From a trade war to a Cold War?

Posted by Cam Hui -

This is the second part of a two part series on the unusual market pattern that we have been undergoing (see part one, Peak fear or Cold War 2.0). While the market may have discounted a substantial amount of the first-order effects of a trade war, the tail-risk of the loss of business confidence in a full-blown trade war is difficult to measure. In addition, the US and China may be on the verge of Cold War 2.0, which would disrupt and bifurcate technology platforms and supply chains.

Cold War 2.0?

The Economist recently devoted a special report to how a trade war is becoming a Cold War 2.0:

Fighting over trade is not the half of it. The United States and China are contesting every domain, from semiconductors to submarines and from blockbuster films to lunar exploration. The two superpowers used to seek a win-win world. Today winning seems to involve the other lot’s defeat—a collapse that permanently subordinates China to the American order; or a humbled America that retreats from the western Pacific. It is a new kind of cold war that could leave no winners at all.

This development was not a surprise. I had warned about the risk of a Cold War 2.0 in January 2018 when the US unveiled its National Security Strategy that defined China as a “strategic competitor” (see Sleepwalking towards a possible trade war). In retrospect, that publication of the NSS document was probably as historically important as Winston Churchill’s “iron curtain” speech in 1946 that marked the start of the Cold War with the Soviet Union.

Viewed in that context, these trade talks represent only an initial skirmish in a globalized competition between two political and economic systems. While my base case scenario calls for a brief truce to be achieved probably in late 2019, the onset of Cold War 2.0 represents a tectonic shift in global trade and investment flows that will have multi-decade long investment implications.

Thucydides Trap

Historians are well acquainted with the “Thucydides Trap”, which was named after the Greek historian Thucydides who told the story of how Sparta was unable to accommodate the rise of Athens, which led to war. The Thucydides Trap has been used to explain the start of World War I, in which European powers were unable to accommodate the rise of a newly industrialized Germany.

However, war is not inevitable under the Thucydides Trap. The West was able to contain the Soviet Union while fighting a Cold War without a major World War III conflagration, and restricted conflict to localized proxy skirmishes in Korea, Vietnam, and Afghanistan. Moreover, there are numerous examples of existing geopolitical structure was able to accommodate the rise of new economic powers in a peaceful fashion, such as the rise of post-War Japan, the rise of Asian economies such as Singapore, South Korea, Taiwan, and India.

Trump’s America is leading the West into another Cold War with China. How did we get here?

Boys will be boys?

It began with a lack of historical understanding of how countries develop, and a lesson in America’s own history of economic development.

Michael Porter, in his The Competitive Advantage of Nations, outlined the development path of many national economies. They begin by exploiting their competitive advantage of cheap labor to boost the economy and employment. The next step is an import substitution strategy of copying foreign products with cheap knockoffs, which eventually gives them insights in product design. The final stage of development is an advancement higher value-added design and development.

This is the well-trodden path followed by Japan in the post-War era that made it an economic powerhouse. I can remember as a child during the 1960’s the ridicule heaped on Japanese knockoff products and cars, but that economy eventually became a dominant player in electronics (Sony, Hitachi) and autos (Honda, Toyota). The same development path was followed by other Asian Tigers. Michael Dell exploited the cheap production platforms offered mainly by Taiwan to build his PC empire.

Today’s complaints about China’s theft of intellectual property is not a surprise. I am not denying that this happens, nor am I discounting its effects. Reuters reported that the EU is also complaining about forced Chinese transfer of technology:

The European Union Chamber of Commerce in China said on Monday that results from its annual survey showed 20% of members reported being compelled to transfer technology for market access, up from 10% two years ago.

Nearly a quarter of those who reported such transfers said the practice was currently ongoing, while another 39% said the transfers had occurred less than two years ago.

All countries engage in sort of technology theft or transfer as they climb the value-added ladder. Faced with large technological gaps, theft has been the answer at a particular stage in development. Allan Golomebek documented in Real Clear Markets how America once hijacked foreign technology as an emerging market economy:

In the late 18th century, intellectual property theft was taken seriously indeed. In fact, England had criminalized the export of textile machinery, and even the emigration of textile mechanics. But such harsh measures did not deter attempts. In 1787, for example, Andrew Mitchell — who had been sent to Britain by Pennsylvania businessman Tench Coxe, a close associate of Hamilton — was trying to smuggle new technology out of the U.K when he was intercepted by British authorities. Seized after being loaded on board a ship, his trunk contained models and drawings of one Britain’s great industrial machines.

The city of Lowell, Massachusetts actually got its start after its namesake, Francis Cabot Lowell, visited England in the early 19th century and spent his time trying to figure out how the Brits had managed to automate the process of weaving cloth. Charming his way into factories, he memorized what he saw, and managed to reproduce the weaving machine.

Hamilton didn’t just send Americans to Britain in search of the secrets of the industrial revolution. He used patents to lure immigrants with skills and knowledge to move to the United States. George Parkinson, for example, was awarded a patent in 1791 for a textile spinning machine, which was really just a rip-off of a machine he had used in England. The United States also paid his family’s expenses to emigrate and re-locate to the US.

But probably the greatest thief of intellectual property in America’s early days was Samuel Slater. An immigrant from Great Britain, Slater had a unique asset when it came to stealing manufacturing ideas and processes – an incredible memory. Disappointed by the relatively primitive state of technology in his adopted country, Slater offered his services to a U.S manufacturer. Working only from his memory of the advanced tools used in his native Britain, within a year Slater managed to create America’s first automated textile mill.

From a historian’s viewpoint, the copying or theft of IP can be thought of “boys will be boys” during different stages of development. That said, none of these practices justify China’s practice of IP theft. What is different this time is the realpolitik dimension of China’s practices. Her economy is so large and so important that China has the economic muscle to realize these efforts on a much larger scale than previous historical instances.

A clash of cultures

Some of the public American complaints about the Chinese are overblown, attributable to the differences in cultures and negotiation styles. Shang-Jin Wei wrote in Project Syndicate about these cultural differences:

In an Executive MBA course on the Chinese economy that I have taught at Columbia Business School for the past ten years, we do a mock negotiation between a US and a Chinese team. We then discuss how norms and styles of negotiation may differ across cultures. One takeaway from this session is that some differences in norms of which the two sides are unaware can cause talks to break down.

Consider the example of a three-day negotiation between the US and Chinese teams that will cover nine topics. Let us say that the two sides have reached an agreement on the first six topics after two days of talks. On the final day, they reach an impasse on the last three points, and the Chinese side declares – suddenly, from the US team’s viewpoint – that they have to alter the agreement on the first six topics.

At this point, the American team may very well feel that the Chinese side is untrustworthy or insincere, and the whole negotiation may break down as a result. In my class, we discuss how talks may sometimes collapse purely due to differences in negotiating styles, without either party intending to be devious.

Most American negotiators adopt a checklist approach: if they wish to cover nine topics, they would like to reach agreement on each one in turn. The Chinese, by contrast, are accustomed to taking a more holistic approach, and follow a norm of “nothing is agreed until everything is agreed.”

In the above example, when the Chinese side agreed to positions on the first six topics, they had certain expectations about how the last three points would look at the end of the negotiations. When the discussion about these three topics turned out to be quite different from what they had expected, they asked to revisit the first six, because the various tradeoffs among the nine topics had changed.

Did the Chinese “blow up” the most recent round negotiations as Trump claimed? Yes, and no. It was just a difference in negotiation style. On the other hand, Trump has his own negotiation style. Bloomberg reported that two former Mexican NAFTA negotiators had formed their own private consulting firm to advise others on how to negotiate with the US government:

So what should you anticipate when facing Trump?

“You need to be prepared, expecting the unexpected,” Baker said in an interview. “Even when you have gotten to a place where a deal seems likely, expect an extra push. Be prepared for a hostile and extremely unpredictable environment. You need to be aware that the negotiating positions or many of the ideas that are tabled might end up the next day in a tweet. It’s not a normal negotiation.”

Currency strategist Marc Chandler criticized the American negotiation position in even blunter terms:

Say what you want about Chinese trade practices, and no one seriously defends them, but the US red lines cannot be the basis of serious negotiations. Trump has indicated that the US will not accept a mutually beneficial deal because it needs to be compensated for past wrongs, and he has explicitly stated that he will not allow China to become the largest superpower.

Another difference in culture and negotiation style is that the Chinese prefer to settle differences privately, rather than in full public view. Bloomberg reported on some examples of what happens when Chinese companies default on their bonds:

When a company in developed markets fails to make a bond payment on time as agreed, that information typically becomes public in swift order, and the issuer would normally be declared in default by ratings agencies and investors. But in China, sometimes things aren’t so obvious — one of many idiosyncrasies for global funds to be aware of as they consider the increasingly open local-currency Chinese market.

An opaque practice that’s increasingly concerning analysts is when a debtor stops servicing bonds through an official clearing house, and instead does private deals with bondholders that might involve late payments.

As an example of how similar transgressions have been settled quietly in the West, currency strategist Marc Chandler pointed to the example of Apple and Qualcomm dispute.

In the middle of March, Apple was found guilty of violating 3 patents owned by Qualcomm, but we don’t call it theft. Many of us share passwords, is this theft? Huawei violated the US embargo against Iran. Isn’t the penalty for such action a fine not jail time? Cold War?

