but his chances of success are minimal, as most judges defer to the government’s assessment of its own evidence.

Here is just one example of how a case of mistaken identity devastated someone’s life:

For instance, two months after 9/11, the Treasury Department designated Garad Jama, a Somalian-born American, based on an erroneous determination that his money-wiring business was part of a terror-financing network. Jama’s office was shut down and his bank account frozen. News outlets described him as a suspected terrorist. For months, Jama tried to gain a hearing with the government to establish his innocence and, in the meantime, obtain the government’s permission to get a job and pay his lawyer. Only after he filed a lawsuit did the government allow him to work as a grocery-store cashier and pay his living expenses. It was several more months before the government reversed his designation and unfroze his assets. By then he had lost his business, and the stigma of having been publicly labeled a terrorist supporter continued to follow him and his family.

Presidents can even send troops into the streets:

Presidents have wielded the Insurrection Act under a range of circumstances. Dwight Eisenhower used it in 1957 when he sent troops into Little Rock, Arkansas, to enforce school desegregation. George H. W. Bush employed it in 1992 to help stop the riots that erupted in Los Angeles after the verdict in the Rodney King case. George W. Bush considered invoking it to help restore public order after Hurricane Katrina, but opted against it when the governor of Louisiana resisted federal control over the state’s National Guard. While controversy surrounded all these examples, none suggests obvious overreach.

And yet the potential misuses of the act are legion. When Chicago experienced a spike in homicides in 2017, Trump tweeted that the city must “fix the horrible ‘carnage’ ” or he would “send in the Feds!” To carry out this threat, the president could declare a particular street gang—say, MS‑13—to be an “unlawful combination” and then send troops to the nation’s cities to police the streets. He could characterize sanctuary cities—cities that refuse to provide assistance to immigration-enforcement officials—as “conspiracies” against federal authorities, and order the military to enforce immigration laws in those places. Conjuring the specter of “liberal mobs,” he could send troops to suppress alleged rioting at the fringes of anti-Trump protests.

Now imagine Trump in charge of the government under a State of Emergency. If you are a Trump supporter, imagine Hillary Clinton as POTUS declaring a State of Emergency.

P/E multiple contraction ahead?

Past Presidents who have declared States of Emergency have only done so under extraordinary circumstances, and they have shown respect for the Constitution. By contrast, Donald Trump was elected to be a disruptor, and he has shown little respect for Washington norms. As an example, Trump wanted his personal pilot to head the FAA, and he has a record of demanding personal loyalty instead of loyalty to upholding the Constitution.

I had written about the importance of institutions as a key ingredient for long-term growth (see How China and America could both lose Cold War 2.0). Josh Brown recently railed against the erosion of the rule of law:

When you hear an investor compare US, UK, German and Japanese stock market valuations with the countries that make up the Emerging Markets index, try to keep in mind the fact that the discounts of the latter are nearly always warranted. We can debate about the degree of cheapness in emerging Latin American or Asian stock markets – this is subjective. What is not up for debate is whether or not there ought to be a discount. Of course there needs to be.

And the reason why, very simply, is the presence of a rule of law that applies to everyone – or, at least, the perception of a rule of law. Shares of stocks are contracts; agreements between the owners of a business and those who manage it on behalf of those owners. And these contracted agreements – regarding the payment and allocation of cash flows, safeguarding of intellectual property, continuance of competitive business practices, respect for minority shareholders, etc – are sacrosanct.

The same could be said of the governance environment in which the companies operate. Investors need to feel that there is fairness and a set of rules that everyone must adhere to. No one would build a house on quicksand and no one would exchange currency for pieces of paper in an environment where legal protections no longer mattered.

This is the kind of behavior that investors find in emerging market countries. According to FactSet, US equities trade at a forward P/E of 15.1, which is just slightly above the historical 10-year average.

Compare this to the forward P/E of EM countries with executive power concentrated in autocrats and weak institutions. They mostly trade at single digit forward P/E multiples. Watch for the market to start pricing a political risk premium under a State of Emergency. Such a development would be equity and USD bearish, and gold bullish.

Here is Egypt.

Here is Hungary.

Russia, the home of the kleptocrats, trades at 4.6x forward earnings.

Turkey, which has been the bad boy of the markets, trades at 5.9x forward earnings and the historical average is under 10.

China trades at 10x forward, but the historical average is in the low teens.

For an explanation of why P/E ratios would deflate, imagine the following extreme scenario. Donald Trump declares himself President For Life. At what rate would you lend the US Treasury money for 10 years? The current rate of 2.7%? What would you demand? 4%? 7%? 10% or more? Add 3-5% for an equity risk premium over the 10-year Treasury yield, and invert the result. That’s how you approximate a target P/E ratio.

Supposing you decided that you would lend money to a Treasury controlled by Trump at a rate of 7%. Adding in an equity risk premium of 4% translates to a forward P/E of 9x earnings. If the SPX were to fall from 15x to 9x forward earnings, the index would fall to roughly 1600.

No doubt the Democrats will fight Trump’s powers through the Courts, but even if they were to succeed in restraining presidential powers, the process will take several months, and the markets will shoot first and ask questions later.

George Washington`s last stand

I close with a relatively obscure story from a key episode in American history. It was 1783. The Revolutionary War was over, but the country was bankrupt and the Continental Congress refused to pay the troops. Some of George Washington`s men had urged him to take command and rule as an undeclared king:

On March 15, 1783 the officers under George Washington’s command met to discuss a petition that called for them to mutiny due to Congress’ failure to provide them back pay and pensions for their service during the American Revolution. George Washington addressed the officers with a nine-page speech that sympathized with their demands but denounced their methods by which they proposed to achieve them.

Washington refused. It was a key moment in American history. He could have become President For Life, but he had too much respect for the institutions that he fought for. Go and read the foll account of Washington`s address to the troops.

Ursus Interruptus

Posted by Cam Hui - January 13, 2019

The latest signals of each model are as follows:

Ultimate market timing model: Sell equities
Trend Model signal: Neutral
Trading model: Bullish

Why I turned bullish

A number of readers were surprised by my change of recent change of view (see A rare “what’s my credit card limit” buy signal), I had been adopting a cautious tone since August (see Market top ahead? My inner investor turns cautious).

The September to December decline had been highly ambiguous. I believed that unless I could pinpoint the reasoning behind the risk-off episode, it was impossible to call a market bottom. However, US equity prices had already fallen about 20% on a peak-to-trough basis, and the historical evidence indicates that such a decline is already discounting a mild recession. How much worse can it get?

In addition, technical signals such as the Zweig Breadth Thrust (see A rare “what’s my credit card limit” buy signal) indicate that psychology is washed-out and turning around. The statistical odds favor high prices over a one-year time frame.

That said, I stand by my assertion of a choppy market for the next few months. Even though the odds are in the bulls favor, key risks remain unresolved and they are likely to weigh on the market in the near term.

Negative fundamental momentum, in the form of downward earnings revisions and a decelerating macro outlook;
China and the trade war;
Trump’s likely confrontation with the Democrats may lead to a political risk premium; and
Credit markets remain unsettled, and monetary policy could put downward pressure on stock prices.

What is the market discounting?

FT Alphaville reported that Nikolaos Panigirtzoglou at J.P. Morgan Securities calculated the recession probabilities embedded in different asset classes, and most asset classes were already pricing in recession odds of over 50%.

More importantly, earnings are already discounting a mild recession:

As some recessions are shallower than others, Panigirtzoglou breaks down the historical data even further: deep versus mild. A deep recession is one in which the S&P 500 earnings fell by more than the median amount of bygone recessions — typically this occurs when the S&P 500 drops 33 per cent. A mild one is the reverse and an average slide of 18 per cent. Given this, Panigirtzoglou calculates that if a recession comes, the chances of it being a mild one sit at 88 per cent.

With respect to earnings, a mild recession is already priced in. In the 11 recessions since 1948, S&P 500 earnings have fallen an average 18 per cent from their peak. Given that prices average 26 per cent, Panigirtzoglou reckons that earnings account for 70 per cent of the decline in equity prices during recessions. Therefore, with the 16 per cent slide in US equities since their peak, markets are already pricing in an 11 per cent decline in earnings — two percentage points more than what normally happens during a mild recession.

The price action of the US equity market are pricing in a 16/18=88% chance of a mild recession or a 16/33=48% chance of a deep recession.

How bad can expectations get? In order to be bearish, you would have to be betting on a deep recession and a catastrophic outcome. The latest update from FactSet shows that the market is trading at a forward P/E of 15x, which is slightly above its 10 year average.

My set of long leading indicators designed to spot a recession in advance were deteriorating for most of 2018, but bottomed out just short of a recession reading in Q4 2018. While the recession warning panel is still flickering, it did not turn red and it has begun to improve marginally. New Deal democrat, who monitors high frequency economic data and splits them into long leading, short leading, and coincident indicator, gave a similar assessment:

While the nowcast remains positive, there are changes in both the long and short leading forecasts. The bad news is that the short-term forecast (roughly through summer) moved from neutral to negative this week. The good news is that the long-term forecast, for the first time in many months, moved back to slightly positive.

In summary, the stock market has valuation support. The market is moderately cheap, and it is already discounting a mild recession.

Bullish breadth thrusts

The technical picture for stock prices is also constructive. The market has exhibited a number of breadth thrusts which indicate strong upward price momentum indicator bullish conviction. The Zweig Breadth Thrust is only one of many ways that the strong price momentum is showing up. SentimenTrader also observed two strong 90% up volume days within two weeks following 52-week lows have been strongly bullish.

Wally Deemer also pointed out that the market recently experienced an episode of breakaway momentum. There have only been 11 such episodes in the last 40 years, and they have tended to be bullish.

While the market never goes up in a straight line, the historical experience of the intersection of breakaway momentum and ZBTs have resolved themselves bullishly (x-axis = trading days, y-axis=% gains).

In short, the market is enjoying valuation support and positive price momentum, which has historically been a bullish sign. What more could a bull ask for?

Negative fundamental momentum

However, some near-term risks remain. As we enter earnings season, estimate revisions have been falling, and stock prices have tended to move coincidentally with forward 12-month estimates.

In addition, top-down data has been missing expectations, as evidenced by the falling Citigroup US Economic Surprise Index (ESI), as well as global non-US ESI.

Regular readers know that commodity prices is a key input to my trend model. IHS Markit reports that its Global Metal Users PMI, which is a leading indicator of World GDP growth, is falling.

In addition, the relative returns of global industrial stocks relative to MSCI All-Country World Index (ACWI) are tracing out a rounding top, indicating cyclical deceleration.

The upcoming Q4 earnings season will be a key test for the market. It is unclear how much of a decline is already priced in. John Butters of FactSet pointed out that Q4 guidance was roughly in line with historical average:

The earnings guidance issued by S&P 500 companies for Q4 has been slightly more positive than average, while revenue guidance issued by S&P 500 companies for Q4 has been slightly more negative than average.

Watch China!

China also poses a high degree of tail-risk for investors. The Chinese economy accounted for roughly one-third of global growth and about half of global capital expenditures. This is the China bear’s favorite chart, which indicates the precarious nature of her over-leveraged economy.

In the past, Chinese debt has been less of a concern for global investors as most of it has been denominated in RMB, and therefore financial contagion risk is low. However, a Bloomberg article pointed out that external debt has ballooned to about USD 2 trillion, which is a significant level even in the context of China’s large foreign exchange reserves.

China’s economy is now showing signs of weakness, and the trade war is making things worse. Caixin reported that a UBS survey indicated that a considerable number of export manufacturers have either moved or considered moving their production out of China:

Most export manufacturers in China have already moved or plan to shift some production outside the Chinese mainland, as the Sino-U.S. trade dispute adds to existing headwinds for businesses, a survey by Swiss investment bank UBS has showed.

Thirty-seven percent of the respondents said they have moved some production out of the mainland in the past year, the bank said in a report released on Friday about the poll. Another 33% of respondents said they plan to do so in the next six to 12 months.

The trade war also creates uncertainties. A mid-level American delegation arrived and concluded a round of constructive talks last week, and the issues are becoming clear for both sides. Here is what the outline of an “easy” trade deal would look like (via the NY Times):

China is buying American soybeans again and has cut tariffs on American cars. It is offering to keep its hands off valuable corporate secrets, while also allowing foreign investors into more industries than ever before.

In addition, Beijing would roll back its retaliation for the first round of American tariffs. In addition, China is has offered some liberalization on investment in the auto and financial services sectors, and loosening of the JV requirement of forced technology transfers, though Beijing has long maintained it never forced technology transfer in the first place, and all deals were voluntary.

In return, the US may or may not roll back tariffs levied on Chinese goods since the start of the trade war.

That’s the easy deal. The difficult issue is an agreement on China’s industrial policy and IP transfer. US chief negotiator Robert Lightizer has pressed for a verification process of China’s commitments to Chinese concessions on these issues.

Leland Miller of China Beige Book appeared on CNBC to state that he believes there is tremendous economic pressure on China to reach a deal, but it will be a deal in name only. In effect, the trade deal will amount to the “easy” deal (my words, not his), and possibly some provisions of the “difficult” deal, but the enforcement of the agreement will be a function of future US-China relations. In a past CNBC appearance, Miller explained that US-China trade frictions will rise in 2020. There is a growing consensus in Washington that China is a challenge for the US, and presidential candidates will all posture to show how tough they are on China. Even if we were to see a trade truce in 2019, friction is likely to rise next year.

Political risk premium

As the Democrats take control of the House of Representatives, the chairs of the various committees are expect to investigation both Trump, his family, and his cabinet. White House staff is preparing for a deluge of subpoenas as Democrats settle into their seats. In addition, the results of the Mueller probe is likely to become public some time in 2019. The combination of all these events are likely to put tremendous political pressure on Trump and how he governs.

We have already seen a brief taste of the conflict between Trump and the Democrats during the latest government shutdown impasse. Trump has threatened to declare a State of Emergency in order to get funding for the border Wall. A decision like that is well outside constitutional norms, and it will likely get challenged in the courts. (Even if you support Trump’s potential declaration of a State of Emergency, would you also support President Hillary Clinton’s declaration under similar circumstances?)

Unilateral declarations of emergency and martial law are what happens in emerging market countries under strongman rule. Most of these markets trade at single digit P/E ratios. Should Trump provoke a such a constitutional crisis, expect the markets to begin pricing in a political risk premium to the US equity market.

Stress in the credit market

Another source of risk comes from possible stress in the credit market. On the surface, conditions appear benign. Credit spreads have widened and begun to normalize after the December risk-off episode, and levels are nowhere near the high stress readings seen in past recession.

Beneath the surface, however, the internals appear ominous. Median corporate leverage has returned to level equal to or above past market tops.

BBB debt, which is the lowest level of investment grade credit, now dominate the IG bond universe. Should the economy weaken, expect many of the BBB credits to be downgraded to junk, which would flood the junk bond market with supply in an environment of uncertain demand.

At the same time, global central banks are tightening and withdrawing liquidity from the financial system.

Notwithstanding the Fed’s slightly more dovish tone, the Fed’s tightening bias will have a negative effect on the growth of the monetary base. If history is any guide, negative growth in the monetary base has been a headwind to equity prices.

Investment implications

To sum up, what does this all mean?

My previous base case scenario had been a recession in late 2019 or early 2020, with a slowdown that begins in early 2019. Stock prices would decline, first to discount the effects of a slowdown, and later a recession. The recession would serve to unwind the excesses of the previous expansion, notably high leverage in China, and the unresolved banking problems in Europe.

In reality, stock prices declined in Q4 2018 in a steep fashion, and the market is already discounting a mild recession. Technical conditions became washed-out, and different measures of breadth thrusts are pointing to an intermediate term bottom. While a number of risks remain, none of them, with the exception of a growth deceleration, will necessarily be realized in the next six months. It is also unclear how much of the growth slowdown is already discounted in the market. Real GDP growth fell from a 3-4% annualized pace in the latter half of 2018 to about 2% in 2019, which is well above recessionary conditions.

The other risks, namely China, trade war, political risk premium, and credit deterioration from monetary tightening may not fully manifest themselves over the next six months. Undoubtedly, the market will respond to news flow from these sources of risk in the future, but their near-term resolutions are unlikely to be catastrophic for stock prices.

To be sure, the global economy is undergoing a tightening cycle. Callum Thomas has shown that tightening cycles, as proxied by the slope of the yield curve, tends to lead equity market volatility by 2 1/2 years.

In conclusion, I had mainly focused on the risk conditions in the past, while ignoring valuation. Today, the combination of favorable valuation and positive momentum has changed my outlook. Based on these conditions, I would expect stock prices to grind upwards for the remainder of 2019, but in a volatile manner.

Possible roadmaps

As the economy is likely to sidestep a recession, here are some possible historical patterns that the market might follow. These episodes all involved some kind of scare, but the market ultimately avoided a recession.

2011 was the year of the Greek Crisis in Europe, and a budget impasse in Washington. The market dropped, stabilized and chopped around for a few months, rallied, weakened and corrected, and then went on rise into fresh highs.

There was a growth scare at the end of 1994, when the yield curve neared inversion but did not do so. The market made a double bottom before going on to advance to new highs.

1962 was the year of the “Kennedy Slide”. There was no recession but it was accompanied by JFK’s attack on the steel industry and a “businessman’s panic”. The market’s final bottom coincided with the Cuban Missile Crisis.

