Why the yield curve panic is a buying opportunity

Posted by Cam Hui -

There was some confusion from readers in response to my bullish pivot in yesterday’s post (see How the market could melt up). Much of the confusion was attributable to the bear porn that has been floating around since last Friday from the inverted yield curve when the 10-year Treasury yield fell below the 3-month.

One example came from Ben Carlson at A Wealth of Common Sense, though Carlson did qualify his analysis that the timing of a stock market pullback has varied:

The timing of these market corrections varies widely. In late 1980 and early 2000, the inverted yield curve signaled a quickly approaching stock market peak. In the other three instances, it was almost two years until stocks broke down.

 

 

Troy Bombardia has also weighed in with his own analysis of past inversions.
 

 

I beg to differ. The underlying mechanism of this inversion is very different from previous episodes, and that’s why I don’t think a recession is in the cards.
 

How it’s different this time

Firstly, I had pointed out yesterday that while the belly of the yield curve was flattening, or inverting, the long end of the curve is steepening. This is an indication of differing expectations about growth and inflation from the long end of the bond market, compared to the belly. In short, not all of the bond market thinks the economy is slowing to recessionary levels.
 

 

Past recessions have been caused, in part or in whole, by excessively tight monetary policy. In some cases, there were contributory factors, such as financial bubbles in 2000 and 2007. New Deal democrat constructed a simple model based on the year/year change in Non-Farm Payroll employment (blue line) and the Fed Funds rate (red line). In the past, whenever the Fed Funds rate of change has risen above the NFP line, a recession has ensued. In other words, the rise in the Fed Funds rate is an indication of a hawkish Fed that tightened monetary policy until employment growth rolled over, and plunged the economy into recession.
 

 

Here is the same chart overlaid with the 10-year vs. 3-month Treasury yield spread (black line). Unfortunately, the 3m10y spread data only goes back to 1982, so the full history is not available. Nevertheless, past recessionary episodes saw the Fed Funds line rise above the NFP line, and it was confirmed by an inverted yield curve.
 

 

Here is why this time is different. Will the Fed Funds and NFP lines cross this time? The Fed has announced a dovish tilt and put rate hikes on hold. The red Fed Funds line will now flatten. Arguably employment growth will start to slow, but will it slow sufficiently for the two lines to cross?

In other words, is the Fed’s dovish U-Turn enough to avoid a recession in 2019 or 2020? The trend of the blue NFP growth line has been a gentle slope upwards, though the latest data point does show a deceleration. In the absence of a dramatic drop-off in employment growth to 100K or less in the next few months, the US economy should be able to sidestep a recession.

In that case, the latest panic in the stock market over the inverted yield curve is a buying opportunity.
 

Supportive sentiment

The latest sentiment reading are also supportive of a stock market advance. Callum Thomas has been conducting an (unscientific) weekend Twitter sentiment poll since July 2016. The latest reading show that equity sentiment to its second worst level since polling began, which is contrarian bullish.
 

 

In conclusion, the combination of these factors are screaming “buy the dip” on equities.

 

How the market could melt-up

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Melt-up ahead?

The recent equity rally has raised the scores of all models across all time frames to bullish. The Ultimate Market Timing Model, the Trend Model, and the Trading Model are all upgraded to bullish.

While this is not my base case scenario, there is a decent chance that the stock market may melt-up in light of the Fed’s extraordinarily dovish statement last week. One parallel to the market hiccup of late 2018 would be 1998, when the Fed stepped in to rescue the financial system in the wake of the Russia Crisis.
 

 

A melt-up in the current environment would be supported by the combination of loose monetary policy and easy fiscal policy.
 

The Fed’s about face

Fed chairman Jerome Powell made his position clear in his opening statement from last week’s post-FOMC press conference:

My colleagues and I have one overarching goal: to sustain the economic expansion, with a strong job market and stable prices, for the benefit of the American people. The U.S. economy is in a good place, and we will continue to use our monetary policy tools to help keep it there.

As long as inflation expectations remain under control, the Fed will focus on policies to “sustain the economic expansion”. This shift in policy made a number of market analysts rather uneasy. The comment from currency strategist Marc Chandler is an example of that view:

The median forecast shaved this year’s GDP to 2.1% from 2.3% and next year to 1.9% from 2.0%. The forecast for 2021 was unchanged at 1.8%. Long-term growth is estimated at 1.9%. This is the disconnect: An economy expected to grow above trend but still requires easy monetary policy.

The Powell Fed is starting to look like the Greenspan Fed. Instead of taking away the proverbial punch bowl just as the party gets going, the Greenspan Fed saw every risk as an opportunity to ease. While it did rescue the economy from the Russia Crisis in 1998, it ultimately inflated a stock market bubble that ended with the NASDAQ top in just under two years.

Could that be the template for today? The last three recessions were not directly attributable to the Fed action. The Great Financial Crisis (2008) was a financial crisis, the NASDAQ top (2000) was the result of a popped market bubble. and the mild recession of 1990 was sparked by the combination of the S&L crisis and the Iraqi invasion of Kuwait.
 

Easy fiscal policy = Reflationary

In addition to an easy monetary policy, the markets can also look forward to an easy fiscal policy, which should be stimulative. The Trump administration has abandoned all Republican fiscal orthodoxy by proposing a budget that will not balance for 15 years. The fiscal deficit will go out as far as the eye can see, even with rosy growth assumptions.

A major factor in the deficit are the Trump tax cuts. Moreover, Trump wants to spend more on the military, and less on everything else. Even if Trump gets his entire wish list, namely:

  • Congress approves all of his budget priorities, such as Medicare cuts;
  • The economy achieves the rosy growth assumptions higher than market expectations; and 
  • He wins a second term.
His own OMB projects that he will leave office with a higher debt to GDP ratio than when he assumed office.

Are you worried about the deficit, or just the wrong kind of deficit?
 

MMT ascendant?

What if a Democrat wins the White House in 2020? This chart of how American politics has been polarized serves as a useful guide to future policy. If a Democrat were to win control of the White House, policy would take a dramatic lurch leftward. In the current political climate, that means the likely ascendancy of Modern Monetary Theory (MMT) as a policy framework.
 

 

I have written about MMT before (see Peering into 2020 and beyond and The boom of 2021) so there is no point in repeating myself. There has been much criticism voiced of MMT as an economic theory, but what we are concerned here is not whether MMT is a viable theory, it is whether its framework will be implemented, which would result in greater fiscal stimulus.

Some of the criticism confuses MMT, which is a description of an economic framework, with the policy initiatives of the Democrats, such as the Green New Deal. The greatest practical impediment to the implementation of MMT is the requirement of a close coordination of fiscal and monetary policy. Even then, this Barron’s article outlines the limits to the independence of the Federal Reserve:

Central bankers have no popular mandate. They are not elected and are only indirectly accountable to the public. Yet they are granted the “independence” to take unpopular decisions, at least up to a point. Their independence isn’t guaranteed, nor does it always mean the same thing at different points in time. Rather, it is contingent on circumstances.

As Philipp Carlsson-Szlezak and Paul Swartz of Bernstein Research put it in a recent note, “Central banks cannot escape their political underpinnings.”

In the years after the financial crisis, the political environment probably constrained the Federal Reserve’s ability to boost the U.S. economy. Things may now be shifting in the other direction.