In addition, the Chinese is very well aware of their own history. The current interaction with the West is often viewed in the historical context of their humiliation during the Opium Wars, when a vastly numerically Chinese population was subjugated by superior Western technology, and Beijing was forced into giving up colonial concessions. A more recent historical event that Chinese negotiators are also very well aware of are the costs the Plaza Accord imposed on Japan’s economy, as explained by The Economist:

The Plaza Accord is best understood not as a one-off event but as a critical stage in a multi-year dispute, which ranged from agriculture to electronics. America accused Japan of stealing intellectual property and plotting to control future industries. Robert Lighthizer, America’s lead negotiator against China today, earned his spurs in these earlier battles. In 1990 the two countries agreed to a “Structural Impediments Initiative”, which bears a striking resemblance to the crux of the debate today. America wanted Japan then—and wants China now—to improve its competition laws, open more widely to foreign investors and weaken its giant conglomerates (keiretsu groups in Japan, state-owned firms in China).

The rest is history. Japan fell into a multi-decade slump.

A clash of civilizations

Samuel Huntington hypothesized about a seminal Foreign Affairs article about A Clash of Civilizations as a paradigm in the post Cold War era. While Huntington’s main focus was a clash of the West against the Muslim world, the more likely coming clash is with China.

The latest trade dispute is just a microcosm of that clash. I have outlined the differences in culture, outlook, and negotiating styles of the two sides. No matter how hard American negotiators force the issue, China is a sufficiently strong economically that it will never change its legal, social, and cultural system to suit America. At the same time, a strong consensus is building in Washington that China is an economic and strategic threat. The imposition of a blacklist on Huawei, and the possible blacklist of Hangzhou Hikvision Digital Technology and other Chinese spy-tech firms, are also signals that Washington has gone beyond a trade war. It has progressed to a Cold War designed to stifle Chinese economic development.

Patrick Chovanec, who taught business at Tsinghua University in Beijing and now works at as a investment strategist in New York, lamented the hardening Washington views on China in a series of tweets:

People talk about how there has been a sea change in how people in Washington, DC think and talk about China. I’ve been thinking of my own experience of this, which I have found rather disturbing.

Five years ago, people in DC were quite curious about China. They did not know quite what to think about it, and were eager to hear new perspectives and insights they had not heard before. When visiting from China, I found nearly all doors open and interested.

Today, nearly everyone has a hardened view on China. They may never have been there, but they know what they think. Perspectives or insights that don’t fit neatly within those boxes are viewed with suspicion. Talking to people is like sitting for an ideological litmus test.

It’s rather unpleasant and I tend to avoid it. I spent more time talking to people in DC about China when I lived in China and occasionally visited, than now when I still follow these issues and live a few hours away. You’re just courting a quarrel, which is not worth it.

So it’s not merely that views on China, at least in DC, have shifted. It’s that they’ve grown hardened and insular and incurious, in a way that’s so different from just a few years ago.

The risks of Cold War 2.0

Washington has become fertile ground for Cold War 2.0. As part of its series on US-China dispute, The Economist suggested that there is not enough win-win and too much win-lose in the view of both sides, which will doom the relationship [emphasis added]:

Ask American experts how a great-power competition with China might end well, and their best-case scenarios are strikingly similar. They describe a near future in which China overreaches and stumbles. They imagine a China chastened by slowing growth at home and a backlash to its assertive ways overseas. That China, they hope, might look again at the global order and seek a leading role in it, rather than its remaking.

Chinese experts also sound alike when explaining their own best-case scenario. Put crudely, it is for America to get over itself. More politely, Chinese voices express hopes that in a decade or so America will learn the humility to accept China as an equal, and the wisdom to avoid provoking China in its Asian backyard.

It is sobering that none of these experts predicts a future in which America and China both feel like winners. That should give all sides pause. The original cold war with the Soviet Union ended with an American victory. In a new Sino-American cold war, both countries could lose.

Arguably, the Trump administration should be careful what it wishes for. A China that decouples from the West could present far greater foreign policy challenges in the future because it will be exponentially more difficult to deal with. In the modern era because of the sheer size of the Chinese economy, America has not confronted an adversary with an economy more than 40% of GDP until today, and strategies that worked in the past may be ineffective in this instance.

It is useful to remember the history of American foreign policy as we approach the 30th anniversary of the Tiananmen massacre. The strategy during Cold War 1.0 involved an economic quarantine the Soviet Union. American policy makers 30 years ago chose to remain engaged with Beijing at the time, because they were terrified of what the Chinese leadership might do otherwise if isolated. China had a history of supplying nuclear technology to Pakistan, and missiles to Middle East interests. Today, China has made largely an about face and stands against nuclear proliferation, and it is well integrated in the global economy. The US decision to remain engaged was a useful pre-condition of development, Deng Xiaopeng’s Southern Tour three years later was the catalyst for its well-known growth revival. What policy levers will the West have if China decouples and pursues a disruptive foreign policy, other than military options that could lead to a hot war?

In addition, the current Trumpian policy path of confronting China and while pressing allies to bear more of their defense costs could backfire in a spectacular fashion. In Cold War 2.0, countries will have to choose sides, and the risk is Asia becomes a Chinese sphere of influence, where China’s major Asian trading partners fall under Beijing’s orbit for economic reasons.

The way forward

Even though a new Cold War appears inevitable, that does not mean long-term investment returns will necessarily be subpar. Mike Santoli pointed out that equity returns during the Cold War were not only positive, but stellar. Can history repeat itself in Cold War 2.0? If history just rhymes, what is the new poem?

Here is how today’s world is different. America came out of World War II in a dominant position as it was the only major industrialized economy running at full strength and not devastated by war. It enjoyed an unparalleled competitive advantage over Europe and Japan, and the Soviet economy was based on an inadequate economic model that ultimately failed. Today, the Chinese economy is one of the fastest growing major economies, and it has the potential to become the biggest economy in the world in the near future. A Sino-American Cold War 2.0 conflict is likely to play out to a very different script than Cold War 1.0.

Much depends on how the relationship is managed by both sides. Under a Cold War 2.0 scenario, technology platforms and supply chains will bifurcate. Disengagement could be conducted in an orderly, or a disorderly fashion. Nouriel Roubini warned of the risks in a Project Syndicate essay:

The global consequences of a Sino-American cold war would be even more severe than those of the Cold War between the US and the Soviet Union. Whereas the Soviet Union was a declining power with a failing economic model, China will soon become the world’s largest economy, and will continue to grow from there. Moreover, the US and the Soviet Union traded very little with each other, whereas China is fully integrated in the global trading and investment system, and deeply intertwined with the US, in particular.

A full-scale cold war thus could trigger a new stage of de-globalization, or at least a division of the global economy into two incompatible economic blocs. In either scenario, trade in goods, services, capital, labor, technology, and data would be severely restricted, and the digital realm would become a “splinternet,” wherein Western and Chinese nodes would not connect to one another. Now that the US has imposed sanctions on ZTE and Huawei, China will be scrambling to ensure that its tech giants can source essential inputs domestically, or at least from friendly trade partners that are not dependent on the US.

Just like Cold War 1.0, the battlefield of Cold War 2.0 can be found in Europe, where China is trying to flex its economic muscle. Already, the budget constrained Italian government has signed on to China’s Belt and Road Initiative as a way of fracturing the western alliance:

In this balkanized world, China and the US will both expect all other countries to pick a side, while most governments will try to thread the needle of maintaining good economic ties with both. After all, many US allies now do more business (in terms of trade and investment) with China than they do with America. Yet in a future economy where China and the US separately control access to crucial technologies such as AI and 5G, the middle ground will most likely become uninhabitable. Everyone will have to choose, and the world may well enter a long process of de-globalization.

Whatever happens, the Sino-American relationship will be the key geopolitical issue of this century. Some degree of rivalry is inevitable. But, ideally, both sides would manage it constructively, allowing for cooperation on some issues and healthy competition on others. In effect, China and the US would create a new international order, based on the recognition that the (inevitably) rising new power should be granted a role in shaping global rules and institutions.

The key question is how both sides manage the relationship. There will be a divorce, but will it be amicable, or acrimonious? [emphasis added]

If the relationship is mismanaged – with the US trying to derail China’s development and contain its rise, and China aggressively projecting its power in Asia and around the world – a full-scale cold war will ensue, and a hot one (or a series of proxy wars) cannot be ruled out. In the twenty-first century, the Thucydides Trap would swallow not just the US and China, but the entire world.

The upcoming trade negotiations will be a key pivot point. Here are some key questions for American negotiators.

In this era of globalized supply chains, Trump’s 1950’s dream of returning manufacturing to American soil is nothing more than a fantasy. However, his measures have had an impact. Trade patterns are shifting, and manufacturers are moving their production away from China to other EM countries like Vietnam, Thailand, Mexico, and Eastern Europe. Can Trump and Lightizer accept this paradigm shift?

As well, will Trump insist on measures that blacklist key Chinese companies like Huawei and deny them access to US technology? China has hinted that it would retaliate by cutting off rare earth exports, which would devastate global supply chains and send the global economy into synchronized downturn. Or will both sides come to a face-saving truce, so that the parties can prepare for an orderly bifurcation of technologies and supply chains?

John Kemp, writing at Reuters, observed that supply chains eventually readjust, regardless of the immediate effects of embargoes. In the 18th and 19th Century, the American Revolution and later the Napoleonic wars cut off Britain’s Royal Navy supplies naval mast lumber from New England, Prussia, and Russia. Eventually new supplies were found from Canada, the Adriatic, India, and New Zealand. Kemp also pointed to the 20th Century examples of wartime Germany and apartheid South Africa developing coal-based substitution technology in response to a petroleum shortage.