From a technical perspective, the breadth thrusts were signals of the initial bottom is in, but to expect further volatility in the next few months. Don’t be surprised if the stock prices were to weaken again to test or undercut the December lows in a double or multiple bottom. Looking out 6-12 months, history tells us that returns should be positive.

Model readings

In light of my recent change in investment view, there have been a number of questions about the readings of different models. I will explain how each model is positioned, starting with the one with the longest horizon going to the shortest.

The Ultimate Market Timing Model is an asset allocation model for investors with a long-term horizon. It was designed to avoid the worst of bear markets, and minimize unnecessary trading. Its recent sell signal was based on the combination of a recession forecast, and market action based on trend following models. This model will remain at a “sell” until the composite of global equity and commodity prices start moving above their moving averages. The slow reaction time of this model is a feature, not a bug.

The Trend Model is based on, as stated above, a composite of global equity and commodity prices. Readings have shifted from highly negative to a weak neutral. Investors using this model for asset allocation should re-balance their portfolios from an underweight equity position back to their neutral target weights as specified by their investment policy statement.

The Trading Model is the one with the shortest time horizon. Last week’s powerful Zweig Breadth Thrust signal moved this model from a “sell” to a “buy” signal. Over the next week, the market advance may start to stall as it has reached a key resistance zone.

Short-term momentum (1-2 day horizon) is overbought and starting to roll over.

Longer term (3-5 day horizon) momentum remains overbought, indicating possible downside risk.

As well, the credit market`s rally stalled in the last two days of the week, while stock prices continued to grind upwards. This is another sign that risk appetite is waning.

In light of the unusual breadth thrust activity, it would be premature to turn overly bearish in the short-term. The market may pause and consolidate, or stage a minor pullback, under these circumstances. An upside breakout through the resistance zone would be highly bullish, and I am keeping an open mind as to short-term direction. Corrective action should be bought, and downside risk is likely to be restricted to only 1-2% in the coming week.

Disclosure: Long SPXL

The Animal Spirits are stirring

Posted by Cam Hui - January 9, 2019

Mid-week market update: In light of Monday`s Zweig Breadth Thrust signal, I thought I would do one of my periodic sector reviews to analyze both sector leadership and the implications for stock market direction.

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

A review of the latest RRG chart shows a market in a bottoming process, with defensive sector leadership starting to roll over, and selected high beta and cyclically sensitive sectors becoming the emerging market leaders. While defensive sectors such as the Consumer Staples, Healthcare, REITs, and Utilities, are in the leading quadrant, they are losing relative strength. By contrast, Communication Services, led by selected FAANG stocks and high beta names, and Materials appear to be poised to become the next market leaders.

The ZBT signal clarifications

I have had a million questions about the recent ZBT buy signal (see A rare “what’s my credit card limit” buy signal). Many questions and comments revolved around distinguishing the short and intermediate term outlooks after such signals.

Rob Hanna of Quantiable Edges documented the past forward 20-day performance of such signals. From this table I can make a number of observations. These signals are rare, they often occurred at major market bottoms, and all were profitable after 20 trading days.

The ZBT is a burst of price momentum in a short period that moves from deeply oversold to deeply overbought. Ryan Detrick observed that the McClellan Oscillator (NYMO) went from super oversold to super overbought within two weeks. The last time this happened was the market bottom in March 2009.

I observed in my post (see A rare “what’s my credit card limit” buy signal) that the market often paused and consolidated its gains for about 2-3 after the ZBT signal. Urban Carmel also found that similar NYMO breadth thrusts saw short-term pullbacks and consolidations, though they ultimately resolved themselves bullishly.

In short, ZBT buy signals are very rare, and they tend to mark major market bottoms. While the one to 12 month track record has shown positive gains, expect a brief pullback and consolidation to digest the gains after the signal. Any weakness should be interpreted by traders as an opportunity to buy.

A high beta revive

When I view the market through a sector and market internals prism, high beta groups are starting to revive. The chart below of the market relative performance of different high beta groups, from high beta to low volatility, to NASDAQ internet, and IPO stocks, all show bottoming patterns. These groups have rallied through relative downtrends and they are in the process of making broad based saucer shaped relative bottoms.

Investors looking for emerging market leaders might consider Communication Services.

As well, the cyclically sensitive Materials sector may also serve as useful diversification to the high-octane FAANG names contained in Communications Services.

In conclusion, sector rotation analysis reveals a market that is undergoing a bottoming process. Defensive sectors are rolling over in relative strength, and selected high beta groups are becoming the emerging market leadership.

My inner investor is drawing up a buy list of names, and he plans to re-balance his portfolio from underweight to market weight equities. My inner trader went long on Monday at the ZBT buy signal, and he plans to add to his positions on any pullback.

Disclosure: Long SPXL

Will the Fed pause in March?

Posted by Cam Hui - January 8, 2019

In the wake of Powell’s statements last Friday, the market now expects no changes in the Fed Funds rate this year, with a slight chance of a rate hike.

Contrast those expectations with the dot plot, which has penciled in two rate hikes this year.

The history of Fed policy is slow incremental changes. Has the market gone overboard on the dovish when it expects a change from two hikes to no hikes?

What Powell said

The market got all excited on Friday during the ASSA panel discussion featuring Powell, Yellen, and Bernanke. A full transcript of the discussion can be found at the WSJ. In effect, what Powell said changed from “we expect to hike two more times in 2019, with the usual data dependency caveats”, to “anything can happen”. Included in the range of possibilities is a pause in rate hikes, and an re-evaluation of the runoff in the Fed’s balance sheet. It doesn’t mean that the Fed will pivot to the most dovish course of action, which is what is discounted by the markets.

Here is what Powell said that made the markets go haywire and risk-on:

But financial markets have been sending different signals, signals of concern about downside risks, about slowing global growth, particularly related to China, about ongoing trade negotiations, about what maybe let’s call general policy uncertainty coming out of Washington, and among other factors. So, you know, you do have this difference between, on the one hand, strong data, and some tension between financial markets that are signaling concern and downside risks. And the question is, with those contrasting sets of factors, how should we think about the outlook and how should we think about monetary policy going forward?

Now when we get conflicting signals, as is not infrequently the case, policy is very much about risk management, and I’ll offer a couple of thoughts on that to wrap up. First, as always, there is no preset path for policy, and particularly with the muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves. But we’re always prepared to shift the stance of policy and to shift it significantly, if necessary, in order to promote our statutory goals of maximum employment and stable prices.

Powell also said that he is listening to the markets:

I think the markets are pricing in downside risks, is what I think they are doing, and I think they are obviously well ahead of the data, particularly if you look at this morning’s labor market data and the other data that I cited. So markets are expressing concerns, again, about global growth in particular – I think that’s becoming the main focus – and trade negotiations, which are related to that. And I’ll just say that we’re listening carefully to that. We’re listening with – you know, sensitively to the message that markets are sending, and we’re going to be taking those downside risks into account as we make policy going forward.

While Powell did allow that the Fed would be willing to re-evaluate the balance sheet runoff, otherwise known as Quantitative Tightening (QT), the statement came with a lot of “ifs” [emphasis added]:

I’ll say again, if we reached a different conclusion we wouldn’t hesitate to make a change. If we came to the view that the balance sheet normalization plan or any other aspect of normalization was part of the problem, we wouldn’t hesitate to make a change.

Listening to the market?

What about listening to the market? By responding to every Jim Cramer rant and every blip in the market, the Fed risks creating a Put in the market, which encourages excessive risk taking to blow a financial bubble. From this viewpoint, additional pressure from the White House is unhelpful for maintaining financial stability.

I am also old enough to remember the November 15, 2010 Open Letter to Ben Bernanke opposing QE signed by a number of prominent conservative economists and fund managers. The signatories include Kevin Hassett and David Malpass, who are both members of the current Trump administration.

The following is the text of an open letter to Federal Reserve Chairman Ben Bernanke signed by several economists, along with investors and political strategists, most of them close to Republicans:

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

Cliff Asness
AQR Capital

Michael J. Boskin
Stanford University
Former Chairman, President’s Council of Economic Advisors (George H.W. Bush Administration)

Richard X. Bove
Rochdale Securities

Charles W. Calomiris
Columbia University Graduate School of Business

Jim Chanos
Kynikos Associates

John F. Cogan
Stanford University
Former Associate Director, U.S. Office of Management and Budget (Reagan Administration)

Niall Ferguson
Harvard University
Author, The Ascent of Money: A Financial History of the World

Nicole Gelinas
Manhattan Institute & e21
Author, After the Fall: Saving Capitalism from Wall Street—and Washington

James Grant
Grant’s Interest Rate Observer

Kevin A. Hassett
American Enterprise Institute
Former Senior Economist, Board of Governors of the Federal Reserve

Roger Hertog
The Hertog Foundation

Gregory Hess
Claremont McKenna College

Douglas Holtz-Eakin
Former Director, Congressional Budget Office

Seth Klarman
Baupost Group

William Kristol
Editor, The Weekly Standard

David Malpass
GroPac
Former Deputy Assistant Treasury Secretary (Reagan Administration)

Ronald I. McKinnon
Stanford University

Dan Senor
Council on Foreign Relations
Co-Author, Start-Up Nation: The Story of Israel’s Economic Miracle

Amity Shlaes
Council on Foreign Relations
Author, The Forgotten Man: A New History of the Great Depression

Paul E. Singer
Elliott Associates

John B. Taylor
Stanford University
Former Undersecretary of Treasury for International Affairs (George W. Bush Administration)

Peter J. Wallison
American Enterprise Institute
Former Treasury and White House Counsel (Reagan Administration)

Geoffrey Wood
Cass Business School at City University London

How do these people feel today? Are they still concerned about “debasement and inflation”? Were they listening to the markets then? Are they listening now?

Listening to the data

Fed watcher Tim Duy thinks that the Fed is preparing the market for a pause in March, as long as the data cooperates:

Low inflation means the Fed can move patiently. They don’t feel compelled to maintain the pace of quarterly rate hikes. Still, that doesn’t mean they won’t. My baseline expectation is that the data flow remains sufficiently soft and economic uncertainty sufficiently high to keep the Fed on the sidelines until at least mid-year. There is a chance of course that the correction in equity markets has left us all too pessimistic about the outlook for growth and inflation this year. If so, Fed commentary might turn hawkish again sooner than I anticipate.

Just because the economy is softening doesn’t mean the Fed will necessarily deviate from its tightening path. The latest SEP from the December FOMC meeting shows that the Fed has already penciled in a slowdown in GDP growth, and cut the projected hikes in Fed Funds from the September meeting. Arguably, if the growth rate stays at or above the projected growth path, rate hikes and policy normalization will continue.

For a better read on the state of the economy, the latest NFIB small business survey is revealing, as small businesses have little bargaining power and they are therefore a good barometer of the economy. NFIB optimism is coming off the boil, but remains elevated. This is consistent with the observation from Powell and others that the economy is in a good place, and “most of the hard data that we see coming in remain quite solid and suggest ongoing momentum heading into 2019”.

How about inflation? NFIB prices continue to trend upwards.

NFIB compensation is also telling a similar story about wages.

The “biggest problem” continues to be “labor quality”, which suggests that wage pressures will continue to rise.

What about financial stability? The NFIB survey of credit conditions are stable.

In conclusion, the Fed may decide to pause in March, but sensitive barometers like the NFIB small business survey are still showing rising inflationary pressures and minimal financial stability problems. We should get more clues from the December FOMC minutes, which will be released Wednesday, and speeches from Powell and Clarida on Thursday. While the Fed may decide to pause its pace of rate hikes in March, the data suggests that a pause in the rate of balance sheet normalization is a long shot.

A rare “what’s my credit card limit” buy signal

Posted by Cam Hui - January 7, 2019

The Zweig Breadth Thrust (ZBT) is a variant of the IBD Follow-Through day pattern, but on steroids. Steven Achelis at Metastock explained the indicator this way [emphasis added]:

A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

Monday’s strong NYSE breadth has pushed the ZBT Indicator into buy signal territory. Call this a “what’s the limit on my credit card” buy signal for investors, though not necessarily traders.

Here is how the market has behaved after ZBT buy signals.

The history of ZBT buy signals

The chart below shows the history of ZBT buy signal in the last 20 years.

Even though the sample size was small (N=4), we can make the following observations:

The market was always higher a year later, which is consistent with Marty Zweig’s original observation
The market came back down to re-test and undercut the lows after the ZBT buy signal in three (60%) of the instances.

Here are the histories of the individual buy signals. Here is the one from May 14, 2004. Tactically, the market weakened for two days after the buy signal. It proceed to rally, and then pulled back to test and undercut the previous low three months later.

The ZBT buy signal of March 18, 2009 was the best performing signal of the last 20 years. The market still saw a three day tactical pullback and consolidation after the signal.

The buy signal of October 14, 2011 only saw a brief one day pullback after the buy signal. However, the market did weaken and correct within two months.

The buy signal of October 18, 2013 was one of the strongest momentum thrusts of the ZBT buy signals in the last 20 years. The market kept rising and never looked back. When the corrective pullback occurred 3 1/2 months later, the decline did not weaken sufficiently to test the previous low.

The buy signal of October 8, 2015 was the weakest of the ZBT signals in the last 20 years. The market consolidated and pulled back within a week, rallied, and weakened again to undercut the previous lows within a three month period.

In conclusion, the ZBT buy signal is a rare display of bullish positive momentum. While investors have to be prepared for some short-term setbacks, the odds favor higher stock prices in a 12-month time frame.

The short-term outlook for traders is a bit more challenging. While the breadth thrust does signal positive momentum, stock market indices have risen into resistance zones where the rally may stall.

The challenge for the bulls is to push the market into overbought territory and keeping it there. In the past, such “good overbought” conditions has led to sustained advances. The one constructive condition is the market isn’t even overbought on the 5-day RSI yet.

Disclosure: Long SPXL

H1 2019 roadmap: Expect volatility

Posted by Cam Hui - January 6, 2019

The latest signals of each model are as follows:

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

A look ahead to H1 2019

It gives me little pleasure to say “I told you so”. But I told you so.

I warned in early December that earnings were going to disappoint in 2019 (see 2019 preview: Winter is coming). Since then, tumbling earnings estimates have been one of the main reasons for the weakness in stock prices.

The recent warning from Apple is just setting the table for further disappointment, and the upcoming Q4 earnings season will be revealing as to how far estimates have to fall. I expect more market sloppiness in Q1 and the first six months of 2019, until the uncertainties surrounding the upcoming growth deceleration and trade war are resolved.

A Wile E Coyote moment

Call the growth deceleration whatever you want. Bloomberg reported that Ben Bernanke called it a Wile E. Coyote moment for the American economy because the stimulus effects of the tax bill is wearing off:

U.S. economic growth could face a challenging slowdown as the Trump Administration’s powerful fiscal stimulus fades after two years, according to former Federal Reserve Chairman Ben Bernanke.

Bernanke said the $1.5 trillion in personal and corporate tax cuts and a $300 billion increase in federal spending signed by President Donald Trump “makes the Fed’s job more difficult all around” because it’s coming at a time of very low U.S. unemployment.

“What you are getting is a stimulus at the very wrong moment,” Bernanke said Thursday during a policy discussion at the American Enterprise Institute, a Washington think tank. “The economy is already at full employment.”

The stimulus “is going to hit the economy in a big way this year and next year, and then in 2020 Wile E. Coyote is going to go off the cliff,” Bernanke said, referring to the hapless character in the Road Runner cartoon series.

As this analysis from FactSet shows, the tax cut boost to EPS estimate is over. Q4 2018 estimate revisions are normalizing compared to its own history.

Analysis from Ed Yardeni found that forward 12-month earnings estimates are flat to down across all market cap bands:

From a top-down perspective, the market faces the additional headwinds of likely macro disappointment. The Citigroup US Economic Surprise Index (ESI) measures whether macro data is beating or missing expectations. The historical experience shows that ESI has tended to fall early in the year, possibly because of faulty seasonal adjustment effects. The latest readings show that the disappointments are already underway.

There is also economic weakness from overseas. Not only did the latest US ISM report decelerate and miss expectations, global PMIs are all falling. As a reminder, roughly 40% of the revenues of S&P 500 come from non-US sources.

Eurozone PMIs are weak, with the core European countries of France and Germany leading the way downwards.

The weakness is probably not over. Nordea Markets pointed out that Sweden is a small open export-oriented economy and serves as a good leading indicator for the rest of Europe. The latest readings for Swedish PMI indicates more pain to come.

Then we have China. The Apple warning highlighted the weakness in China, even without the full effects of the tariffs. The latest Caixin PMI, which measures the activities of smaller companies, came in below expectations and under 50, indicating economic contraction.

China ESI is also indicating macro disappointment.

What about stimulus? When the economy weakens like this, doesn’t Beijing respond with a stimulus program? To be sure, there have been some limited stimulus, such as tax cuts, reserve requirement ratio cuts by 1% in two stages of 0.5%, and administrative measures ordering banks to lend to small businesses. The WSJ reported the government is singling out the small business sector for special attention:

Shoring up smaller private businesses—which provide more than 80% of employment—has become a priority after years when policies and practices largely favored big state-owned companies. In recent months, Beijing has rolled out several measures to help small companies issue bonds, get bank credit and be covered with more tax breaks.