Consider Fed Chairman Jerome Powell’s latest experience testifying before Congress, which occurred this past week. On Tuesday and Wednesday, he took questions from the Senate and the House, respectively. While many of the questions focused on technical issues, such as the implementation of the new Current Expected Credit Loss accounting standard, the optimal level of bank reserves held on deposit at the Fed, and the Fed’s process for vetting proposed bank mergers, several members from both parties pushed Powell and his colleagues to focus on raising wages and altering the economic split between workers and investors.

Political priorities change. The Fed sails in a sea of political winds that cannot be ignored.
 

A clash of generations

Analyzing theories like MMT to determine whether they represent good policy is futile for investors. Even if it turns out to be bad policy, the consequences won’t be felt for years, and investors should instead focus on the likelihood of its implementation, and its fiscal effects.

Here are two perspectives on MMT that represent some out of the box thinking. Srinivas Thiruvadanthai, Director of Research at the Jerome Levy Forecasting Center, wrote a Twitter thread that framed MMT as a generational conflict between Baby Boomers and MIllennials:

My pet theme: inflation is everywhere and always a political phenomenon in the current context of clash of generations, between Millennials and Boomers. In a way reflected in AOC vs Schultz.

The Boomers are entering retirement and sitting on assets that are richly valued. Inflation is poison in more ways than one. In fact, rising wages are poison because it cuts into their living standards. They want sell down their big houses and downshift.

The same thing happened in Japan but was decisively won by the retirees because they were preoponderant. In contrast, the Millennials are more or less the same size as the Boomers. So, the clash won’t be so decisively settled.

Ironically, Boomers when they were in the same position as Millennials today, i.e in the 1970s, won the battle decisively because they were dominant demographically. That is one reason why we had inflation.

The point being economic theories don’t have as much influence as people think. People use them to rationalize whatever policies favors them. Part of the reason for MMT gaining strength is it appeals to a constituency and the increasing divergence of interests.

As Millennials grow older and participate in the political process, their influence will grow. Over time, they will flex their political muscles, and the implementation of MMT will deliver the inflation that will favor their generation at the expense of the older Boomers. Whether that happens in 2020, or in the years beyond, is an open question. The midterm election of 2018 saw more Millennials participate in the political process, and expect that generation’s political power to grow as time goes on.
 

 

Even if the Democrats win the White House in 2020, the biggest practical obstacle to their ambitious legislative agenda is the Senate, as Bloomberg explains:

The sweeping liberal ideas backed by many of the party’s candidates — Medicare for all, a “Green New Deal,” and a $15 federal minimum wage — would struggle to get past a Senate where Republicans are likely to retain powerful influence over what legislation becomes law, even if a Democrat defeats President Donald Trump and takes office in January 2021.

Some Democrats are sounding warnings about the expectations being raised among the progressive voting base that helped the party gain control of the House and who’ll be crucial to any chances of winning the White House.

The Senate is going to make or break the progressive agenda in 2021, regardless of how well we do at the top of the ticket,” said Adam Jentleson, a former spokesman for Senator Harry Reid of Nevada.

The problem is math and congressional procedure. In the best case scenario for Democrats — another wave election that consolidates the party’s hold on the House and wins them a majority in the Senate — any far-reaching changes still would struggle to get 50 votes in the Senate, let alone the 60 votes needed to advance most legislation.

 

Dutch Disease?

For another perspective on MMT, FT Alphaville characterized the USD’s global reserve status as a Dutch disease:

Imagine that you are the finance minister of a small, developing country that has just discovered an ore belt rich in cobalt, a metal that has more than doubled in price over the last five years. You, a capable technocrat, are familiar with Dutch disease. You know that the sudden discovery of reserves of a high-value commodity can cause sclerosis in other industries, particularly manufacturing, as happened in The Netherlands after the discovery of natural gas in the late 1950s.

Now: imagine you are the Secretary of the Treasury of the United States of America. For “cobalt-rich ore,” substitute “dollars,” or “dollar-denominated assets,” or perhaps just “Treasuries.” You still need to worry about Dutch disease. We just never talk about it that way, because the whole framework of booming-commodity-sector analysis is a condescension we reserve for developing countries.

Remember, one of the principles of MMT is a government that runs deficits and borrows in its own currency is only limited by inflation, and the willingness of investors to lend to it in that currency. The US is in a unique position as the producer of a global reserve currency, which suggests that its debt limit is far higher than what normally might be expected under a standard economic theoretical framework, such as the one outlined by Rogoff and Reinhart:

America creates about a quarter of global GDP, but well over half of the currency reserves of the world’s central banks is socked away in dollars — $6.6tn of $11.4tn. The dollar is by far the dominant currency for international credit. Dollars are so important as an invoice currency for global trade that shifts in the value of the dollar are an effective predictor for international trade volumes. So many currencies are either explicitly pegged to the dollar, or tied to it through trade, that 50-60 per cent of global GDP swings with the dollar, making it part of a “dollar zone.”

The dollar is universally a store of value, a medium of exchange and a unit of account — all the things we consider “money.” It is arguably the only currency that is all three of these things. The United States Treasury is not the only place to get dollars. The United States isn’t even the only place to get dollars — foreign institutions create dollar-denominated assets, for example — but it is the best place to get dollars.

Inflation is ticking up, but in a Dutch disease fashion:

So let’s go back to the original research on Dutch disease. We have a basic model of an economy where the export of a single commodity raises the exchange rate, discouraging the export of manufactured goods. If the commodity is the dollar, then demand for the dollar raises the value of the dollar itself — this isn’t too hard to wrap our heads around, and since 1980 the dollar has appreciated, even as the US has declined as a share of global GDP.

We’d expect to see inflation in nontradable services, like medical care and college tuition, but not in tradable goods, like t-shirts and TV sets. And we’d expect a decline in the value added to GDP from manufacturing. None of these are dispositive, and Alphaville is sadly not an econometrician. But they have all happened.

Bottom line: If MMT is framed as a clash between generations, then its influence is likely to grow over the next decade. Moreover, the position of the USD as a major global reserve currency also facilitates the implementation of MMT, as debt capacity is likely higher than predicted by standard economic models.
 

Green shoots

I have been calling for a brief market correction over the next 2-3 months because of short-term economic weakness. So far, stock prices have not reacted to the fears of a slowdown. While a correction may still occur, its likelihood is diminishing because I am seeing green shoots of growth.

In the US, the latest update from FactSet shows that forward 12-month EPS are bottoming. Forward EPS estimates were declining for most of 2019, but they bottomed and began turning up in the last few weeks, which is a sign of improving expectations.
 

 

Over in Asia, the risks to China is highlighted by the evolution of the biggest tail-risk in the BAML Fund Manager Survey, which is the risk of a China slowdown.
 

 

In response to the well-known slowdown in China, Yuan Talks reported that Beijing is already enacting stimulus policies to cushion slowing growth:

China will not let economic growth slip out of a reasonable range despite the additional downward pressure, said Premier Li Keqiang on Friday at a news conference at the conclusion of the annual parliament meeting.

China lowered the economic growth target this year and set it as a range, which is actually a signal of stabilisation for the market, said Li. China is target a GDP growth range of 6 – 6.5 per cent this year.

Li said China can resort to quantity-based or price-based policy tools such as banks’ reserve requirement and interest rate tools to to boost the economy, which bolstering higher expectations for more stimulus policies.

One timely data point is South Korean exports, which is a sensitive barometer of global and Chinese growth because much of South Korea’s trade is with China. The March 1-20 year-over-year export statistics are improving. Exports were -4.9% v -11.1% in Feb. Exports to China was -12.6% v -17.4% in Feb.
 