In an environment where supply chains are disrupted and constrained, innovation like German coal gasification can still occur. While the prospect of a prolonged Cold War 2.0 may be intimidating, it does not preclude continued growth and the adoption of new productivity enhancing technologies. Long-term global equity returns can therefore parallel the equity market experience of Cold War 1.0.

In the short run, however, the risk of disruption is high. Watch how the trade negotiations evolve. The next 12-24 months will determine the long-term path of the new global order, as well as the degree of volatility that investors can expect from investments.

The week ahead

The headlines blared from Schaeffer’s Research, the Dow hasn’t fallen for five consecutive weeks since 2011. Schaeffer’s went on to torture the data until it talked with a bearish conclusion, based on recent data…

And a bullish conclusion based on longer term data.

This confusing analysis does not tell us much about the near-term outlook for the stock market. Then, I got to thinking, what if 2011 could be a template for stock prices?

In 2011, the market was afflicted with the combination of a budget impasse in Washington, and a Greek debt crisis that raised an existential threat for the continuation of the eurozone. Bad news kept coming, as there were weekly summits, meetings to talk about more meetings, and there seemed to be no one in charge. Stock prices fell, then chopped around in a wide range for about two months, and, more importantly, stopped responding to bad news. Finally, a backroom deal was done and the ECB stepped in and rescued the market with its LTRO program.

A similar template may be in play today. The market has been spooked by the prospect of a trade war that could crater the global economy. Stock prices fell, but they aren’t responding very much to the bad news. The market has been rising during daytime trading hours, and falling overnight and on weekends from trade war developments. If you had a crystal ball and knew that the trade talks were falling apart, you might guess that the market would be down 10-20%. Instead, it’s less than 5% from its all-time highs.

Consider how the technical and sentiment patterns developed in 2011. When the market fell in the summer of 2011, it began to exhibit a positive RSI divergence during the range bound chop. Sentiment, as measured by the VIX term structure and the 10-day moving average of the equity-only put/call ratio, spiked initially and then faded.

Fast forward to 2019. RSI is exhibiting a positive divergence as the index tested support at 2800. The 10 dma of the equity-only put/call ratio is making its initial fear spike, while VIX term structure fears are starting to fade. If the 2011 pattern were to be a template for 2019, 2800 support needs to hold and a trading range needs to develop as we await trade negotiation developments in the coming weeks and months.

There are indications that fear levels are spiking. The 10 dma of the equity-only put/call ratio rose above 0.70. Past episodes of similar spikes when the market was not in a bear phase, as defined by % above 200 dma below 50%, (shaded regions) have seen low downside risk and V-shaped bottoms (red arrows).

Kevin Muir at The Macro Tourist pointed out that bond sentiment is off the charts, indicating a stampede into defensive investments.

But the point to ask yourself is whether that is a good bet? I contend that with everyone leaning so heavily one way, the surprise will not be how much money they make, but instead if things don’t play out exactly as ominously as forecasted, how quickly the trade goes sour.

There is little room for error. Or put it another way, the global economy better collapse as quickly as these bears believe as even a lengthening of the process will make their trade unprofitable.

 

On the other hand, the Citigroup Economic Surprise Index, which measures whether top-down economic figures are beating or missing expectations, is rising, and that will put upward pressure on bond yields.
 

 

To be sure, this market may need a final flush before bottoming. Some sentiment indicators, such as the AAII Bull-Bear spread is -11, and it have not reached the “OMG sell everything” panic readings. However, we have seen past short-term bottoms with AAII sentiment at current levels.

The CNN Business Fear and Greed Index is 27, which is low but not at the sub-20 target zone seen at bottoms. However, there have been other instances when the market has seen minimal downside risk with the index in the 20-40 range.

I conclude that the market is undergoing a bottoming process, though the jury is out whether the actual bottom is in. Stock prices are likely to be choppy and range bound for the next few weeks as it responds to trade negotiation headlines. While Trump the Tariff Man has adopted a belligerent tone, Trump the Dow Man has exhibited a pattern of making encouraging statements whenever stock prices near the bottom of its range.

This environment of uncertainty calls for investors to to maintain a neutral position on risk. If you don’t have an edge, why expose yourself? Adopt a wait and see position and stay at the portfolio’s investment policy asset allocation weights.

For traders, this argues for a buy-the-dip and sell-the-rip positioning until the impasse is resolved. Since the market is near the bottom of its range, the risk/reward relationship calls for a buy the dip position.

Disclosure: Long SPXL, TQQQ

Peak fear, or Cold War 2.0?

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: 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.
 

An unusual market

Ever since Trump’s weekend tweet cratered the trade talks three weeks ago, the stock market has behaved in an unusual way.
 

 

First, it is unusual in that this trade tension induced pullback has been very shallow. Stock prices are less than 5% from their all-time highs despite the heightened trade tension. In addition, the market has been trading in an unusual way. The chart below depicts the returns of the market since the above Trump tweets. While the index (black line) is down -4.1% since that day, the open-to-close return, which shows the returns during the day (blue line), was actually a positive 1.7% during this period. The spread is an astounding -5.8%. During this period, the market had reacted negatively to overnight and weekend news, while strengthening during daytime trading hours.
 

 

This is the part one of a two part publication, designed to address the following questions:

  1. What are the fundamental, macro, and technical factors that are supporting market prices during normal market hours?
  2. How do we talk about the elephant in the room, namely the risk of a trade war, and how it might turn into Cold War 2.0?

Here is the risk/reward valuation assessment. The market trades at a forward P/E ratio of 16.1, which is below the 5-year average of 16.5 but above the 10-year average of 14.7. Assuming a trade truce, the relief rally would shrink risk premiums and expand P/E to raise prices by up to 5%. Then pencil in a modest 3-4% forward EPS growth rate to year-end, and the total upside price potential to year-end is 8-9%. By contrast, downside risk is 4-8% if trade talks fail, Trump imposes a 25% tariff on remaining Chinese imports, and the tariffs last a year or more. This makes valuations moderately undemanding.
 

No signs of recession

Let us start with the good news. There are no signs of a bear market inducing recession on the horizon. The Fed has signaled it is prepared to be patient. The latest FOMC minutes revealed that it will view any tariff induced price surges as “transitory”, which reduces the odds of a rate hike in the near future.
 

 

The credit markets are showing few signs of stress. Interest rate spreads, from investment grade, to high yield, and emerging market bonds, remain tame.
 

 

New Deal democrat monitors high frequency economic indicators by categorizing into coincident, short leading, and long leading indicators. His assessment last week indicates low recession risk, though he added a caveat about policy uncertainty:

Although most measures of the yield curve are screaming “recession,” the overall long-term forecast continues to improve. There’s a contradiction between the increasingly inverted yield curve and the revival in housing due to lower mortgage rates. The short-term forecast deteriorated to slightly negative this week. The nowcast stayed positive.

I continue to suspect that governmental decisions, especially mercurial tariff practices, are blindsiding a significant portion of the economy. Put another way, while I have confidence in forecasting what the economy will do if left to its own devices, it’s far from being left to its own devices at present.

I agree. The yield curve is giving an inconsistent signal. While the 10 year to 3 month spread has inverted, the 2s10s is not inverted though flattening, but the 10s30s is strongly positive and steepening.
 

 

The American economy is continuing to grow.
 

Undemanding valuations

Brian Gilmartin of Trinity Asset Management recently pointed out that the stock market is experiencing P/E compression. Forward 12-month EPS is at roughly the same level as the January 2018 peak, but prices have fallen since then.
 

 

Valuations are not particularly demanding. The market trades at a forward P/E ratio of 16.1, which is below its 5-year average of 16.5 but above its 10-year average of 14.7.
 

 

That said, FT Alphaville reported that David Kostin at Goldman Sachs estimates that earnings could decline by up to 6% if a 25% tariff were imposed on all Chinese imports. Based on that estimate, the forward P/E ratio could rise to as much as 17.1, which makes stock prices moderately overvalued, but downside risk is not catastrophic. Assuming forward P/E falls to the 5-year average of 16.5, that puts downside risk at 4%, or 6% if it declines to the current level of 16.1.

Using event study analysis, Neil Dutta at Renaissance Macro separately arrived at a similar answer. He estimates downside risk on the S&P 500 to be about 2600, or 7-8%, if Trump were to impose a 25% tariff on remaining Chinese imports.

The real question is how much of these trade fears are already in the market. For now, the first-order effects of a trade war seems to be relatively localized. Cameron Crise of Bloomberg News constructed a beta-weighted basket of China sensitive stocks, and found that they underperformed and responded rationally to trade news.
 

 

Here is the risk/reward assessment. Assuming a trade truce, P/E expansion could raise prices by up to 5%, assuming that a relief rally normalizes the forward P/E ratio to September 2018 pre-decline level of 17x earnings. The January 2018 peak saw forward P/E of 18.5, which represents even more price gains, but that is not my forecast. Then pencil in a modest 3-4% forward EPS growth rate to year-end, and the total upside potential to year-end is 8-9%. By contrast, downside risk is 4-8% if trade talks fail, Trump imposes a 25% tariff on remaining Chinese imports, and the tariffs last a year or more. This makes valuations moderately undemanding.
 