Mr. Li urged the state-owned bank executives on Friday to lend to small businesses at closer to benchmark rates, according to people with knowledge of the meetings. Borrowing at rates close to the benchmark is a privilege long enjoyed by big state-owned companies

“Stabilizing employment relies on thousands of small and micro enterprises, which can’t develop without support from inclusive finance,” Mr. Li told a group of bankers, according to state-run China Central Television.

Mr. Li also told the bankers that as they allocate 30% of new lending to small businesses they should cap the ratio of bad loans at 2%, the people with knowledge of the meetings said. That level is low for lending to smaller businesses, which are considered riskier borrowers, though the current overall bad-loan ratio for all commercial banks is just below 1.9%, according to data from the banking regulator.

While the efforts are well-intentioned, such initiatives may amount to nothing more to the proverbial “pushing on a string” as they will just create more bad loans:

China Citic Bank in eastern Zhejiang province, a private business hub, received government orders last month to boost loans to small companies at a rate so low as to be unprofitable, according to a credit manager at the main provincial branch.

“Some of this lending will definitely lead to losses given such a low interest rate,” the officer said. “But since it’s an administrative order, we have no choice.”

The Chinese authorities are running out of bullets. John Authers of Bloomberg illustrated the problem of diminishing return on credit driven stimulus with this graph.

Bottom line, both the US and global economies are decelerating.

The silver lining

While the combination of top-down and bottom-up fundamental momentum is negative, there are a number of contrarian silver linings for equity bulls. These factors are early indications that the market is starting a bottoming process, and downside risk may be limited from current levels.

I offered a bottom spotting checklist last week (see How to spot the bear market bottom), and one of the conditions is some signs of long-term sentiment capitulation. In particular, I stated that I would like to see II %Bears to rise above %Bulls, as sentiment had been stubbornly complacent. Lo and behold, the latest survey shows a spike in %Bears above %Bulls.

Here is a longer term perspective of II sentiment from Tiho Brkan. The spike in bearish sentiment is a constructive sign that the market is undergoing a bottoming process, though sentiment tends to be an imprecise indicating for timing exact bottoms.

Still, I would like to see further signs of prolonged bearishness. As an example, the AAII asset allocation survey shows that while individual investors are pulling back their equity allocations, readings are nowhere near levels that indicate full capitulation.

Another constructive sign that the market may bottoming is the behavior of insiders. Insiders bought the dip in October and November, and they are buying the latest market weakness.

To be sure, this group of “smart investors” were buying the dip all the way down during the 2008-2009 bear market. Nevertheless, this represents a hopeful sign that fundamentals are not collapsing and the stock market offers good value at current levels.

The trade war wildcard

So is the market bottoming here, and investors should be preparing to buy stocks at current prices?

Not so fast! I had offered the following qualifications to my forecast in early December (see 2019 preview: Winter is coming):

If the economy avoids a recession under the “mild winter” scenario, I expect stock prices to weaken in H1 2019, and that should provide the buying opportunity for investors. If the US and China can keep the trade tensions controlled, and the world sidesteps a recession, then the mild winter scenario is very much in play.

On the other hand, if either the trade conflict deteriorates into a full-blown trade war, or if the macro data in my set of long leading indicators weaken enough to signal a recession, then all bets are off.

Much depends on the progress of the Sino-American trade negotiations. Here are the bull and bear cases.

From the bulls’ viewpoint, Trump’s behavior in the last few weeks has demonstrated that he is acutely aware of the judgment of the stock market. A trade war induced recession is virtually certain to sink his chances of re-election in 2020. He will do everything in his power to come to an agreement with the Chinese. One template might be the NAFTA 2.0 negotiations, where he extracted a number of minor concessions and declared victory. The urgency for a deal from China’s viewpoint is equally evident. The Chinese economy is slowing, and Beijing can ill-afford a slowdown which threatens financial and social stability. Chinese negotiators have already put together a package of substantial concessions. Somewhere between the American and Chinese positions, there is common ground for a trade agreement which will de-escalate tensions.

The bears will argue that both sides have limited negotiating room. There is already a substantial bipartisan consensus in Washington that China poses a threat to America from both trade and geopolitical perspectives. If Trump were to conclude a deal, he risks being outflanked in 2020 as being “soft on China”.

In addition, a CNN interview with Trump economic advisor Kevin Hassett is a hint that the Americans are digging and believe they have substantial negotiating leverage, which presents the risk that the US could overplay its hand. Hassett told CNN that, in the wake of the Apple earnings warning based on sales weakness in China, that “There are a heck of a lot of U.S. companies that have a lot of sales in China that are basically going to be watching their earnings be downgraded … until we get a deal with China. It’s not going to be just Apple.” Hassett went on to state that the Apple news puts American negotiators in a better position: “I think that puts a lot of pressure on China to make a deal. Their economy, for them, you might call a ‘recession.’ It’s slowing down in a way that they haven’t seen in a decade.” He added that, “China is feeling the blow of our tariffs.”

From the Chinese perspective, China will hold annual session of the National People’s Congress, China’s parliament, in March just after the expiry of the 90-day deadline. This is the most important political event of the year. Xi Jinping cannot be seen to be humiliated ahead of the Congress. Xinhua report “As required by the 19th National Congress of the Communist Party of China, Beijing is committed to deepening reform and furthering opening-up. In the process, some economic and trade issues that are of Washington’s concern will be solved.” Translation: Xi can only make concessions within the framework of the policies adopted at the party congress of October 2017, which is an affirmation of its industrial policy.

Xi stated at the 2017 congress, “The Communist Party of China will lead the country to basically realize socialist modernization by 2035.” The plan calls for “stronger and bigger” state-run companies. And China will move closer to achieving the target if it acquires overseas companies with advanced technologies in accordance with “Made in China 2025,” a carefully designed blueprint for upgrading China’s strategic industries. In other words, it cannot, and will not abandon “China 2025”.

The “China 2025” industrial policy has been a major stumbling block for both sides. The recent arrest of Huawei CFO Meng Wanzhou, as well as American efforts to lock major Chinese 5G providers Huawei and ZTE out of its market, as well as the market of its major allies, are viewed by Beijing as an effort to obstruct China’s 2025 industrial policy.

Realistically, the best case scenario would see no deal by the March 1 deadline, but both sides agree to keep talking, and the next round of tariffs put on hold while negotiations continue. It would be a “kick the can down the road” solution. The worst case would see negotiations break down and the next round of tariffs imposed on China. The IMF has projected a full-blown trade war would take 1.6% off China’s GDP growth and 1.0% off US GDP growth. Recession fears would spike, and the markets would undergo a major risk-off episode.

Fed policy error risk

The other major risk to the market is a Fed policy error that over-tightens the economy into recession. There is an enormous gulf between market expectations and the Fed’s dot plot. The market now expects no rate hike this year, and a possible rate cut by the end of 2019. By contrast, the Fed’s dot plot has two more quarter point rate hikes penciled in.

Who is right?

The market got very excited last Friday when Jay Powell charted a less hawkish tone by walking back his past remark about balance sheet reduction being on autopilot. He went on to state that the Fed is listening to the markets and the downside risks they are conveying. In short, the Fed is data dependent, and policy direction is especially unclear when the Fed abandons forward guidance.

While recent Fed speakers have hedged their remarks about being data dependent, recent former insiders like Bill Dudley has been more frank. A Bloomberg interview with former New York Fed president Bill Dudley shed some light into the Fed’s thinking. Dudley was a member of the triumvirate of the Fed chair (Yellen), Vice Chair (Fischer), and New York Fed President (Dudley) who drove most of the important monetary policy decisions. It was therefore illuminating to hear someone who can speak so honestly about Fed policy, and Dudley’s comments revealed a strong model-based cultural approach to policy decisions:

The recent stock market slump was probably necessary for U.S. policy makers to achieve their goal of restraining the expansion, former Federal Reserve Bank of New York President William Dudley said.

“Their view is, the economy is growing at an above-trend pace, we already have a very tight labor market, we need to slow the economy,” Dudley said in a Bloomberg Television interview Thursday. “Somewhat tighter financial conditions aren’t really a bad thing. They’re probably a necessary thing for the Fed to achieve its objectives.”

What about financial stability?

In his time at the New York Fed, which spanned the global financial crisis, Dudley elevated the importance of systematically incorporating changes in financial conditions into monetary policy decisions.

An index he designed while working as chief economist at Goldman Sachs Group Inc. before joining the Fed shows that conditions — a measure which combines the stock market, credit spreads and the exchange rate — are the tightest in about two years.

“What the Fed’s saying in their forecast is they still think — despite the sell-off in the stock market, despite the slowdown in global growth — that the economy is going to grow at an above-trend pace next year, and that’s why they’re continuing to tighten,” Dudley said.

“If the stock market were to keep going down, and the economy starts to weaken, then the Fed will definitely take a pause.”

Here is what it means to listen to the markets. Monetary policy operates with a lag, and the Fed is not going to react to every blip in stock prices. Financial conditions indices have begun to rise, indicating heightened stress, but levels are not excessive compared to past pre-recessionary readings.

Similarly, credit spreads are edging up, but levels are not alarming.

There is undoubtedly a debate raging at the Fed between the camp of the modelers and the camp of the pragmatists, led by Powell. In last Friday’s discussion, Powell made a parallel between the current situation to the 2015-2016 slowdown, and implied that the Fed could slow its pace of monetary policy tightening as it did during that period. Gavyn Davies, writing in the FT, compared and contrasted the data from two eras, and highlighted the likely opposition to the Powell narrative:

For some further context on the entrenched model-based culture at the Fed, here is the historical relationship between the growth in Average Hourly Earnings and the Fed Funds Rate. Regardless of the debate on the effectiveness of the Phillips Curve, it is not dead in the eyes of policy makers.

Bottom line, there is a Powell Put, but it is unclear where the strike price is. A strictly model-driven Fed could turn out to be a lot more hawkish than the market thinks, especially in light of the blowout December jobs report.

Two scenarios

In conclusion, the roots of the current pullback is one of the most ambiguous that I encountered during my career. I expect market in H1 2019 to be sloppy as it resolves these uncertainties. Conventional technical analysis suggests that the stock market is undergoing a bottoming process. Long-term sentiment is showing signs of capitulation, and insiders are buying. If history is any guide, the market should make an initial bottom in January, following by a rally and several months of choppiness, followed by a re-test of the previous lows. The re-test, which is expected to occur within a 2-6 month time frame, would be the final bear market bottom. The template to follow are past market panics, where stock prices fell but the economy did not fall into recession.

On the other hand, should a trade war erupt, or if an overly hawkish Fed pushes the economy into recession, all bets are off. The template might be the 2001-2002 market, where the market made an initial panic low in the aftermath of the 9/11 attack, rallied, and chopped around, only to decline into an ultimate double bottom a little over a year later.

In both cases, expect the market to be choppy in the next few months.

The week ahead: Can the breadth thrust carry the day?

When the stock market surged on the combination of the Job Report and dovish Powell comments, a lot of technicians got excited because of the breadth surge that exceeded the 9:1 ratio. This is consistent with a possible Zweig Breadth Thrust. The market became deeply oversold during the decline that ended December 24, 2018. Day 1 of the ZBT count began on December 27, and the market has 10 trading days, which would end next Thursday January 10, 2019 to flash a ZBT buy signal.

The bulls can also point to an unconfirmed breakout of a cup and handle formation on the hourly chart, with an upside target of about 2700.

There are different ways of interpreting the current conditions. SentimenTrader observed that the historical records shows that such breadth thrusts tend to resolve bullishly over the next three months. While such a development is intermediate term bullish, he was silent on what happens in the interim.

On the other hand, a historical study from OddStats documented what happened when the SPX rose 3% or more within a 10 day period. The results are not very encouraging.

As expected with breadth thrusts, the market is back to an overbought reading.

Technical analyst Wally Deemer also cast doubt on the sustainability of the rally based on a lack of leadership.

My inner investor remains bearish. My inner trader took profits on his long positions last Wednesday, and Friday`s bullish reversal has him very near his stop loss levels. Despite the breadth thrust exhibited by the market, he is watching to see if there is any bullish follow through before covering his shorts.An interim bottom is at hand, but it remains to be seen if we have seen the final low yet.

Disclosure: Long SPXU

A simple decision vs. a decision process

Posted by Cam Hui - January 3, 2019

I got some pushback from a reader to my weekend post (see How to spot the bear market bottom) about the FT Alphaville article indicating that former Secretary of Defense Mattis raised concerns about how the White House lacked a decision making process. The reader went on to defend Trump’s decisions.

I try very hard to remain apolitical on this site. Everyone is entitled to their own opinion, but there is a distinction between a decision, and a process. Here is an example from the investment realm. Josh Brown recently ranted about people “who called the correction”. Click this link if the video is not visible.

Josh Brown’s main complaints can be summarized as:

Anyone can make a market call. If you are wrong, very few people will remember, or you can delete your articles or tweets.
Managing a portfolio is a much tougher task. Portfolio managers are measured by actual returns. As an example, if you decide to sell out, what is your discipline for buying back in?
Just because someone doesn’t say anything, it doesn’t mean that they are unprepared for market volatility. Most firms have compliance guidelines about what individual portfolio managers or advisors can or cannot say or publish.

Despite my own efforts at transparency (see A 2018 report card) where I have published my track record, and owned up to bad calls, I sympathize with Brown. Josh Brown’s rant amounts to distinguishing a decision (market call) to an investment process. A timely market call means little if there is no investment process behind it.

What is an investment process?

At a minimum, here are the steps that professionals have in an investment process. They may call it different things, but the steps are more or less the same:

Decide on what to buy and sell, otherwise known as alpha generation;
Decide on how much to buy and sell, otherwise known as portfolio construction, or risk control;
Timing the trade so that you take maximum advantage of short-term conditions, and, if you are responsible for lots of assets, make sure your trading leaves a minimal footprint in the market; and
Periodically review and diagnose steps 1-3 to ensure that they are working as intended. In particular, good organizations learn from their mistakes, and make adjustments when things go wrong.

We focus most of our energy on step 1 because that’s the sexy part of investing. My timely call for a top in August (see Market top ahead? My inner investor turns cautious) was exciting. On the other hand, I would lose most of my readership if I devoted most of my time discussing the different ways of dissecting factor risk, or the pros and cons of arrival price vs. VWAP as a trading benchmark.

That’s the essence of the difference between a decision and a process. The market call is the decision. The process is how you implement that decision. The returns of your portfolio depends the strength of the investment process.

What I try to give you is step 1, the rest is up to you. Incidentally, the decision making process in step 2, how much to buy and sell, is a function of each portfolio’s return objectives, risk preferences and pain thresholds, tax situation and jurisdiction, and a whole host of other factors. Most portfolio managers will develop an investment policy statement (IPS) as a framework for step 2, which I know nothing about. That’s why nothing on this site can be construed as investment advice.

My limited guidance for investors

While I cannot give specific advice, here is some guidance that I can offer.

Over the years, I have been asked by readers on guidance on how to develop their personal IPS. I have hedged my answers, since I am not in a position to give investment advice for the reasons I cited. However, this liquidity based strategy from UBS can served as a useful framework for creating an investment plan.

The approach calls for splitting an investment portfolio into three buckets:

Liquidity: What you need for the next three years, which includes considering life and disability insurance needs.
Longevity: What you need to for the next 4 years and your lifetime.
Legacy: What you are going to leave for the kids.

On a separate topic, the recent equity market weakness would have moved the equity portion of many balanced portfolios below their equity target weight. The question then becomes, “When should you rebalance your portfolio weights as part of a disciplined investment process?”

The most obvious approach is to rebalance either periodically (quarterly, or annually) back to target weights. I call that the value approach of buying assets when they are cheap (gone down) and selling assets when they are expensive (gone up).

However, a past post from 2014 (see Rebalancing your portfolio for fun and profit) uncovered a research paper that indicated a price momentum strategy could yield better results. Here is the abstract [emphasis added]:

While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.

Go check it out.

How much do the bulls have left in the tank?

Posted by Cam Hui - January 2, 2019

Mid-week market update: Happy 2019 to everyone. The post-Christmas period started off with a bang. After bottom out on December 24, the stock market enjoyed four consecutive days of gains – until today when it was spooked overnight by a series of disappointing PMI prints.

The Caixin Manufacturing PMI fell to 49.7 from 50.2 (50.0 expected), indicating contraction. As a reminder, the Caixin PMI differs from China`s official PMI as the Caixin measures mostly the activity of smaller companies, while the official PMI measures the activity of larger SOEs.

Beijing has responded to past episodes of weakness with a stimulus program, but the stimulus announced so far has been underwhelming, as it has consisted mostly of targeted tax cuts. Anne Stevenson-Yang of J-Capital observed that China lacks the debt service ability for another round of shock-and-aw credit-driven stimulus.

The market was further hit by the news of weakness in eurozone M-PMIs, indicating deteriorating European growth. The outlook for the core European countries of France and Germany stand out as particularly problematical.

While the disappointing PMI figures put stock prices under pressure at the open, the bulls must have been encouraged by the intra-day recovery to see the market close only slightly negative on the day.

Relief rally played out

The relief rally of the last few days appears to be playing itself out. The market had moved to a deeply oversold condition, and began to rebound on December 26. Subscribers received an email alert that I was selling all of my long positions and reversing to the short side in my trading account. Despite the market recovery during the day, the SPX has broken down out of a rising wedge on the hourly chart. The path of least resistance in the near-term is down.