 

In Europe, top-down economic indicators are also improving. The Citigroup Europe Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has bottomed and started to rise again.
 

 

There was also a silver lining in Friday’s disappointing eurozone PMI. While headline PMI declined, it was attributable to weakness in Germany and France, and from the manufacturing sector. IHS Markit did report some good news: “Elsewhere, the rate of output growth accelerated to its highest since last September as service sector growth hit an eight-month high.”
 

 

The slowdown in eurozone manufacturing may be reaching its nadir. China Beige Book found that Chinese headline growth is highly correlated to German IFO with a one-month lead. The nascent turnaround in Asia is good news for eurozone manufacturing exports.
 

Technical analysis review

There is an additional technical perspective to the melt-up bull case. Regular readers will recognize this monthly price chart of the Wilshire 5000, which was prescient at spotting a negative RSI divergence last August and flashed a sell signal (see Market top ahead? My inner investor turns cautious). The vertical lines represent buy (blue) and sell (red) signals based on zero line crossovers by the monthly MACD histogram. While I am not in the habit of anticipating model signals, the market is 3-4 months from a buy signal at the current pace. Past buy signals has been a highly effective at spotting long dated profitable uptrends.
 

 

In addition to US stocks, the technical condition of stock markets around the world have improved sufficiently that all trend model scores have been upgraded. None of these formations appear bearish. At worse, they can be characterized as “constructive”, which calls for accumulation instead of an outright buy signal.

Here is Europe. The weakest markets seem to be the core European countries of Germany and France. Peripheral Europe is behaving even better than core Europe.
 

 

UK equities are also performing well, despite Brexit anxieties.
 

 

The markets of China and her major Asian trading partners have also recovered.
 

 

Lastly, commodity prices, as measured by industrial metals, and the CRB Index, are in the early parts of uptrends.
 

 

What about the yield curve?

Some market anxiety has arisen recently because of the behavior of the yield curve. In particular, the belly of the curve has inverted. The spread between the 10-year and 3-month T-Bill is now negative, and the 2s10s spread has fallen to 11bp, which was the level last seen at the height of the December market sell-off.
 

 

Should you be worried? A flattening or inverted yield curve is a bond market signal of slowing economic growth. As the theory goes, as the Fed raises rates, the long end of the yield curve falls to reflect lower growth expectations. An inverted curve has been an uncanny signal of impending recession in the past.

This time really is different. The Fed has given a dovish signal, and the belly of the curve has fallen faster than the front end. Moreover, while the 2s10s spread has been flattening, the 10s30s has steepened in the last few months.
 

 

Which yield spread should you focus on? The short end and the belly of the curve, which is most affected by Fed policy, or the long end, which is mostly determined by the market? The answer is both, but I am skeptical of a recession signal from a flattening or inverted yield spread that is unconfirmed by the other, especially when the Fed is dovish. I was far more concerned about recession risk last year when the 2s10s and 10s30s were flattening in lockstep.

The following chart of yield curve recessionary signals indicate that false positives occurred twice in the 1990`s when inversions or near inversions in the short end were not confirmed by the long end. The first was in late 1994, when the Fed adopted a dovish tilt after a series of rate hike, and in 1998, when the Fed stepped in to rescue the financial system in the wake of the Russia and LTCM Crisis.
 

 

It is also difficult to believe that a recession is imminent when the Conference Board Leading Economic Index is so strong and shows no signs of deterioration.
 

 

In conclusion, the combination of accommodative fiscal and monetary conditions may be setting stock prices for a market melt-up into 2020 of unknown magnitude. The market has shrugged off slowing growth fears, and early signs of a pickup are beginning to appear. While a correction may still happen, I would regard any weakness as an opportunity to buy.
 

A “show me” week ahead

Looking to the week ahead, it is instructive to see how sentiment has shifted in a single day after soft flash PMI data from Europe, and the inverted yield 3m10y yield curve. Subscribers received an alert that my inner trader had taken an initial long position in the market, and the pushback was considerable.

FactSet reported that the market has not been reacting to negative earnings guidance, which may be a sign that a slowdown is already priced in. This interpretation should be given greater consideration as forward EPS estimates are now bottoming out.
 

 

From a technical perspective, the S&P 500 pulled back to test a resistance level turned support, as the VIX Index neared its upper Bollinger Band, which is a sign of an oversold market.
 

 

The VIX Index spent much of Friday above its upper BB, which is one mark of an oversold market, but pulled back below the key level just at the close. Here is the 5-minute chart.
 

 

After the market closed, the news that Robert Mueller submitted his report hit the tape, which may serve to spike volatility next week. On the other hand, the news that Mueller has recommended no further indictments. such as Donald Trump Jr. or Jared Kushner, may be interpreted positively and spark a risk-on rally.

Short-term breadth deteriorated to mildly oversold condition as of Friday’s close. While the market can go lower, the 1-2 day risk/reward is tilted bullishly.
 

 

The upcoming week will be a “show me” week that may yield insights to a lot of unanswered questions. The chart below shows the S&P 500, and the relative performance of different market cap segments of the market. The answers may give some clues to the future direction of the market:
 

  • Can the resistance turned support level of ~2800 hold?
  • Are mid and small caps, which have been underperforming, hold their relative support lines? 
  • NASDAQ stocks, which have been on a tear and appear a little extended, continue their market leadership status?

 

Do the bulls still have control of the tape? Is the market rallying on a series of “good overbought” readings on RSI-5, only to see any pullbacks halt with RSI-14 at about the neutral 50 line?
 

 

If the bulls were to maintain control of the tape, I would like to see better performance by equity market risk appetite factors. So far, the relative performance of high beta vs. low volatility, pure price momentum (MTUM), blended momentum (FFTY) are all range bound. Can they break out of their ranges? In which direction?
 

 

Credit market risk appetite indicators have not given many clues. The duration adjusted price relative performance of high yield (junk bonds), investment grade, and EM bonds are all tracking the stock market. There are no significant divergences.
 

 

Finally, much has been made of the poor recent performance of the DJ Transports by some technical analysts. Can the Transports hold their absolute and relative support levels? That will also provide another clue to future market direction.
 

 

My inner investor was neutrally positioned at his target asset allocation weights. He allowed his equity weight to drift slightly upward as the market rallied and he is not trimming those positions back. His view is to remain cautious by avoiding being the FOMO buyer, but to buy any dip that occurs.

My inner trader is giving the bull case the benefit of the doubt. He covered all of his short positions on Wednesday in the wake of the dovish FOMC statement. He has taken a small initial long position in the market.

Disclosure: Long SPXL
 

Sector selection guide for sentiment, momentum, and contrarian investors

Posted by Cam Hui -

Mid-week market update: The instant market reaction on FOMC day can often be deceptive. Instead of a general market comment, I will focus instead on analyzing sectors using sentiment, momentum, and contrarian approaches. As a measure of sentiment, John Butters at FactSet recently analyzed sectors by the number of buy, hold, and sell rankings.
 

 

The sector with the most buy ratings is Energy, but I am going to set aside Energy and Materials from this analysis as commitments to those sectors amount to a bet on commodity prices, which has historically been inversely correlated to the USD. As the chart below shows, the USD Index has been range bound since November, and so has the relative performance of Materials. The relative performance of Energy to the market has also been range bound for 2019, despite the rally in oil prices.
 

 

I can make a couple of observations from the FactSet bottom-up analysis:

  • The least favored sectors are defensive, namely Consumer Staples, Utilities, and Real Estate, plus Financials. From a bottom-up aggregated basis, the presence of defensive sectors in the least favor groups indicates a high beta tilt in analyst rankings.
  • The most favor sectors are mostly high beta sectors, which include Communication Services and Technology, which is heavily FAANG tilted, plus Health Care. This also indicates a high beta tilt from the analyst community.

 

Fundamental momentum

The bottom-up high beta tilt of analyst rankings make me somewhat uneasy. The latest warning from FedEx earnings call should not be ignored:

We see solid economic growth in the U.S. but somewhat below last year’s pace. Internationally, performances is mixed across regions as overall growth moderates. The Eurozone and Japan still appear sluggish while emerging markets growth eases at a gradual pace. A recurring theme in global surveys on economic activity is a negative impact from global trade frictions and heightened uncertainty. World trade is slowing, and leading indicators point to positive but ongoing deceleration in trade growth in the near term.

Since our last earnings call, we have seen the overall China economy slow down further, and this has impacted other Asian economies. Given the size of China, no markets will be able to absorb more than a fraction of what China produces, but customers continue to look to diversify from China. We have also seen some customers evaluate mode optimization. Our network and portfolio lets customers respond quickly and act locally for our customers in China, as well as around the world.

In addition to the downbeat assessment from FedEx, which is regarded as a bellwether for global economic activity, there has been also been an enormous divergence between global stock prices and estimate revisions.
 

 

The following chart from Yardeni Research Inc. drills down at a sector level to how forward 12-month EPS estimates have been changing.
 

 

I can make the following observations from this analysis of estimate revision, which is a way of measuring fundamental momentum:

  • The intersection of most favored by analysts and best estimate revisions is Health Care.
  • The sectors with the best estimate revisions are Health Care and Industrials.
  • Technology, which is highly ranked by analysts, saw estimates rise dramatically but recently saw some downgrades.
  • The intersection of sectors least favored by analysts and a reasonable level of estimate revisions are Financials and Consumer Staples, which saw flat estimate revisions. 

 

Price momentum

From a technical perspective, let us also consider how the sectors with the most buy rankings have performed against the market. Only Technology stocks are in a relative uptrend against the market. Health Care is in a relative downtrend this year, which is unsurprising given its low-beta characteristic and the market has been rallying. Communication Services stocks have been surprisingly range bound on a relative basis.
 

 

Consider the same analysis for the least favored sectors. Surprisingly, all have been range bound relative to the market, except for Consumer Staples, which has been in a relative downtrend this year. Be aware, however, that the relative performance of Financial stocks have been highly correlated to the shape of the yield curve. A steepening 2s10s yield curve has historically been favorable to the outperformance of this sector.
 

 

The analysis from RRG charts also supports the results of this analysis. Technology, Industrials, and Communication Services are the leadership groups, while defensive sectors like Consumer Staples, Real Estate, and Utilities are lagging.
 

 

Pick your poison

What sectors should you buy, or sell? That depends on your investment temperament..

  • For pure momentum investors: The choice is clear. Buy Technology.
  • Fundamental momentum investors: The obvious choice of a favored sector with good analyst rankings and improving estimates is Health Care. A little ignored sector if you want to focus a lightly ignored sector with improving fundamentals is Industrials. 
  • Contrarian investors: Contrarian investors who want to focus on sectors with low expectations and reasonable fundamental and technical behavior might want to look at Financials and Consumer Staples, with the caveat that a bet on Financials is a bet on a steepening yield curve.

Different strokes for different folks. You can pick your poison. As an alternative, a diversified approach of overweighting sentiment and price momentum (Technology), fundamental momentum (Health Care), and contrarian picks (Consumer Staples, Financials) will result in a portfolio with a more balanced market beta.
 

FOMC preview: Peak dovishness?

Posted by Cam Hui -

The big market moving event this week on this side of the Atlantic is the FOMC meeting, which concludes on Wednesday with a statement, followed by a press conference by Fed chair Jerome Powell. Ahead of that event, let us consider what market expectations are for Fed policy.

The CME’s Fedwatch Tool shows that the market does not expect any rate hikes for the remainder of 2019, and a slight chance of a cut by the December meeting.
 

 

What about the size of the balance sheet? Callum Thomas conducted an unscientific Twitter poll last week that asked respondents when they expect the Fed to pause quantitative tightening, or QT. The biggest response was Q2, followed by answers in Q3 and Q4 later this year.
 

 

As we approach the FOMC meeting, investors have to be prepared for excessively dovish expectations from Fed policy.
 

FOMC projections

Investors will be closely watching the evolution of Fed projections from the FOMC statement. Economic data has been coming in a bit on the soft side, how far will the Fed shade down its growth projections for 2019, and what does it mean for monetary policy? Currency strategist Marc Chandler highlighted his non-consensus view that the dot-plot may still reveal a tightening bias, despite the recent dovish rhetoric from Fed officials:

The Fed’s view of the economy has probably not changed materially. The economy hit a soft patch at the end of last year and early this year as various crosscurrents hit, but the underlying fundamentals remain frim. Financial conditions tightened dramatically, but have eased nearly as quickly. The S&P 500 is up over 12% since the start of the year. The Federal Reserves’ real broad trade-weighted dollar index fell in both January and February, to snap an 11-month rally. US interest rates remain below Q4 18 levels. The 10-year note yield was near 3.25% in early November and finished last week below 2.60% for the first time since early January. The two-year yield closed the week a little above 2.40%. It peaked shy of 3.0% four months ago…

In December, two of the seventeen officials anticipated that no hikes were necessary this year. It is easy to see how the four officials that saw one hike could join the standpat camp. Eleven Fed officials had foreseen the need for two or more rate increases, almost evenly divided (6/5 in favor of three). It seems unreasonable to expect them all to completely reverse themselves. The median forecast will still likely anticipate a hike. The market is not there. The January 2020 fed funds futures contract implies a 2.30% average effective rate. It is currently at 2.40%.

Ed Yardeni had already anticipated a hawkish dot-plot, but he believes Powell will downplay its message and its usefulness in the press conference.

In his speech, Powell reviewed two previous instances. In 2014, the dots caused “collateral confusion,” according to the then Fed Chair Janet Yellen, when the markets misread the Fed’s intentions. She stated that what matters more than the dots is what is said in the FOMC Statement released after each meeting.

Similarly, former Fed Chairman Ben Bernanke once said that the “dots” are merely inputs to the Fed’s policy decision-making; they don’t account for “all the risks, the uncertainties, all the things that inform our collective judgement.”

 

QT timing

The other market concern has been the pace of balance sheet normalization, otherwise known as quantitative tightening. Chairman Powell made his views clear in a speech on March 8, 2019. He prefaced his remarks with the criteria that balance sheet reduction will stop when it is consistent with the Fed’s task of conducting monetary policy, or the size of the banking system’s reserves.

The Committee has long said that the size of the balance sheet will be considered normalized when the balance sheet is once again at the smallest level consistent with conducting monetary policy efficiently and effectively. Just how large that will be is uncertain, because we do not yet have a clear sense of the normal level of demand for our liabilities. Current estimates suggest, however, that something in the ballpark of the 2019:Q4 projected values may be the new normal. The normalized balance sheet may be smaller or larger than that estimate and will grow gradually over time as demand for currency rises with the economy. In all plausible cases, the balance sheet will be considerably larger than before the crisis.

When will the balance reach that level? With the usual caveats about data dependency, the answer is “later this year” [emphasis added].

While the precise level of reserves that will prove ample is uncertain, standard projections, such as those in the table, suggest we could be near that level later this year. As we feel our way cautiously to this goal, we will move transparently and predictably in order to minimize needless market disruption and risks to our dual-mandate objectives. The Committee is now well along in our discussions of a plan to conclude balance sheet runoff later this year. Once balance sheet runoff ends, we may, if appropriate, hold the size of the balance sheet constant for a time to allow reserves to very gradually decline to the desired level as other liabilities, such as currency, increase. We expect to announce further details of this plan reasonably soon.

Fed governor Lael Brainard echoed a similar sentiment in a speech on March 7, 2019 [emphasis added]:

After holding the size of the balance sheet roughly flat since mid-2014, once the normalization of the federal funds rate was deemed well under way in October 2017, the Committee started to allow the size of the balance sheet to shrink in line with the pledge to “hold no more securities than necessary to implement monetary policy efficiently and effectively.” We have made substantial progress, as demonstrated by the level of reserves. Reserves are already down by 40 percent since their peak and are likely to be down by more than half this summer. In my view, asset redemptions should come to an end later in the year, which would provide a sufficient buffer of reserves to meet demand and avoid volatility. We have gathered information from market contacts and have surveyed banks to assess their demand for reserves.17 I would want to see a healthy cushion on top of that to avoid unnecessary volatility and ensure that the federal funds rate will be largely insulated from daily swings in factors affecting reserves.

The message from Fed speakers could not be more clear. Expect an end to QT later this year, which means either Q3 or Q4. If the modal response of Q2 from the Callum Thomas is reflective of market expectations, then investors should be prepared for a hawkish surprise.
 

Inflation trends

What about inflation? The Fed has made it clear that as long as inflationary expectations remain tame, they are likely to remain on hold.

However, CPI trends are a little unsettling. While core CPI (black line) has moderated a bit, both median CPI and sticky price CPI are stubbornly firm, with median CPI standing at or near cycle highs. Any hint of renewed growth could serve to elevate inflation and inflationary expectations again.
 

 

In addition, if the Fed’s recent dovish about face was in response to market conditions, then both stock prices and volatility have normalized. In that case, why should the Fed continue its course of excessive dovishness?
 

 

In conclusion, market expectations for both interest rate policy and balance sheet reduction appear to be excessively dovish in light of the data, and recent Fedspeak. Investors should be prepared for a hawkish surprise from Fed policy.

 

Recession jitters: The new fashion?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

More recession jitters

I have been warning about the possibility of weakness in Q2 in these pages. Recently, I am seeing more and more evidence of recession jitters come across my desk. The respected UCLA Anderson Forecast issued a statement last week stating that economic growth is likely to slow in 2019 to 1.7% and to near recessionary conditions in 2020:

In his outlook for the national economy, UCLA Anderson senior economist David Shulman notes that while the global economy started out strong in 2018, signs of its weakening will likely be everywhere by year’s end. “The weakness is being amplified by the protectionist policies being employed by the Trump administration and the uncertainties associated with Brexit,” he writes. “This economic weakness has triggered a major contraction in global interest rates, making it difficult for the Fed to conduct its normalization policy, and has put a lid on long-term interest rates.

“After growing at a 3.1 percent clip on a fourth-quarter-to-fourth-quarter basis in 2018, growth will slow to 1.7 percent in 2019 to a near-recession pace of 1.1 percent in 2020,” Shulman adds. “However, by mid-2021, growth is forecast to be around 2 percent.” Payroll employment growth will decline from its monthly record of 220,000 to about 160,000 per month in 2019 and a negligible 20,000 per month in 2020, with actual declines occurring at the end of that year. In this environment, the unemployment rate will initially decline from 3.9 percent in January to 3.6 percent later in the year and then gradually rise to 4.2 percent in early 2021.

Antonio Fatas, the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, rhetorically asked in a blog post if low unemployment is sustainable. In other words, this is as good as it gets for unemployment and the economy? Past turns in the unemployment rate have been followed by recession.
 

 

The latest Jobs Report saw the headline unemployment rate decline from 4.0% in January to 3.8% in February, which is constructive, but the internals of the report don`t appear as rosy. RecessionALERT pointed out that 60% of states have reported an increase in unemployment rate.
 

 

The Leuhold Group also sounded a warning for equity investors. The combination of low unemployment and top quintile valuations is unfriendly for long-term (7-year) returns.
 

 

As good as it gets?

Returning to Fatas` analysis, he observed that, in the past, low unemployment rates were unsustainable, and they have displayed a V-shaped pattern at the lows.

In the case of the US, history suggests that “full employment” is not a sustainable state and that once we reach such a level a sudden increase in unemployment is very likely. In the figure below I plot unemployment rates around the peak of each of the last five cycles (where zero represents the month the recession started). I plot 5 years before the recession started and 10 months after the recession.

 

 

All cycles display a V-shape evolution for unemployment. Unemployment reaches its lowest point around 12 months before the recession and, in most cases, unemployment is already increasing in the months preceding the recession. What is interesting is the absence of a single episode of stable low unemployment (or full employment). It seems as if reaching a low level of unemployment always leads to dynamics that soon generate a recession. Recessions die of old age if “age” is measured in terms of how much economic slack is left. If this pattern was to be repeated, the US must be today very close to an inflection point, a recession.

He went on to demonstrate the V-shaped recovery in employment using quantile regressions:

We can quantify this intuition by relating this result to an academic literature that analyzes the determinants of the tail risk of unemployment (or GDP) changes. This literature looks at the determinants of worst potential outcomes over a specific time window. Some examples: Cecchetti (2008), Kiley (2018) Adrian, Boyarchenko, and Giannone (Forthcoming).

Empirically this is done with the use of quantile regressions. In this case we are interested in the tail risk of sharp unemployment increases, which are associated with recessions, and I will capture that by coefficient on the 90th percentile of the distribution in a quantile regression (Fatas (2019)).

The results of such a regression are displayed in the table below. All three coefficients are negative (which is what one would expect as there is reversion to the mean in unemployment rates). But the interesting part is that the size of the coefficient increases as we move from small changes in unemployment to large changes (from q10 to q90). This means that low unemployment rates are particularly good at predicting the tail risk of large increases in unemployment (recessions)

 

 

What makes low unemployment unsustainable? To say that low unemployment leads to recession is similar to saying that expansions die of old age. Fatas attributes the unemployment V to the buildup of excesses in the economy. In other words, low unemployment is just an indicator that we are in the late cycle of an expansion.

The academic literature tends to emphasize two set of variables: those associated to macroeconomic imbalances (such as inflation) and those associated to financial imbalances. Interestingly, the introduction of these variables in the quantile regressions above makes the above effect go away (see Fatas (2019)). In particular, once we control for credit growth, it is not any longer the case that low unemployment is a good predictor of the tail risk associated to recessions (we still observe a reversion to the mean but we do not obtain a larger coefficient for the p90 quantile).

This result suggests that recessions follow periods of low unemployment because imbalances are built during those years. What is interesting is that the evidence shows that this is always the case, that the US economy has never managed to sustain a low rate of unemployment without generating the imbalances that lead to a recession. If history is an indicator of future crisis, and given the current low level of unemployment, a recession is likely to be around the corner.

Fatas uses the Chicago Fed’s National Financial Conditions Index (blue line) to measure financial excesses. So far, this indicator, along with the St. Louis Fed’s Financial Stress Index, remains tame.
 

 

However, the real excesses of this expansion cycle can be found outside the US. As I have noted before, a technical breakdown in the relative performance of bank stocks have signaled bear markets or financial crises in the past.
 

 

The worries of this expansion cycle have been dominated by the increasing fragility of the Chinese economy. If China were to stumble, the rest of Asia would tank, and so would the major resource producing countries like Australia, Canada, New Zealand, and Brazil. Europe is also highly vulnerable to a China slowdown. China Beige Book pointed out that China’s headline growth has a 0.81 correlation with Germany’s IFO Index with a one-month lead.
 

 

While the American economy is not highly exposed to trade, I remind readers that 39% of S&P 500 sales come from foreign sources. Non-US economic weakness will have an outsized effect on US equity prices, especially if the global investors pile into  USD assets because US is viewed as a safe haven. A rising USD would have the double whammy of further depressing operating margins owing to poor exchange rate translation.
 

 

New Deal democrat’s Recession Watch

New Deal democrat, who monitors high frequency economic statistics and categories them into coincident, short leading, and long leading indicators, remains on “recession watch”, which he is careful to distinguish from an actual recession forecast:

The summary for my long leading forecast changes to the following:

  • 3 negatives: Interest rates, housing, and credit conditions.
  • 1 positive: Corporate profits.
  • 1 neutral: Real retail sales per capita.
  • 2 mixed indicators: Money supply and the yield curve.

In sum, with more complete information, the “Recession Watch” call centered on Q4 2019 remains, and in fact, has received more support. To reiterate, treat this in a similar way to a “Hurricane Watch”, as if the 5-day forecast cone for the hurricane included your area. There is an enhanced chance of the event occurring, but not a sure thing unless the conditions continue – in this case, the long leading indicators do not quickly reverse, and the short-term leading indicators turn negative for a sustained period of time

While the long leading indicators that measure corporate sector has been healthy, the household sector is not behaving well. Real private residential investment to GDP has been declining.
 

 

The cyclically sensitive housing sector has been weak. While monthly releases can be noisy, single family housing starts is one of the least volatile data series, and it peaked out about a year ago.
 

 

Real retail sales per capita has tended to peak ahead of past recessions. The last high was in October, and this indicator has been declining ever since.
 

 

In addition to the warnings raised by NDD, I would add that leading indicators of employment appear to be rolling over. Weakness in employment raises the concerns about a V-shaped turnaround in the unemployment rate pointed out by Antonio Fatas. Temporary employment growth has historically led Non-Farm Payroll in the last two cycles, and temp jobs seem to be topping out.
 

 

As well, the quits rate has been a useful indicator of labor market health, but it is part of the JOLTS data, which is reported with a time lag. This chart of the quits rate (blue line) and initial jobless claims (inverted scale, red line) suggests that the quits rate may be due to decline in near future. If this is indeed the inflection point, then it would indicative of a weakening job market.
 

 

As an indication of the usefulness of the timely initial jobless claims, initial claims (inverted scale, blue line) have been remarkably correlated with stock prices during this expansion cycle.
 

 

The Citigroup US Economic Surprise Index, which measures whether macro-economic data is beating or missing expectations, has been cratering, indicating the misses are worsening.
 

 

Business Insider reported that Morgan Stanley sounded a similar warning. Leading indicators are declining, and investors should be prepared for falling earnings growth.
 

 

FactSet reported that the Q1 negative guidance rate is 74%, which is above the 5-year average of 71%. In addition, Business Wire reported that a review by Gartner Inc. of earnings calls revealed a high degree of management anxiety about a downturn.

“S&P 500 company executives are concerned about the risks and uncertainty from government interventions rather than suspecting any global macroeconomic downturn in the near term,” said Tim Raiswell, vice president at Gartner’s finance practice. “Talk of capital and cost-efficiency programs was increasingly common in earnings calls as 2018 progressed.”
 

“Mentions of the words ‘downturn’ and ‘slowdown’ were four times more likely to appear in earnings call in 4Q18,” said Mr. Raiswell. “Yet it’s important to consider that 4Q18 brought relatively extreme drops in stock prices. After 10 years of economic expansion, it’s not surprising to see analysts asking company executives about their preparations for cyclical economic weakness.”

More importantly, slowdown fears are beginning to affect business confidence [emphasis added]:

“Given the lack of realistic precedents in many cases, all parties are largely guessing about the extent to which political rhetoric will become firm policy and what the impact will be on companies’ order books,” said Mr. Raiswell. “In this uncertain environment and after a long stretch of expansion since 2009, a significant number of leading firms are taking a recessionary stance and making preparations to capitalize on a downturn rather than be a casualty of one.”

Many large firms reported that cost management initiatives are well underway, largely targeting overhead categories such as marketing, advertising and finance, as well as direct industrial production costs. For example, P&G, Estée Lauder, Whirlpool and others all detailed significant firmwide productivity programs. Several vehicle manufacturers, such as Honda, Ford and Nissan, began initiatives to consolidate their production in fewer facilities to drive efficiencies. Many more firms reported deliberately lower capital expenditure than expected in 2018, as growth capital was reallocated.

The S&P 500 trades at a forward P/E ratio of 16.3, which is just below its 5-year average of 16.4 and above its 10-year average of 14.7. In this environment of likely downgrades to the economic outlook and elevated valuation, investors need to be prepared for the possibility of disappointment and de-rating in the weeks and months ahead.
 

 

The Powell Put

What about the Fed? Won’t it rescue the stock market? While we will hear more from the Fed at its upcoming FOMC meeting, it is difficult to see how its policy could become any more dovish in light of the current environment. The Fed’s past behavior indicates that it will ride to the rescue should stock prices crash, it is nevertheless constrained by its dual mandate of maximum employment and stable prices. As the chart below shows, while core CPI (black line) has softened, both median CPI and sticky price CPI are stubbornly firm. In fact, median CPI is at or near a cycle high, and these trends in inflation could handcuff the Fed from easing monetary policy should the economy weaken.
 

 

There is a Powell Put, but expect the strike price to be lower than current market levels. The Fed is likely to tolerate minor corrections, just not market crashes.

In conclusion, dark clouds are appearing on the economic horizon. While they do not necessarily mean that a hurricane is ahead, investors have to be prepared for storm fears, and act accordingly. I reiterate my belief that any growth scare is likely to be temporary. There are few signs of excesses in the US, if unwound, that are likely to plunge the American economy into recession. Most of the risks come from abroad. China is the main source of global concern, and it has already begun another stimulus program, and Beijing is going to pull out all stops to ensure the economy is not tanking ahead of its 70th anniversary of Mao`s revolution in October. Therefore any growth jitters are likely to be ephemeral, and any resulting market weakness will only be only corrective in nature.
 

The week ahead: From one BB to another

Looking to the week ahead, the market staged a remarkable rally last week as indices moved from one end of the Bollinger Band to the other. The VIX Index (bottom panel) fell from the top of its BB to the bottom in five days. At the same time, the S&P 500 rallied from the bottom of its BB to the top. The market is not testing a resistance zone while exhibiting negative RSI divergences, which is a sign calling for caution.
 

 

Another worrisome sign is the narrowness of market cap leadership. The relative performance of the megacap S&P 100 is in a relative downtrend, and so are the mid and small cap stocks. The only index showing any leadership are the NASDAQ 100 stocks, indicating narrow leadership.
 

 

Selected breadth indicators are also displaying a series of negative divergences as well. % bullish, % above their 50 dma, and % above their 200 dma are making lower highs even as the S&P 500 made higher highs in the past two weeks.
 

 

Short-term breadth was overbought and rolling over, which is often a signal of short-term weakness.
 

 

Notwithstanding the unpredictability of the market reaction to next week`s FOMC meeting, the market also faces historical headwinds in the upcoming week. Rob Hanna at Quantifiable Edges observed that the week after quadriple witching tends to have a bearish bias.
 

 

My inner investor is neutrally positioned at roughly his target asset allocation weights. My inner trader has been leaning bearish and he increased his short positions as the market rallied last week.

Disclosure: Long SPXU

 

The secret of cryptocurrencies revealed!

Posted by Cam Hui -

For the longest time, I never “got” crytocurrencies. I never bought into the idea of an urgent need for a currency that is outside the control of the “authorities”, or how you ascribe value to something that had no cash flow. If it has no cash flow, then how do you calculate a DCF value? Here is the perspective from Morningstar:

As with copper ingots, seashells, peacock feathers, and gold before it, cryptocurrency is a medium of exchange, rather than something that creates wealth on its own. It can be used to purchase cash–but it does not earn it. Try as you wish, your bitcoin receipt won’t trigger dividend checks, any more than will a sheaf of peacock feathers or a mountain’s worth of copper.

Assessing cryptocurrencies by calculating the value of their future payments is therefore a dead end. If cyber coins can be appraised, even tentatively, another approach must be found.

That cryptocurrencies do not generate cash does not mean that they lack worth. Seashells and peacock feathers don’t go very far these days, but throughout history and across societies, gold has reliably been prized. So, too, have been rare gems.

How do you keep it safe? One of the functions of a bank, which exists within the formal financial system, is to keep you money safer than stuffing it under the mattress. Banks are there to mitigate situations of the apocryphal story of the Bitcoin pioneer who put a token $100 into BTC during its early days. Several years later, he realized he was a millionaire but he lost his password.

This also brings up the issue of the role of money and banking in managing a medium of exchange that functions as a store of value.

Money and banking

Notwithstanding the stories of how crypto-exchanges have been hacked and drained of their holdings, the existence of the cryptocurrency ecosystem brings up a crucial question of money and banking. How do you lend out a cryptocurrency? What is the interest rate, and what are the mechanisms for determining the correct rate, as well as the yield curve?

If there is a financial intermediary standing between cryptocurrency users in order to facilitate lending, such as a bank or an exchange, how do you deal with reserve requirements, and the issues that arise from a fractional banking system?

These issues can’t be just swept under the rug. Money lenders have existed throughout human history. There is the Biblical story of Christ and the money lenders in the Temple. The Koran specifies prohibitions against lending, which spawned the industry of Islamic finance.

Consider gold, which is a recognized store of value in many quarters. The historical experience shows an inverse relationship between real interest rates and the price of gold.

Banking matters. Interest rates matter.

The Epiphany

My epiphany came from an article in FT Alphaville. The fact that cryptocurrencies have no cash flow is a feature, not a bug:

Last week, Martin Walker came up with an elegant way of thinking about them: as zero coupon perpetual bonds — something that pays no return, and never gets repaid. This is a sophisticated kind of nothingness, in the financial sense.

Cryptos may be based on nothingness, but it doesn’t necessarily follow that they’re worthless. In fact, the value they provide might depend upon them being linked to nothing, rather than something. This is a kind of security that crops up very rarely, like precious metals, or great works of art.

I had been thinking about cryptocurrencies in the wrong way. Traditional financial vehicles, like stocks and bonds, can be calculated with DCF models using cash flow estimates. They are therefore “concstrained” in their valuation.

Financial securities have constraints that can be used to model their risk and define their value. Bonds are issued by highly trusted borrowers, and provide predictable cash flows and specified dates of maturity, when they are converted into money. Equities provide less predictable cash flows, in the form of dividends, that come at the discretion of company managers. In the case of currencies, the value is realised through buying goods or services – a role that cryptocurrencies have yet to properly assume.

In each of those cases, the value of the security is partly constrained by these realities, despite the psychological volatility of the markets where they are traded. Very risky equities might provide very high returns, but there is still something that anchors their worth – usually a particular business proposition. Bonds will very rarely provide high returns, unless they are bought at distressed values. Currencies that actually work as currencies are anchored to their own purchasing power measured against a collective basket of goods and services available in an economy, which is why they have no value on a desert island.

By contrast, BTC and other crytocurrencies have unconstrained value.

In the case of something like bitcoin, there is basically no anchor. There are no discounted cash flow models, or estimated valuations in Chapter 11. If such things existed, bitcoin would be a far less effective medium for speculation. In its current form, it is a rare example of an unconstrained security, valued as a pure projection of psychological volatility in a secondary market. Such things are usually referred to as “bubbles”, but they can offer a perverse kind of value.

Why would you want to invest in something that is unconstrained? The answer is that sometimes asymmetrical utility can be derived from large windfalls. If you have a small amount of initial capital, you might take on a less favourable risk-reward profile for a shot at a higher nominal windfall that is unachievable elsewhere. The classic example of this is the lottery (which former Alphavillian Kadhim Shubber compared to bitcoin here, in relation to its entertainment value). Extreme returns are possible in unconstrained securities because there is no basis for their value in the first place. The upper bound is some unknown quantification of psychological appetite for speculation.

In essence, they take on the characteristics of a lottery ticket:

Now let’s consider the psychology. Demand for cryptocurrencies is very high in urban centres where young people, mostly disengaged from other financial securities, are plagued by monthly cash-flow problems (often caused by high living costs). These individuals have tendencies to blow small windfalls on luxuries, like holidays.

If they invest £200 in equities, the annual dividend returns are obliterated by their daily cash flows in a modern city. If they make £800 on that investment, they are liable to spend the proceeds, because the amount feels so distant from the lower boundary of urban residential real estate prices. This has little to do with discipline; it is better explained by the relative pricing of daily living costs, meaningful assets, and salaries.

Individuals in these situations may prefer to speculate on nothingness, hoping their peers transfer wealth to them, than plough into markets for established securities, where the risk-reward profile is better but the upper limit on returns is nominally minuscule. This also explains why, often, they are more attracted to equities that look like zero coupon perpetual bonds (certain tech companies), which are similar to unconstrained securities, except that management can extract the proceeds.

A real life example

Years ago, when I lived in Boston, and later in the Connecticut, my wife and I used to take weekend trips into New York City for the art auction previews at Christie’s and Sotheby’s. It was a cheap excursion, and it was a free way to see high-end art before they disappeared into someone’s private collection.

I can recall one specific incident when we were at an Impressionist preview. We came upon a small Renoir portrait of a young girl, and the auction estimate was $2-3 million. The picture was stunning, and bore the classic brushstrokes of Pierre Auguste Renoir (similar image below). My wife turned to me and said, “I don’t like being poor!”

Notwithstanding the fact that we could barely afford to insure such a painting, this begs the question, “Why is the painting by a well-recognized artist such as Renoir or Rembrandt worth millions? How is it different from the pictures painted by millions of children that wind up on their parents’ fridge doors?”

Works of art don’t generate any cash flow, if at all. An owner could sell tickets for people to see a painting, but the DCF value of the exhibit, after the rental of the space, security costs, and so on, is not going to be anywhere near the price paid for the art.

The answer is the speculative value of the art, or the crytocurrency, as they have “unconstrained” value. On the other hand, the value of art, just like seashells as stores of value, rise and fall based on their fashion. You can buy the work of an up-and-coming artist and see it soar in value several year later, purchase the work of a recognized artist like Renoir or Rembrandt in the expectation that it will hold its value, or see the artist’s work go out of fashion and depreciate to the value of a child’s drawing on a refrigerator.

From oversold to overbought to…

Posted by Cam Hui -

Mid-week market update: In my last post, I suggested that the stock market is headed for a corrective period, though a short-term bounce was possible this week because of its oversold condition (see Correction ahead: Momentum is dying). The market has staged a remarkable recovery this week by surging to test a key resistance level and readings are now overbought.
 

 

The key question then becomes, “Is the correction thesis dead?”
 

A review of momentum

The correction call was based on the observation that price momentum was rolling over. In particular, I focused on the narrowing MACD histogram as a sign of weakening momentum. Let us review how MACD has behaved since the relief rally this week. Here is the weekly S&P 500. Past episodes of weakening momentum has seen either the market correct, or consolidate sideways.
 

 

Here is the NASDAQ Composite, which is the one bright spot in the market.
 

 

The small cap Russell 2000 continues to see waning momentum.
 

 

Outside the US, developed market equities, as measured by EAFE, is also exhibiting a similar pattern of weakening momentum despite the price recovery this week.
 

 

Emerging market stocks led global markets with a MACD roll over.
 

 

Bottom line: With the except of the NASDAQ, weekly momentum remains weak across the board.
 

Other momentum factors

What about the price momentum factor. There are two ways of measuring price momentum using ETFs. The MTUM is a pure price momentum ETF, while FFTY mimics the IBD 50 based on a combination of price and fundamental momentum. The relative performance of both ETFs had been highly correlated until last fall, but there are few signs of a strong momentum rebound.
 

 

In addition, the market rebound has moved short-term breadth from an oversold to an overbought condition.
 

 

Moreover, the daily S&P 500 chart shows negative RSI divergences on the 5 and 14 day RSI.
 

 

At a minimum, I would not want to be buying a market that is testing resistance while overbought and exhibiting negative breadth divergences. Overbought markets can become more overbought, but it pays to be cautious when breadth readings have become so extreme so quickly.

Disclosure: Long SPXU

 

Correction ahead: Momentum is dying

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Momentum is dying

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

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

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

 

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

Dying momentum everywhere

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

 

The small cap Russell 2000 is also rolling over.
 

 

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

 

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

 

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

 

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

 

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

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

 

Weak fundamental momentum

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

 

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

 

Recession scare ahead?

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

 

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

 

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

 

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

 

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

 

Still bullish to year-end

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

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

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

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

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

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

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

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

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

 

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

 

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

 

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

 

Buy the dip, or sell the rip?

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

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

The week ahead

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU

 

Consolidation or correction?

Posted by Cam Hui -

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

 

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

A mixed leadership message

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

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

 

The silver lining

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

 

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

 

The bear case

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

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

 

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

 

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

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

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

 

The last word

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

 

Disclosure: Long SPXU
 

An EM warning

Posted by Cam Hui -

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

 

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

 

Disappointment everywhere

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

 

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

 

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

 

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

 

The next one was Argentina.

 

What about China?

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

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

 

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

 

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

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

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

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

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

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

 

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

 

The boom of 2021

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

The Great MMT Experiment of 2021

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

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

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

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

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

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

The rise of the millennials

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

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

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

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

A growing acceptance of deficits

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A very Republican MMT

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

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

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

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

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

Well, what is Trump saying about quantitative tightening?

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

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

Again, it sure sounds an awful lot like MMT.

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

Who wins in 2020?

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXU

A tale of two treaties

Posted by Cam Hui -

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

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

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

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

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

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

Then the squabbles began:

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

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

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

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

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

Both sides have differing views of defense policy:

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

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

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

…and on it goes.

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

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

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

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

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

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

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

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

Defining intention

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

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

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

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

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

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

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

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

US-China: Cold War 2.0

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

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

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

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

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

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

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

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

Investment implications

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

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

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

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

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

My inner trader remains short the US market.

Disclosure: Long SPXU

Still bullish, but time to reduce risk

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Take some chips off the table

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

 

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

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

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

 

Rising financial stress

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

 

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

 

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

 

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

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

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

 

Weak market internals

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

 

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

 

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

 

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

 

Trade deal blowback

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

 

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

 

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

 

What about the US Dollar?

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

 

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

 

Why I remain bullish

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

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

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

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

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

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

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

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

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

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

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

 

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

 

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

 

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

The week ahead: Vulnerable to a setback

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

Disclosure: Long SPXU
 

Defying gravity

Posted by Cam Hui -

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

 

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

The bull case

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

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

 

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

 

The bear case

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

 

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

 

Dipping my toe in on the short side

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

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXU

 

China is healing

Posted by Cam Hui -

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

 

Real-time signs of recovery

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

 

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

 

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

 

Trade peace ahead?

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

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

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

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

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

 

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

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

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

Chinese weakness? That’s so 2018.
 

Peering into 2020 and beyond

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Gazing into the crystal ball

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

 

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

Short and long-term outlook

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

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

     

    Near term growth scare

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

     

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

     

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

     

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

     

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

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

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

     

    No 2019 recessionary bear

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

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

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

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

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

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

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

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

    The Powell Put is firmly in place.

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

     

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

     

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

     

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

     

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

    Cold War 2.0

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

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

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

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

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

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

    The Great MMT experiment

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

    What is MMT?

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

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

    Here are the policy implications of accepting MMT:

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

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

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

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

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

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

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

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

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

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

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

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

     

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

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

    After the war, inflation eroded the debt away:

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

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

    Here is the key conclusion [emphasis added]:

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

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

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

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

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

    The outlook for 2020″sl

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

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

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

    The week ahead: A market stall ahead

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

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

     

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

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

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

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

     

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

     

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

     

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

     

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

     

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

     

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

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

    Disclosure: Long SPXL

     

    Nearing peak good news?

    Posted by Cam Hui -

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

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

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

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

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

     

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

    Fade the news

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

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

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

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

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

     

    Bearish tripwires

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

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

     

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

     

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

     

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

     

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

    Disclosure: Long SPXL

     

    The Art of the Deal meets the Art of the Possible

    Posted by Cam Hui -

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

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

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

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

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

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

    Intellectual property rights

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

     

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

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

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

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

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

    […]

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

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

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

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

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

    Structural reform

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

    Currency strategist Marc Chandler framed the problem this way:

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

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

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

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

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

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

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

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

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

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

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

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

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

     

    Here comes the growth scare

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

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

    Bullish and bearish over different time frames

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

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

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

     

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

    The growth scare in Europe

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

     

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

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

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

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

     

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

    A US slowdown ahead?

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

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

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

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

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

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

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

     

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

     

     

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

     

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

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

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

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

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

     

    Why I am bullish

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

     

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

    Traversing the valley of weak growth

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

     

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

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

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

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

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

    What could go right

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

     

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

     

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

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

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

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

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

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

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

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

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

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

     

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

     

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

    Bullish tripwires

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

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

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

     

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

     

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

     

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

     

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

     

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

    The week ahead

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

     

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

     

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

     

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

     

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

     

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

     

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

    Disclosure: Long SPXL

     

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

    Posted by Cam Hui -

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

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

     

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

    The necessity of a trade deal

    Both sides desperately need a deal.

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

     

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

     

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

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

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

     

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

     

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

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

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