A panic attack?

The stock market may just be undergoing one of its period panic attacks that could prove to be a buying opportunity. SentimenTrader observed that the number of overnight downside drops are consistent with conditions seen at the 2002 and 2008 market bottoms.
 

 

Other sentiment models are flashing bullish signals. Fund flows out of equity mutual funds and ETFs are at an extreme, which has historically been contrarian bullish.
 

 

Is this a panic attack to be bought? My former Merrill Lynch colleague Fred Meissner pointed out two contradictory signals in the charts. On one hand, the daily chart shows the stochastics to have recycled to a buy signal. As well, the market is exhibiting positive RSI divergences as it tests the lower end of the range, which should provide some downside support.
 

 

On the other hand, the weekly chart is on a sell signal.
 

 

He interprets these conditions as a range-bound market, bounded by 2800 below and about 2900 above. We will not see much clarity on market direction until a decisive breakout either way. In all likelihood, stock prices will remain choppy until the late June Trump-Xi meeting in Japan.

In conclusion, in the absence of trade tensions, the future looks bright for US equities. Macro, fundamental, sentiment, and technical models are supportive of the bull case.

Then there is the elephant in the room. What happens if the Sino-American relationship deteriorate into a full-blown trade war, or worse still, a Cold War 2.0? That will be a topic that I will address in Part II tomorrow.
 

The week ahead

I will have an assessment of the tactical market outlook in tomorrow’s report. Stay tuned.

 

Range-bound, with a bullish lean

Posted by Cam Hui -

Mid-week market update: It appears that the stock market is may be range-bound until Trump and Xi meet in Japan in late June. A high level of uncertainty is the order of the day, with short-term direction will be determined by the latest news or tweet.

As the chart below shows, the range is defined by a level of 2800 on the downside, and 2895-2900 on the upside. From a technical perspective, direction cannot be determined until either an upside or downside breakout is achieved.

There is some hope for the bulls. The market is forming a nascent inverse head and shoulders formation, with a measured target of 2980 on an upside breakout. As good technicians know, head and shoulders formations are not complete until the neckline breaks. The current pattern can only be interpreted as a setup that may fail.

The presence of unfilled gaps both above and below current levels do not give any hint on likely direction. However, the market is giving a number of bullish clues from a technical perspective.

Breadth and sentiment support

The combination of breadth and sentiment are supportive of a bullish resolution. The top panel of the chart below depicts the % of stocks above their 200 day moving average (dma). I have drawn the line at 50% as a way of delineating major bull and bear phases for the last 15 years. The bottom panel shows the 10 dma of the equity-only call/put ratio (CPCE), or the inverted put/call ratio for easier analysis. The 10 dma of CPCE fell below 1.40, which is an indication of high fear. Past instances of low CPCE that were not in bear phases (shaded regions) were always resolved with a V-shaped rebound.

Here is the same analysis, but using the % above the 50 dma as a way of defining more minor pullbacks. As this indicator tends to be more noisy, I applied a 20 dma filter on that indicator (red line) to define bull and bear phases. Even though the daily % above 50 dma did briefly fall below the 50% line, both the current reading and the 20 dma are above 50%, indicating the lack of a broadly based breadth support for even minor weakness.

Here are the conclusions from both of these studies:

  • The  market is not in a bear phase, regardless of how it is measured
  • Non-bear high fear episodes have seen quick market rebounds

There are several caveats to this analysis. First, never say “never” in any historical study because the real-time resolution can surprise you. The current macro backdrop carries a high level of event risk, and a breakdown in trade negotiations could result in a full-blown trade war that could crater the global economy and stock prices. That said, I cautiously interpret these results as the risk/reward is tilted to the upside, based purely on technical and sentiment analysis.

There is also some short-term support for the bull case. I wrote on the weekend (see Tariff Man vs. Dow Man) that one of the challenges for the bulls was to break the pattern of lower lows and lower highs on short and medium term breadth indicators. Tuesday’s market rally managed to break this pattern.

These is the short (3-5 day) breadth pattern from Index Indicators as of Tuesday’s close. Based on today’s market action, readings are likely to experience some deterioration, but they should not be serious.

The longer term (1-2 week) breadth pattern tells a similar story.

My inner trader is keeping an open mind on how the market may break, but he is maintaining his bullish lean on the market.

Disclosure: Long SPXL, TQQQ

Imminent war with Iran?

Posted by Cam Hui -

The headlines look ominous. The US has dispatched a carrier task force to the Persian Gulf, and a second one is due to arrive soon. The State Department ordered the evacuation of all non-essential personnel from Iraq:

The U.S. State Department has ordered the departure of non-essential U.S. Government employees from Iraq, both at the U.S. Embassy in Baghdad and the U.S. Consulate in Erbil. Normal visa services at both posts will be temporarily suspended. The U.S. government has limited ability to provide emergency services to U.S. citizens in Iraq.

We had a threatening Presidential tweet over the weekend.
 

 

Reuters reported that Exxon Mobil is evacuating foreign staff from an Iraqi oilfield near Basra:

Exxon Mobil has evacuated all of its foreign staff, around 60 people, from Iraq’s West Qurna 1 oilfield and is flying them out to Dubai, a senior Iraqi official and three other sources told Reuters on Saturday.

Though it was said to be a purely precautionary measure:

Production at the oilfield was not affected by the evacuation and work is continuing normally, overseen by Iraqi engineers, said the chief of Iraq’s state-owned South Oil Company which owns the oil field, Ihsan Abdul Jabbar. He added that production remains at 440,000 barrels per day (bpd).

Is the US about to attack Iran? Should you buy tail-risk insurance?
 

Precautionary measures

The short answer is no. What was revealing about the State Department evacuation order is they evacuated non-essential personnel, but they did not evacuate dependents, which would be the standard procedure ahead of an imminent attack. Moreover, while the Germans and Dutch suspended training missions of Iraqi forces, the French did not. Another normal operating procedure would be to inform allies with forces in the region so that they can be prepared for conflict. This suggests that these moves were purely precautionary measures should conflict break out.
 

Maximal pressure

Much of the pressure comes from National Security Adviser John Bolton, who is a “anyone can go to Baghdad but Real Men go to Tehran” hawk from the Bush-Cheney era, according to The Economist:

When Donald Trump hired John Bolton to be his national security adviser, he reportedly joked that the mustachioed hawk was “going to get us into a war”. It is easy to see why. When serving under George W. Bush, Mr Bolton embellished intelligence on Cuban and Syrian weapons and lobbied hard for the invasion of Iraq. After leaving government he argued that America should bomb Iran to set back its nuclear programme. Now that he’s back, he appears to be on the warpath once again.

It was Mr Bolton, not the commander-in-chief, who announced on May 5th that America had dispatched an aircraft-carrier strike group and bombers to the Persian Gulf. This was in response to undisclosed intelligence which, unnamed officials claimed, showed that Iran and its proxies were planning attacks on American forces (or its allies) in the region. On May 9th Mr Bolton reviewed war plans, updated at his request, that call for sending up to 120,000 troops to the Middle East if Iran attacks or restarts work on nuclear weapons, according to the New York Times. Such planning is not a sign of imminent conflict.

Bolton may be trying to achieve a Gulf of Tonkin like incident, or trying to provoke Iran into a military response for a casus belli.

Some fear Mr Bolton is looking for a provocation by Iran, adding ominous undertones to recent events in the region. On May 12th four oil tankers were struck by a “sabotage attack” off Fujairah, part of the United Arab Emirates (UAE). The incident remains murky, but Emirati, Saudi and American officials claim that four ships—two Saudi, one Emirati and the other Norwegian—had 1.5-metre to 3-metre holes blown in their hull, near the waterline. Unnamed American officials were quoted fingering Iran or its proxies as the likely culprit, without presenting evidence. Fujairah lies just outside the Strait of Hormuz, a key chokepoint that Iranian officials have threatened to block if America attacks.

Business Insider suggested that Trump is trying to replay his

North Korean negotiation tactics of applying maximal pressure:
Observers point to a similar pattern in his treatment of another state where the US is determined to neutralize a nuclear threat: North Korea.

With North Korea, Trump initially threatened the “total destruction” of the state following a series of missile tests by Pyongyang in 2017, then when North Korea agreed to denuclearization talks the president stepped back from threats of military action, and lavished praise on its leader, Kim Jong Un.

With Iran maximum pressure is again being used as leverage to bring Tehran to the negotiating table, they claim. Trump on Thursday tweeted: “I’m sure that Iran will want to talk soon,” and according to multiple reports has told advisers that he wants a diplomatic solution to the current crisis.

“He is trying to rerun the North Korea thing, to be as extreme as he can be up until the point of military action,” Thomas Wright, a Brookings Institution fellow told the New Yorker in an article published Friday.

So far, the tactics haven’t worked:

Iran’s leaders have thus far shown little willingness to reopen negotiations with the US unless it reenters the Obama administration-brokered nuclear agreement, and President Hasan Rouhani in remarks Thursday gave his own summary of US policy.

“In the morning they send their carrier, at night they give us telephone numbers. But we have enough numbers from the Americans,” he remarked.

 

A simple misunderstanding?

Here is a simple explanation of what’s happening. The WSJ attributed the racheting up of tensions as a simple misunderstanding of intelligence and misread of each other’s intentions:

Intelligence collected by the U.S. government shows Iran’s leaders believe the U.S. planned to attack them, prompting preparation by Tehran for possible counterstrikes, according to one interpretation of the information, people familiar with the matter said.