Short-term breadth (1-2 day time horizon) had become overbought (readings are as of the close Monday).

Longer term (3-5 day horizon) had recovered to a near overbought level, and the 2:1 advance-decline breadth today will extend the reading closer into the overbought territory.

V-shaped bottoms are rare. A more likely scenario is a low, rally, and then a decline to re-test the previous low. The re-test may see an undercut of the old low, but the key indicator to watch will be whether momentum indicators such as RSI flash positive divergence signals.

The current news backdrop is extremely fickle, and the markets have been understandably jittery. Nothing goes up or down in a straight line. Prepare for some short-term downside volatility.

Disclosure: Long SPXU

How to spot the bear market bottom

Posted by Cam Hui - December 30, 2018

The latest signals of each model are as follows:

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

Bottom spotting

The outsized daily swings in the major US equity averages tell the classic story of a bear market. Normal bull markets simply do not experience consecutive multiple daily moves of 2% or more.

The market’s panicked price action is highly reminiscent of past panics in 1962, 2002, and 2015. In those cases, the market bounced, and made a lower low several months later. In all cases, stock prices were higher a year later.

My base case scenario calls for an initial low, rally, followed by choppy price action, and a final low within 6-8 months. The most recent exception to this rule was 2001-2002, when stock prices cratered in the wake of the 9/11 attack, but made the final low just over a year later. Arguably, the 2002 low was distorted by the 9/11 shock, and the market made a double bottom in 2002 within the space of three months.

At this point, market psychology is becoming its own reality, and psychology may wind up dominating intermediate term market action. This week, I go bottom spotting as I offer a checklist of the signs of a market bottom, and try to estimate the downside risk posed by the current bear market.

A market bottom template

In a recent Forbes article, Brett Steenbarger studied the psychology of past major market bottoms and found a number of common elements of an initial drop, rally, and a second decline that violates the previous low:

Perspectives from market history are helpful here. Nothing progresses in a straight line. If you look at the history of big bear markets, there is usually a harrowing initial decline lasting several months followed by a rally that retraces a decent portion of the drop, taking out the bears. It is from that lower high that the major part of the damage from the bear occurs. Let’s examine some examples:

Initial Drop: June, 1901 – December, 1901 – Dow 78.26 – Dow 61.52
Rally: December, 1901 – April, 1902 – Dow 61.52 – Dow 68.44
Bear Decline: April, 1902 – November, 1903 – Dow 68.44 – Dow 42.15
Initial Drop: September, 1929 – November, 1929 – Dow 381.17 – Dow 198.69
Rally: November, 1929 – April, 1930 – Dow 198.69 – Dow 294.07
Bear Decline: April 1930 – July, 1932 – Dow 294.07 – Dow 41.22
Initial Drop: January, 1973 – June, 1973 – Dow 1051.70 – Dow 869.13
Rally: June, 1973 – October, 1973 – Dow 869.13 – Dow 987.06
Bear Decline: October, 1973 – December, 1974 – Dow 987.06 – Dow 577.60

If we look at more recent bear market periods, a similar pattern emerges. The initial declines from March, 2000 to April, 2000 (particularly steep in the NASDAQ Index) and from October, 2007 – January, 2008 were followed by nice bounces (April, 2000 to August, 2000 and January, 2008 to May, 2008) and then by steep declines into bear lows (August, 2000 to October, 2002 and May, 2008 to March, 2009).

Here is where the psychology part comes in:

It isn’t necessary to resort to mystical wave counts, Fibonacci levels, and chart patterns to explain what happens in bear markets. It’s all about stopping out the crowds. The euphoric bullish crowds are stopped out on the initial down leg; the desperate bears are stopped out on the rally leg; and the now comfortable bulls (and remaining longer-term bulls) are stopped out on the bear move to lows.

Rinse and repeat.

In other words, bear markets are markets of maximum pain for both bulls and bears.

A market bottom checklist

I do not know if the market has made its initial bottom. My preliminary assessment of the market action suggests that it has not, but that is only a guess. Nevertheless, here is a checklist that the stock market is starting to make a bottom. Not all of them have to occur, but the more items in the list that have been checked off, the greater confidence I have the market has bottomed.

Wait for a Tesla blow-up. Every bear market and recession unwinds the excesses of the previous cycle. Tesla is one of the icons of the excesses of the current expansion. The company has never has been cash generative, and relies on its creditors to finance its growth and operations. As the credit cycle turns down, the market will be less inclined to extend credit to cash eating concept companies like Tesla. In addition, the company faces severe competitive threats from incumbent manufacturers in electric vehicles. Consumer Reports recently highlighted luxury electric cars being unveiled by established manufacturers like Jaguar, Mercedes, Audi, and Porsche, some of which are already in dealer showrooms. All of them are far less likely to suffer from production delays and quality problems that have plagued Tesla.

So far, the stock is holding up well. An implosion in a cash eating concept company like Tesla will be one sign of credit market capitulation.

Wait for signs of investor capitulation: While short-term sentiment models have all reached off-the-chart panic levels, longer term indicators show that investor sentiment remain relatively complacent. At a minimum, I would like to see II % Bears rise above % Bulls as a pre-condition for a durable market bottom.

While institutions have become increasingly cautious, they have not panicked yet. One of the signs of institutional capitulation would see the BAML Fund Manager Survey show an underweight in equities.

Wait for absurdly cheap valuation. Scott Grannis recently observed that the equity risk premium (ERP), which he defined as the earnings yield (E/P) minus the 10-year Treasury yield, is cheap. While stocks are attractive, they are not the absurdly cheap levels that we would see during a market capitulation that takes out the “comfortable bulls” (in the words of Brett Steenbarger above).

How absurdly cheap? How about Apple (AAPL) at 100, when Buffett started accumulating his position, and where Berkshire’s holdings in AAPL is over 10x what it was when they began buying in early 2016? While those levels may only be a dream, such levels are possible during a market panic.

Wait for the high profile Berkshire rescue: So far, we haven’t seen a credit crisis yet. In past credit crises, Warren Buffett has managed to use the cash hoard and balance street strength of Berkshire Hathaway to rescue and backstop troubled companies at highly favorable terms. Examples include Goldman Sachs at the height of the GFC, and more recently Canada’s Home Capital Group, whose stake Berkshire exited in December. Watch for a Berkshire rescue as a sign that the credit risk frenzy has reached its peak.

How far down can stocks fall?

I am often asked about the downside risk potential in the US equity market. It is difficult to answer that question without knowing the fundamental reason for the bearish episode. From a chartist’s viewpoint, however, a reasonable round number initial downside S&P 500 target would be 2100, which represents both a Fibonacci retracement level, and a zone of resistance now turned support.

Much depends on the perceived reason(s) for the price decline. Until we can diagnose the fundamental reasons for the market weakness, it is impossible to determine and calculate a downside price target.

There are some good fundamental reasons for a bearish episode. Last week, I had attributed the decline to the market discounting an economic slowdown in H1 2019 (see What just happened in the stock market?). Further confirmation of this thesis came from two sources. Near Deal democrat, who has been monitoring high frequency economic data and splitting them into long leading, short leading, and coincident indicators, wrote this week that his short leading indicators has deteriorated from positive to neutral. The weakness that began showing up in his long leading indicators six months ago is now becoming evident in his short leading indicators.

As well, JPM Research pointed out that estimate revisions had been falling in non-US market for much of 2018, and the US is just now playing catch-up. Is it any wonder why US equities are under pressure and underperforming global markets in December?

However, a H1 slowdown does not mean a recession, but further growth deterioration into recessionary conditions is likely to exacerbate downside risk. However, all bets are off if the Sino-American trade truce heats back up into a trade war.

The tea leaves are mixed. Mid-level officials from both sides are scheduled to meet in early January. The Economist reported that China have prepared a series of concessions:

Chinese negotiators are focusing on two themes, according to people familiar with the talks. First, they are walking away from the “Made in China 2025” plan, a blueprint for turning the country into an advanced manufacturing power. Foreign businesses object to it because it specifies market-share targets for China in sectors from biotech to robotics. Chinese officials have already downplayed its significance, describing it as a vague, aspirational document. References to it have all but vanished from state media. Now, the government appears ready to rescind it formally. Even the Global Times, a nationalist state-owned tabloid, has called for a new plan.

Second, the government wants to show that foreign companies play on a level field. Liu He, the lead Chinese trade negotiator, has asked the central bank to devise guidelines for how “competitive neutrality” would work in China, according to someone briefed on the project. The idea, promoted by the oecd rich-country club, is that state-owned companies can form part of a healthy market economy provided they enjoy no special advantages. China will try to convince Mr Trump that it is serious about meeting this standard.

On the other hand, Reuters reported that the White House is considering an emergency executive order banning Huawei and ZTE equipment in American networks. Such a move would send a chilling signal to China that the Americans plan to shut them out of the crucial 5G market, and cripple Beijing’s industrial policy of migrating up the value chain, It would most certainly stall any progress in trade talk and heighten the risk of Cold War 2.0.

In addition, I had also highlighted last week a BIS paper that warned about financial risk, and how the financial cycle was different and distinct from the business cycle. Former Dallas Fed president Richard Fisher recent appeared on CNBC and worried out loud about the risk of possible financial contagion from Europe. Fisher stated that the ECB had pushed bond yields into negative territory for so long that it was bound to create excesses. Since the eurozone is the second largest credit pool in the world outside of the US, the risk of financial contagion is high should Europe plunge into recession.

Indeed, the risk of a European recession is rising. Bloomberg reported that over half of Germany’s small and medium sized businesses expect a contraction next year. If Germany, which is the locomotive of the eurozone, were to slow, what happens to the rest of Europe? What happens to its banking system?

Trump unbridled

The final risk posed to the markets is the unpredictability of Trump’s behavior. About a year ago, I suggested that 2018 would be the year of “full Trump” (see Could a Trump trade war spark a bear market?) which would signal an abrupt shift in policy after his dramatic tax cut victory. Indeed, the rhetoric on Trump specific initiatives, such as rising trade tensions, holding China to account, and the Wall, have become far more prominent in 2018.

The risk in 2019 is that “full Trump” becomes “Trump unbridled”, which will cause greater anxiety for the markets. To be sure, Trump did not cause the stock market to fall, but his recent behavior has rattled Wall Street that is likely to exacerbate downside risk, in a similar manner that the widespread use of portfolio insurance hedging techniques exacerbated price risk in the Crash of 1987.

Official Washington was recently unnerved by a series of events out of the Trump administration, such as the abrupt decision to pull troops out of Syria; the Mattis resignation; the impasse over the government shutdown in which Trump initially proclaimed that he would be glad to “own the shutdown” and later laid responsibility for the shutdown to the Democrats; the leaked story that Trump was so unhappy with Powell that he was seeking to fire the Fed chair; and Secretary Mnuchin’s bizarre announcement on Christmas Eve that he had consulted the heads of major US banks and assured that the market that there was plenty of liquidity when there was no apparent liquidity problem.

FT Alphaville nailed the issue on the head when it reported that Mattis was concerned about the lack of a decision making process within the Trump administration:

Last week after James Mattis resigned, Alphaville spoke to a former administration official who was familiar with the Defence Secretary’s relationship with President Trump. That conversation became a small part of a broader FT story, but what stood out for us was this: Mr Mattis wasn’t just concerned that the White House was making bad decisions. He was concerned that the process to make decisions had disappeared.

Here’s the former official:

I think over time it likely became more apparent to the secretary that the president had begun to seek out his counsel less on major decisions. And the manifestation of that was a widening in the rhetoric and the substance, in the policy decisions that were made not necessarily as part of an orderly national security staff or national security council process, but rather by either a small group in the white house or by the president himself… If you precipitously withdraw with no apparent process, do so via tweet, and not with the consultation of allies, not with the consultation of senior uniformed military personnel, that is anathema to both process and the ability to achieve a sustainable posture that defends the country.

The President of the United States is not Louis XIV, the Sun King of France who wielded absolute power at his whim and discretion, “L’etat, c’est moi.” The US government has a process to making decisions, and the process can help avoid bad decisions. If you don’t like the decision, change the process, or the people involved in the process:

Normally, US presidents stand at the end of a long chain of people preparing them to make decisions. Presidents get scenarios, consequences, precedents, and so even though they often make bad decisions, we seldom see them make disorienting, head-scratchingly weird decisions. On a football pitch, we might see a wing make a hopeless cross into traffic. That’s a bad decision. But we never see a wing, say, pick the ball up off the field and shower it with glitter. That’s a weird decision. It’s not how anyone does football.

Good process limits a president to actions that are possible and plausibly legal, with at least guesses on consequences, plans to carry them out and a gut check that we’re not all throwing glitter on a football.

FT Alphaville went on and dissected the unusual nature of the Mnuchin Christmas Eve incident:

In its annual report this year, the US Financial Stability Oversight Council worried about a couple of things, in particular non-financial corporate borrowing, and how that might feed into a stock-market slump. But the council didn’t show much worry at all about whether the six largest US banks could meet their immediate obligations.

Of all the things that have failed to improve over the last decade, exactly these banks are in fact better capitalised now, and subject to more careful macroprudential oversight. Look here: the Fed’s Comprehensive Capital Analysis and Review says the largest US banks held an aggregate capital ratio of 12.3 per cent last year. That’s great! It’s not 20 per cent, and we have quibbles about risk-weighting of assets, but still.

In evaulating these banks, the Fed even subjects them to hypothetical, stressful financial markets scenarios that are way worse than what we’re seeing in reality now: 2-1/4 per cent drops in GDP growth, 7 per cent unemployment, 30 per cent troughs in stock indices. And that’s not even the Fed’s worst hypothetical. Those banks that Steve Mnuchin called this weekend: they are the last item in a long list of what people in financial markets might be worried about.

And now, literally on the night before Christmas, after determining that a thing that is not a problem is not a problem, the Secretary of the Treasury of the United States of America is convening the President’s Working Group on Financial Markets, an organisation that doesn’t really exist. It doesn’t have an office, or legal authority, or even employees. There’s an executive order from 1988 that says the president can tell several department and agency heads to get together and talk, then report back to the president. The working group is a way for a president to say HELLO AMERICA I AM DOING A THING.

In other words, good processes keep you from making rookie mistakes. The current administration has demonstrated a series of rookie mistakes, starting with the ham-fisted implementation of the travel ban when Trump first assumed office.

Trump has been behaving like he is the chief executive of a company he controls, which he is not. He is the head of a government, and the government has checks and balances that he has chafed against. To be sure, he was elected to disrupt official Washington, but the lack of process and his assumption of king-like absolute power is leading to uncertainty. Markets hate uncertainty, and a year of Trump unbridled will raise uncertainty and lower equity returns.

Consider, for example, Trump’s unhappiness with Jay Powell and the Fed’s decision to raise interest rates in December. There are reports that Trump and Powell are expected to meet in the next few months. There is little upside to the meeting and plenty of downside potential.

Here is how the meeting may be resolved. It is clear the Trump and the Fed are involved in a skirmish over monetary policy, but how do you downplay the skirmish in the aftermath of the meeting? Could Trump tweet a mis-characterization of what was discussed in order to declare victory and put himself in a favorable light? Even if an uneasy truce were to be achieved, could some future event cause Trump to violate the understanding and claim that the Fed is acting in bad faith? Worse still, what if Trump were to downgrade Powell’s position as Fed chair to governor and appoint a new Fed chair? Could Senate Republicans rebel and refuse to confirm the new nominee? There are actually two chairmanships, and the most important one is the chair of the FOMC. Could the members of the FOMC, composed of Fed governors and regional Fed Presidents, rebel and elected Powell as the FOMC chair? Just imagine the uncertainty and the market effects.

The markets would react badly even if Trump got his way and he was able to dictate monetary policy. In the modern era, only EM countries have seen the government dictate monetary policy. Argentina and Turkey are two examples that come to mind. The stock markets of those countries generally trade at single digit P/E ratios. Is that the outcome that Trump wants?

We haven’t even seen the Democrats take control of the House committees and launch investigations. The results of the Mueller probe should become clearer in 2019. In all likelihood, a 2019 year of Trump unbridled, with no government processes to constrain his actions, is going to create more volatility for the markets.

The 1962 market template

The stock market of 1962 may be a useful template for investors. While Trump is not JFK, and JFK is not Trump, a study of the market reaction to the Kennedy era may be revealing for insights into the market reaction to strong-arm presidential tactics against business, as well as market psychology when the economy sidestepped a recession.

JFK became President in 1960, and he was elected as an outsider and disruptor, much like Trump. Kennedy proceeded to embark on a serious foreign policy misadventure, namely the disastrous Bay of Pigs invasion of Cuba. Trump has alienated numerous allies, and parted ways with his Secretary of State and Secretary of Defense.

JFK went outside traditional norms and attacked the steel industry. He went on to send FBI agents into the offices and homes of steel executives. The steel companies eventually caved, but the “Kennedy Slide” began in December 1961, sparked by a “businessman’s panic” of what industries Kennedy might target next. The market bottomed coincided with the height of the Cuban Missile Crisis. 1962 was not a recession year.