That view of the intelligence could help explain why Iranian forces and their allies took action that was seen as threatening to U.S. forces in Iraq and elsewhere, prompting a U.S. military buildup in the Persian Gulf region and a drawdown of U.S. diplomats in Iraq.

Meanwhile, administration officials said President Trump told aides including his acting defense chief that he didn’t want a military conflict with Iran, a development indicating tensions in the U.S.-Iran standoff may be easing.

Ironically, the more the media portrays Bolton as the puppet-master, or the man behind the throne, of rising tensions with Iran, the less likely war will be. Trump has a history of casting aside aides who become more overshadow him. Just remember the fate of Steve Bannon.

For the last word, I offer the article from the satirical site, The Onion, which announced that John Bolton stumbled into the Capitol Building claiming that he had been shot by Iran.
 

 

Relax! War is not imminent.
 

Tariff Man vs. Dow Man

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: Neutral (downgrade)
  • 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.
 

Trump’s two personas

Trump’s two personas are on a collision course with each other. On one hand, he likes to style himself as Tariff Man, because he believes the US has had a raw deal from its trading partners. The list of offenders starts with China, but it is numerous. Tariffs are the best tool to address that imbalance. On the other hand, Trump the Dow Man loves a booming stock market, which he tracks obsessively, and views it as a form of validation of the success of his administration.

As trade jitters rose, the stock market has become nervous and sold off. Markets hate trade wars, and they hate uncertainty. While Tariff Man and Dow Man can coexist when trade tensions are low, we will reach some tipping point where Trump has to choose.

Jason Furman raised a number of insightful points in a recent Twitter thread.

It would be rational to escalate the trade war with China if the short-run cost for the U.S. economy are outweighed by the long-run benefits of a more favorable trade agreement.

This is not a priori bad economics, it is a numerical cost-benefit question.

I have seen many quantification of the SR [short run] cost (usually something like 0.5pp hit to GDP growth if the tariffs are expanded and sustained).

But I have seen no quantification of the benefit of plausible or best-case Chinese concessions relative to what they have already conceded.

The LR [long run] benefits conditional on a favorable resolution is just one input into a view on the strategy, you would also need to know how the trade war changes the probability of a favorable resolution. But we should be able to take a stab at quantifying the LR benefits.

In theory equity markets are doing this sort of present value calculation—we lose upfront but this strategy raises the chances we get more IP protections, soybean sales, etc. And they seem to be saying that the potential LR benefits don’t outweigh the SR costs.

This is consistent with my hunch that there would be only a very small macro difference for the U.S. economy between China’s last offer and our latest demand. But I wish I had more than a hunch. Anyone seen anything better?

In other words, would the price of a trade war be worthwhile? We have a reasonable idea of what the costs are, but has anyone calculated the net benefits under varying assumptions and scenarios? In particular, has anyone in the Trump administration done a cost-benefit analysis?

If not, will Trump the Tariff Man or Trump the Dow Man gain the upper hand in the crunch? What are the bull and bear cases?

I find that investors should re-orient their portfolios to a neutral risk position, and adjust their asset allocation back to investment policy targets. The heightened level of uncertainty is likely to boost volatility, and investors may want to take advantage of this environment of elevated option premiums by selling covered calls to boost expected returns. It would be a way of getting paid via option premiums while you wait for a resolution of the trade conflict.
 

The bear case

The bear case is easy to make, and in a multi-dimensional fashion. From a trade negotiation perspective, things don`t look good. The trade talks are already foundering, and Trump’s most recent decision on Huawei could torpedo the talks entirely. The latest initiative will ban Huawei from selling equipment into the US, and forbid US companies from selling to Huawei. The latter move could cripple Huawei and lead to its destruction. In effect, it will be unable to access components as key components of a 5G network, and there is some question as to whether it will be able to service existing installed networks.

China will view this as a grave escalation in the trade conflict. While the initial reason for the conflict was “fair trading” by China, the Huawei decision is a signal that the US intends to keep China down and retarding its ability to develop its economy and innovate into higher value-added products. Bloomberg reported that China’s state media has suggested that there is little interest in continuing talks in the current environment:

China signaled a lack of interest in resuming trade talks with the U.S. under the current threat to escalate tariffs, while the government said stimulus will be stepped up to buttress the domestic economy.

Without new moves that show the U.S. is sincere it is meaningless for its officials to come to China and have trade talks, according to a commentary by the blog Taoran Notes, which was carried by state-run Xinhua News Agency and the People’s Daily, the Communist Party’s mouthpiece.

The National Development and Reform Commission is studying the impact of U.S. tariffs and will ensure growth is kept in a “reasonable range,” spokeswoman Meng Wei said at briefing in Beijing Friday.

The U.S. has been talking about wanting to continue the negotiations, but in the meantime it has been playing “little tricks to disrupt the atmosphere,” according to the commentary on Thursday night, citing Trumps steps this week to curb Chinese telecom giant Huawei Technologies Co.

“We can’t see the U.S. has any substantial sincerity in pushing forward the talks. Rather, it is expanding extreme pressure,” the blog wrote. “If the U.S. ignores the will of the Chinese people, then it probably won’t get an effective response from the Chinese side,” it added.

Jin Canrong of Renmin University wrote a scathing editorial in China`s state controlled media Global Times that outlined possible retaliatory measures:

  1. China could restrict the sale of rare earths to the US
  2. China could sell its vast Treasury holdings
  3. China could punish American companies doing business in China

While I would discount threat 2, as the sale of Treasuries would have minimal effect, and would force China to shift assets into another major currency, the other two threats have the potential to seriously damage the global growth outlook and spark a risk-off stampede. The greatest exposure are the technology stocks, which have been the market leaders. A cutoff of rare earth exports would crater the semiconductor industry, and global growth. As well, the list of companies with the highest revenue exposure to China reveals a technology bias.
 

 

The Economist recently highlighted a study by Thiemo Fetzer and Carlo Schwarz of the University of Warwick. The study measured the trade-offs between the political harm of retaliatory tariffs (horizontal scale) against the economic costs of retaliation (vertical scale). They found that the EU’s retaliatory measures were designed to minimize blowback to European interests, but Beijing’s response was designed to cause maximum political damage to Trump’s base without regard to China’s own cost.
 

 

China is an autocracy and it has a much higher pain threshold than conventional Western democracies. Will Dow Man cry uncle?

From a US economic perspective, wobbles are starting to appear. While Trump may view the Q1 GDP print of 3.2% as a triumph, which gives me room to negotiate from a position of strength, final demand after stripping out the effects of exports and inventory buildup was an anemic 1.4%.

The highly sensitive housing sector is weakening, despite the support from lower mortgage rates. Single family housing permits, which leads housing starts, is weakening across the board. Tariff effects will worsen the situation. A recent CNBC interview with the CEO of Clayton Homes, which builds manufactured housing, revealed that the company’s costs will rise 4-5%, and those increases will eventually have to be passed on to buyers.
 

 

In addition, the latest retail sales figures are weak. In the past, real retail sales has peaked about a year or more before recessions, and the high in this cycle was October 2018.
 

 

The labor market is also starting to soften. After reaching multi-decade lows, initial jobless claims have begun to rise, and initial claims (inverted scale) have shown a coincidental inverse correlation to stock prices.
 

 

New Deal democrat pointed out that initial claims has historically led the unemployment rate by several months, though it has moved coincidentally with unemployment during this expansion cycle. Regardless of whether the relationship is leading or coincident, rising initial claims is likely to put upward pressure on the unemployment rate in the immediate future.
 

 

These conditions may put the Sahm Rule into play later this year. The Sahm Rule is designed to spot a recession in real-time, and it was proposed by Federal Reserve economist Claudia Sahm. It formed part of a fiscal policy initiative as part of the Hamilton Project, which called for direct and automatic payments in the event of a recession, but such a program requires a real-time recession rule. The Sahm Rule trigger is: “when the three-month average of the unemployment rate is 0.50 percentage or more above its low during the prior 12 months … that’s in a recession and time to start stimulus payments”. While the trigger rule is only backtested and it is untested in real-time, the Sahm Rule has had not false positives since 1970.

My long tenure as a bottom-up equity quant has taught me how market factors react to unexpected shocks. My models were the typical multi-factor stock selection model, with a combination of value, growth, expectations, and price technical factors. When the market encounters an unexpected macro shock, the first set of factors to react are the price technical models. Top-down strategists then begin to revise their earnings and interest rate outlook, which feed into expectation models. Earnings estimates then change, because while company analysts recognize the direction of the change, they need to see the exact details of the change before they can determine the magnitude. Finally, fundamental factors such as growth and value then work again.

We already saw the initial stage, when price responded to the change in trade tensions. Bloomberg reported that some strategists are now beginning to revise their outlook downwards:

It’s a minority view, to be sure, but for Mike Wilson, Morgan Stanley’s chief equity strategist, the escalation has increased the likelihood for a prolonged economic downturn — the most reliable killer of bull markets. JPMorgan Chase & Co’s head of cross asset fundamental strategy, John Normand, warned that stocks could fall another 10%.

“The risk of an economic downturn has increased substantially,” Wilson said in a note to clients Monday. “While last week’s correction helped move the risk-reward closer to balanced, we think there is likely more downside than upside based on our high conviction view that earnings expectations remain too high by 5-10%.”

When will Dow Man take notice of all of these developments? For some context, the S&P 500 fell -2.4% last Monday. That equates to a market cap loss of $600 billion, which is more than the total value of the annual US imports from China.
 

 

The bull case

The intermediate term bull case for equities rests on the combination of a relatively constructive outlook for growth, and excessively defensive positioning.

First, the outlook for the US economy is not exactly dire. While there is some evidence of deceleration, the economy is not about to fall into recession. Sure, retail sales is soft, but University of Michigan Consumer Sentiment printed a 15-year high.
 

 

Even if you believe that the economy is showing the warning signs of a recession, not all of the pre-conditions for a recession are present. Monetary policy remains accommodative, and the Fed has signaled that it stands ready to ease in case of weakness. In addition, there are no signs of any credit crunch, which exacerbates the downside path of a downturn. Analysis from UBS reveals that the leveraged loans market is most exposed to tariff effects.
 

 

So far, leveraged loans have performed roughly in line with high yield in 2019, though this is an indicator to keep an eye on.
 

 

In addition, excessively cautious institutional sentiment is likely to put a floor on any pullback. State Street Confidence is already at historic lows, indicating defensive positioning.
 

 

The latest BAML Global Fund Manager Survey reveals that the number of managers that have taken out tail-risk hedges is at all-time highs. Most past spikes in hedging behavior has signaled minimal downside risk, except for the 2008-09 bear, and the downdraft in late 2018.
 

 

The Fear and Greed Index is telling a similar story. The index hit a low of 32 last Monday, but it has recovered to 36 on Friday. While readings are not the sub-20 levels seen in past capitulation bottoms, the market has bottomed in the past at similar levels in the past.
 

 

Resolving the Tariff Man vs. Dow Man dilemma

After a review of the bull and bear cases, here is how I resolve the Tariff Man and Dow Man dilemma. In the absence of tail-risk, expect Trump to adopt the Tariff Man persona and act tough on China, as well as other trading partners. Should tail-risk appear, either in the form of deteriorating economic conditions, or a market slide, Dow Man will become the dominant persona.

This analysis argues for a choppy range bound market for the next few months, with limited downside risk and restricted upside potential. Trump and Xi are expected to meet in Japan in late June, but there are no further interim talks scheduled. Until Trump’s latest trade tantrum that upside markets, the Trump administration had been telling us that a deal was 90% done, and talks were constructive. It is therefore possible that Trump and Xi could put aside their difference and close the last 10%. That said, even if they were to come to an agreement in principle, negotiators will have to iron out the details, which will take time, and there will be the inevitable ups and downs of bargaining. Hence the choppiness.

Ironically, a significant market rally will exacerbate trade war risk, because Trump will think that he has a cushion to push for more concessions. On the other hand, a market decline will weaken Trump’s hand. But the big and slow institutional money is already defensive, and short market beta, which should limit downside equity risk. The combination of a Fed Put and a Tariff Man Put should also put a floor on stock prices.

Under these conditions, investors should re-orient their portfolios to a neutral risk position, and adjust their asset allocation back to investment policy targets. The heightened level of uncertainty is likely to boost volatility, and investors may want to take advantage of this environment of elevated option premiums by selling covered calls to boost expected returns. It would be a way of getting paid via option premiums while you wait for a resolution of the trade conflict.
 

The week ahead

Last week, I made a strong case for a bullish rebound. While stock prices appear to have made a short-term bottom, and I remain tactically bullish, the bull case is less clear-cut as it was last week. The hourly S&P 500 chart shows the index in a short-term uptrend. It rally the 50% retracement level last week, but the advance was halted, with possible gaps to be filled on the upside.
 

 

Historical studies are supportive of further market strength. I had highlighted analysis from Rob Hanna of Quantifiable Edges, who flashed a buy signal based on his Capitulative Breadth Index (CBI) on Thursday May 10, 2018 when it reached an oversold value of 10. CBI remained at 10 Friday, and rose to 13 Monday. If we were to set day 0 as Thursday May 10, last Friday would be day 6, and Hanna’s historical study suggests further gains ahead.
 

 

Even though the market rebound appears to have begun, Ryan Detrick of LPL Financial observed that the DJIA is down for four consecutive weeks, which is a rare event.
 

 

Troy Bombardia pointed out that when the S&P 500 pulls back for two weeks after a prolonged advance, the intermediate term outlook is bullish, though there could be some turbulence in the first week.
 

 

Sentiment readings remain fearful, which is contrarian bullish. ETF fund flows between risky and safe assets are at an extreme.
 

 

The 10-day moving average of the CBOE equity-only put/call ratio is showing high levels of fear. Most instances of these extreme readings have been signals of low downside risk.
 

 

After Friday’s market close, Reuters reported that the Commerce Department may walk back some of the harsh treatment of Huawei, which could alleviate some of the trade tensions:

The Commerce Department, which had effectively halted Huawei’s ability to buy American-made parts and components, is considering issuing a temporary general license to “prevent the interruption of existing network operations and equipment,” a spokeswoman said.

Potential beneficiaries of the license could, for example, include internet access and mobile phone service providers in thinly populated places such as Wyoming and eastern Oregon that purchased network equipment from Huawei in recent years.

In effect, the Commerce Department would allow Huawei to purchase U.S. goods so it can help existing customers maintain the reliability of networks and equipment, but the Chinese firm still would not be allowed to buy American parts and components to manufacture new products.

Nevertheless, the bulls still face a number of challenges. A review of the relative performance by market cap groupings show that mid and small cap stocks are testing key relative support levels. Decisive downside breaks may be signals that the bears have taken control of the tape.
 

 

As well, the relative performance of the top five sectors that comprise over two-thirds of index weight indicate that the glamour FAANG sectors, namely Technology, Consumer Discretionary (AMZN), and Communication Services (GOOGL), are struggling. These stocks will have to maintain some semblance of market leadership if the market is to rebound in a sustainable fashion.
 

 

In particular, semiconductor stocks, which are growth cyclical stocks within the Technology sector, have decisively broken down on an absolute and relative basis. To be sure, the downward pressure came from the Huawei blacklist news, but this could be a technical warning for the bull camp.
 

 

In addition, both short (1 week) and intermediate term (2-3 week) breadth indicators are deteriorating by exhibiting a series of lower highs even as the index rebounded. Unless the bulls can stage upside breakouts through those downtrends, rallies are likely to fail.
 

 

Where does that leave us? I am inclined to give the bull case the benefit of the doubt, though my level of conviction is lower than it was last week. The market is nearing a short-term crossroad, and I am maintaining an open mind to all possibilities.

I give the last word to Zero Hedge, which reported Friday morning that Dennis Gartman made a recommendation to short the market. Gartman has long been an uncanny contrarian indicator: “I feel a great Disturbance in the Market, as if millions of bearish voices suddenly cried out in terror and were suddenly silenced. I fear something terrible has happened.”
 

 

My inner investor will opportunistically trim his equity position back to investment target weight in the days to come.

While a downgrade of the intermediate term trend model from bullish to neutral would normally translate into a trading sell rating, I am temporarily maintaining the buy rating mainly because of the bullish momentum from the relief rally. My inner trader remains nervously long. He is ready to take profits should the market approach the old highs, or flatten his long positions should it significantly weaken.

Disclosure: Long SPXL, TQQQ

 

Bottoming

Posted by Cam Hui -

Mid-week market update: There are numerous signs that the US equity market is making a short-term tradable bottom. Firstly, the market is washed out and oversold. While oversold markets can become more oversold, we saw some bullish triggers in the form of positive divergences on the hourly SPX chart.

Even as the index fell, both the 5 and 14 hour RSI made higher lows and higher highs. In addition, the VIX Index failed to make a higher high even as prices declined. Possible upside targets are the three gaps left open in the last few days.
 

 

Bullish setups everywhere

There were many bullish setups in the last few trading days. Rob Hanna at Quantifiable Edges pointed out last Friday that his Capitulative Breadth Index (CBI) hit 10 last Thursday. Historical studies show a definite bullish edge on a three-week horizon when CBI rises to 10 or more.
 

 

To be sure, a CBI reading of 10 does not necessarily mark the exact bottom. Hanna went on to report that CBI remained at 10 on Friday, and rose to 13 on Monday. He followed up with a post on Monday explaining why a failed bounce is not a sell signal.
 

 

In addition, Schaeffers Research observed that the 5-day equity put/call ratio had spike to levels seen at previous panic bottoms.
 

 

John Authers, writing at Bloomberg, pointed to the sentiment index produced by Longview Economics, which was published Friday morning. All of these readings, from Quantifiable Edges, Schaeffers, and Longview, are screaming “short-term market bottom”.
 

Authers went on to attribute the oversold rally to a lack of bad news. I interpret these conditions as seller exhaustion.
 

The sky didn’t fall. Risk assets enjoyed a slight rebound Tuesday after the big selloff sparked by the U.S.’s decision to impose additional tariffs on China and that country’s decision to respond in kind. The relief rally can be justified by the likely absence of pressing reasons to sell for the next few weeks. The current target appears to be for the U.S. and China to strike some kind of deal at the Group of 20 summit in Osaka late next month. That gives time for both sides to try to find a way to avoid any further escalation. Meanwhile, the tariffs announced in the last few days will not take effect until the end of this month.

 

How durable is the rally?