S&P 500

Trump has broken virtually all the norms of Washington, and one of his signature initiatives is to strong-arm companies from offshoring jobs. He has attacked traditional allies, and spooked the markets with his protectionist measures.

History doesn’t repeat itself, but rhymes. While I am definitely not suggesting an end-of-world nuclear button crisis in the near future, the 1962 experience may serve as a useful roadmap for what investors may expect in 2019, even if the economy were to sidestep a recession. Trump’s unconventional approach to policy making is likely to keep the market on edge for 2019 and beyond.

In conclusion, the technical price action of the market is consistent with a bear market. I have offered a checklist of events that occur at market bottoms, but I do not know where the market may bottom out. Much depends on the fundamental drivers of the bear market, policy risk from both the White House and Federal Reserve, and how they are ultimately resolved.

The short-term outlook

Looking ahead to the next few weeks, stock prices constructively bounced after experiencing a deeply oversold condition. Mark Hulbert observed that sentiment became even more bearish even after the nearly 5% rebound last Wednesday, which is contrarian bullish:

Early indications are encouraging in this regard, since the average market timer reacted to Wednesday’s big rally by actually becoming even more bearish. The Commentariat also appears to be solidly bearish, confidently announcing that the bear market remains alive and well, as evidenced on MarketWatch Thursday morning by Michael Sincere and Lawrence McMillan.

Hulbert’s sentiment readings of newsletter writers is in the bottom 4%, and NASDAQ timers is in the bottom 3%:

Consider the average recommended equity exposure among a subset of short-term stock market timers I monitor, as measured by the Hulbert Stock Newsletter Sentiment Index (HSNSI). This average currently stands at minus 15.6%, which means that the average timer is allocating about a sixth of his equity trading portfolio to going short.

This minus 15.6% reading is one of the lowest on record. Only 4% of readings since 2000, in fact, were any lower. The last time that the HSNSI was as low as it’s been this month was February 2016, which was the bottom of the correction (some say bear market) that began in May 2015.

A similar picture is painted by the sentiment data for stock market timers who focus on the Nasdaq market in particular (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). They’re even more bearish than those reflected in the HSNSI; the HNNSI currently stands at minus 61.1%. Only 3% of readings since 2000 have been lower than this.

In addition, Friday’s rally carried the S&P 500 above a downtrend line, which is another constructive sign that further near-term gains are possible.

The bulls should temper their enthusiasm, however. Urban Carmel pointed out that 4-5% gains in a single day, especially after a long decline, are normally usually not indicative of the ultimate low. Here are just a few examples. Prepare for a brief rally, and then a re-test and likely undercut of the previous lows.

Past short-term bounces off deeply oversold conditions have typically lasted between two and six trading days. Further upside may be possible, as breadth indicators are not overbought yet.

There is more potential upside into the overhead resistance zone at 2500-2550.

While V-shaped bottoms are uncommon, they are not totally unheard of. Last Thursday began the day 1 count of the Zweig Breadth Thrust setup signal. If the ZBT Indicator can rise above 0.615 within 10 trading days, it would flash a rare ZBT momentum buy signal. While I am not holding my breath for the buy signal, I am keeping an open mind.

My inner investor de-risked to a minimum risk portfolio several months ago. Given the recent fall in stock prices, his portfolio is actually underweight equities. Subscribes received an email alert last Wednesday morning that my inner trader was doubling up on his bullish bet, and he is nervously hanging on to his long positions.

Disclosure: Long SPXL, TQQQ

A 2018 report card

Posted by Cam Hui - December 26, 2018

The year is nearly over, and it is time to issue a report card for my investor and trading models. Overall, both had good years, except for the trading blemish at year-end.

My inner investor could not have asked for much more. He was correctly bullish during the run-up from early 2016, and turned cautious at the January top. He turned bullish again as the market corrected in February, and became cautious again in August (see A major top ahead? My inner investor turns cautious).

The cautiousness turned into bearishness in early December when my Ultimate Market Timing Model flashed a sell signal after a 10% drawdown (see A bear market is now underway). As a reminder, the Ultimate Market Timing Model is a very slow turnover model that changes its views only every few years. It was designed for by investors with long term horizons, with the intention of avoiding the worse of equity drawdowns associated with major bear markets:

I am indebted to the blogger at Philosophical Economics who suggested a macro overlay to trend following systems (see Building the ultimate market timing model). Major bear markets generally occur under recessionary conditions. Why not ignore moving average signals until your macro model is forecasting a recession?

This “Ultimate Market Timing Model” is ultimately beneficial for long-term investors. If you could cut off the left tail of the return distribution and avoid the really ugly losses, you could run a slightly more aggressive asset mix and receive a higher expected return with lower risk. For example, if the standard risk-return analysis dictates a 60% stock and 40% bond asset mix, you could change it to a 70/30 mix with this model, and get downside risk similar to the 60/40 portfolio. To be sure, this system isn’t perfect, and anyone using such a model will have to incur “normal” equity risk, and it would not have kept you out of the market in the 1987 Crash.

Little did I expect the market to fall so dramatically after that sell signal, but I can’t ask for much more in an asset allocation model, either on an intermediate or long term perspective.

Trading Model: Lessons learned

The trading model also had a reasonably good year. The hypothetical return of the signals, based on end of day prices, no transaction costs, and no dividends, was 40.6% to December 26, 2018, compared to capital only return of -7.7% for the SPX. The trading model managed to catch virtually every major turning point, except for the one major blemish at the end of the year.

The above chart of the out-of-sample returns of the trading model is revealing in a number of respects. The model trailed the market since its March 1, 2016 inception until recently. That’s one feature of these kinds of market timing and swing trading models.

Daily stock returns were positive 54.0% of the times during the measurement period. That means that if you no other information, the default bet should be a bullish one, and if you are flipping a coin, you would have a 4% disadvantage.

Conceptually, market timing is designed to avoid bear phases, and they tend to outperform simple buy-and-hold strategies when there is a major bear phase. In effect, market timing and swing trading act as a form of downside insurance, and insurance has a cost. Think of it as a long position married with a put option.

That’s the first lesson learned.

The second lesson for traders can be learned from the drawdown at the end of the year, where the model was caught long as the market tanked. The drawdown is a feature, not a bug of the design of the trading model.

The initial version of the trading model depended on price momentum as applied to a composite of US equity, non-US equity, and commodity prices. Regardless of the actual trend, if the trend is improving, it is a buy signal, and if the trend is deteriorating, it is a sell signal.

One of the problems encountered with a pure price momentum model is momentum extremes. Should you continue to buy when the market is overbought, or short when the market is oversold? The second version of the trading model combined both price momentum, and took advantage of counter-trend moves when the market became either overbought or oversold. By and large, this combination worked well…until an oversold market became increasingly more and more oversold as it did in December 2018.

Trading = Making a bet somewhere

Here is another key lesson for traders. Trading models and systems are not magical black boxes. You have to make a bet somewhere in order to realize better returns. The corollary to that is sometimes those bets don’t pay off. To protect yourself, understand the bets you are making, what the weaknesses of the trading system are, and when it may not work. And no bet works all of the time.

For traders, another lesson is to understand the bets that your trading systems are making, and control your risk accordingly. One way is to customize the position sizing based on specific risks of the trading system, or to diversify trading systems based on factor exposures.

Rob Hanna at Quantifiable Edges had a terrific example of how a trading system failed:

After the strong and persistent selling over the last few days I decided to examine other times like now where the SPX dropped at least 1.5% for 3 days in a row. The study below looks back to late 1987 and shows all 10 occurrences over the time period, along with their 10-day returns. The consistency and size of the bounces over the next 10 trading days is “very good indeed”.

This system worked well…until it went long into the Crash of 1987. The moral of this story is “Understand your bets. Beware of tail-risk.”

I will close with an observation from Ray Dalio of Bridgewater. Drawdowns are opportunities for learning. Don’t be afraid of mistakes.

What just happened in the stock market?

Posted by Cam Hui - December 23, 2018

The latest signals of each model are as follows:

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

What is the market discounting?

The velocity and ferociousness of the recent US equity market weakness caught even bears like me by surprise. My social media feed has been filled with extreme bearishness. Opinions are now becoming bifurcated. Either the decline is the signal of something big, or the fall in stock prices represent a buying opportunity for fundamentally oriented investors.

It is impossible to make a buy, hold, or sell decision without some understanding of what the market is discounting. In other words, what bet are you making if you decide to buy or sell stocks here?

Further analysis reveals that investors are discounting only a mild US slowdown in 1H 2019, but no recession. From a technical perspective, both the US and global markets have violated well-defined uptrend lines, just as they did in 2015 and 2007. It remains an open question as to whether the trend line breakdowns will result in just a mild pullback, or a deeper bear market. (Please note that the curves and arrows drawn on the charts are only stylized, and do not represent technical projections or targets).

A slowdown ahead

There are plenty of signs that growth is decelerating, which both Ed Yardeni and Urban Carmel were prescient enough to warn about. My set of long leading indicators, which are designed to spot recessions a year in advance, began to deteriorate last summer and now stands at a near-recession reading. The deteriorating is becoming evident in growth expectations, as GDP growth is expected to slow from the torrid 3-4% annualized rate to about a 2% pace in 2019.

The transportation sector is a highly cyclical sector and represents a short leading indicator of economic growth. The recent FedEx (FDX) earnings report was disturbing, as the company stated “global growth has slowed but we are very surprised by the magnitude of the headwind, which is what might be seen in a severe recession”. The price performance of FDX and the DJ Transports has historically led GDP growth by roughly six months, and they are pointing to a sharp deceleration in economic growth. However, I would not characterize the decline to be severe enough to declare a recession (yet).

In addition, the latest update from FactSet shows forward EPS estimate revisions have been flattening, which is another indication of diminished growth expectations from Wall Street.

No recession expected

How has the market responded to these signals? The latest BAML Fund Manager Survey was highly revealing. Institutional managers overwhelming rejected the idea of a global recession in 2019 (top panel), but expected growth to decelerate (bottom panel). In other words, they only expect a slowdown.

What are they doing with their equity allocation? Last week, I highlighted analysis from Kevin Muir of The Macro Tourist, who believed that managers were in a crowded long in USD assets, including equities. As US growth slows in early 2019, managers will begin to normalize their overweight position in US equities. That is precisely what is the Fund Manager Survey is telling us. Instead, managers are re-allocating their weights to the high beta EM equities, which is consistent with the view that the world would avoid a 2019 recession.

The relative performance of US, EAFE, or developed non-US markets, and EM equities relative to the MSCI All-Country World Index (ACWI) tells the same story. US stocks have been range bound on a relative basis since August and they have begun to break down only recently. Instead, EM equities are gaining relative strength.

In other words, both the survey data and real-time performance data reflect the view that the market expects a US growth deceleration, but no global recession. Otherwise investors would not be buying the high-beta and high risk EM sectors, no matter how beaten up and cheap they seem.

The financial cycle vs. business cycle

One key risk to the outlook comes from a deteriorating financial cycle. A recent BIS paper, “The Financial Cycle and Recession Risk”, made a distinction between the business cycle, whose analysis is well captured using my long leading indicators, and the financial cycle.

Financial cycle booms can end in crises and, even if they do not, they tend to weaken growth. Given their slow build-up, do they convey information about recession risk? We compare the predictive performance of different financial cycle proxies with that of the term spread – a popular recession indicator. In contrast to much of the literature, our analysis covers a large sample of advanced and emerging market economies. We find that, in general, financial cycle measures provide valuable information and tend to outperform the term spread.

One of the best real-time indicators of the financial cycle is the relative market performance of bank stocks. Past technical breakdowns of bank stocks have signaled periods of financial stress, and the relative performance of regional banks (bottom panel) have shown to be an even more sensitive barometer. Bank stocks recently violated a key relative support line, which is an indication that the financial cycle is turning down.

As an aside, consistent with the analysis from the BIS paper, the bear market and recession that began in 2000 was not the result of financial stress, but a Tech Bubble that was not largely financed with debt. If punters had bought NASDAQ stocks on margin, the resulting downturn would have been far worse.

The usefulness of the relative performance of US bank stocks is their correlation of the relative performance of European banks. The relative performance effect appears to be global, with the exception of selected localized events such as the recent US tax cut effect on financials. This is an indication that bank stocks are capturing the global financial cycle.

Where are the stresses in the financial system? They don’t seem to be emanating from the US. Financial conditions have deteriorated, but they don’t appear to be out of control.

Yield spreads have widened, but readings are not levels seen before the last recessions.

In this cycle, the financial risk originate outside the US. For one, Europe never fixed its banking leverage problems from its last cycle.

John Authers at Bloomberg recently cited USD liquidity as a possible problem for eurozone banks:

Meanwhile, the agonies for banks in the euro zone grow ever worse. The new reason for their problems, which have happened even though the European Central Bank, unlike the Fed, is still engaged in QE, seems to be a shortage of dollars. This is partly because of the Fed, but also possibly in part because of another signature U.S. policy. The tax reform package passed a year ago provided for the repatriation of foreign U.S. corporate subsidiaries’ earnings. Previously, those earnings sat in the accounts of foreign banks, providing a supply of dollars. Now that the big and successful U.S. tech groups are no longer leaving large piles of cash in Europe, the problems for Europe’s over-bloated and inefficient banking system have grown much more acute

Indeed, offshore USD liquidity is tightening, and has the potential to put downward pressure on equity prices.

And who can forget the debt building in China.

The Chinese economy is already slowing. The SCMP reported that unemployment is rising as the trade war is starting to bite. This will handcuff China’s maneuvering room in its trade negotiations with the US as Beijing has historically put a heavy policy weight on employment and social stability.

Beijing is now officially worried about unemployment, as the US-China trade war continues to weigh on the world’s second largest economy.

On Wednesday, the State Council unveiled policies ranging from refunding unemployment insurance payments to companies that do not lay off staff to giving subsidies to jobless young people aged 16 to 24 rather than only to college graduates without jobs, according to a document on the government’s website.

The cabinet’s policy paper, which was drafted on November 16 but only made public this week, had already been passed down to local governments last month. The local governments were told to draft their own versions, taking account of local conditions, within 30 days.

Beijing has prioritised employment stability over other economic targets in various meetings, but the document offers the first sign of unease within the central government leadership over whether it can fight off unemployment pressure, as the trade war continues to reduce corporate hiring demand, particularly from export manufacturers.

Reuters report that China plans a stimulus package to support growth:

China will ratchet up support for the economy in 2019 by cutting taxes and keeping liquidity ample, the official Xinhua news agency said following an annual meeting of top leaders amid a trade dispute with the United States.

The government has launched a raft of measures, including reductions in reserve requirements for banks, tax cuts and more infrastructure spending, to ward off a sharp deceleration in the world’s second-largest economy. Further policy steps are expected.

Another round of stimulus is unlikely to have similar effects as past packages. If the stimulus is purely fiscal in nature, investors are likely to be disappointed with the magnitude of the effect. If the stimulus is credit driven, John Authers pointed out that credit impulses are growing less and less effective as a way to boost growth.

Then there is the trade war. The most benign outcome would see Trump extract minor concessions from Beijing and declare victory. Another possible bullish scenario would involve Trump, under pressure from declining stock prices, continue to negotiate but delay the implementation of the next round of tariffs.

Regardless of how the trade dispute will be resolved in the near-term, trade frictions are unlikely to go away. Leland Miller of China Beige Book recently made the point on CNBC that there is a bipartisan consensus in Washington that trade with China is a big problem. Miller expects trade tensions to ramp up in the runup to the 2020 election, as both sides will try to position themselves as being “tough on China”.

Assessing the bull and bear cases

How will these risks resolve themselves? Unfortunately, my time machine is in the shop getting fixed and I don’t have a definitive answer.

Conventional macro business cycle models indicate that while recession risks are rising, but readings are not high enough to make a recession call for late 2019 or early 2020. I can therefore make the case that the American economy slows in 2019, but avoids a recession. In that case, the current market carnage represents a buying opportunity. New Deal democrat‘s long leading indicators have been bouncing around but readings are neutral, indicating no recession ahead. He warned against projecting the deterioration of model readings into the future to make a recession call:

The long leading indicators remained neutral again this week. The nowcast remained positive. The short-term forecast a weaker positive, Although there were no rating changes, stocks, commodities, the regional Fed new orders indexes, and the US dollar all turned less positive or more negative.

I want to add a note this week that I think people are getting ahead of themselves, projecting weak trends to weaken even further, and assuming that means recession. It has struck me this week how in many ways the current situation reminds me of year-end 1994. Alan Greenspan was aggressively raising rates in the face of non-existent inflation. Sentiment turned awful, and portions of the yield curve briefly inverted. And then … it didn’t happen. There was a big slowdown in 1995 followed by a big rebound. I’m not on recession watch now, and I won’t go on recession watch unless and until the broad range of data justifies it.

Indeed, the latest update from Open Insider shows that this group of “smart investors” are buying the dip.

On the other hand, global recession risks are rising. While correlation is not causation, but German manufacturing and Chinese industrial activity. Further Chinese weakness could see financial contagion effects leak into the European banking system.

From a technical perspective, I would look for conditions when the market stops responding to bad news. One example can be found during the eurozone and Greek Crisis of 2011. During the summer of 2011, the eurozone was at risk of breaking apart, and European leaders were having almost weekly summits on how to solve the problem. At times, it seemed that Europe was leaderless, and no one was in charge. The crisis lifted after the ECB unveiled its LTRO program to backstop the banking system in order to buy time for member states to engage in structural reform. Some time during that process, the market stopped falling on bad news.

We have not arrived at that point yet. The market response to the FOMC decision shows that the market had unrealistically high expectations for Fed policy.

In addition, % Bears from the Investors Intelligence survey (blue line) edged up last week but remains stubbornly low. The latest survey was done early in the week, when the market was already tanking. Ideally, I would like to see % Bears exceed % Bulls as the sign of capitulation. The lack of a spike in II Bears is an indication that long-term sentiment is insufficiently washed-out for a long-term bottom.

My recommendation is to monitor the evolution of financial risk, as well as the evolution of investor psychology in order to determine the timing of a market bottom. My inner fundamental and macro analyst is keeping an open mind as to the possible outcomes. My inner technician believes that this is the first leg down of a deeper bear market.

The short-term outlook

Looking ahead to the next few week, to say that the market is oversold is an understatement as readings are now at off-the-charts levels. The CBOE put/call ratio (CPC) reached 1.82 last Thursday, which is the highest level in its history since 1995. A historical study shows past SPY returns when CPC 5 dma crosses above 1.24 for 1st time in a month, n=13 since 1995. 92% closed higher within 5 days with average return of 2.5%.

The Zweig Breadth Thrust Indicator is also oversold, and readings are comparable to levels seen at the panic selloffs in 2008 and 2011.

The NYSE McClellan Summation Index (NYSI) has reached the oversold levels seen at previous major bear markets. The good news is the positive divergence on stochastics (bottom panel).

The % Bullish indicator is also in blind panic territory.

One reader likened the panic as “hanging on a horse running in a burning barn”. The following observation from SentimenTrader is just one of many examples of this panic.

Conditions are more than ripe for a relief rally. That said, some caution is warranted. Urban Carmel pointed out that while the market has historically seen a bounce under similar conditions, but the market has re-tested the lows soon afterwards (see red arrows).

My inner investor interprets these conditions as the signs of an intermediate term bear market. He de-risked his portfolio in September and he is glad he missed the carnage.

My inner trader was caught long, and he is hanging on to play the bounce. When the rally comes, he is watching short-term breadth for an overbought condition to short into for the likely re-test of the previous lows. Volatility will be treacherous. Adjust your position sizes in accordance to your risk tolerance.

I have received a number of words of encouragement on the record of the trading model this year. The latest drawdown is a shock and disappointment. I will write a full analysis of the trading model in the near future.

Seasons Greetings and happy holidays to all.

Disclosure: Long SPXL

A bloodbath on Wall Street

Posted by Cam Hui - December 19, 2018

Mid-week market update: I had expected to begin to wind down and relax for the holidays this time of year. Instead, we got a bloodbath in the stock market.

To say that the market is oversold is an understatement. Sure, standard measures indicate oversold conditions, such as the VIX Index had risen above its upper Bollinger Band. Interestingly, the VIX Index failed to rise today despite the carnage in the stock market, which could be a sign of hope for equity bulls.

The Fear and Greed Index is also showing extreme conditions.

Oversold markets can become more oversold. How oversold? This report from UBS puts the velocity of the sell-off into context.

Here is the full chart from UBS:

Rebound ahead?

Here is what happened next. Out of the 14 instances, 8 of the following years saw very positive returns of +12% to +44% while 6 saw very negative returns.

SentimenTrader also found that returns in the following quarter tends to be positive, though it is difficult to generalize with such a small sample size.

In other words, expect fat-tailed performance in the coming year. For what it’s worth, the stock market weakness created a Zweig Breadth Thrust oversold condition, which is a setup for a possible ZBT buy signal. Should the market rebound sufficiently to achieve a breadth thrust in the 10 trading days after the recovery from the oversold condition, it would generate a rare ZBT buy signal indicating positive momentum. Even without a ZBT buy signal, such oversold conditions can be useful signals of a market that is stretched to the downside.

My inner investor has de-risked his portfolio, but my inner trader remains bullishly positioned in anticipation of a relief rally, but he is feeling the pain and getting very nervous.

Disclosure: Long SPXL

How China and America could both lose Cold War 2.0

Posted by Cam Hui - December 17, 2018

In a past post (see Pax Americana or America First?), I showed how the combination of the unequal sharing of productivity gains and the inward looking America First policies were eroding US competitiveness, and raising the fragility of the post-WW II Pax Americana boom.

Even though the US and China appears to be locked into a Cold War 2.0, I would like to demonstrate how both countries appear to be locked into paths that will eventually stall their growth.

Andy Haldane’s about face

We begin the story with the Bank of England’s chief economist Andy Haldane, who recently made a remarkable speech to some students at Oxford. Haldane said that he had changed his mind about the drivers of economic growth:

I thought I understood the story of economic growth, its drivers and determinants. But recently I have changed my mind. I have a new story of growth. I think this story carries important implications for understanding the future challenges of technology and for devising the future policies and institutions necessary to meet them. That might require, among other things, a repurposing of successful institutions like this one, turning them from universities into multiversities.

The old neoclassical models weren’t good enough:

In the second half of the 18th century in the UK, ideas began sprouting like morning mushrooms. These ideas emerged seemingly spontaneously and roughly contemporaneously. They were also relatively closely clustered geographically. They included James Hargreaves’ spinning jenny in 1764, Richard Arkwright’s water frame in 1769 and James Watt’s steam engine in 1775.

In the fullness of time, these ideas began to revolutionise both industry and work. After a lengthy adoption lag, they spread across sectors and across regions. They migrated from being mere ideas to becoming “GPTs” or General Purpose Technologies.12 In the process, they generated waves of investment in new factories, machines, processes and infrastructures. There was, in the jargon, capital-deepening.

Neo-Classical theories of economic growth are very clear what would be expected to happen next.13 When an outward shift in the economy’s technological frontier is combined with higher levels of physical capital, the fuse is lit on higher productivity among companies, higher wages among workers and, ultimately, higher living standards among societies. So it was during the Golden Era.

Chart 2 plots productivity, wages and GDP per head in the UK since the Industrial Revolution. All three plateaued prior to 1750. Since then, all three have moved up in lockstep. Ideas and innovation have borne continuous fruit in higher productivity, pay and living standards. This fruit has been shared roughly equally between owners of companies (profits) and workers in companies (wages). We know that because labour’s share of the national income pie is similar today to 1750.

Here is the problem with those models. Why did other waves of innovation fail to transform societies?

You do not need to go that far back for examples of big ideas which had a transformative impact on industry and society. Immediately prior to the Industrial Revolution and running chronologically, these included the windmill in the 12th century, the mechanical clock in the 13th, the cannon in the 14th, the printing press in the 15th, the postal service in the 16th and the telescope and microscope in the 17th.

It will surprise no-one that waves of innovation, big and small, have been lapping the shores of society for the entirety of human civilisation. In other words, while ideas and innovation may well be a necessary condition for economic growth, the historical record suggests they may not themselves have been sufficient. Other forces appear to have been at play, translating these ideas into sustained growth in living standards.

Haldane came up with two ideas:

What might those forces be? I want to provide two different, but complementary, lenses on the growth story. The first focusses on a rather broader set of “capitals” – not just physical capital (plant and machines) but human (skills and expertise), intellectual (ideas and technologies), infrastructural (transport and legal systems), social (co-operation and trust) and institutional (national and civic, private and public) capital.

History suggests each of these capitals may have played an important supporting role in the story of growth. Ideas alone, without the support of one or more of these broader capitals, have historically run aground. For example, in the UK many of the foundations for growth after the Industrial Revolution were laid in the centuries preceding it. It was on this platform of “capitals”, plural, that ideas and innovation then built.

Take human capital. The most dramatic improvements in educational standards in the UK occurred prior to 1750 (Chart 3). So too did the largest improvements in measures of social, infrastructural and institutional capital.19 Ideas needed these foundations to flourish. A steam engine is not much use without the skills to build it, the tracks to run it on, the institutions to oversee it, the trust of the public to accept it. The causes of the growth inflexion in 18th century England were as much sociological as technological.

The other revolutionary idea came from an important paper by Broadberry and Wallis, whose conclusion was “don’t lose when you’re in a recession”:

Another lens through which to view this alternative growth story has recently been provided by economic historians, Steve Broadberry and John Wallis.20 Indeed it was probably this lens on the world, above all others, that led me to change my own story about growth.

FT Alphaville explained the Broadberry and Wallis paper this way. Innovation and the conditions for innovation are critical to growth, but institutions are just as important:

In a 2017 paper for the National Bureau of Economic Research, they collected growth data for several European countries back to the 14th century. They had noticed that poorer countries go through more frequent contractions. In other words, they shrink a lot. So Broadberry and Wallis decided to quantify not just periods of growth, but periods of shrinkage. They found the countries that began sprinting in the 19th century didn’t grow faster. They just shrank less often.

When economies start to grow fast, says Wallis, “80 per cent of the increase in growth rate can be explained by shrinking rather than growing.” It was his idea to look at shrinking, and he was surprised by how important it ended up being. That Solow-Swan story of how to grow isn’t enough on its own. It needs a complement, the story of how not to shrink. Broadberry and Wallis point to what economists call “institutions” — customs and laws that create order and make regular transactions even possible.

To grow, it’s not enough to provide labour, capital and ideas. You have to be able to co-ordinate exchange, to trust that when you extend credit, your counterparty will be there, and the plant you just bought won’t be arbitrarily seized by the government. In the post-colonial United States, for example, it was impossible to charter a bank in many states unless you were a patron of the right political party. Getting rid of that — moving towards equal treatment under the law — was as important to the American industrial revolution as the capitalisation of the mills in Lowell, Massachusetts.

Institutions prevent countries from shrinking, because they provide a baseline guarantee of economic co-ordination. They create trust, which makes growth less fragile. (Though Wallis avoids the word “trust,” which he finds too morally loaded.) Countries that fail to develop institutions fail to become rich countries:

The fading American Dream

To summarize, the conditions for growth are the following:

Create the conditions for innovation and their exploitation
Create the institutions to foster growth

That sounds like the American Dream, where anybody can make it, where if you build a better mousetrap the world will beat a path to your door.

Here is the actual data. Alan Krueger, who was Obama’s chairman’s of the Council of Economic Advisors, called it the Great Gatsby Curve. Krueger studied the connection between concentration of wealth in one generation and the ability of those in the next generation to move up the economic ladder compared to their parents.

Here is an updated version of that data that include EM economies. At the top of the list is China. The US is just behind developed markets in the UK and Italy. The American Dream is alive, but in the “socialist” Scandinavian countries, as well as former British colonies Australia and Canada.

We have all heard about the stories of nepotism and cronyism in China. Many Politburo are princelings, or the sons of former revolutionaries. The SCMP recently reported that the deputy Communist Party chief in Shenzhen had 1 billion yuan in cash that money launderers refused to touch. If we were to focus on the other tail of the income distribution, China tops the world in child poverty rates, while the Scandinavians rank at the bottom.

What about the US? The Financial Analysts Journal recently published an article entitled “Corporate Political Strategies and Return Predictability”. Here is the abstract [emphasis added]:

We assess whether observable corporate political strategies can serve as channels of value-relevant political information flow into stock prices and form the basis for profitable return predictability strategies. We document that returns of politically connected firms’ stocks lead those of their non-connected peers, suggesting that information shocks associated with new policies and other political developments become evident first in the stock prices of firms that pursue political strategies and then, with delay, in those of similar, non-connected firms.

Former IMF chief economist Simon Johnson discussed the response to the Great Financial Crisis and other EM crises in The Atlantic:

To IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out…

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders…

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

That’s why institutions matter. Innovation matters, but institutions create the equality of opportunity, though the equality of results is not necessarily an objective. The situation has deteriorated sufficiently that even Barron’s (!) has called for a bigger welfare state:

Life is filled with risks, and most of them skew to the downside: losing a job or getting hit by a car is much likelier than winning the lottery. While private insurance and ample savings can help, those who are most vulnerable to sudden drops in earnings or unexpected expenses are often the people least able to afford these protections.

The inequality gap has opened up not just among individual Americans, but at the community level, as this Brookings study concluded:

The 2016 election revealed a dramatic gap between two Americas—one based in large, diverse, thriving metropolitan regions; the other found in more homogeneous small towns and rural areas struggling under the weight of economic stagnation and social decline.

Here is another remarkable observation. Dollar stores now feed more Americans than Whole Foods, even though most of them don’t sell fresh food. The number of dollar stores in America now outnumber McDonald’s and WalMart stores.

Another sign of fragility can be found in the divergence in life expectancy between Americans and other western developed economies.

As the Broadberry and Wallis paper showed, you win by not shrinking. Corruption, inequality, and weakening institutions raise economic fragility. The Chinese boom is fragile. In America, the weakening of institutions did not begin with Trump, but the populism manifested by Trump is just another symptom of that fragility.

How the bear market could end

Posted by Cam Hui - December 16, 2018

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:

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

What happens after the sell signal?

Last week’s publication generated much discussion (see A bear market is now underway). Some of the questions related to the duration and downside target in a bear market. How far can stocks fall? How long will it last? What might be the trigger for a buy signal?

To reiterate my thesis from last week. Poor technical action and a recession forecast for late 2019 or early 2020 prompted the equity sell signal. The recession forecast stems from the combination of near-recession conditions based on conventional US macro indicators, evidence of global weakness in both Europe and China, and the near certainty of a trade war which would further tank global growth.

What might turn this bear thesis around, or put a halt to the bear market? Here are a couple of possible fundamental triggers:

An end to the trade war
More stimulus underpinned by the ascendancy of MMT in fiscal policy circles

The bear market scenario

My base case scenario for the bear market goes something like this. Kevin Muir at The Macro Tourist recently made the case that global investors had been piling into US assets, and the recent strength of the American economy created a positive feedback loop. As more managers bought US equities, they pushed up the USD exchange rate, which resulted in positive momentum and further pushed up the USD and US equity prices. That trade is over, and they are now in a crowded long.

The latest BAML Fund Manager Survey confirms those observations. Global managers believe that the US has the best growth potential of all the regions around the world.

Managers are overweight US equities, while either market or underweight every other region in the world.

The US as safe haven growth trade is now running out of steam. The relative performance of US stocks against the MSCI All-Country World Index (ACWI) has been flat since September.

I made the case that we should start to see evidence of slowing US growth in early 2019 (see 2019 preview: Winter is coming), which would likely start to spark recession fears, and prompt global managers to reduce their overweight positions in US stocks.

How far can the market fall? While I am always “data dependent” and the trigger for a market selloff depends on the actual fundamental trigger, technical analysis can provide some clues. Based on the assumption (and this is just an assumption) that a bear market has begun, as evidenced by the MACD sell signal shown below (red line), the logical initial downside target for the SPX would be 2100, which represents the first Fibonacci retracement level of the move that began in 2009, and a key past resistance turned support level. Such a retreat would represent a peak-to-trough drawdown of 30%, which would be a relatively mild bear market by recent standards.

Here is what worries me. A 2019/2020 recession has become the consensus view. A Duke University/CFO Global Business Outlook survey reveals that 48.6% of CFOs expect one by the end of 2019, and 82% expect a recession by the end of 2020. Many institutions have already begun to de-risk in anticipation of a downturn. What might derail my bearish thesis?

Peace in our time?

A peace accord in the Sino-American trade war could be enough to spark a market rally. While the US economy would continue to slow, the psychological and economic effects of ending protectionist practices might be enough to change what might have been a global recession into a just a mild downturn. It has the potential to become the equivalent of the ECB’s implementation of the LTRO program that put an end to the Greek Crisis of 2011.

Currently, the American side is sending mixed signals. There is some debate as to arrest in the Huawei Affair was just unfortunate timing, or a deliberate signal to the Chinese. In addition, the SCMP reported that the US is proposing further restrictions on the transfer of technology to China, particular in the areas of AI and biotech:

The US on Monday proposed new export restrictions on additional technology sectors considered crucial to national security, furthering the Trump administration’s campaign to crack down on intellectual property theft by foreign nations including China.

In a posting in the Federal Register, the Department of Commerce identified 14 categories of new technologies – among them biotech, artificial intelligence and machine learning, data analytics and robotics – about to be subject to limits on investments by foreign entities.

“This proposed set of rules can potentially be a major change in the tech business,” said Richard Matheny III, a lawyer with the global trade group at the Goodwin Procter law firm in Washington.

“Many biotech companies, for example, that historically haven’t been subject to such controls will need to consider these restrictions, including when taking investments, collaborating with non-US persons on technology development, and exporting products.”

These measures will be interpreted as a direct attack on China’s development strategy, intended to retard China’s future growth path. Them’s fighting words.

On the other hand, Reuters reported that Trump stated in an interview he is willing to intervene in the case against Huawei CFO Meng Wanzhou under the right circumstances (despite her Canadian lawyer’s statement during her bailing hearing that as much admitted that she had a role in circumventing US sanctions against Iran):

When asked if he would intervene with the Justice Department in her case, Trump said in an interview with Reuters: “Whatever’s good for this country, I would do.”

“If I think it’s good for what will be certainly the largest trade deal ever made – which is a very important thing – what’s good for national security – I would certainly intervene if I thought it was necessary,” Trump said.

At the same time, the WSJ reported that the Chinese had tabled a constructive offer with the following features:

Significant purchases of American LNG and soybeans (an easy step);
Reduction in tariffs on autos from 25% to 10%;
Adjustment to equity caps for foreign investments in certain sectors, which would allow foreign firms to take a majority stake in joint ventures;
The reduction or elimination of Chinese content rules in China 2025; and
Allow more foreign firms to participate in China 2025.

A key concession under consideration would be dropping the numerical targets for market share by Chinese companies, these people said. Made in China 2025 sets defined goals of raising domestic content of core components and materials to 40% by 2020 and 70% by 2025, an increase that comes at the expense of foreign competitors.

This offer represents substantial concessions, but will it be enough? The devil is in the details, and US trade representative Robert Lightizer has stated that he does not just want to see proposals, but verifiable steps that changes are being made. In other words, he is approaching the trade deal like an arms reduction treaty.

Is there a trade deal in the cards?

Trade negotiation analysis

Here is my take. A recent podcast interview by Axio’s Jonathan Swan’s interview with New York Times White House reporter Maggie Haberman is highly revealing about Trump’s decision-making process.

First of all, Trump keeps his views close to his vest, even to staff. He loves suspense, and can reverse his decisions on a dime. Haberman has learned not to write “Donald Trump has decided…” Here are the key excerpts from the transcript:

I’m now hedging in a way that is almost comical. So like, I recently broke the story that Trump had settled on Pat Cipollone for his White House Counsel. And when I wrote that story, I think I published it on a Saturday afternoon, I knew that Pat Cipollone … The fact I had was that Pat Cipollone had started filling out his paperwork. So I didn’t write … My lead sentence wasn’t … you know, I could pull it up now … but it wasn’t, “Donald Trump has decided …” It was, I literally wrote, “Pat Cipollone has begun filling out his paperwork for this,” because I knew that that was a fact.

The sentence, “Donald Trump has decided …” I made a big mistake early on. My story was correct. I broke the story that he was pulling out of the Paris climate deal. But I made the big mistake of saying, “Donald Trump has decided,” because, yes, he told people he decided. But then after I published my story he spoke to a White House official and he said, “What do you think I should do?”

But it doesn’t mean he hasn’t made up his mind. He’s just always polling people, even … I knew that they were scheduling the event for the next day. The speech was written. They were calling surrogates. All of these things were happening in the afternoon, so it wasn’t correct to say, “He’s on the fence.” But you need to find new language. Because there is no such thing as, “Donald Trump has decided.” It’s not a verb that you can almost use with this guy. Because he loves to create misdirection. He loves to keep flexibility open. And he loves to reverse himself. So it’s very, very challenging.

Another recent example: I broke a story that Nikki Haley was resigning as U.N. Ambassador. And I knew that it was right. I knew, I had incredibly good sourcing on it, and I knew it was happening. I still felt this little thing in my stomach when we published. I was like, “Shit, maybe this guy’s going to screw me.” You know, “Maybe he’s going to pull the rug out and say, ‘Guess what? It’s not happening. She’s U.N. Ambassador for life,’” or something. So it’s nerve-racking. And I’ve started to find ways to hedge that I would probably never do in any normal circumstance.

What about the trade war with China? She starts with analyzing the background on his accomplishments so far and what other signature initiatives are unfinished:

I think we’re at a pretty pivotal moment right now for the president. If you look in the rearview mirror, the stuff he’s accomplished is not nothing. I mean, he’s passed a big tax bill, and he’s done a ton of deregulation. He’s confirmed two Supreme Court Justices and a lot of judicial nominees. That’s all in the bucket of conventional Republican president, any other Republican president would’ve pursued those goals.

But the two goals that are definitional Trump goals, which is to change China’s behavior and to build the wall, they were two issues that defined him as a politician. He’s in a really tough spot right now. He’s kicked the can down the road on both issues. He’s signed a short-term continuing resolution to defer the shutdown fight over the wall. And he’s had this dinner with President Xi in Buenos Aires on the weekend, which resulted in, effectively, a 90-day ceasefire of this trade war and this confusing mess of competing statements that came out of both camps afterwards.

So there’s a huge TBD next to these two issues. And I find it very hard to see how he gets the money to pay for his wall. And I find it very hard to see how he gets China to do any of the really big important stuff, like change their industrial theft practices and these issues that are really, really systemic. So the question then becomes: Okay, if Trump can’t get those things done, and then he has Mueller coming down his neck, Democrats taking over the House and a blizzard of subpoenas, and a wobbly stock market, how does he respond to all of those pressures?

China is one of the key bogeymen to his political base, and Haberman doesn’t think he will back down (paragraphs in bold are questions from Jonathan Swan):

But do you expect that he has it in him to modulate some of his own behavior, or do you think it’ll be some continuation of what we have seen in recent days with the muddled messaging on China?

I don’t think he thinks it’s in his best interest to modulate. I mean, he even basically said that to us when we talked to him a few weeks ago. We said, “You keep calling the press the enemy of the people. You know that that could have consequences, that crazy people could actually …” I think Jim even said someone could die?

He did.

And Trump said, “My people like it. I go to the crowds and that’s what they like.” You take the wall as an example. There were advisers telling him, “Please talk about the economy”; Republicans on the Hill, “Please talk about the economy.” And Trump would say, “When I talk about the economy, people get bored.” They want to hear about these inflammatory issues and these really hardcore base issues.

So I don’t think he sees it in his political interest to modulate. And I expect that he would respond in the way he usually does, which is by picking a foil, which will probably be a Democrat or maybe even an establishment Republican, and hammering them in a pretty savage way; blaming others, lashing out, and creating the idea for his base that he’s fighting for them and being foiled by XYZ bogeymen.

Of course, that’s just one reporter’s opinion, but it does open a very different kind of window into Trump’s decision-making process. The market will undoubtedly oscillate between risk-on and risk-off as news on the trade negotiations hit the tape.

I am open minded about a potential deal, but remain skeptical. The most revealing market signal may come from soybean prices. Despite the news about renewed Chinese buying, soybean prices halted at key resistance level and just below its 200 dma.

The MMT recovery?

A second possible source of fundamental support for economic growth may come from the possibility of Trump and the Democrats finding some common ground to avoid a recession. As the Democrats take control of the House in 2019, it would be easy to sketch out a scenario in which House committees overwhelm the White House with investigations and subpoenas in an uncertain political environment where the Mueller has not even tabled his report.

On the other hand, both side could find some common ground. How about more government debt and spending? To be sure, the IMF has pointed out that the US is the only advanced economy that is expected to increase its debt-to-GDP ratio in the next five years. But Trump is a “debt guy”, and the Democrats have their own spending priorities, such as universal healthcare. Why not more debt-driven fiscal stimulus?

In 2019, expect more discussion about the Modern Monetary Theory (MMT), which holds that policy makers should not be too concerned over fiscal deficits as long as the debt is denominated in its own currency. Here is a defense of MMT from the Roosevelt Institute:

They insist that the notion of “fiscal sustainability” or “solvency” is not applicable to a sovereign government — which cannot be forced into involuntary default on debts denominated in its own currency. Such a government spends by crediting bank accounts or issuing paper currency. It can never run out of the “keystrokes” it uses to credit bank accounts, and so long as it can find paper and ink, it can issue paper currency. These, we believe, are simple statements that should be completely noncontroversial. And this is not a policy proposal — it is an accurate description of the spending process used by all currency-issuing sovereign governments.

And, yet, there are a number of misconceptions circulating that need to be addressed. Many (often of the Austrian persuasion) interpret this simple statement as a Leninist plot to destroy the nation’s currency by flying black helicopters dumping an infinite supply of bags of money all over the planet. This is usually accompanied by a diatribe on the evils of fiat money, with a call to return to “sound money” based on shiny yellow metal. Others suggest that we are instead proposing to ramp up the size of government, until it completes Obama’s plan to gobble up the whole economy. Almost all critiques eventually produce a lecture on the lessons to be learned from Weimar Germany and from Zimbabwe.

The strangest criticism of all is that we MMT-ers argue that “deficits do not matter”. In a recent exchange in the New York Times, Paul Krugman put it this way: “But here’s the thing: there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency.” In that piece he took Jamie Galbraith to task for arguing that “Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks” facing a sovereign government. I won’t go into the details, but Krugman produced a simple model in which ever-larger budget deficits generate ever-rising prices. You can see the rest of that back-and-forth here. But the strange thing is that Krugman never actually addressed Galbraith’s points that insolvency, bankruptcy, or higher interest rates are non-issues for a sovereign government. Nor did Krugman even try to justify his claim that MMT-ers “say that deficits are never a problem”.

Deficits don’t matter inasmuch as they will not force the government into insolvency, but they do matter as long as they don’t produce inflation, or inflation expectations, that raise the funding cost of debt:

In fact, MMT-ers NEVER have said any such thing. Our claim is that a sovereign government cannot be forced into involuntary default. We have never claimed that sovereign currencies are free from inflation. We have never claimed that currencies on a floating exchange rate regime are free from exchange rate fluctuations. Indeed, we have always said that if government tries to increase its spending beyond full employment, this can be inflationary; we have also discussed ways in which government can cause inflation even before full employment. We have always advocated floating exchange rates — in which exchange rates will, well, “float”. While we have rejected any simple relation between budget deficits and exchange rate depreciation, we have admitted that currency depreciation is a possible outcome of using government policy to stimulate the economy.

Stephanie Kelton is a leading advocate of MMT, and she was an advisor to Bernie Sanders in his failed presidential campaign. Kelton has stated that deficits have been a political football for Republicans as long as they don’t interfere with GOP priorities. No one asked “how will you pay for it” during the last two rounds of tax cuts when it was clear that tax cuts did not pay for themselves in the Reagan era, nor the Bush II era. No one asked “how will you pay for it” about the post 9/11 Iraqi invasion, or Trump’s “space force”. It is only a priority when Republican priorities such as cutting Social Security and Medicare arise, see Kelton’s Bloomberg essay “Republicans Want To Make Social Security the Next Caravan”.

Combine that with Donald “the debt guy” Trump, who the Washington Post reported told his former economic advisor Gary Cohn to just “print more money”:

Trump reported told Cohn to print more money, according to three White House officials familiar with his comments.

“He’d just say, run the presses, run the presses,” one former senior administration official said, describing the president’s Oval Office orders. “Sometimes it seemed like he was joking, and sometimes it didn’t.”

Are the MMTers right? Here is the actual interest expense of federal debt, normalized by GDP. Even if rates were to rise, interest costs are in the lower range of the historical experience. The MMT debate therefore hinges on at what price the bond market will finance any debt surge.

For some perspective on the price of a potential debt surge, the chart below approximates incremental deficit financing costs, assuming that each year’s deficit is half financed with 2-year debt and half with 10-year debt. The blue line depicts the absolute dollar costs, and the red line depicts costs as normalized by GDP. From this perspective, incremental debt costs are well under control, and they have actually improved since the deficits from the Reagan years.

Whatever you might think of MMT, Trump and the MMT crowd are likely to find some common ground. The open question is whether both sides can come together to craft a deal for further fiscal stimulus, such as an infrastructure bill.

Can another massive fiscal stimulus save the American economy? Possibly. Much depends on the degree of cooperation between the White House and the Democratic controlled House, and any ultimate agreement on a bill.

At a minimum, investors should expect more discussion of MMT in 2019.

In conclusion, stock market fundamentals are under the threat of rising recession risk, and I have penciled in a 30% drawdown for US stock prices. There are two possible factors that could either mitigate or halt the decline, namely the reversal of the trade war, or further fiscal stimulus supported by the theories of MMT. The jury is out as to whether these positive catalysts can actually happen, so I remain “data dependent”.

The week ahead

The technical conditions of the stock market continues to show the pattern of a bear market. The chart below shows the 20 dma of the new low/new high ratio. Past spikes have generally been seen in bear phases, and not corrections within a bull move.

Deteriorating long-term breadth is another sign that the market is in a major bear phase. In the past, the bulls have taken begun to take back control of the tape when % bullish (black vertical line) have violated its downtrend, followed by % of stocks above the 200 dma (blue line).

Bear markets are also marked by higher levels of volatility. Sharp drops are often followed by sharp rallies. We have recently seen a sharp drop, and sentiment certainly looks washed-out. The most recent AAII sentiment survey showed a dramatic rise in bearishness, indicating possible capitulation. Past readings at these levels have tended to be contrarian bearish.

Other short-term sentiment indicators are also supportive of a bounce (see Good news and bad news from the sentiment front). The NDR Daily Sentiment Composite is in the “extreme pessimism” zone, where the historical annualized gain stands at 32%.

The latest update from Open Insider shows that this group of “smart investors” are buying the latest dip in the market.

Next week is option expiry week, and Rob Hanna found that December OpEx has historically shown the best risk/reward ratio for the bulls.

In a separate post, Hanna observed that December’s positive seasonality isn’t just restricted to OpEx week, but it has persisted for up to three weeks.

From a technical perspective, the roof hasn’t caved in on the bulls despite all of my talk of a bear market. The market tanked Friday, but the decline was insufficient to set of a Dow Theory sell signal, though the recent Dow Theory buy signal came to nought.

Longer term breadth indicators from Index Indicators show a positive divergence that has been observed in past market bottoms.

Short-term breadth is oversold, with the caveat that oversold markets can become more oversold.

There has been some analysis floating around the internet that highly negative Fridays have tended to see bearish follow-through on Mondays. My own investigation of data of SPX returns shows that there were 60 instances where the SPX fell by -2.0% or more on a Friday. The subsequent median return was 0.07%, with a batting average of 55.0%, compared to 0.05% median return and 53.4% batting average on all days. In other words, there may be a minor rebound effect, but Monday returns are virtually indistinguishable when the market tanked the previous Friday.

In summary, major bear legs simply do not start with technical and sentiment so stretched on the downside. Even if you are bearish, which I am, traders would be well advised to wait for a rally before going short.

That said, there are still some near-term risks. The latest update from FactSet shows that forward EPS estimates fell last week. As estimates have moved coincidentally with stock prices, further erosion in EPS estimates could prove to be a headwind for the market.

In addition, next week`s FOMC meeting could be a source of volatility.

My inner investor has already de-risked his portfolio to his minimum equity allocation. My inner trader remains positioned for a rally into year-end.

Disclosure: Long SPXL

Good news and bad news from the sentiment front

Posted by Cam Hui - December 12, 2018

Mid-week market update: This market is becoming increasingly jittery. Indeed, the chart below shows that the stock market moves more per dollar traded than usual, indicating a lack of liquidity.

This indicates that volatility is likely going to increase. Such an environment can be both profitable and trying for traders, as I have both good news and bad news from the sentiment front.

Long-term complacency = More downside risk

Let us start with the bad news. My former Merrill Lynch colleague Fred Meissner of The FRED Report is finding signs of long-term complacency in the Investors Intelligence data, and readings are similar to levels observed before the Crash of 1987.

The Investor’s Intelligence poll has three categories: Bulls, Bears, and those expecting a correction. We only chart the Bears, and this is why. Managers that are bulls are invested, and managers that are expecting a healthy correction generally remain invested. Managers that are bears are the only ones that really sell, and we assume that they have already sold – in other words, a low %Bears number is ammo for a decline. What normally happens, as markets decline, is that the % Bears number advances. We can see this in the 2010 to 2012 correction, the 2015 to 2016 correction, also in the 1990’s and in the 1970’s. Our concern is that this is not happening during this current corrective phase. One of the most significant times we saw this is during the 1986 to 1988 period, specifically during the 1987 crash period.

Low II %Bears readings indicate complacency:

The takeaway is that low %Bears very often leads to violent declines, especially if the %Bears does not increase as the market is correcting. In addition, it is not low %bears in a vacuum. If the market is rallying and the %bears are low, it is a condition to be monitored but not necessarily a reason to sell. It is how the %Bears react in periods of consolidation and/or correction that is most important.

However, he is not calling for a 1987 style crash (chart annotations are mine).

This does NOT mean we are entering another 1987-like period, but it does mean advisors should be on their guard and know what defensive steps they want to take in a more protracted decline.

I agree. II sentiment is not consistent with levels seen at long-term market bottoms. In light of the technical breakdowns that I have pointed out before, this suggests further downside risk for stock prices.

Short-term washout

On the other hand, Mark Hulbert recently wrote that his sentiment indicators are at washed-out extremes. Both his market timers (blue line) and NASDAQ timers (red line) indices are at levels not seen since Brexit. This sentiment extreme indicating a crowded short is setting the potential for a market rally. However, Hulbert has noted in the past that his sentiment models are most effective at predicting returns only on a one-month horizon.

Smart money vs. retail money

For a different perspective on sentiment, I am indebted to one of my readers for the (sort of) good news. He has dissected the put/call option activity between the smart money and the retail money. The “smart” money is defined as the index put/call ratio, because the pros tend to dominate activity in index options. By contrast, retail investors dominate individual stock option activity, and their sentiment is better measured by the equity-only put/call ratio.

As the chart below shows, we would prefer to be buying when both the “smart” money and retail money indicators agree with each other, which is defined as a low index put/call ratio (red line, bottom panel) and a high equity-only put/call ratio (blue line, bottom panel). The two indicators are combined in the top panel as the equity put/call – index put/call (blue line, top panel).