The next question for investors and traders is, “How durable is this rally?”

Rob Hanna’s analysis suggests that his CBI buy signals have a positive risk/reward of at least three weeks. In the very short-term, the market is climbing the proverbial wall of worry. Despite today’s advance, the CBOE put/call ratio end-of-day estimate stands at 1.15, indicating some degree of residual fear and skepticism about the rally.
 

 

My inner trader remains long this market, and he is hanging on for this rally. In a future post, I will discuss the intermediate term outlook for stocks after the relief rally peters out.

Disclosure: Long SPXL, TQQQ
 

Exploring the trade stalemate scenario

Posted by Cam Hui -

I wrote yesterday (see Why investors should look through trade tensions):

Calculated in economic terms, China would “lose” a trade war, but when calculated in political cost, America would lose as Trump does not have the same pain threshold as Xi.

Based on that analysis, I concluded that it was in the interests of both sides to conclude a trade deal, or at least a truce, before the pain became too great. In addition, the shallow nature of last week’s downdraft led me to believe that the market consensus was the latest trade impasse is temporary, and an agreement would be forthcoming in the near future.

I then conducted an informal and unscientific Twitter poll on the weekend, and the results astonished me. The poll was done on Saturday and Sunday, and a clear majority believes that it will take 10+ months to conclude a US-China trade deal, or it will never be done.
 

 

In view of this poll result, it is time to explore the stalemate scenario. What might happen if negotiations became drawn out, or if the trade war escalates?

Let me preface my analysis with the following: I am not trying to take sides in this dispute, nor am I trying to form an opinion on what should or shouldn’t be in any agreement. My objective is to analyze the situation, and determine the possible courses of action for each side, and determine whether they are bullish or bearish for risky assets.
 

China’ conditions

So far, most of what the market has heard has been the story from the American side. It was said that an agreement was close, but the Chinese marked up the text at the last minute and made wholesale changes. That’s when Trump hit the roof and set a short deadline for negotiations under the threat of increased tariffs. That’s the American side of the story, or spin.

Here is the Chinese side. Bloomberg reported that Vice Premier Liu He set out China’s conditions in an interview in Beijing after he returned from the latest round of negotiations in Washington, and a similar account appeared in China Daily.

China for the first time made clear what it wants to see from the U.S. in talks to end their trade war, laying bare the deep differences that still exist between the two sides.

In a wide-ranging interview with Chinese media after talks in Washington ended Friday, Vice Premier Liu He said that in order to reach an agreement the U.S. must remove all extra tariffs, set targets for Chinese purchases of goods in line with real demand and ensure that the text of the deal is “balanced” to ensure the “dignity” of both nations.

The conditions are:

  1. Removal of all US tariffs
  2. Realistic targets for the Chinese purchase of US goods
  3. A “balanced”deal to ensure mutual “dignity”

Let me try and read between the lines and explain China’s view. There has been too much distrust on the American side, and they believe the deal is unbalanced. Lightizer’s insistence on not lifting tariffs and the imposition of compliance penalties on China, but not on the US, are some examples of the lack of balance in the nature of the proposed agreement.

There are two types of negotiations, ones between roughly equal partners, and between unequal partners. First, in any negotiation, everything is up for grabs until the agreement is final. In a negotiation between equals, there are trades. You may have to give up something to get something. I interpret Liu’s remarks as a belief that the American side believes it is in a dominant position, and it is in a position to ask for concessions without offering anything in return.

As for the issue of a last minute change in text, Liu insinuated that the American side also went back on previously agreed upon conditions:

Liu’s comments, however, revealed yet another new fault line: a U.S. push for bigger Chinese purchases to level the trade imbalance than had originally been agreed.

According to Liu, Trump and Chinese President Xi Jinping agreed “on a number” when they met in Argentina last December to hammer out the truce that set off months of negotiations. That “is a very serious issue and can’t be changed easily.”

So where are we, and what is the calculus for each side?
 

Trump’s choices

One school of thought is Trump believes he has the upper hand because of the strength of the US economy, which gives him the cushion to continue a trade dispute. Here is Bloomberg:

Donald Trump is making a high-stakes bet on his 2020 re-election with his decision to impose new tariffs on China: that the U.S. economy is strong enough to absorb an all-out trade war — and might even benefit.

Trump set out his rationale in a series of tweets Friday morning after raising tariffs to 25% on $200 billion in goods from China and threatening more. Chinese and U.S. officials held brief talks in Washington that were unproductive, according to people unfamiliar with the matter.

“Tariffs will make our Country MUCH STRONGER, not weaker,” the president predicted in a tweet. “Just sit back and watch!”

Should the president’s instinct prevail, he’ll enter next year’s election with the most powerful asset for an incumbent — a strong economy. As of now, he can boast of historically low unemployment numbers, positive economic growth and stock market highs. He’d also vindicate a more aggressive approach toward China than his predecessor Barack Obama — and by extension, former Vice President Joe Biden, whom Trump said Friday is likeliest to emerge as next year’s Democratic presidential nominee.

Obama and “the Administration of Sleepy Joe” allowed China to get away with “murder,” Trump said in another tweet.

Part of that “cushion” are the new tariffs pouring into the Treasury, which Trump has offered to use to buy American agricultural products to offset the loss of Chinese markets, which he will redistribute to starving nations around the world.
 

 

There are a couple of risks with such a course of action. First, the US economy may not be as strong as Trump thinks. While the headline Q1 GDP growth was very strong at 3.2%, final sales, which is reflective of demand after adjustments, was an anemic 1.4%. Initial jobless claims have also started to retreat from their recent record levels (inverted scale on chart), and initial claims has been highly correlated with Trump’s other favorite indicator, namely stock prices.
 

 

Rising tariffs and the expansion of the tariff list will hurt the US economy. CNBC reported that analysis from Goldman Sachs showed that the burden of rising tariffs has been borne by US consumer and businesses, not Chinese exporters. (Larry Kudlow was forced to admit on Fox that tariffs are paid by the US importer, not the Chinese exporter, via Axios):

Goldman Sachs said the cost of tariffs imposed by President Donald Trump last year against Chinese goods has fallen “entirely” on American businesses and households, with a greater impact on consumer prices than previously expected.

The bank said in a note that consumer prices are higher partly because Chinese exporters have not lowered their prices to better compete in the US market…

“One might have expected that Chinese exporters of tariff-affected goods would have to lower their prices somewhat to compete in the US market, sharing in the cost of the tariffs,” Goldman said.

“However, analysis at the extremely detailed item level in the two new studies shows no decline in the prices (exclusive of tariffs) of imported goods from China that faced tariffs.”

Bloomberg reported that Trump’s plan to cushion the agricultural sector by buying their product and redistributing it to poor countries faces a number of historical hurdles. Jimmy Carter banned grain exports to the Soviet Union, and tried to support farmers with purchases. That program didn’t work very well.

In the 1980s, crops expanded just as the export ban caused Soviet Union countries to start buying grain elsewhere. At the time, growers could deliver supplies to the Commodity Credit Corporation below certain loan rates.

It wasn’t until 1985 that the government cut that rate and stockpiles started to fall, said Pat Westhoff, director of the Food and Agricultural Policy Research Institute of the University of Missouri in Columbia. One of the worst droughts in history hit America in 1988, solving the overhang.

The purchases aren’t a “very effective” way to deal with overhang, “and that’s what the government eventually realized,” said Arlan Suderman, chief commodities economist at brokerage INTL FCStone Inc. “It does help support cash prices, but it limits rallies in the market because the market knows if it rallies too much, there are all those bushels still in the bin that will come out.”

The aid program also had problems. It was also the wrong kind of farm product for poor countries:

Aid programs are also too small. The U.S. government’s Food for Peace program usually buys and ships about $1.5 billion worth of goods a year to other countries. On top of that, the nations in need are usually seeking food-grade commodities, such as rice and wheat, said Joseph Glauber, former chief economist at the U.S. Department of Agriculture. The vast majority of U.S. corn and soy production is for use in animal feed or biofuel.

Many poor countries may also not have the facilities needed to process soybeans, which can also yield cooking oil. Some countries may also be opposed to large amounts of aid because it could hurt their farmers.

“Bangladesh does not want raw U.S. soybeans — they want wheat, or wheat flour, milk powder and such,” Basse said.

In addition, such an initiative amounts to dumping, and would be subject to WTO complaints.

Trump’s move could also generate disputes in the World Trade Organization as the measures can be seen as market distorting. The aid could send prices lower, hurting countries like Brazil and Argentina, which are also major corn and soybean exporters.

“You can’t just dump grain at concessional prices,” Glauber said. “That would constitute an export subsidy. That is something the WTO members agreed not to do.”

If Trump’s calculus is based on a strong US economy, it could turn out to be an enormous policy mistake which he will not realize until Q3 or Q4. By then, it will be too late to avoid a major slowdown in 2020 ahead of the election.
 

Chinese retaliation

In response to the US raising the tariff rate from 10% to 25% on an existing list $200b of imports, China announced a retaliatory measure of up to 25% on a measly $60b of US agricultural exports.

Is that the only Chinese response? What else can China do?

A well-reasoned analysis by Brad Setser came to the conclusion that currency depreciation is the most logical asymmetric response, but it will be strictly China’s choice.