What are the indicators saying now? Retail investors are highly fearful, as measured by the spike in the equity-only put/call ratio. By contrast, the pros are skeptical that the bull case, as their hedging is manifested in an elevated index put/call ratio. This combination is not immediately bearish, as the spike in the equity-only put/call ratio can be supportive of a short-term rally, but the high index put/call ratio suggests any market strength is probably not sustainable.

Here is the big picture. Expect a rally, but don’t expect it too last very long.

My inner investor remains cautious on the stock market. My inner trader covered his short positions last Friday and flipped to the long side in anticipation of profiting from an oversold rally.

Disclosure: Long SPXL

Pax Americana, or America First?

Posted by Cam Hui - December 11, 2018

December is the season for investment advisors and portfolio managers to meet with their clients. Here are some thought on your an allocation framework as you prepare for those meetings. As a cautionary message, let’s begin with a “buy and forget” portfolio featured in Fortune in 2000 and how they performed by 2012.

Haha. Experienced portfolio managers and advisors don’t make those kinds of mistakes. We all know that diversification is the only free lunch in investing.

For the simple answer on personal investing, I refer readers to a Business Insider article by Chelsea Brennan, “I spent 7 years working in finance and managed a $1.3 billion portfolio — here are the 5 best pieces of investing advice I can give you”:

Understand your goals
Index fund investing is the easiest way to win
Be in it for the long term
Don’t assume you have it all figured out
Be prepared for anything

Unfortunately, I see American investors making the diversification mistake, as well as mistakes 4 and 5 again and again. Much of what passes for financial planning in the US is based on the mistaken assumption of a backtest that has severe survivorship problems. This will becoming increasingly evident as American policy changes from the era of Pax Americana to America First.

The long term record

Tiho Brkan pointed out that when US investors make their investment allocation decisions, they often consider this familiar chart of the record of equity returns. Looks pretty good, right?

If you went into a client meeting in most industrialized countries with that chart, you would have been laughed out of the room. That’s because if you step back more years, and the return pattern is less familiar and feels distinctly uncomfortable.

America ascendant

Here is the survivorship problem. A bet on US equities in the last 100 years has been a bet on Pax Americana. Morgan Housel explains what happened in a rather long article:

This is a short story about what happened to the U.S. economy since the end of World War II.

That’s a lot to unpack in 5,000 words, but the short story of what happened over the last 73 years is simple: Things were very uncertain, then they were very good, then pretty bad, then really good, then really bad, and now here we are. And there is, I think, a narrative that links all those events together. Not a detailed account. But a story of how the details fit together.

The entire article is well reading in its entirety, but here is a brief summary:

August 1945, World War II ends: The fear at the time was another Depression. What was America going to do with all of those men coming home from the war? How were they going to find jobs?
Low interest rates and the birth of the American consumer.
Pent-up demand for stuff led to a credit boom and a hidden 1930s productivity boom led to an economic boom.
Gains are shared more equally than before: The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor.
Debt rose tremendously. But so did incomes, so the impact wasn’t a big deal.
Things start cracking in the early 1970s: America dominated the world economy in the two decades after the war. Many of the largest countries had their manufacturing capacity bombed into rubble. But as the 1970s emerged, that changed. Japan was booming. China’s economy was opening up. The Middle East was flexing its oil muscles.
The boom resumes, but it’s different than before: All that matters is that sharp inequality became a force over the last 35 years, and it happened during a period where, culturally, Americans held onto two ideas rooted in the post-WW2 economy: That you should live a lifestyle similar to most other Americans, and that taking on debt to finance that lifestyle is acceptable.
The Big Stretch. the internet after that: The lifestyles of a small portion of legitimately rich Americans inflated the aspirations of the majority of Americans, whose incomes weren’t rising. A culture of equality and Togetherness that came out of the 1950s-1970s innocently morphs into a Keeping Up With The Joneses effect.
Once a paradigm is in place it is very hard to turn it around: The post GFC hangover sets in.
The Tea Party, Occupy Wall Street, Brexit, and the rise of Donald Trump each represents a group shouting, “Stop the ride, I want off.”

While what Housel described was American economic history in the post World War II period, the US boom really began when the Great Powers battled each other to exhaustion in World War I, while the US economy remain largely unscathed.

Stocks for the long run? Just ask the Germans how their asset classes fared since the start of the 20th Century.

For some perspective, an American investor would have made over 1200 times their money in real terms if they had invested in equities between 1900 and 2013.

The French fared as well as the Germans in total return, but with less drawdown. Still, returns paled when compared to US assets.

China, which is a major global engine of growth today, suffered considerable dislocation after Mao’s victory and didn’t turn around until recently.

Bottom line: US equities should behave as they have in the last 100 years as long as there is no permanent loss of capital (see China, or undiversified bets such as the Fortune buy-and-forget portfolio), or a loss of the US competitive advantage.

The effects of America First

Here is where Trump’s America First policies pose a threat to long-term equity returns. Before we begin, I would like to preface these remarks by pointing out that Morgan Housel’s history of the post-War America shows that the problems of populism did not just originate with Donald Trump. Trump’s ascendancy is just one manifestation of the problems that plague American society.

American foreign policy has pivoted from the US as the leaders of the free world, which I call the Pax Americana model, to a win-lose world view. Why should Americans maintain troops to protect Europe, South Korea, or other countries around the world? Why does Article 5 of the NATO treaty matter? In effect, Trump is trading off the soft power of America to focus on hard power, based on the principles of America First.

Even as Trump withdraws from global leadership, A recent Pew Research Center poll shows that the residents of most countries prefer the old world order of American leadership over one dominated by China.

Does soft power matter? As an example, the accounts from Brookings show that China is trying to develop its soft power by attracting foreign students to its universities [emphasis added]:

In a classroom adorned with Mandarin characters. They are not studying in Nairobi but at China’s prestigious Peking University. The Kenyan students explain how China has given them full scholarships to receive educational opportunities they are deprived of at home and how they will gain skills they can take back to enrich their own countries.

China is keen to promote itself as a benefactor of international students. On the other side of the Pacific, the United States—the country that has actively inspired the world’s smartest and most curious students to come study on its shores for generations—seems to be moving in the opposite direction. Through a series of policies and actions, the Trump administration is driving foreign students away from the United States. Chinese students themselves only narrowly avoided being victims of a total ban pushed by Trump staffer Stephen Miller. China views this accelerating trend as an opportunity to fill the gap. In many parts of Africa and Asia, this change is already underway. And as foreign students pick Chinese campuses over U.S. ones, a critical element of America’s soft power is in danger of being eroded.

The United States is still the world’s hub when it comes to higher education. In 2016, more than 1 million international students enrolled at U.S. colleges and universities, while fewer than half a million studied in Chinese higher education institutions.

But China’s outreach to students in African and Asian countries, especially in developing regions where it has growing economic ties, so far has been highly successful. In 2016, over 60 African and Asian countries sent more students to China than to the United States. Laos, for example, sent 9,907 students to China and only 91 to the United States. The disparity holds true for countries farther afield: Algeria, Mongolia, Kazakhstan, and Zambia sent more than five times the number of students to China than to the United States. Since 2014, the total enrollment of African students in China has surpassed that of the United States. In 2016, China hosted more than 60,000 African students, which represented a 44-fold increase over the year 2000.

At the same time as China has endeavored to expand its international higher education system, the U.S. government has scaled back its financial commitments. The Fulbright Program, a hallmark of U.S. cultural diplomacy since 1946, has faced calls for funding cuts since the Obama administration. Generations of participants—who are sponsored by the U.S. government—have gone on to important positions in academia, politics, think tanks, journalism, arts, and business around the world. Despite this impressive legacy, the Trump administration recommended a 71 percent reduction in funding for the program in its 2019 budget proposal.

The WSJ reported that foreign student enrollment is falling in the US:

“Students are not feeling welcome in some states, so they are looking beyond those states and heading to places where they will feel welcome,” she said.

The slowdown comes as U.S. schools struggle with demographic and revenue challenges due to the falling number of Americans graduating from high school. As a result, U.S. colleges and universities have become increasingly dependent on revenue generated from international students. Public schools often charge international students more than what domestic students pay.

The U.S. is also losing students to English-speaking countries such as Canada, Australia and the U.K, which have all seen growth in the past year.

“We’re hearing that they have choices; we’re hearing that there’s competition from other countries,” said Allan E. Goodman, president of the Institute of International Education.

As the US closes its borders to immigrants, the dynamism of the economy becomes visibly hobbled by the barriers erected to international students, who study at top US schools and who stay to startup new businesses. Bill Kerr, D’Arbeloff Professor of Business Administration at Harvard Business School, documented how the US has been an enormous beneficiary of inventor talent flow over the years.

Kerr wrote: “These inflows have reshaped US innovation in advanced technology sectors. The contribution of immigrants to sectors like computer science and biotech have increased dramatically over the past 40 years.”

Where will the immigrants come from to found next Intel, Apple (Steve Jobs’ father was a Syrian from Aleppo), or Google? Can Pax Americana survive America First, which looks like a policy of short-term gain for long-term pain?

This is a point to ponder as investors review their long-term investment plans.

Forget the Powell Put, what about a Trump Put?

Posted by Cam Hui - December 10, 2018

I have been engaged in a running debate about the possibility of a Trump Put in the market. My friend believes that Trump is likely to pull back from a full-scale trade war with China, as it would tank the stock market and increase the likelihood of a recession. The Republicans lost the House in 2018 with the unemployment rate at 3.7%. A recession in 2019 or 2020 will not only lose them the White House, but probably both houses of Congress. Trump wants to avoid that scenario at all costs.

The WSJ reported that Trump has been glued to the stock market and therefore highly sensitive to price gyrations:

As the stock market churned this week, President Trump anxiously called advisers both inside and outside the White House looking to ensure that his talks with China were not driving the selloff.

Fresh off what he described as a historic weekend meeting with China’s President Xi Jinping, Mr. Trump has questioned why the markets weren’t reacting more positively to the news of the potential breakthrough with Beijing. In consulting with advisers, he remained convinced that the volatility wasn’t his own doing, but rather, the product of the Federal Reserve’s plan to raise the benchmark interest rate.

As the stock market churned this week, President Trump anxiously called advisers both inside and outside the White House looking to ensure that his talks with China were not driving the selloff…

Fresh off what he described as a historic weekend meeting with China’s President Xi Jinping, Mr. Trump has questioned why the markets weren’t reacting more positively to the news of the potential breakthrough with Beijing. In consulting with advisers, he remained convinced that the volatility wasn’t his own doing, but rather, the product of the Federal Reserve’s plan to raise the benchmark interest rate.

In short, the President’s daily mood seems to be sensitive to stock prices:

Wall Street analysts took note of the administration’s comments this week around the trade talks. Analysts at Morgan Stanley declared them indicative of the administration’s “markets-sensitive” approach to policy-making.

Nomura Securities said that it was yet “another indication that President Trump is sensitive to the market and economic disruptions that his trade policies can generate. That sensitivity may suggest that there are limits on how he will push those policies.”

Treasury Secretary Steven Mnuchin, speaking at The Wall Street Journal CEO Council in Washington on Tuesday, said that “the (stock) market is now in a wait and see” moment with regard to China: “Is there going to be a real deal at the end of 90 days or not?”

Is there a Trump Put in stock prices? If the market were to really tank, could a Trump change of heart on China turn the market around?

How NSS 2017 institutionalized America First

There is a tension between Trump’s focus on stock prices, and his core belief that America is being cheated by its trade partners, and by China in particular. It is unclear how this dynamic will play out.

I believe that that the die was cast in late 2017 when the National Security Strategy 2017 (NSS 2017) designated China as a strategic competitor (see Sleepwalking towards a possible trade war), and the Washington defense establishment widened the scope of the conflict. It is no longer just a trade dispute, but a struggle for strategic dominance.

Here is an evenhanded analysis of NSS 2017 by Peter Feaver in Foreign Policy from December 2017, which was described it as “America First all grown up”. He had five main takeaways:

Give the administration credit for some unusual achievements related to the NSS. This is the first Administration to publish the NSS in its inaugural year. Bill Clinton, George W. Bush, and Barack Obama all tried and failed to make that deadline.

Give the administration credit for an NSS that is, to a surprising degree, well within the bipartisan mainstream of American foreign policy.

Give the drafters credit for trying gamely to reform Trump’s problematic catch phrase label – “America first” – by reinterpreting it to mean something more benign.

That said, this is a bleaker, less optimistic NSS than the last several – in that respect, something of a throwback to Bush’ 2002 NSS, which was written in the wake of the 9/11 attacks. The implicit theme of this NSS is competition – the word or its cognates appears nearly 75 times in the document. The NSS repeatedly reminds the reader how the United States faces competition and even exploitation from adversaries and partners alike. The NSS repeatedly reminds the reader how the United States faces competition and even exploitation from adversaries and partners alike.

The devil will be in the details of execution, which will require bridging gaps between the rhetoric of Trump’s NSS and the reality of the policies pursued thus far.

Here is a key quote of how NSS 2017 institutionalized “America First”:

The NSS advanced a concept that has not had wide currency until now: the “national security innovation base (NSIB),” referring to the “American network of knowledge, capabilities, and people—including academia, National Laboratories, and the private sector—that turns ideas into innovations, transforms discoveries into successful commercial products and companies, and protects and enhance the American way of life.” The NSS notes, rightly, that the efforts by China (and others) to steal U.S. intellectual property should be viewed not merely as an economic problem, but also fundamentally as a national security threat. I think the NSS misses a step here in failing to recognize that this is not merely an “American” network, but rather a globalized network with America as a critical node. Thus, steps that have the unintended effect of hobbling the flow of ideas and human capital into the United States might hurt the NSIB. But Trump deserves credit for raising the salience of this concern.

Trump’s Deep State Frankenstein?

I don’t mean to sound like some conspiracy theorist, but here is how the wheels of government works. Remember the Bloomberg story back in October that some Chinese spy chip had been discovered on the motherboard of servers used by Apple and Amazon? Both companies subsequently denied the story. The denial appeared to have been made at a technical level, rather than corporate lawyers (see this Medium article discussing the technical issues). Reuters reported that the denial was supported by the UK’s cyber security agency supporting the Apple position, and the denial was also supported by the US Department of Homeland Security.

Here is the conspiracy theory part. This incident is consistent with an effort by US intelligence agencies to discredit the Chinese and retard their sales overseas. The SCMP reported that entire incident is forcing American vendors to re-think their relationship with Chinese suppliers. Several allies have banned Chinese telecom 5G equipment from their networks. That`s how the Deep State works.

The Huawei affair is different. The arrest and subsequent extradition request was likely the case of the left hand of the US government did not know what the right hand was doing during the summit at Buenos Aires. Trump didn’t know, but NSC advisor John Bolton did. During her bail hearing, Huawei CFO Meng Wanzhou`s lawyer so much as admitted that Huawei busted sanctions by tricking American banks to send funds to Iran.

So this becomes a case of the dog that caught the car, what to do next?

The Huawei arrest is undoubtedly putting a chill on trade negotiations. Supposing that Trump wanted to use Meng Wanzhou as a bargaining chip to get some concessions from China and declare victory, such a course of action will not be without incurring significant political cost. Bloomberg reported that there is bipartisan support for holding Huawei to account, and any ZTE-like pardon will be met with a political fight.

After Huawei Chief Financial Officer Meng Wanzhou was arrested in Vancouver Dec. 1 at the behest of U.S. authorities for allegedly violating American sanctions on selling technology to Iran, Democrats and Republicans have quickly called on Trump to hold the Chinese company accountable.

The dilemma Trump could face on Huawei is partly of his own making. In May, his Commerce Secretary Wilbur Ross went after ZTE Corp., a rival Chinese telecoms equipment maker, with charges of violating sanctions agreements by selling U.S. technology to North Korea and Iran. When the administration eased the punishment at the request of Chinese President Xi Jinping, a bipartisan group of lawmakers criticized Trump for going soft on China.

“If @Huawei has been helping violate US sanctions by transferring US technology to Iran they should be barred from operating in the US or from purchasing US technology,” Senator Marco Rubio of Florida said Thursday on Twitter.

Senator Mark Warner, a Virginia Democrat, added to the criticism on Thursday “It has been clear for some time that Huawei, like ZTE, poses a threat to our national security.”

This is how bureaucratic infighting works. Put the President in a difficult situation in order to shape events in accordance to your own agenda.

Huawei has long been a concern for the U.S. government and lawmakers who believe Chinese technology companies are avenues for surveillance by the country’s intelligence agencies.

Now Trump is in a tough spot to navigate domestic political pressure with successful trade negotiations, said Derek Scissors, China expert at the American Enterprise Institute.

Fining Huawei or requiring personnel changes accomplishes nothing. If he lets Huawei off the hook, it may look like the ZTE fiasco, where he canceled tough action because “too many jobs in China lost,” Scissors said. “But serious steps against Huawei will effectively end this round of trade talks because the company — not its officials — is so important to the Communist Party.”

In conclusion, it will take a lot more than just a few Trump tweets to stop Cold War 2.0 between the US and China. At the same time, Trump’s focus on stock market movements may prompt presidential tweets that will spark temporary market rallies. Unless Trump takes actual institutional steps to reverse course, such as sidelining hardliners like Navarro, Lightizer, Bolton, along with any other NSC staffers who authored NSS 2017, don’t expect Trump to put a floor on stock prices.