One view, more or less, is that China has no need to upset the apple cart. The yuan’s recent stability hasn’t required heavy intervention (at least so long as the financial account remains controlled) or forced China to raise interest rates, and China has shown that it can stabilize its domestic economy by relaxing lending curbs and a more expansionary fiscal policy. Letting the yuan move too quickly could upset the restoration of domestic confidence in China’s economic management, and, well, force China to dip into its reserves to keep any move limited…

I suspect that China has more than enough firepower to maintain the yuan in its current band if it wants to even with U.S. tariff escalation. The tariffs—plus the Iranian and Venezuelan oil sanctions—might be enough to push China’s current account into an external deficit (China is the world’s largest oil importer, so the price of oil matters for the overall balance as much as U.S. tariffs). But if China signaled that the yuan would remain stable, portfolio inflows would likely continue—and a modest deficit need not put any real strain on China’s reserves (especially if Xi insists on a bit more discipline in Belt and Road lending to avoid new debt traps).

The other view is that China has shown that it is firmly in control of its exchange rate and balance of payments, and thus it is in a position to let its currency weaken without putting its own financial stability at risk. Controlled depreciations are hard—the market (even a controlled market like the market for the yuan) obviously has an incentive to front run any predictable move (as China learned in 15 and 16). But I suspect China could pull that off —it would just need to signal at some point that once the yuan had reset down, China would resist further depreciation. The goal, in effect, would be to reset the yuan’s trading range around a new post U.S. tariff band, not to move directly to a true free float.

That would let Chinese firms (who have already started to complain) cut their dollar prices (offsetting some of the impact of the tariff) without reducing their yuan revenues, and help China make up for lost exports to the United States with additional exports to the rest of the world…

Obviously, a controlled depreciation would be highly bearish, as it raises the possibility of a currency war, especially in Asia.

Another option is to do nothing, other than the token tariff retaliation to save face. The fiscal drag of the new US tariffs amounts to a tax increase, and the US economy will slow. Trump’s support in the farm states will erode. China can engage in further stimulus of its economy, though that is not their preferred course of action. China’s Total Social Financing retreated in April, but levels are not out of line with debt growth seen in Q1.
 

 

The political decision

So what now? How long can the trade dispute last, and what kind of damage will it do to the economic growth outlook for China, US, and the world?

It ultimately comes down to a political decision. Brad Setser also made an astute observation in the course of his analysis:

At some point Trump will have to decide whether he wants to run for re-election as the “tariff” man who disrupted world trade, or as the defender of a reformed status quo (after a great deal, that inevitably would involve a lot of messy compromises that don’t change many Chinese trade practices).

Tariff Man would drag out the dispute, and frame China as the boogeyman in the 2020 election. A recent NY Times article hypothesized that was precisely Trump’s 2020 re-election strategy. Run as Tariff Man, and vilify the Democrats, and in particular Joe Biden and the Obama administration for being soft on China. That decision will cause a lot of pain, for both Trump politically and for the markets.

On the other hand, a conciliatory Trump who initially appears tough on China but makes a deal with only minor concessions, in the manner of the KORUS and NAFTA negotiations, will be bullish. This will be in keeping with his Art of the Deal persona, the person who can make a great deal after staring down the Chinese.

I have no idea how this will turn out. My rational brain tells me that the logical outcome is for both sides to come to an agreement quickly before real damage is done. But either the political dimension, or a miscalculation of the political calculus could alter that path.

There are a number of indicators that I would monitor. In the US, I would watch initial jobless claims for signs of job market deterioration, NFIB small business confidence for signs of flagging small business confidence, as small business owners form the bulk of the Republicans’ support, the yield curve, and the stock market. A flattening yield curve would be a sign that the bond market expects slowing growth,

As for China, I would watch the CNYUSD exchange rate. Can it rise to 7 or beyond? In addition, the relative performance of Chinese property developers. Continued outperformance by this sector is a sign of stimulus and plentiful liquidity, and cratering real estate stocks would be a sign of rising stress in the Chinese economy.

Watch these indicator to see how the pressure on each side evolves, and you will know the level of urgency each has to go back to the negotiation table for a deal.

 

Why investors should look through trade tensions

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.
 

Looking through a trade war

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

 

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

Imagine a trade war

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

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

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

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

 

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

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

 

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

 

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

 

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

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

 

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

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

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

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

 

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

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

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

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

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

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

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

 

Playing the investing odds

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

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

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

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

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

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

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

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

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

 

How far can stock prices rise?

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

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

 

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

The week ahead

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

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

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

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

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

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

 

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

 

Is it time to turn bearish?

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

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

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

 

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

 

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

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

 

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

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

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

Disclosure: Long SPXL, TQQQ

 

Some lessons on trading market surprises

Posted by Cam Hui -

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

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

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

 

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

 

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

The latest news

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

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

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

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

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

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

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

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

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

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

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

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

 

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

The market’s reaction

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

 

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

 

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

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

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

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

 

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

 

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

Disclosure: Long SPXL, TQQQ
 

How to navigate Trump’s trade gambit

Posted by Cam Hui -

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

 

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

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

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

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

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

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

 

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

 

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

Assessing both positions

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

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

 

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

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

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

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

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

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

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

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

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

What’s Trump’s Plan B?

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

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

 

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

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

 

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

 

Unsurprisingly, farm bankruptcies have been rising.
 

 

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

The market’s verdict

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

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

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

 

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

 

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

 

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

Disclosure: Long SPXL, TQQQ
 

Green shoots, rotten roots?

Posted by Cam Hui -

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.
 

Are the green shoots turning brown?

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

 

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

 

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

 

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

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

Look for the market to wobble first

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

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

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

 

Hanna continued:

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

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

The message from sector analysis

A review of sector leadership came to the following conclusions:

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

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

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

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

 

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

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

 

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

 

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

 

Limitations of RRG analysis

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

 

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

 

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

 

Investment implications

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

 

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

 

From a technical perspective, NASDAQ 100 leadership remains intact.
 

 

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

 

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

Disclosure: Long TQQQ, SPXL
 

A resilient advance

Posted by Cam Hui -

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

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

 

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

 

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

Intermediate term bullish

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

 

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

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

 

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

 

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

 

Brief pullback ahead?

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

 

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

Disclosure: Long SPXL
 

A stampede you could front run

Posted by Cam Hui -

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

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

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

An unusual agreement

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

RIAs are already bullish

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

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

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

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

 

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

Hedge funds still cautious

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

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

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

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

 

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

 

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

 

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

 

Orderly advance, or blow-off top?

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

 

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

 

Stay tuned.

Disclosure: Long SPXL
 

Sell in May? The bull and bear debate

Posted by Cam Hui -

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.
 

Sell in May and go away?

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

 

Here are the bull and bear cases.
 

Weak seasonality

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

 

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

 

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

 

Don’t expect China to rescue global growth

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

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

 

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

 

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

 

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

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

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

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

 

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

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

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

Further policy easing is widely expected.

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

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

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

Margin headwinds ahead?

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

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

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

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

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

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

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

 

Bullish momentum supportive of further gains

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

The Powell and Xi puts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What I am watching

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

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

 

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

 

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

 

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

 

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

 

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

 

Buy, or fade the breakout?

Posted by Cam Hui -

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

 

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

 

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

 

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

Cautionary signals

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

 

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

 

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

Momentum, momentum!

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

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

 

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

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

 

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

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

 

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

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

Disclosure: Long SPXL
 

A Healthcare rebirth? And broader market implications

Posted by Cam Hui -

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

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

 

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

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

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

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

 

There are broader market implications as well.
 

Healthcare the only Big 5 laggard

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

 

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

 

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

Disclosure: Long SPXL
 

Will a volatility collapse lead to a market collapse?

Posted by Cam Hui -

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.
 

The calm before the volatility storm?

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

 

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

 

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

 

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

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

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

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

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

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

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

Some volatility can be ignored

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

 

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

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

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

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

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

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

 

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

 

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

Which way the greenback?

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

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

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

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

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

 

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

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

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

 

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

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

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

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

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

 

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

Untangling the macro and investment implications

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

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

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

These are all very good questions with no answers.

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

 

Timing the dollar rally

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

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

 

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

 

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

 

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

The week ahead

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

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

 

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The statistics for % positive tell a similar story.
 

 

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

 

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

Disclosure: Long SPXL
 

Debunking VIXmageddon and other bear myths

Posted by Cam Hui -

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

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

 

 

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

VIXmageddon ahead?

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

 

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

 

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

 

Do you feel better now?

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

 

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

Anemic volume

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

 

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

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

 

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

 

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

Not all indicators work forever.
 

Buyback blackout

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

 

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

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

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

Reasons to be hopeful, and cautious

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

 

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

 

My inner trader remains bullishly positioned.

Disclosure: Long SPXL
 

Can the market advance continue? Watch China!

Posted by Cam Hui -

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

 

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

 

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

 

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

 

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

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

A cyclical recovery

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

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

 

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

 

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

 

What next?

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

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

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

What to watch

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

 

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

 

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

 

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

Disclosure: Long SPXL
 

How “patient” can the Fed be?

Posted by Cam Hui -

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.
 

What are the limits to “patience”?

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

 

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

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

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

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

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

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

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

Mixed signals from the labor market

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

 

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

 

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

 

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

 

A warning from small business?

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

 

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

 

Financial stability risk

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

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

 

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

 

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

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

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

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

 

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

 

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

 

 

 

Bullish or bearish?

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

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

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

 

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

 

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

 

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

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

The week ahead: Earnings Season ahead

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL