Login 
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 […]
There has been a lot of hand wringing about the rising level of protectionism in the US and around the world. Let’s take an alternative view to perform our analysis. Imagine an alternative universe, where Donald Trump did not secure the GOP nomination in 2016, but another Republican went on to win the election. I am going to make the bold assertion that trade tensions would have risen in any case.
There are two reasons for my conclusion. First, globalization has stalled, and the low hanging fruit from globalization and globalized supply chains has mostly been harvested. In addition, a Republican President would have enacted a tax cut, and the resulting fiscal stimulus would have created a positive growth differential with the rest of the world and pushed up the USD. The combination of shrinking benefits from globalization and a rising exchange rate would inevitably heighten trade tensions.
Credit Suisse recently presented analysis indicating that the growth in global trade has flattened out. Global trade had been rising steadily since 1960, but growth has stalled since the Great Financial Crisis.
The UN Conference on Trade and Development also presented a study concluding that stagnation in the development of global value chains, as measured by foreign value added share in exports (FVA) that began in 2012, has continued. At the same time domestic value added (DVA) has been climbing during the same period.
In short, the low hanging fruit from globalization and global supply chains has been harvested.
Trump has governed very much like a run-of-the-mill Republican in his first year in office. A recent study published at VOX used a “synthetic control method” to replicate how the American economy would have performed without Trump. This technique was used to measure the effects of one-time events such as German reunification, and the costs of Brexit. The study found that there has been no Trump effect on the economy.
Now let’s take that exercise a little further and imagine that another Republican had won the White House, and he had the cooperation of a friendly Congress. Historically, the priority of every GOP led administration has been tax cuts. Trump`s tax cut plan is therefore no surprise.
What is unusual about the current round of tax cuts is that it was enacted during a period of boom. In the past, budget deficits have risen in lockstep with unemployment. This time, Trump chose to enact a round of fiscal stimulus while the economy was firing on all cylinders.
Steve Collender, otherwise known as @thebudgetguy, recently wrote that Trump’s trillion dollar budget deficits are here to stay:
According to CBO, the deficit this year will be $804 billion and will rise to $981 billion next year and $1 trillion in 2020. CBO then projects that it will keep rising through the end of the 10-year projection window until it hits $1.5 trillion in fiscal 2028.
These projections are based on current law, which says that many of the tax cuts enacted in 2017 expire as the Tax Cuts and Jobs Act requires. If, as many expect, the law is changed so that none or only some of the provisions are allowed to expire, the revenue loss will be even greater and the deficits even larger.
CBO’s projections are also based on solid economic growth. Although CBO’s forecast is less rosy than what the Trump administration used in its budget, it still assumes that what is already the longest economic expansion in U.S. history will last another 10 years. Slower economic growth or a downturn will obviously increase the deficit even further.
As a result, CBO’s already-unprecedented projected trillion dollar-plus deficits should be considered as the best-case scenario. It’s actually more likely that the deficit will reach $1 trillion at least a year earlier in 2019, that is, next year.
While the deficit hawks may bemoan the projections of runaway debt, would the outcome have been significantly different under any other Republican administration? Tax cuts are part of the GOP’s DNA. Any other Republican would have passed a tax cut in some other shape or form. As Vice President Dick Cheney famously said in 2004, “Ronald Reagan proved that deficits don’t matter.”
Here is why fiscal policy matters. Currency strategist Marc Chandler recently invoked the policies of Ronald Reagan in his budget and foreign exchange analysis:
In 2008 and 2009, those advocating more aggressive fiscal policy, including in the US, including the Federal Reserve, were defeated on political and ideological grounds. “A debt crisis cannot be resolved by issuing more debt,” went a popular refrain. Fast forward a decade and the fiscal stimulus that is being provided in the form of tax cuts and spending cuts are larger than in 2008-2009.
The last time the US pursued such a policy mix on anywhere near this magnitude was in the early 1980s. The US ended up sucking in so much of the world’s saving that it led to cries of relief. The dollar’s recovery from the 1970s slump began generating large trade deficits, chronic current account deficits, and a protectionist backlash. In September 1985, the G5 met at the Plaza Hotel in New York and agreed on sustained coordinated intervention to drive the dollar lower.
The Reagan stimulus drove up the budget deficit, but at the same time it raised the growth differential between the US (red line) and the rest of the world (blue line). The positive growth differential put upward pressure on the USD (black line), which made US exports less competitive, and raised trade tensions.
If the Republicans of our alternative universe enacted a tax cut and fiscal stimulus plan in 2017; economic growth would have surged from the Keynesian stimulus; the USD would have inevitably risen and raised trade tensions. The difference in trade tension between Trump and any other GOP White House is only a matter of degree.
Here is where Trump is philosophically different from other GOP presidents. While most Republicans are free traders, Trump is the opposite in his thinking on trade. The current occupant of the White House has sought to reverse much of the effects of globalization of the last few decades.
We know who won and who lost from the era of globalization from Branko Milanovic’s well-known elephant chart. This chart depicts the income growth across global income percentiles for the period 1988 to 2008. The winners were the middle class in the emerging economies, as they benefited from rising incomes as companies offshored production, and the very rich, who engineered globalization. The losers were the inhabitants of the subsistence economies, because their economies were too undeveloped to benefit from the globalization wave, and the middle class in the developed economies, who saw stagnant real income growth as jobs got offshored.
If Trump were to be successful in his trade initiatives, what would the effects be on markets and the global economy?
Let’s return to the elephant chart. Trump’s objective in raising tariffs is to force manufacturing back to US shores. By reversing the globalization effect, the winners would be the middle class of the developed economies, such as the US, and the losers would be the emerging markets.
For investors, this brings up a key question. While emerging market asset prices are understandably likely to deflate under a Trump program, what happens to Wall Street? US stock prices were big winners under globalization. If regulatory changes forced manufacturing back inside the US, labor costs would rise, and margins would fall. Moreover, global trade would decline, and so would sales growth. While some of those negatives would be offset by higher American household income and spending power, the likely net effect would be lower earnings growth, and falling P/E multiples.
Bottom line, Trump’s trade policies would be bearish for stock prices. As to whether the outcome is politically desirable, I leave that conclusion up to the reader. That answer is well beyond my pay grade. In these pages, I only analyze markets.
Understandably, there has been a lot of market angst over a looming trade war. Indeed, the University of Michigan Business Confidence Index shows a rising level of anxiety.
How worried should you be?
I approach the question in a number of ways. First, let’s measure the Trump effect on the economy. An article over at VOX used a technique called “synthetic control method” that is frequently used to estimate the effects one-time shocks, such as German re-unification or Brexit. They found that Trump had little or no net effect on economic growth or employment:
Our approach is to let the data speak for itself. We let an algorithm determine which combination of other economies matches the evolution of real GDP in the US beforethe 2016 election with the highest possible accuracy. For this purpose we rely on a large data set of 30 other OECD economies and observations from 1995Q1 up to 2016Q3. Assuming we find a good match, we can then compare the evolution of the US economy since the election of Trump to its doppelganger that did not get the ‘treatment’ of electing Trump.
This so-called synthetic control method goes back to Abadie and Gardeazabal (2003) and has been successfully applied to study the effects of similar one-off events such as German reunification, or the introduction of tobacco laws in the US (Abadie et al. 2010, 2015). We also use it in a recent study that identifies the economic costs of the Brexit vote (Born et al. 2018b).
It is important to stress that the economies picked by the algorithm and the weight they are assigned is entirely data-driven and open to replication by other researchers. The better the algorithm constructs a close economic doppelganger for the US economy as a weighted combination of other OECD economies, the more accurate our results will be. For the US, the matching algorithm attributes high weights to Canada and the UK, but also to Denmark and Norway (for details, see Born et al. 2018a).
One of Trump’s signature policies has been to hold trade partners’ feet to the fire in order to obtain what he perceives as a better trading relationship. As the market has a disposition to free trade, these trade initiatives have been viewed as equity bearish.
The chart below shows the incidence of the word “tariff” or “tariffs” in the Fed’s Beige Books in 2018. While the level of anxiety has risen since the April Beige Book, a simple frequency count indicates that concerns have stabilized and began to taper off.
Goldman Sachs also found the frequency of Trump’s tweets on trade bear little relationship to the VIX Index.
These last two charts constitute a Rorschbach test on the market’s reaction to trade policy. Is the market telling us that Trump’s bark is worse than his bite when it comes to trade policy, or is it under-reacting?
If you are in the former camp that the message from Mr. Market is correct, then you should be shrugging off the trade jitters and jump on the fundamental momentum bandwagon. As earnings season progresses, stock prices are likely to undergo a FOMO (Fear of Missing Out) rally.
On the other hand, if you take Kevin Muir’s position and Trump will increasingly press his trade policy views as we approach the mid-term elections, then you should either sell everything or possibly short the market.
It’s your call.
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
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 latest BAML Fund Manager Survey shows that institutional managers have turned decidedly cautious on the outlook for the global economy. Profit expectations are tanking, positioning has turned more defensive, as global equity weights are being trimmed, and bond weights are rising, though managers remain underweight the asset class.
At the same time, the SPX has staged an upside breakout from a cup and handle formation, with an upside target of 2925-2960. The bullish surge is supported by a recovery in both European and China-related markets.
Who is right, the bulls or the bears? How about both? The difference may be just a question of different time horizons.
I am certainly sympathetic to the latest round of institutional cautiousness. Accounts that take weeks or months to trade in and out of positions should be de-risking their portfolios. While I am not suggesting the clients should “sell everything”, they should be adjusting their risk profile to a neutral position, especially if their equity betas are above their targets.
There are numerous signs that the American economy is in the late stages and an expansion, and a recession could begin as soon as H2 2019. A number of my long leading indicators, which are designed to spot a recession a year in advance, are flashing warning signals. My long leading indicators are classified into three categories: household, corporate, and monetary indicators.
Among the household indicators, the disappointment in housing starts is a warning sign. I would add the caveat that this is a noisy series, but a downturn in this highly cyclical industry has occurred ahead of past recessions.
That said, real retail sales remain healthy, indicating that the household sector is still in good shape. This is not a time to panic about an imminent recession.
Among the corporate indicators, corporate bond yields have tended to bottom well ahead of past recessions. This indicator tends to be very early, therefore a bottom in yields should not be interpreted as a reason to panic, just a sign of a late cycle expansion.
Other elements of the corporate sector are not signaling caution. So far, corporate profits, another long leading indicator, are not rolling over. In addition, there are no signs of a credit squeeze, which is a pre-condition for a recession.
The monetary long leading indicators are the most problematical. The yield curve, whether measured as the 2-10 spread or the 10-30 spread, is flattening. In the past, an inverted yield curve has been an uncanny predictor of recessions. As usual, the Fed has trotted out a series of excuses why the yield curve is displaying a false signal (see (Don’t fear) the yield curve). Moreover, there has been growing disagreement between the regional Fed Presidents, who have voice concerns about the flattening yield curve, and the Fed governors, who have found reasons to ignore its signal. Historically, it is the latter group that has held the greatest power in determining monetary policy. At the current rate of raising the Fed Funds target by 0.25% every three months, the yield curve is likely to invert late this year, indicating a recession in late 2019.
Even if we were to discount the predictive power of the yield curve because of the Fed`s QE program that affected the long end of the curve, real money supply growth, measured as either M1 or M2, has turned negative ahead of past recessions. The Fed`s policy of normalizing monetary policy has seen money supply growth decelerate. While the data is very noisy, both real M1 and real M2 growth are decelerating rapidly and are on the verge of turning negative.
While I am not in the habit of anticipating model readings, there are signs that economic momentum is slowing, and the current path of monetary policy is setting the economy up for a recession to begin in H2 2019. The CME`s latest market derived expectations show one quarter point rate hike in September, followed by a second in December. Such a policy path is likely to invert the yield curve and drive real money supply growth negative some time this year.
Notwithstanding the market’s expectations, the path of policy normalization appears to be set on a pre-determined path, especially when viewed in the context that the current real Fed Fund rate remains negative indicating a highly accommodative policy. Moreover, the Fed has made it clear that it is uncertain about how to adjust policy in the event of a trade war, and it will take a wait and see approach before reacting. A recent BOE study that modeled the effects of a full-blown global trade war found that inflation would spike, which would put policy makers in the uncomfortable position of deciding whether to ease in the face of rising inflation, however transitory it may seem.
Similarly, Bloomberg recently highlighted a study indicating problematical inflationary pressure facing the Fed in the event of a trade war:
A multi-colored graphic that’s made the rounds at the Federal Reserve hints at what Chairman Jerome Powell could face if President Donald Trump succeeds in throwing globalization into reverse: Higher prices for many goods and potentially faster inflation.
Plugged as possibly the chart of the century by economist and originator Mark Perry, it shows that prices of goods subject to foreign competition — think toys and television sets — have tumbled over the past two decades as trade barriers have come down around the world. Prices of so-called non-tradeables — hospital stays and college tuition, to name two — have surged.
“We would have fewer choices, potentially less quality, less productivity and higher prices if we reverse globalization,” said Timothy Adams, president of the Washington-based Institute of International Finance, who’s discussed the chart and its implications with Fed policy makers.
Just as globalization has been a headwind holding back inflation, its unraveling could end up being a tailwind in the years ahead, pushing costs higher as countries and companies retreat from the international marketplace. That would be on top of the one-time effect that Trump’s tariffs will have on prices of selected imports, putting pressure on the Fed to raise interest rates at a faster pace than the gradual path it has currently mapped out.
Under these circumstances, it would be eminently sensible for investors with long time horizons to begin de-risking their portfolios now.
On the other hand, I have been in the tactical “last hurrah rally” camp for several weeks. While the long-term forecast calls for caution, the near-term outlook looks bright.
As we enter Q2 earnings season, the outlook from FactSet is upbeat. Q2 guidance is the second most bullish since FactSet began monitoring earnings guidance. Both the sales and EPS beat rates are well above their historical averages, indicating positive fundamental momentum.
In addition, stock prices are behaving as expected. The market is rewarding earnings beats and punishing misses. There had been some concern among analysts that the market reaction may be skewed if companies raised concerns about rising tariffs and trade friction, regardless of past results. So far, that does not appear to be the case.
From a technical perspective, the upside breakout of the SPX from its cup and handle formation confirms that the bulls have taken control of the tape. As well, the upside breakout in US equities is supported by strength in Europe, as evidenced by the upside violation of the downtrend by the Euro STOXX 50.
Over in Asia, China and Chinese related equities are bottoming after exhibiting positive RSI divergences. They appear to be poised for relief rallies.
The technical price recoveries in these regions are also supported by recoveries in the regional Economic Surprise Indices (ESI), which measure whether high frequency economic releases are beating or missing expectations. Here is ESI Europe.
ESI China is also making a nascent recovery.
In conclusion, this market is something for everyone if the scenario that I outlined becomes reality. Traders can take advantage of a momentum driven rally which is likely to take the major indices around the world to fresh highs. At the same time, long-term investors can take advantage of any market strength as an opportunity to de-risk.
Looking to the week ahead, the key risk to the bullish narrative is an upside breakout in the USD Index. The USD Index is once again testing a key resistance level while exhibiting a negative divergence. However bearish the technical indicators, this does not preclude further USD strength, which is likely to induce a risk-off episode, particularly in emerging market stocks and bonds.
In addition, the market has shown a high degree of concern about weakness in the Chinese yuan (CNY), and it has viewa falling CNYUSD exchange rate as the trade war turning into a currency war. I agree with Ed Yardeni`s assessment that such an interpretation is erroneous. If the currency of country B fall against the currency of country A, but the currencies of countries C, D, and E also rise against the currency of country A, then country B is probably not manipulating its exchange rate. The problem lies with the policies of country A.
While the Fed continues to gradually normalize monetary policy, the People’s Bank of China cut reserve requirements sharply in recent weeks. That undoubtedly contributed to the 6.2% plunge in the yuan from its mid-April peak.
If Trump does raise the ante by slapping a 10% tariff on $200 billion of imports from China, a stronger dollar relative to the yuan might very well offset most of the inflationary consequences for the US. To add insult to injury, Trump could revive his attacks on China as a “currency manipulator.” However, in my opinion, it is US trade policies, not Chinese intervention, that is weakening the yuan.
Trump knows that a weak yuan could cause the Chinese some real pain, by increasing the yuan cost of buying dollar-priced commodities, especially oil. China’s PPI inflation rate, which was 4.7% on a y/y basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month.
Nevertheless, I have learned that when the animal spirits start a stampede, it is wise not to stand in front of the herd.
Equity bulls were helped when the PBOC intervened to stop the CNY slide Friday, and a presidential tweet served to soften the greenback. While the technical conditions point to further USD weakness, the behavior of the dollar remains a wildcard for the markets. Could labeling China a currency manipulator be next?
In the meantime, the SPX pulled back from its upside breakout at 2800, but the breakout is holding. Also helpful to the bull case is the all-time high seen in the NASDAQ Composite last week.
As well, I would also point out that mid and small cap stocks have broken out past their January highs, which addresses the complaints I have read that the market advance was accomplished with narrow participation.
The upcoming week will be a test of character for the bulls. If the market were to follow the script from late 2017 and melt-up, then breadth conditions are tactically sufficiently oversold for stock prices to rise.
Otherwise, expect further consolidation and sideways action next week.
Publications will be lighter than usual as I will be in South Africa on safari and visiting friends in the Cape Town area. I will be publishing my usual weekend updates, though mid-week commentaries may not be forthcoming as internet access may be spotty. That said, even though I will be on safari, the accommodations can hardly be described as “roughing it”.
My inner investor remains constructive on equities. My inner trader would normally be piling in on the long side, but in view of his trip and possible uncertain internet connection, he is keeping his long commitment relatively light.
Disclosure: Long SPXL
Mid-week market update: It’s finally happened. The SPX staged a convincing upside breakout from its cup and handle formation. Depending on how you draw the lower line, the upside target is in the 2925-2960 range. The first test will be resistance of the January highs.
Upside breakouts are bullish. What more do you need to know?
The upside breakout has been confirmed by the bullish market action in other US and non-US indices. The NASDAQ Composite has already made an all-time high.
The broadly based Wilshire 5000 has made a similar upside breakout of a cup and handle formation.
I wrote earlier in the week that China related plays were wash-out and poised for relief rallies (see Tariffs to the left, tariffs to the right…Contrarians buy China!).
European markets have also turned up. The Euro STOXX 50 has rallied and violated a downtrend, which is bullish.
In short, the upside breakout in the SPX is supported by both US and non-US indices. The next challenge for the bulls is to maintain momentum with a series of “good overbought” conditions. Should that happen, it could form the backdrop for a FOMO (Fear of Missing Out) bullish stampede in the manner of the late 2017 market melt-up.
Disclosure: Long SPXL
The news about the Sino-American trade war seems to get worse every day. Callum Thomas pointed out that corporate managements are increasingly raising concerns about rising tariffs.
Chinese stocks have cratered, along with the stock indices of China’s largest Asian trading partners. However, a couple of contrarian buy signals are appearing. First, trade tensions are now showing up in the one place that you might expect, FX volatility.
As well, Chinese and other Asian markets are washed-out and poised for relief rallies, which would also be supportive of higher global equity prices.
From a technical perspective, Chinese and Asian markets are showing signs of a turnaround. The Shanghai Index recently flashed a buy signal when the stochastic recovered from an oversold condition, which was supported by a positive RSI divergence. Chinese share prices fell Monday because of softer than expected economic data, but such conditions may present as an ideal entry point.
The Hang Seng Index in Hong Kong also exhibit a similar pattern of positive RSI divergence and stochastic buy signal.
The South Korean KOSPI also flashed a stochastic buy signal.
The same goes for the Taiwan market, which is important as it is a bellwether for the semiconductor industry.
I could go on, but you get the idea. In short, the stars are lining up for an oversold rally in China-related plays. After all, how can you not buy when pictures like this one goes viral?
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
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 bulls appear to have taken control of the tape. The SPX is exhibiting a bullish cup and saucer formation. If it achieves a decisive breakout at 2800, the upside target is about 2950*. In all likelihood, the upside breakout will occur, as there is strong breadth support as small cap, midcap, and NASDAQ indices all achieved all-time highs last week.
As US stock prices are poised for fresh highs, one of the key questions is the nature of the leadership that investors should expect. A standard approach of using Relative Rotation Graph charting yielded some answers, but a further factor-based analysis indicated a surprising level of risk exposure.
* I had previously published an upside target of 3050 in a past versions of the cup and handle analysis. The 3050 figure was a arithmetic error. My apologies for the mistake.
The fundamental and macro backdrop of the stock market has been unchanged for the last several months. The nowcast and short (3-6 month) leading indicators are very positive, which is supportive of stock prices.
If you are looking for a quick and dirty indicator of stock market direction, look no further than initial jobless claims, which has shown a remarkable inverse correlation with equities.
As well, the latest update from FactSet shows that forward 12-month EPS continue to rise, indicating positive fundamental momentum that is supportive of higher prices. In addition, John Butters of FactSet observed that the coming quarter is the second best quarter for corporate guidance since 2006, which should set the backdrop for a solid Q2 earnings season.
The market action of the past few months has been consistent. It has reacted positively to rising growth fundamentals, but news driven events mainly related to trade jitters have caused temporary setbacks. The likely upside breakout at 2800 indicates that market psychology is discounting the negative effects of a trade war.
I use the Relative Rotation Graphs, or RRG chart, as the primary tool for the analysis of sector leadership. As an explanation, 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.
An RRG chart of the US market reveals that the leading sectors of the market are Technology, Consumer Discretionary, and REITs. Healthcare stocks may represent the emerging leadership, and the most obvious laggards are Industrials and Financials.
Is that the full story? One of problems with float weighted indices is the index may be dominated by just a few stocks. As an example, Amazon and Netflix comprise about 30% of the Consumer Discretionary sector. The RRG chart of equal weighted sectors against the equal weighted index provided a way of verifying our preliminary conclusions of sector leadership. The conclusions are roughly the same, as the sectors are all roughly in the same sector leadership spots.
Another way of verifying the sector leadership trends is to analyze sector behavior in Europe. While US stocks have been leading European stocks, the market internals of both markets have tended to be relatively synchronized. The RRG chart of European stocks also tell a similar story. Technology and Consumer Cyclical stocks are the leaders, followed by Healthcare. Financial stocks are the laggards.
RRG analysis represents a first cut at leadership analysis. Here is a more detailed look at selected individual sectors that I would overweight.
The continued strength in Technology stocks has been a surprise, especially in light of evidence of faltering price momentum. However, the relative strength of the sector, whether on a float or equal weighted basis, is testament to powerful market leadership at work.
Consumer Discretionary stocks stand out well in the RRG analysis, but a comparison of the float and equal weighted relative returns reveals that much of the sector’s strength is a float weighted attributable to Amazon and Netflix. Nevertheless, the equal weight analysis shows that the sector is making a broad saucer shaped relative base, and it has potential for outperformance.
Healthcare is another sector making a constructive saucer shaped relative base.
Finally, I would suggest taking overweight positions in the interest sensitive sectors as a hedge against market weakness. These are defensive sectors, but they are also exhibiting similar saucer shaped bottom relative return patterns.
An overweight position in interest sensitive sectors may be appropriate, as the latest CFTC Commitment of Traders report indicates large speculators, which are mostly hedge funds, have taken a crowded short position in the 10-year Treasury Note. Such an extreme position is potentially contrarian bullish.
No analysis of sector leadership would be complete without an analysis of the sector factor beta. An RRG analysis of factors, or styles, shows that market leadership is dominated by small cap and selected growth styles. Value factors such as quality, and dividend growth are laggards.
The strength exhibited by small cap leadership highlights a factor exposure that many investors may have missed. Small cap outperformance has been highly correlated with USD strength.
The USD Index is technically vulnerable to a pullback. It has tested a key resistance level and failed while exhibiting a negative RSI divergence. In addition, the index rallied to test the underside of an uptrend, and it also failed at resistance. These conditions suggest that the path of least resistance for the USD Index is down.
The recent strength of the USD in the past few months makes the leadership of Technology stocks that much more remarkable. Analysis from FactSet shows that the sector has the most foreign exposure of the index. A rising dollar would create headwinds for the earnings in this sector, and still these stocks outperformed. Should the USD weaken as expected, then it should create even a greater tailwind for this sector. The obvious key risk is a trade war that hurts both the supply chain and margins of this highly globalized sector.
In light of the USD sensitivity, one approach that investors could adopt is a barbell strategy to overweight Technology and the interest sensitive stocks of Utilities and REITs.
Another factor sensitivity that I would like to address is the yield curve. Historically, the relative performance of Financial stocks has been correlated to the shape of the yield curve. A steepening yield curve has been bullish for outperformance of this sector, and a flattening yield curve bearish. The only exception has been the market reaction in the wake of Trump’s electoral win, where Financial stocks rallied in anticipation of better earnings through deregulation and tax cuts.
The yield curve has been flattening form most of this year in response to Fed policy. It is hard to see what might reverse that trend, and therefore I would suggest a continued underweight in Financial stocks.
In summary, a review of sector leadership shows a number of sectors that investors could overweight:
Lastly, the relative performance of Financials has historically been correlated to the yield curve. As long as the yield curve continues its flattening trend, it will be difficult for Financials to outperform.
Looking to the week ahead, even though the SPX has staged a marginal upside breakout at 2800, near term caution is warranted on a tactical basis for a number of reasons. First, the upside breakout was achieved while exhibiting a negative divergence on RSI-5.
The negative divergence is clearer and more visible on the hourly chart. If the index were to pull back, there are a couple of downside gaps that could be filled, with initial Fibonacci support just below the second gap at about 2760. If that breaks, secondary support can be found at 2740.
The near-term action argues for a brief period of pullback and consolidation. Breadth indicators have become overbought and they are pulling back. Even if intermediate term price momentum is strong, look for a minimum pullback to levels just below neutral, as was the case during the strong period at the end of 2017.
The upcoming week is OpEx week. Analysis from Rob Hanna of Quantifiable Edges show that the directional bias for July OpEx is little more than a coin toss.
My inner investor is still long the market. My inner trader has a minor long commitment, and he is prepared to add to his position on market weakness, or a decisive upside breakout.
Disclosure: Long SPXL
I had a number of questions and comments from my last post (see Wall Street: Where the Wild Things are) when I wrote that my trading account, while still bullish, had taken “partial profits earlier this week as part of his risk control discipline when readings became short-term overbought”. The comments ranged from “where can I find a record of where your decisions to take partial profits” (answer: you can’t) to “why did you not tell us when you made that trade?”/
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
What does this mean, beyond the usual legalese? Why is the content “not investment advice”?
What many investors don’t realize that the process of constructing a portfolio involves three major decisions:
Much of the content on this site revolves around question 1. I know nothing about you. I don’t know what your return objectives are. I don’t know your tax situation, or even your tax jurisdiction. I don’t even know how much risk you can tolerate. With respect to the first question, I therefore don’t know if any investment or instrument discussed is appropriate for you. Since I know nothing about you, I would not even try to answer the last two questions.
That’s why nothing on this site is investment advice.
If I was your fund manager, we would have discussed your investment situation, and I would know enough about you to create an Investment Policy Statement (IPS). We don’t have that kind of relationship.
That’s why nothing on this site is investment advice.
If I were the manager of a fund that you bought into, there would be disclosure documents about the sorts of investment instruments that the fund can buy, and the risk levels that the fund is expected to undertake. We don’t have that kind of relationship either.
That’s why nothing on this site is investment advice.
At the same time, I write about my investment views on the site, and I will express bullish or bearish opinions on the market, sectors, or specific instruments. I believed that it was appropriate to disclose any possible conflicts that I may have because of my own investment positions.
That’s where the “trading alerts” come in.
Whenever I initiate a new trading position, subscribers get an email alert of those changes for conflict disclosure purposes. However, subscribers will not receive notification of changes in position sizing because any conflict has already been disclosed.
Here is the part that created the misunderstanding. I know nothing about you. I don’t know if my trading positions are appropriate for you. My tax situation is not your tax situation. My pain threshold is different from your pain threshold. In the absence of any such discussions, changes in my own position sizing is not necessarily relevant to your situation, and therefore it would be misleading for me to disclose those trades.
There are a number of other websites that offer real-time chat room services. This is not one of them. There are a number of key differences between Humble Student of the Markets and a chat room.
First, the holding time horizon of “my inner trader”, which represents my trading account, is longer than most chat room day trading or swing trading services. I publish and update the idealized track record returns of my inner trader on a weekly basis based on trades using signals from the subscriber trader alerts. The average holding period is 18.0 trading days.
I disclose the track record of “my inner trader”, which is contrary to the practice of many other trading services.
As the average holding period of these trades is relative long, there is little urgency to making the trades on the day of the signal. In fact, my analysis shows that the returns from waiting 1, 3, and 5 days after the signal are better than the base case where the trades are executed on the day of the signal.
For another perspective, here are the relative returns of a hypothetical account that traded five days after the signal day. My conclusion from this analysis indicates that my trade timing isn’t perfect, and it is arguably early.
One last point about chat rooms. The going rate for a chat room subscription, where you get access to real-time signals, is about USD 200 per month, or over USD 2000 per year. That pricing structure is an order of magnitude higher from Humble Student of the Markets (see our pricing page).
In conclusion, readers who are looking for high frequency trading advice should look elsewhere (one useful site to take a look at is LaDuc Trading, where Samantha LaDuc takes the bold step of actually disclosing her trading record). At Humble Student of the Markets, my primary objective is to write about investments. A secondary objective is trading, but even then, the time horizon of my trades is longer than many day and swing trading services.
Mid-week market update: There is a children’s book called Where The Wild Things Are by Maurice Sendak that stands as a metaphor for the stock market’s action. Here is a summary from Wikipedia:
This story of only 338 words focuses on a young boy named Max who, after dressing in his wolf costume, wreaks such havoc through his household that he is sent to bed without his supper. Max’s bedroom undergoes a mysterious transformation into a jungle environment, and he winds up sailing to an island inhabited by malicious beasts known as the “Wild Things.” After successfully intimidating the creatures, Max is hailed as the king of the Wild Things and enjoys a playful romp with his subjects. However, he starts to feel lonely and decides to return home, to the Wild Things’ dismay. Upon returning to his bedroom, Max discovers a hot supper waiting for him.
A number of films have been made from the story, including a full length feature movie. Here is a animated short from Youtube (click link if the video is not available).
As the SPX corrected after testing a key resistance level at about 2800, Where the Wild Things Are is an apt metaphor for the market and its animal spirits. The question for the investors is what part of the story we are at. Are we at the stage where Max is romping with the Wild Things, or is Max about to leave the island, where the Wild Things threw their final tantrum by roaring their terrible roars, and showed their terrible teeth (FANGs)?
Here is the bull case. From a technical perspective, the SPX is tracing out a bullish cup and handle formation. If the market were to stage an upside breakout from resistance, the measured target is about 3050. That target is consistent with my past analysis using point and figure charting that yielded upside targets of between 3000 and 3100 (see How far can this rally run?).
Market breadth is also supportive of new highs. Various flavors of advance-decline lines, such as the NYSE, SPX, and so on, have already achieved all-time highs, indicating broad based strength.
There is also fundamental and top-down macro support for higher prices. As we enter into Q2 earnings season, corporate guidance is highly upbeat, which should make for an excellent reporting season.
NFIB small business confidence remains very strong, which should be supportive of small cap performance. I would also add that the key vulnerability of the economy to a trade war is business confidence. So far, confidence is holding up well in the face of trade concerns.
The economic nowcast is on fire. The Atlanta Fed’s Q2 GDPnow stands at 3.8%, the New York Fed’s nowcast is 2.8%, and the St. Louis Fed’s nowcast is 3.4%. In addition, Jim O’Sullivan of High Frequency Economics observed that the elevated (and exaggerated) NFIB confidence level is consistent with 6% GDP growth.
Despite the roaring nowcast and evidence of fundamental momentum, a case could be made that the market setting is the equivalent of Max preparing to leave the island of Wild Things. In particular, metrics of risk appetite look unhealthy and they appear to be rolling over.
Exhibit A is the performance of the price momentum factor, which has breached a relative uptrend. In addition, the relative returns of high beta (SPHB) compared to low volatility (SPLV) remains range bound. If the animal spirits are running wild, shouldn’t we be seeing evidence of this in the risk appetite indicators?
Similarly, risk appetite cracks are showing up in the credit markets. High yield (HY), or junk bonds, are exhibiting a negative divergence with stock prices. In addition, investment grade (IG) bonds have been underperforming for the last few months, which is another red flag.
I resolve the bull and bear cases this way. I interpret the deterioration in risk appetite as an intermediate term cautionary flag. In the short run, a last gasp momentum can still carry stock prices to new highs. I agree with Kevin Muir of The Macro Tourist about his misgivings about the stock market, but current intermediate term sentiment and positioning is just a little too bearish for the market to crash here.
Although I am worried the moment I bare my soul about my lack in faith of any meaningful dip happening soon the Rosenberg-Gundlach decline will begin, I can’t help but lay it out on the table. I know all the reasons why the stock market should go down. The investor in me agrees 100% with the skeptics who worry we are late-cycle and that risks are rising. But the trader in me is even more concerned that everyone is already positioned for this outcome. Markets often go where they will hurt the most and make the majority look foolish. That path is higher – not lower.
Tactically, today’s muted response to the latest round of trade war angst in the US equity market, which fell -0.7% compared to losses of over 1% in Europe and Asia, is encouraging for the bull case. The hourly SPX chart shows an initial Fibonacci retracement support at about 2755, with further support at the 50% retracement level and former breakout-turned resistance at about 2740.
In all likelihood, these support levels will be tested. There is also a gap at 2762-2768 that is itching to get filled on weakness. As well, CNBC reported that Bespoke found that stock market returns tend to be subpar during the World Cup, which will not be complete until later this weekend.
Should the index test these support levels in the coming days, equally important will be the cues from non-US markets. Will their behavior be supportive of bullish or bearish momentum?
On the other hand, the bull case depends on the completion of the cup and handle formation with an upside breakout. If the market can decisively break out from resistance at 2800, then the bull case becomes much stronger, and we could see the index at 3000-3100 over the summer. I would then watch for the signs of a top once the Fear and Greed Index reaches overbought levels.
My inner trader is cautiously bullish and he is giving the bull case the benefit of the doubt. He took partial profits earlier this week as part of his risk control discipline when readings became short-term overbought. He is prepared to add to his long positions on a pullback.
Disclosure: Long SPXL
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
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 first real shots in the Sino-American Trade War were fired last week when the US imposed a series of tariffs on $34b of Chinese goods at 12:01 ET on July 6, 2018, and the Chinese retaliated with tariffs of their own. For investors, the current environment presents a dilemma.
On one hand, the prospect of a protectionist curtain descending around the world is bearish for growth, and for equity prices. On the other hand, the near-term outlook for economic growth and earnings are bright. In the absence of trade tensions, US stock prices should be breaking out to new highs.
The conundrum can be illustrated by the readings of the Fear and Greed Index, which is stuck in neutral and showing no signs of momentum nor direction. Is a Trade War Apocalypse just around the corner, which will collapse the index to new lows; or is this a case of sell the rumor, and buy the news? Arguably, the market’s rangebound behavior in 2018 is attributable to the earnings growth vs. trade jitters dilemma.
We examine the bull and bear cases.
Last week, I asked if global markets could continue to rise if non-US markets and economies are weak (see A looming global recession, or buying opportunity?). I concluded that there were nascent signs of a turnaround abroad. This week, we are getting confirmation of a global reflationary rebound.
Start with the US, which has already been showing signs of economic strength. This chart of ISM (blue line) and SPX (orange line) may be all investors need to know about the stock market. ISM Manufacturing roared ahead and beat expectations, and we are seeing a continued positive divergence that is equity bullish.
Friday’s June Employment Report confirmed the upbeat assessment of the American economy. The report delivered a Goldilocks not-too-hot-not-too-cold reading for equity investors. Non-farm payroll beat expectations, and the figures for previous months were revised upwards. However, Average Hourly Earnings was tame, which was a signal that wage growth is not accelerating and does not pressure the Fed to turn more hawkish on monetary policy.
Other internals were also solid. Even though the unemployment rate rose, it was attributable to a rise in the participation rate. Moreover, the flow of “not in labor force” to “employed” rose. These conditions will give Fed policy makers some comfort that there is still slack in the jobs market and there is no urgency to accelerate the pace of monetary policy tightening.
There were also other signs of solid non-inflationary growth. Temporary jobs and quits from the JOLTS report have historically led civilian employment, and the latest jobs report show no signs that temp jobs are rolling over.
It was a solid jobs report that keeps Fed policy on track, and gave the hawks little ammunition to tighten faster. The report was so positive that it prompted David (the world is collapsing into recession) Rosenberg to reassess his bearish outlook for the economy.
On a bottom-up basis, there was also good news. The latest update from FactSet shows that forward 12-month EPS is still rising, indicating positive fundamental momentum. Moreover, Q2 EPS guidance is coming at better than the historical average, which should make for a positive tone for the upcoming earnings season.
There was also good news over in Europe. Weakness in the eurozone Manufacturing PMI was offset by strength in the Services PMI, and the resulting Composite PMI showed signs of stabilization and rebound.
The turnaround can be best seen in the Citigroup Europe Economic Surprise Index.
Notwithstanding the rising trade tensions, there were signs of a rebound in China as well. Last week, I highlighted analysis from China Beige Book of unexpected growth acceleration. Gavyn Davies confirmed that view in the Financial Times:
In China, our nowcast is much more surprising, because it reports an update in growth to above 8 per cent, while most other economists are talking about a slowdown in retail sales and fixed asset formation, with estimates of the GDP growth rate dipping to about 6.5 per cent.
The unexpected strength in Caixin China PMI is also supportive of the rebound thesis.
In light of this evidence of a synchronized upturn in economies of the three global major blocs, global stock prices should be staging a reflationary rally.
The bear case rests on the risks of a trade war. Even though widespread opposition from business groups is building against Trump’s tariffs, both the US and China appear to be digging in their heels in their negotiating positions.
The main damage from the trade war can be found in a deterioration in business confidence. The latest FOMC minutes reflect the heightened angst as expansion plans are put on hold [emphasis added]:
Participants reported that business fixed investment had continued to expand at a strong pace in recent months, supported in part by substantial investment growth in the energy sector. Higher oil prices were expected to continue to support investment in that sector, and District contacts in the industry were generally upbeat, though supply constraints for labor and infrastructure were reportedly limiting expansion plans. By contrast, District reports regarding the construction sector were mixed, although here, too, some contacts reported that supply constraints were acting as a drag on activity. Conditions in both the manufacturing and service sectors in several Districts were reportedly strong and were seen as contributing to solid investment gains. However, many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy. Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.
Reuters reported that the Chamber of Commerce has launched a campaign against Trump’s tariffs. Will he listen to this Republican leaning group ahead of the mid-term elections?
The U.S. Chamber of Commerce, the nation’s largest business group and customarily a close ally of President Donald Trump’s Republican Party, is launching a campaign on Monday to oppose Trump’s trade tariff policies…
“The administration is threatening to undermine the economic progress it worked so hard to achieve,” said Chamber President Tom Donohue in a statement to Reuters. “We should seek free and fair trade, but this is just not the way to do it.”
There are signs that these complaints are falling on deaf ears. Axios reported that, despite widespread polling that the Democrats will retake control of the House and challenge for the Senate in November, “President Trump and some West Wing officials believe Republicans will hold on”. In fact, “Trump is already holding frequent rallies in key areas for the midterms, and will travel even more after Labor Day. He relishes the fight, and loves the idea that he’ll save the House for Republicans.”
Why listen to these defeatist business groups when you think you will win?
At the same time, The Economist reported that Beijing thinks that they can outlast Trump in a trade war of attrition:
An authoritarian regime can limit and dictate the public discussion. After the stockmarket tumbled, authorities warned journalists against citing the trade conflict as an explanation, according to a directive published by the China Digital Times, a website that tracks government censorship. Reporters were also ordered to emphasise the economy’s bright spots. In America, meanwhile, the hurly-burly of its public discourse has been on display. On July 2nd the US Chamber of Commerce, the country’s biggest business group, launched a lobbying campaign to explain how tariffs would hurt the economy. Republican lawmakers in Congress are criticising the president’s trade policies more openly than heretofore—though on past form, if Mr Trump pushes ahead, they will probably fall into line.
Another source of confidence for China is the knowledge that it is not fighting America alone. From steel tariffs on Japan to threats of auto tariffs on Europe and negotiations that might wreck the North American Free-Trade Agreement, Mr Trump is taking on every one of America’s allies. China has tried to rally them to its side. It has asked the European Union to join it in condemning Mr Trump’s trade actions, according to Reuters (the EU declined because of its own trade grievances against China). Even as it raised tariffs on soyabeans from America, it removed them from soyabeans from India, South Korea and others in Asia. Xi Jinping, China’s president, has hinted that its markets will become more open to non-American firms.
There have been many macro models of the effects of a trade war (see my January publication Could a Trump trade war spark a bear market?). The latest estimate from the Bank of England assumes a 10% across the board tariff. It would take 2.5% off GDP, and the secondary effects would roughly double the costs. Moreover, the effects would be felt all around the world.
Bank of England simulations suggest that the impact of narrow, bilateral tariff increases through direct trade channels would tend to be small – reflecting the small share of overall exports affected – and would be largely confined to the countries directly involved. However, a larger, increase in tariffs of 10 percentage points between the US and all of its trading partners could take 2½ per cent off US output and 1 per cent off global output through trade channels alone, although the impact on the UK is smaller reflecting a greater exchange-rate driven boost to net exports.
It would be a very bumpy ride. If the US were to take a 5% hit to GDP growth, it could easily crater stock prices at a magnitude similar to the Great Financial Crisis, if not more.
After reviewing the bull and bear cases, what should investors do? The answer is tricky, because navigating between the bull and bear cases is a study in policy direction and investor psychology.
In the realm of policy, will one side blink in this mano-a-mano war of nerves, as Trump did with in the case of ZTE?
The next data point to watch is NFIB small business optimism, which is due to be reported Tuesday morning. Should confidence show signs of collapse (and the headline gets widespread play on Fox News), it would put pressure on Trump to find a face-saving compromise.
One other issue that investors should consider is how the markets will start to discount the effects of the mid-term elections in November. As the summer progresses and should it become evident that the Democrats will control the House, how will the market react?
An Axios article recounted the advice of the Bush 43 White House OSG (Oh Sh** Group) that was formed in preparation for a Democratic victory. They had this advice for Trump aides:
In other words, governing will become far more difficult that it is today. Not only will it be impossible to get any legislation passed, the Mueller probe, if it’s not concluded, will likely take on a new life of its own. In addition, the Fed will likely have inverted the yield curve by late 2018 or early 2019, which is a recession and equity bear market warning.
The market environment will become increasingly hostile. Don’t be surprised if the markets get spooked by such a scenario in the next few months.
On the other hand, the Credit Suisse Risk Appetite Indicator is already in the panic zone, indicating that much of the downside has already been discounted. In light of the upbeat near-term reflationary environment, risky assets like equities are poised to stage a rip-your-face-off rally on any hint of good news.
I observed last week that the USD is technically vulnerable, and USD weakness would be supportive of non-US asset prices. As well, a falling greenback would take some of the pressure off trade tensions. The USD Index has reacted as expected as it was rejected at a key resistance level while exhibiting a negative RSI divergence. The index is now testing its 50 day moving average (dma).
In conclusion, the strength of the bullish and bearish cross-currents makes it difficult to make a definitive market forecast, but my base case scenario calls for a last hurrah equity rally in the next few weeks. Sentiment remains bearish, indicating significant upside potential on any bullish catalyst. Last Friday’s imposition of tit-for-tat tariffs, along with the better than expected June Employment Report, may have triggered a buy the news rally.
Sentiment has become sufficiently washed out and that even Mexican stocks staged a relief rally.
The SPX impressively regained its 50 dma and broke out through the 2740 resistance level, and filled in a gap at 2740-2755. The bulls now have control of the tape, and the next resistance level can be found at about 2800.
The short-term outlook also confirms the longer term bullish picture. The SPX staged an upside breakout from an inverse head and shoulders formation on the hourly chart last Friday. The measured target is resistance at about 2800.
In the absence of any major bearish surprises, I would expect that the market to grind upwards and possibly test the January highs. The bearish tripwire that I would watch for is whether the VIX Index can fall below its lower Bollinger Band, which can be a signal of a rally exhaustion. As well, I would watch for either overbought readings or excessive bullishness as the index tests key resistance levels.
However, in the short-term (1-2 days), the market may have run ahead of itself and need a pullback or sideways action to consolidate its gains, based on the % of stocks above the 5 dma.
Longer term indicators, such as the % of stocks above the 10 dma, suggest that the market may initially get rejected at resistance at 2800.
The market flashed a buy signal when the stochastics rose above an oversold level in late June. However, the challenge for the bulls will be to sustain some upside breadth and momentum in order to flash a series of “good overbought” readings.
If the global reflation theme is truly in play, then much will depend on the participation of non-US markets. The Euro STOXX 50 has already flashed a buy signal. Watch for a possible upside breakout from its downward sloping channel, which would be positive for the bull case.
The Shanghai market (bottom panel) remains in freefall, but the Chinese stock market is dominated by individual traders and can only be characterized as a casino. Meanwhile, the closely China-related Hang Seng Index, however, is on the verge of delivering a stochastics buy signal. Watch for possible bullish development!
Similarly, the Singapore market is testing a key support level and may be on the verge of flashing a buy signal.
My inner investor remains constructive on equity prices. My inner trader added to his long positions early last week, and he is prepared to buy more should a pullback occur. However, volatility risk is rising because of trade and foreign policy uncertainty. Traders are advised to adjusted their positions in accordance with the heightened risk environment.
Disclosure: Long SPXL
Mid-week market update: I would first like to convey to all of my American friends my best wishes for a Happy 4th of July. Enjoy you day off, as more fireworks may be on the way.
The stock market appears to be starting an oversold bounce. Callum Thomas has been conducting an weekly (unscientific) Twitter poll since July 2016. Sentiment seems to be sufficiently washed out for an oversold rally.
Similarly, breadth readings from Index Indicators also show that the market is ready for a bounce.
The big question is, “How far can stock prices rise?”
The bulls face an intermediate term problem of weakening momentum. Marketwatch highlighted the fact that both the DJIA and SPX are approaching a bearish milestone. As of last Friday, these two stock indices had been in correction territory for 99 days, which is the longest stretch since the GFC.
Ed Clissold of Ned Davis Research also expressed concern about the lack of a breadth thrust:
It’s been 140 days since the $SPX Feb. 8 low, and no breadth thrust. In 10% corrections within bull markets, longest between market low and breadth thrust was 126 days. Means market lows are NOT in place or rally w/no breadth thrust market has made new highs w/o breadth thrusts 50% of the time. BUT, those rallies have been shorter (median 6 mths) and shallower (21%) than w/breadth thrust (22 mths and 56%).
My own observation of price momentum stocks’ inability to hold their relative uptrend is also worrisome.
There are two problematical outcomes that Ed Clissold identified. First, the correction may not be over. Even if it were, any recovery is likely to be weak.
Let’s first address Clissold’s thesis that this correction may not be over. If the market is truly in a corrective phase, then we should see signs of price momentum failure (check), and breaches of uptrends. For the latter, I rely on Chris Ciovacco’s trend following model, where he calculates a 30, 40, and 50 week moving average of the NYSE Composite to determine if the intermediate term trend is flagging. As the chart below shows, there are no indicates of moving average crossovers (yet). Under these conditions, I am inclined to give the bull case the benefit of the doubt. (Note that the SPX is superimposed on the three MAs below and shown for illustrative purposes only).
Ed Clissold also made the point that corrective markets without breadth thrusts have exhibited weak rebounds. This sets up a scenario where the market rallies but either get rejected at resistance, or just make a marginal new high before failing. Should the latter occur, we would see a negative RSI divergence on the monthly chart, which could be a warning of a major market top.
On the other hand, Michael Batnick at The Irrelevant Investor believes that investors shouldn’t be overly worried about the market’s failure to make new highs [emphasis added]:
But in the five plus years since March 2013 the index (TR) has compounded at 13.2% per year. Remember, this is after gaining 26% per year over the previous four years (148% total). So it’s really okay if we go another 100 or 200 or even 300 days without a new high.
Stocks fall into the what have you done for me lately category, but if you define lately as in last few years instead of last few weeks or months, they’ve done plenty.
My own interpretation is somewhere in between the bulls and bears. On one hand, evidence of flagging momentum and the lack of breadth thrusts is problematical for the bulls. On the other hand, the Ciovacco trend model indicates that the bears have not gained the upper hand on an intermediate term time basis.
Here are my bullish and bearish tripwires. The bears have to either force a prolonged consolidation, followed by price weakness so that trend models roll over.
The bulls need to stage a strong upside breakout, preferably aided by evidence of broad global breadth. I demonstrated in a recent post (see A looming global recession, or buying opportunity?) that non-US equity market strength depends on the USD weakness. So far, the market action has been constructive. The USD Index has been rejected at resistance while exhibiting a negative RSI divergence.
The recovery in the Chinese yuan is equally bullish. The CNYUSD stabilized and rallied this week when the PBOC jawboned the exchange rate upward. As there were market fears that China may weaken its currency and start a currency war in response to Trump’s trade war, the combination of CNY strength and broad USD weakness is a welcome development which will not raise trade tensions. (Note that the chart below shows USDCNY, and a rising rate indicates CNY weakness, not strength).
For now, the SPX is cycling upward on a stochastic buy signal in the context of an uptrend. Initial resistance can be found at about 2740, with secondary resistance at 2800.
My inner investor is giving the bull case the benefit of the doubt. My inner trader is long the market, and he hopes to enjoy the ride.
Disclosure: Long SPXL
This is one in an occasional series of articles highlighting hidden investing factors. For the previous article in the series, please see What you may not know about small cap stocks.
There has been some buzz in social media about the following chart that correlates the Fed’s balance sheet with the Smart Money Index (SMI). Readers can draw their own conclusions, but the initial take has bearish implications.
What’s behind the SMI, and is it bearish for stock prices?
I am indebted to Jesse Felder, who analyzed the SMI and explained how it is calculated:
Much has been made of the plunge in the Smart Money Index this year and for good reason. In the past, major downturns in the index like we are witnessing today have proved to be prelude to major downturns in stock prices. Many have wondered about the underlying dynamics for the decline in the index of late and I think it may be fairly easy to explain. The index simply represents the difference between the first 30 minutes of trading and the last hour. The idea here is that novice traders trade the open and more experienced traders trade the close. The difference reflects the net trading of these ‘smarter’ traders.
Felder went on to discuss two reasons why the SMI might not be capturing the same effect as it did a number of years ago. The first is the proliferation of ETFs and algo trading:
However, the truth is that with the dramatic rise in the popularity of ETFs the markets have changed a great deal in the past decade. The vast majority of trading volume is not performed by individual traders but by algorithms. In addition, the vast majority of trade volume also now occurs during the last half hour of trading as passive and other systematic vehicles perform their daily balancing acts needed to match their benchmarks.
I would agree with that assessment. When I managed institutional money, I understood that the time horizon of my models were sufficiently long that I had little or no edge in short-term price movements. My typical practice was to put my orders into an algo whose objective was to meet the volume weighted average price (VWAP) of the day, while limiting my order size to a maximum of 20-30% of average daily volume. We generally missed actual VWAP by a few basis points, because the algo was not perfect in predicting the volume during the day. Nevertheless, we recognized that the trading pattern tended have a “volume smile”, as depicted in this chart of SPY.
Final hour trading patterns can be chaotic, as market makers in different instruments scrambled to square their books by the end of the day. As Jesse Felder explained, these market participants cannot be characterized as “smart money”.
Felder also cited another problem with SMI, namely stock buyback managers are precluded fro trading in the last half hour of the trading day:
Another major change in the markets in recent years is that, more than ever before stock buybacks dominate overall demand for equities. So far this year, they have surged to a record pace. Considering the fact that buybacks are prohibited during the final half hour of trading it could be that the smart money index simply reflects the difference between corporate demand for equities (early in the day) and the natural investor demand for equities (largely reflected at the close).
Ed Yardeni also highlighted stock buybacks as a source of equity demand:
Obviously, buyback activity was boosted by repatriated earnings following the passage of the Tax Cuts and Jobs Act at the end of last year. It lowered the corporate tax rate on such earnings from the 35.0% statutory rate to a one-time mandatory tax of 15.5% for liquid assets and 8.0% for illiquid assets payable over eight years. Odds are that corporations will continue to buy back their shares at a solid pace through the end of this year, though not at the record set during Q1.
Yardeni attributed rising buyback activity a favorable cost of capital comparison of equities to bonds:
[C]orporate finance managers have a big incentive to buy back their companies’ shares when the forward earnings of their corporations exceeds the after-tax cost of borrowing funds in the bond market. Using the pretax corporate bond yield composite overstates the after-tax cost of money borrowed in the bond market. The spread between the forward earnings yield and the pretax cost of funds did widen after 2004 and remained wide well into the next decade. Obviously, it did the same on an after-tax basis. … The bottom line is that as corporate managers have increased their buyback activities, their version of the Fed’s Model has probably had more weight in the valuation of stocks. In theory, this means that valuation should be determined by the corporate version of the model.
BAML projected buyback activity in their latest fund flows report, and it is expected to increase in the next quarter.
At this point, it is tempting to come to a bearish conclusion about how stock buybacks are the only activity holding up the market. However, I would point out that the stock buyback ETF (PKW) has underperformed the market in the last three years. Something else is buoying stock prices, and it’s just buybacks.
Now let’s overlay the original Fed balance sheet and SMI chart with the the PKW/SPY ratio. It’s not a perfect fit, but do you notice a pattern?
In conclusion, here is what we know about the Smart Money Index and stock buybacks:
With the caveat that correlation isn’t causation, but what conclusion should we draw from this analysis?
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
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 markets have taken a risk-off tone recently, which raises the perception of a global slowdown. The protectionist measures announced by the Trump administration have not helped matters, and it appears the global economy is becoming increasingly fragile.
Three weeks ago, I asked if global markets could rise if it depended on purely US leadership (see Can America still lead the world?). Since then, US stocks have staged an upside relative breakout against the MSCI All-Country World Index (ACWI). The performance of non-US equities in both the developed countries (EAFE) and emerging market countries (EM) appear challenging.
The following chart from Topdown Charts shows that global breadth is deteriorating. The number of countries whose stock indices are above their 200 day moving averages (dma) has plunged precipitously.
These readings either represent a terrific buying opportunity, or an ominous signal of an impending global recession. The bear case is supported by the deterioration in global economic surprise indices (ESI), which measure whether economic releases are beating or missing expectations. As the following chart shows, global ESIs have been falling. Moreover, the bottom panel shows that the percentage of countries with ESI greater than 0, indicating a balance between positive and negative surprises, are at recessionary lows.
The probability of a global recession is rising rapidly, according to Ned Davis Research.
Is this the beginning of the end? Is the world about to crash into a global slowdown? To answer those questions, I consider the outlook for the three major trading blocs, the US, China, and Europe. During the course of my analysis, I discovered a bullish catalyst hiding in plain sight.
Starting in in the United States, this region is the bright spot of global growth. The Atlanta Fed’s nowcast of Q2 GDP growth stands at a blistering 4.5%, though the estimate has pulled back from its previous highs.
An examination of global growth expectations shows that American economy stands along as surprising to the upside.
The latest update of the evolution of Q2 2018 EPS estimates from FactSet shows that earnings estimates are still rising even after the tax cut ramp. In the past, EPS estimates has shown a pattern of excess optimism and getting revised downwards as reporting date approaches.
Enough said. There is nothing wrong with the US economy. As I pointed out previously, the US is not at the immediate risk of a recession (see How close are we to a recession?)
China is a different story. We all know about the trouble brewing in China. Fathom Consulting’s indicators show that growth is rolling over, and its estimate of actual GDP growth is 6.2%, which is well below the GDP growth rate.
Financial leverage remains a problem. In the wake the PBOC’s RRR cut which cut yuan borrowing costs, non-RMB debt costs are still stubbornly high. USD borrowing costs for highly indebted Chinese companies are breaching 10%.
In addition, the PBOC’s move to cut the RRR has seriously weakened the CNYUSD exchange rate. While the RRR cut could be viewed as a technical adjustment to raise onshore liquidity so that Chinese banks could bring shadow banking assets back onto their balance sheets, it has also been interpreted as an effort to weaken the currency in the face of a brewing trade war with America. This brings up the spectre of a repeat of the episode of 2015, when a falling yuan cratered the Shanghai Index by 50%, and sparked a correction in global equity markets.
Here is the bull case. First, the current CNY weakness episode is different from 2015. As the above chart shows, the CNY devaluation occurred independent of the USD. Today, CNY exchange rate movement is largely attributable to changes in the USD Index.
As well, Leland Miller of China Beige Book stated in a CNBC interview that Chinese growth is better than expected, and Beijing appears to be starting a stimulative cycle after a period of contractionary fiscal and monetary policy. China Beige Book found that sales and profits are rising, and so are capital expenditures.
In addition, the risks of a 2015-style crash in the Chinese stock market are overblown. In 2015, the decline in Chinese stocks was fueled by skyrocketing margin loans. This time, margin loans are nowhere near the levels seen in 2015.
My own real-time market based indicators of Chinese rebalancing are on track. I track two pairs of New (consumer) China ETFs against Old (financial and infrastructure) China ETFs. Both pairs are pointing to the ascendancy of the New China.
Here is one other real-time puzzle for the China bears. If the Chinese economy is tanking, why is Australia performing so well. The top panel of the accompanying chart shows the performance of MSCI Australia against ACWI, and the bottom panel shows the AUDCAD exchange rate. The economies of both Australia and Canada have similar resource-like characteristics, except that Australia is more sensitive to China, while Canada is more sensitive to US growth.
The apparent view in Europe also appears to be dismal. Angela Merkel is fighting for her political life. European ESI is rock bottom near -100, which is as low as it can get.
The shares of Deutsche Bank are hitting new lows virtually on a daily basis, and its performance is an illustration of how Europe never solved its banking problems since the Great Financial Crisis.
On the other hand, there are a number of silver linings in the European dark cloud. First, Italian consumer confidence unexpectedly rose last week. Wait, what? Yes, that Italy. The political unrest Italy. The Italy governed by the alliance between anti-immigrant Lega Nord and popular Five-Star Movement.
In addition, European stocks appear attractive. FT Alphaville reported that Citi strategist Jonathan Stubbs pointed out that the Free Cash Flow (FCF) of European companies have more than enough to cover their dividends. Stubbs went on to forecast a dividend bull market for European equities.
BNP Paribas strategists outlined a different bull case, namely that European ESI is as bad as it gets, and therefore they are contrarian bullish:
Economic surprise rebound could be a boost? Our analysis suggests that a recovery in surprise indices from an extreme low, as is currently being seen, could be followed by nearly 15% European equity market returns over the next six months . We believe that the latest dovish ECB meeting could be a catalyst for this change.
We just need a positive growth surprise and European equities will soar.
This brings me to my final point of a bullish catalyst for non-US equity, the US Dollar. The level of the USD is important because its performance has historically been inversely correlated to the relative returns of non-US markets. The accompanying chart shows the relative performance of emerging market stocks against ACWI, along with the USD Index. Historically, the rolling 52-week correlation between the two series has been negative. In other words, USD strength leads to EM underperformance.
Here is a chart of the relative returns of South Korea. I chose the Korean market for two reasons. First, it is highly sensitive to Chinese growth because of the physical proximity and trading relationship between the two countries. As well, the South Korean economy is a global indicator of cyclical growth. The long-term correlation between the relative performance of Korean stocks and the USD Index is also negative.
Over in Europe, the chart below shows the relative performance of the Euro STOXX 50 against ACWI (all in USD). While the recent relationship has turned negative, the long-term correlation pattern between the EURUSD exchange rate, which is largely the inverse of the USD Index, has historically been positive.
The bullish catalyst hiding in plain sight for non-US stocks is USD weakness. From a technical perspective, the outlook is hopeful. The USD recently failed at resistance while exhibiting a negative RSI divergence, which is bearish for the currency.
Moreover, the summary of the Commitment of Traders report from Hedgopia indicates that large speculators have pivoted from a net short to a net long position in USD futures. Dollar bulls today no longer have COT positioning as a sentiment tailwind.
We just have to wait for a fundamental catalyst for USD weakness. This could occur in the form of a non-US growth surprise, either in Europe or China. Expectations are extremely low in Europe, and analysis from China Beige Book indicates that it has already detected a Chinese growth surprise that is not reflected in the data.
Another possible trigger for USD weakness might be Trump toning back his belligerent trade rhetoric. As he embarks on the campaign trail for Republican candidates during the mid-term elections, he is likely to receive pushback from businesses as his tariffs begin to bite. These comments from the Dallas Fed’s manufacturing survey is just one example.
Fabricated Metal Product Manufacturing
- Steel tariffs to NAFTA partners is a mistake. Higher steel prices could slow down strong projects and the manufacturing recovery which started in fourth quarter 2017
- I can’t believe the effect the tariff response has had on the metals trade. Somebody needs their head examined if they think this is good for the American economy
- We are about to raise prices for the first time in six years due to the rising cost of steel and aluminum. This is going to cause some uncertainty, with our customers looking elsewhere to purchase products we manufacture
Machinery Manufacturing
- There is lots of uncertainty among manufacturers regarding the impact of the steel tariffs. Even steel sourced from the U.S. is rapidly in price due to capacity constraints
Consider these selected comments from the Kansas City Fed’s manufacturing survey:
“The steel tariffs are not helpful. Material prices are rising and these costs have to be passed along to the consumer.”
“Bracing for the worst concerning China tariffs. We will move the last of manufacturing off shore. Loss of business due to tariffs will have a larger impact than interest rates.”
CNN Money reported that about 21,000 companies have filed for tariff exclusions, indicating that trade actions are starting to bite. Unless these business concerns are adequately addressed, this kind of grassroots opposition from businesses is likely to create electoral headwinds for the Republicans.
In summary, I began this publication with the rhetorical question. Does the current round of non-US equity weakness represent a buying opportunity, or a signal of the beginning of a global recession? Current readings indicate that no signs of a uncontrolled deceleration in any of the three major regions. The ECB recently released a round-up of eurozone growth. They attributed the slowdown to a combination of cyclical and temporary factors, but the expansion remains solid.
Overall, the economic expansion should remain solid, supported by the underlying strength of the euro area economy. Although survey results have again moderated somewhat, they remain consistent with further solid growth. Going forward, the solid growth is expected to continue, albeit possibly at lower rates, as the ECB’s monetary policy measures continue to underpin domestic demand. Private consumption should continue to be supported by employment gains and rising household wealth. Investment is expected to strengthen further on the back of very favourable financing conditions, rising corporate profitability and solid demand. In addition, the broad-based global expansion is providing impetus to euro area exports.
A “solid expansion” is also a reasonable characterization of the global economy. In the absence of recession risk, I can only conclude that the current corrective period is a buying opportunity.
The most likely bullish catalyst is USD weakness. The USD Index is technically primed to pull back. We just have to wait for the fundamental trigger.
Looking to the week ahead, the market will be faced with a number of cross-currents. Asset prices are likely to respond to the headline of the day, but it is unclear which news they will focus on. On one hand, Caixin reported that China opened the economy to more foreign investments. Such a development could be interpreted as conciliatory and serve to lower trade tensions, which is bullish.
The National Development and Reform Commission (NDRC), China’s top economic planner, and the Ministry of Commerce jointly published the 2018 version of the so-called “negative list” on Thursday, which removed foreign ownership restrictions on some industries in China.
The number of restricted items on the latest list dropped to 48 from 63 the previous year. The new list will take effect on July 28.
In a statement on its website, the NDRC said that the culling of the negative list illustrated China’s commitment to further opening up its market to foreign investment.
The new list mapped out opening-up measures in 22 industries, including banking, mining, automotive, shipping, airplane design and manufacturing, railway construction, and agriculture.
On the other hand, the expected victory of left leaning Obrador in Mexico’s election Sunday is likely to cast a chill on US-Mexican relations, and heighten the risk of a collapse of the NAFTA negotiations. As well, the news that North Korea is covertly increasing their nuclear warhead production could raise geopolitical in North Asia.
A similar set of bullish and bearish cross-currents can be found from a sentiment analysis perspective. I had written last week that one of the obstacles to a sustainable rally was the lack of fear, and the market may need a final wash-out before stock prices can rise in a sustainable fashion (see A trader`s guide to spotting market bottoms).
Since I wrote those words, BAML`s funds flow report found that last week was the second largest weekly outflow from equities in its recorded history, and it was the thrd larges ever outflow from US equities.
In addition, the CBOE put/call ratio spiked indicating rising anxiety. Even more encouraging were the days the put/call ratio rose when the market rallied, indicating price strength skepticism.
Jeff Hirsch at Trader’s Almanac also observed that July 1 is seasonally the second best day of the year for stock prices.
On the other hand, I pointed out that Saturday, June 30, is a major QT day for the Fed, when over $30b in Treasury securities are rolling off the balance sheet (see 4 reasons why the bull is still alive).
Kevin Muir at the Macro Tourist observed that QT days have been bearish for equities. Monday, July 1, will be a major test of the QT market weakness thesis.
My inner investor remains constructive on equity prices. The intermediate term outlook remains positive, as measured by breadth and credit market risk appetite.
My inner trader covered his short positions early last week and dipped his toe in on the long side. He expects to add to his long position on Monday should the market hit an air pocket, or if the SPX stages an upside breakout above resistance at 2740 and fills the gap at 2740-2750.
Disclosure: Long SPXL
Now that the SPX flirted with the combination of the 2700 level and its lower Bollinger Band (BB), it’s time to see if the market is ready to bottom on a short-term and intermediate basis.
Let`s analyze outlook from the perspective of breadth, momentum, and sentiment.
The readings from breadth and momentum indicators are mixed. The breadth reading from Index Indicators certainly indicates that the market is oversold, and it would be no surprise for stock prices to bottom and rally from these levels. But is it sufficiently oversold for a durable bottom?
I wrote in my last post (see 4 reasons why the bull is still alive) that I was waiting for a re-test of the lows that was accompanied by a positive RSI divergence. We got the re-test yesterday (Wednesday) as the SPX undercut its previous low, but neither RSI-5 nor RSI-14 exhibited a positive divergence. Arguably, these readings could be interpreted as bearish because RSI-14 put in a lower low, indicating negative momentum, and RSI-5 remained oversold, indicating a “bad oversold” condition that implies further downside.
On the other hand, both RSI-5 and RSI-14 did show positive divergences on the hourly chart. That’s a thin thread for the bulls, but at best we can call it a wash.
There is both good news and bad news for the equity bulls on the sentiment front. Let’s start with the good news. AAII sentiment plunged this week when bullish sentiment pulled back and bearish sentiment spiked. While sentiment can get more bearish, the experience in the last 5 years has shown that downside risk is limited at these sentiment levels. I would note, however, that AAII sentiment is at best an intermediate term indicator and these charts are weekly charts. They tell us little about what might happen tomorrow or the day after.
One worrisome feature of sentiment models is the market is not just showing enough panic for a durable bottom. None of the components in my Trifecta Bottom Spotting Model is flashing a buy signal. At a minimum, I would look for the VIX term structure to invert, indicating widespread fear, and TRIN to spike above 2, indicating a margin clerk/risk manager induced price insensitive capitulation. None of this has happened yet.
Putting it all together, I can conclude that the short-term bottom is near and downside risk is relatively limited, but the market is in need of a final flush before stocks can stage a sustainable rally. My inner trader covered his shorts earlier this week and dipped his toe in on the long side. He is waiting for signs of a capitulation low before fully committing himself as an unabashed bull.
Disclosure: Long SPXL
Mid-week market update: In light of the recent market turmoil, I thought I would publish my mid-week market update early. The Shanghai Index moved into bear market territory by declining 20% on a peak-to-trough basis overnight. The SPX is testing its 50 day moving average (dma). Europe is struggling as both the FTSE 100 and Euro STOXX 50 have violated near-term support levels.
Is this a warning that the bull is dying?
I have some good news and bad news. The good news is the bull market is still alive. The SPX is undergoing a correction, but it remains in an uptrend within a range-bound consolidation that began in February.
The bad news is traders need to expect more short-term pain.
In addition to the above chart showing the SPX in an uptrend, a number of market internals indicate that the bears have not gained control of the tape. Consider, for example, the relative performance of defensive sectors. Consumer Staples stocks are still in a multi-year downtrend relative to the market, and Utilities appear to be trying to be bottom, but they have not shown any inclination to stage a relative breakout beyond their consolidation band.
One other clue about market direction comes from the performances of Financial stocks. The sector has been lagging the market lately, but why are the high-beta broker-dealers beating the sector? Broker-dealer stocks have historically tracked the returns of the sector in general, and in a bear phase, you would expect them to show greater weakness. Instead, they are outperforming.
In short, these charts indicate that the intermediate term outlook for US equities remain bullish.
Here is the bad news. Monday’s selloff created too much technical damage for the market to make a V-shaped bottom. In particular, market leadership such as large cap NASDAQ stocks are rolling over. The NASDAQ 100 has breached an uptrend on both an absolute basis and relative to the market.
Equally serious is the breach of the relative uptrend by the price momentum factor. Assuming that the bull run were to continue, we will have to see a transition from Tech and momentum to another market leader.
One candidate for continued leadership are small caps. The performance of small cap stocks, which have also been market leaders, is more constructive. The Russell 2000 violated an uptrend line on an absolute basis, but its relative uptrend remains intact. However, small caps comprise a tiny weight off the overall market, and they cannot carry the rally by themselves.
While the intermediate term structure is still bullish, these trend violations have created sufficient technical damage that cannot be fixed with a simple V-shaped bottom. The most likely scenario is the market undergoes several days of choppiness that end with a second test of the previous bottom before it can stage a sustainable rally.
I tweeted the signs of a setup for a buy signal on Monday when the VIX Index rose above its upper Bollinger Band (BB). Past reversions of the VIX below its BB have been good trading buy signals. I would also point out that in two of the three past instances when these signals have occurred in the last six months, the market weakened after the buy signal to retest the previous lows before rallying. The retests were accompanied by positive divergence on RSI-5.
The combination of bullish intermediate backdrop, high levels of technical damage, and short-term oversold readings all point to a similar pattern of rally and retest of the lows.
Subscribers received an email alert that my inner trader had covered all of his shorts and taken an initial (small) long position. He will be waiting for the retest in the next few days to add to his long positions.
One possibility for the timing of a retest of the lows could occur this coming Monday. In the past, the stock market has weakened on days when the Fed has conducted its Quantitative Tightening programs when securities were allowed to mature and roll off its balance sheet (see Offbeat Thursday and Friday forecasts). According to the New York Fed, the next big QT day is June 30, 2018, when over $30b of Treasury securities will be maturing. As June 30 is a Saturday, the market effect would not be seen until the next trading day, which is Monday.
My inner trader has taken profits on his shorts and taken a long position, but the commitment is not large.
Disclosure: Long SPXL
A recent Axios story featured an interesting political perspective on Trump’s possible strategy for the midterm elections:
An odd paradox in defining this moment in politics: The more President Trump does, says and tweets outrageous things, the more his critics go bananas and the better he does in the polls.
Indeed, Gallup’s tracking poll of presidential approval has been steadily rising for much of this year. CNBC also reported that a majority of Americans approve of Trump’s handling of the economy for the first time.
Axios went on to state that this strategy is risky because it is entirely dependent on energizing his support base:
The rise in Trump’s numbers, and the shrinking Democratic advantage in House races, are reinforcing Trump’s worship of his own instincts on policy.
- Except many of these choices may make his reelection even more dependent on his worshipful base, and less appealing to swing voters.
- It’s a circular political strategy that relies on ignoring independent voters, and assuming they won’t turn out.
- It creates a narrow, treacherous path to reelection.
Call it a short-term gain for medium term pain electoral approach that creates significant market risk.
One example of Trump’s electoral approach is his latest tweet that raises trade tensions with allies that spooking the markets today.
While the theme of unfair trade may play well with his base, the real pain in the developing trade war hasn’t been fully felt in America’s heartland. Nevertheless, Reuters reported that anxiety levels are rising.
Farmers overwhelmingly supported Trump in the 2016 election, welcoming how he championed rural economies and vowed to repeal estate taxes that often hit family farms hard.
Now those same farmers are seeing crop prices fall and export markets shrink after Trump’s tariffs triggered a wave of retaliation from buyers of U.S. apples, cheese, potatoes, bourbon and soybeans.
“A lot of people in the ag community were willing to give President Trump the benefit of the doubt,” said Brian Kuehl, executive director of Farmers for Free Trade. “The reason you are seeing people increase the pressure now is because the pressure is increasing on them. Now the impact is really starting to hit. It is not something you can just take lightly.”
His group, along with the U.S. Apple Association, will start running television ads on Tuesday attacking Trump’s tariffs in Pennsylvania and Michigan, apple-growing states that could play a role in which party controls Congress after the November elections…
Even before trading partners imposed tariffs, U.S. farmers were facing a tough year. Net farm income was expected to fall 6.7 percent to $59.5 billion in 2018, according to the U.S. Agriculture Department.
Now an even more bearish tone hangs over agricultural markets due to trade spats with NAFTA partners Canada and Mexico, plus mounting tensions with China and Europe.
CNN featured a similar report about the growing unease in farm country:
But in southern Minnesota, where generations of soybean farmers and pork producers are already used to economic uncertainty, Trump’s tough talk on trade has been demoralizing.
The same tariffs that Trump touted on Wednesday have left these growers as collateral damage in an escalating fight with China. Tariffs beget tariffs in the fight, and the Chinese have targeted both American staples, pushing down commodity prices and sinking farm values.
As Republicans and Trump eye Minnesota as a key state for 2018 and beyond, they run the risk that the same tough talk on trade that made Trump so popular in the state might backfire on some of his most loyal supporters.
Time is of the essence, too. While summer is the growing season for soybeans, farmers will begin harvesting in September and October, weeks before midterm elections that will surely be seen as a political referendum on the President.
Moreover, Trump’s industrial tariffs are not hitting their mark. In an era of globalized supply chains, tariffs on intermediate goods have a devastating effect on manufacturing, according to analysis from the Peterson Institute.
An example of the collateral damage is this story about a Missouri nail manufacturer that is at risk of closing its doors because it is owned by a Mexican company that imports Mexican steel as the raw material for its products.
A spokesperson for a Missouri manufacturer of nails says President Donald Trump’s tariff on steel has cut orders by over 50 percent and may result in the business being shut down, putting close to 500 employees out of work.
According to MissouriNet, Mid Continent Nail Corporation in Poplar Bluff, which is the last major nail producer in the U.S. — has already laid off 60 temp workers and is making plans to lay off 200 permanent employees by the end on July in order to stay afloat. Should the business stay in a death spiral company officials warn they could close by Labor Day.
The report notes that Mid Continent is one of the largest employers in Butler County and eliminating the remaining 440 jobs, which pay an average of $12.50 an hour, would devastate one of the poorest counties in the state.
Already, Bloomberg has reported that Harley-Davidson is considering moving production to the EU as a result of Europe’s retaliatory tariffs.
Trump’s electoral strategy is risky because it trades off the immediacy of rising approval against the costs of tariff protection. It’s a race against time. Can the Republicans get the Trump base to turn out and support them before the trade wars collapses the economic roof? How many Trump supporters are willing to lose their jobs, or bankrupt themselves to Make America Great Again?
I wrote in my last post that one of the greatest threat of a trade conflict is business confidence (see How close are we to a recession?). In particular, I highlighted a speech by Atlanta Fed president Raphael Bostic about his observations of the evolution of confidence:
I began the year with a decided upside tilt to my risk profile for growth, reflecting business optimism following the passage of tax reform. However, that optimism has almost completely faded among my contacts, replaced by concerns about trade policy and tariffs. Perceived uncertainty has risen markedly. Projects already under way are continuing, but I get the sense that the bar for new investment is currently quite high. “Risk off” behavior appears to be the dominant sentiment among my contacts. In response, I’ve shifted the risks to my growth outlook to balanced.
Business confidence is a funny and fragile thing. Right now, small business optimism stands at its second highest level in its 45-year history. What happens if the trade war effects start to bite, and begin to hurt sales and employment?
I had also asked in my last post what might happen if the Democrats regain control of Congress. Could the tax cuts get reversed, which would spook the markets?
A reader pointed out a Bob Shiller commentary in the New York Times that corporate tax cuts are difficult to reverse unless there is a war. I stand corrected. However, I can easily envisage the Bernie Sanders and Elizabeth Warren wing of the Democrats becoming ascendant after the next election and starting a new war. At a minimum, expect the deregulation drive to end. Another obvious target might be Big Tech such as Facebook, Google, and Amazon, which are becoming pariahs because of the sheer creepiness of their surveillance business models (see Peak FANG?).
As fund flows have followed performance, BAML highlighted the staggering level of fund flows into the technology sector this year. If they come after the FAANG stocks, what will happen to market leadership, and market confidence?
Bottom line: Trump’s electoral strategy creates a high level of market risk. First, the immediate costs of protectionism are becoming clear, and business confidence could tank as a result. In addition, the electoral consequences of a Democrat victory in November also raises the stakes on the prospects of re-regulation, with a particular focus on the FAANG stocks, which are today’s market leaders.
If Trump chooses to stay with this electoral strategy of energizing his base, then expect further market choppiness in the days and weeks ahead.
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
A minor scuffle erupted in the blogosphere last week. Fed watcher Tim Duy took issue with David Rosenberg’s recession call with an article entitled “No, A Recession Is Not Likely In The Next Twelve Months. Why Do You Ask?“. While Duy acknowledged that Fed policy is likely to be the trigger for the next recession, he disputed Rosenberg’s contention that a recession is about to begin.
I buy the story that the Fed is likely to have a large role in causing the next recession. Either via overtightening or failing to loosen quickly enough in response to a negative shock…
But the timeline here is wrong. And timing is everything when it comes to the recession call. Recessions don’t happen out of thin air. Data starts shifting ahead of a recession. Manufacturing activity sags. Housing starts tumble. Jobless claims start rising. You know the drill, and we are seeing any of it yet.
For a recession to start in the next twelve months, the data has to make a hard turn now. Maybe yesterday. And you would have to believe that turn would be happening in the midst of a substantial fiscal stimulus adding a tailwind to the economy through 2019. I just don’t see it happening.
Duy does not believe that Fed policy is tight enough to cause a recession in the near future:
As far as the Fed is concerned, I don’t think we are seeing evidence that policy is too tight. The flattening yield curve indicates policy is getting tighter, to be sure. But as far as recession calls are concerned, it’s inversion or nothing. And even inversion alone will not definitively do the trick. I think that if the Fed continues to hike rates or sends strong signals of future rate hikes after the yield curve inverts, then you go on recession watch.
With inflation still tame, however, the Fed may very well flatten the yield curve with two more hikes and then take a step back. To be sure, it will be hard to stand down or even reverse course on the yield curve alone. After all, the yield curve is a long leading indicator. It will be the outlying data. But there is a reasonable chance the Fed will not tempt fate in the absence of a very real inflationary threat.
Who is right? Tim Duy or David Rosenberg? In the past, every recession has been accompanied by a bear market.
Is a recession just around the corner?
If Fed policy is one of the main drivers of the next recession, then some key questions come to mind:
Fed chair Jerome Powell gave an important speech last week outlining his approach to monetary policy. Powell deviated from Fed orthodoxy by casting doubt on the effectiveness of the Phillips Curve in an environment of well-anchored inflationary expectations:
What would be the consequences for inflation if unemployment were to run well below the natural rate for an extended period? The flat Phillips curve suggests that the implications for inflation might not be large, although a very tight labor market could lead to larger, nonlinear effects. Research on this question is ambiguous, again reflecting the limited historical experience. We should also remember that where inflation expectations are well anchored, it is likely because central banks have kept inflation under control. If central banks were instead to try to exploit the nonresponsiveness of inflation to low unemployment and push resource utilization significantly and persistently past sustainable levels, the public might begin to question our commitment to low inflation, and expectations could come under upward pressure. So far, we see no signs of this. If anything, some measures of longer-term inflation expectations in the United States have edged lower in recent years.
If not inflation, then what should the Fed focus on? Powell went on and focused on financial imbalances as the cause of recessions [emphasis added]:
Can persistently strong economic conditions pose financial stability risks? Of course, strong economic conditions are a good thing! Such conditions can make the financial system better able to absorb shocks through strong balance sheets and investor confidence. But we have often seen confidence become overconfidence and lead to excessive borrowing and risk-taking, leaving the financial system more vulnerable. Indeed, the fact that the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions. Today I see U.S. financial stability vulnerabilities as moderate and broadly in line with their long-run averages. While some asset prices are high by historical standards, I do not see broad signs of excessive borrowing or leverage. In addition, banks have far greater levels of capital and liquidity than before the crisis.
Powell speech can be seen from both dovish and hawkish viewpoints. The lack of inflationary pressures indicates that Powell is reluctant to be overly hawkish in raising rates. On the other hand, he is likely to keep on hiking and normalizing policy as long as financial stability risks are low.
How low is financial stability risks, and what are long leading indicators telling us about the risks of a recession? Starting with the indicators from the Chicago and St. Louis Fed, current indicators of financial stress are tame, which are signals that credit conditions are still relatively easy.
My other monetary condition recession indicators are all in neutral territory but deteriorating. In the past, either real M1 or M2 growth has turned negative ahead of recessions. Money supply growth is still positive, but decelerating. At the current rate of deceleration, real M2 growth will turn negative in Q3 or Q4.
In the past, annual changes in employment and annual changes in the Fed Funds rate has converged ahead of recessions. At the current pace, the two lines are expected to cross late this year if the current pace of convergence continues.
Yield curve inversions have also been an uncanny forecaster of past recessions. The yield curve is flattening, and should the Fed raise rates at the current pace, we should see an inverted yield curve either in late 2018 or early 2019.
While I do not believe in anticipating model readings, the current trajectory of these long leading indicators suggest that we will get a recession warning in late 2018, and a possibly recession in late 2019. Since the markets look ahead 6-12 months, that would put the window for a stock market top some time between this winter and next summer. I would caution that this is a highly speculative forecast, as we do not have the recession signal yet. In practice, I prefer to stay “data dependent” in determining my investment view.
Assuming the speculative scenario that a recession were to begin in late 2019. That implies a probable market top about late this year. However, there are a couple of factors that could either spook the markets early or accelerate the recession schedule. The biggest threat is a trade war.
Much depends on how a trade war affects business confidence. Reuters reported that Jerome Powell expressed concern about rising business uncertainty because of trade policy.
“Concerns seem to be rising,” said Powell, speaking to a European Central Bank conference in Portugal. While Powell said he would not comment on specific proposals from the Trump administration, “for the first time we are hearing about decisions to postpone investment, postpone hiring, postpone making decisions. That is a new thing. If you ask is it in the forecast yet, is it in the outlook, the answer is no. And you don’t see it in the performance of the economy.”
Atlanta Fed President Raphael Bostic echoed the Fed Chair’s remarks in a recent speech:
I began the year with a decided upside tilt to my risk profile for growth, reflecting business optimism following the passage of tax reform. However, that optimism has almost completely faded among my contacts, replaced by concerns about trade policy and tariffs. Perceived uncertainty has risen markedly. Projects already under way are continuing, but I get the sense that the bar for new investment is currently quite high. “Risk off” behavior appears to be the dominant sentiment among my contacts. In response, I’ve shifted the risks to my growth outlook to balanced.
One important real-time indicator of trade jitters is soybeans, which is a target of China’s retaliatory tariffs. The bad news is prices have cratered. The good news is they are showing signs of stabilization, indicating that the initial round of panic may be playing out.
If Trump’s trade dispute with China extends into September, which is harvest season for soybeans, then a political dynamic begins to come into play. The negative effects of low agricultural product prices will begin to seriously affect the Republicans’ electoral prospects in the farm states, which formed the bulk of Trump’s support in 2016.
Should the Democrats make significant headway in the midterm elections and win back control of Congress, the market will begin to discount the reversal of the recently passed tax cuts. The boost to corporate earnings from fiscal policy in 2018 will turn into a headwind in 2019. The combination of contractionary fiscal policy and monetary policy could prove to be a potent combination that crashes economic growth. Watch the polls in the fall, as the markets will anticipate outcomes before the November elections.
The following chart from FactSet tells the story of how forward EPS, which are coincident with stock prices, have evolved this year. Earnings estimates rose in two phases, beginning with a tax cut surge, and then followed by a continuing cyclical rebound on business optimism. What if the Democrats retake Congress and the market begins to anticipate the reversal of the tax cuts?
While I remain intermediate term bullish on equities, I recently turned cautious (see Is the trade war correction over?). While the window for a correction that conform to the rally and pullback pattern that began in March is nearly closed, short-term readings suggest that a final flush may be in order before stock prices can stage a sustainable rally.
The most disturbing technical pattern is faltering leadership from the NASDAQ leadership. The NASDAQ 100 breached an uptrend line while exhibiting a series of negative RSI divergences.
Mid cap stocks also display a similar pattern of uptrend violation, and the weakness was confirmed by declining RSI momentum.
While small caps remain in an uptrend, I highlighted the vulnerability that these stocks face because of their high correlation with the USD Index (see What you may not know about small cap stocks). Equally disturbing is the uptrend violation shown by the SPX.
These technical conditions suggest that the market may either need to consolidate sideways, or it needs a final capitulative selloff to flush the weak hands out of their long positions.
I will be monitoring the performance of the price momentum factor, which remains in a relative uptrend. Watch for a test of the trend line should the market panic, and see if the uptrend stays intact.
My inner investor remains constructive on stocks. My inner trader is still tactically short, but his commitment is relatively light.
Disclosure: Long SPXU
This is one in an occasional series of articles highlighting the hidden investing factor exposures, starting with small cap stocks. Small caps have been on an absolute tear lately, both on an absolute basis and relative to large caps.
Does that mean you should jump on the small cap momentum train?
Momentum is evident even from a fundamental viewpoint. Analysis from Yardeni Research reveals that small cap earnings estimates have been rising faster than large caps, even after the tax cut earnings surge. If you squint, you will see that the slope of small cap EPS revisions is steeper than large cap revisions.
However, small cap outperformance can be partly explained by their USD exposure. The correlation between the size factor and the USD is evident in the chart below.
While correlation isn’t causation, there are valid fundamental reasons for this relationship. Large cap companies tend to be more global in nature, and therefore more sensitive to fluctuations in exchange rates. A rising USD hurts large cap earnings, but domestically oriented small caps earnings improve on a relative basis.
From a technical perspective, some caution is warranted on the USD. The USD Index is currently testing a key resistance level, while exhibiting a negative RSI divergence.
Under such bearish USD circumstances, investors are cautioned to give some second thought to the continued outperformance of small cap stocks.
Mid-week market update: The fate of this market is becoming highly news dependent. Ed Yardeni recently stated in on CNBC that he has never seen a “president this bullish and bearish at the same time”. The market wants to go up on earnings, but it has been held back by Trump`s protectionism.
Will stock prices rise or fall? Is the trade war correction over?
Unfortunately, my time machine is in the shop getting fixed. However, we can rely on technical and sentiment analysis to give us some clues. First and most encouraging was the market price action overnight. The Shanghai market stabilized and showed a minor gain after the horrendous drop Tuesday. The stock markets of China’s major Asian trading partners also showed signs of recovery, and the markets in Hong Kong, South Korea, and Singapore successfully tested key support levels.
In addition, I had highlighted a technical pattern on June 10, 2018 (see Can America still lead the world?) indicating that the market had broken down out of a series of bearish wedges. Each breakdown was accompanied by either the VIX breaching or touching its lower Bollinger Band. Subsequent corrections have lasted roughly two weeks, and each pullback have been increasingly shallow, which is intermediate term bullish.
If history is any guide, and notwithstanding more trade war jitters, the market’s weakness should end this week. Tactically, it is less clear whether we have seen the actual bottom of this correction just yet.
However, my sentiment models suggest that fear hasn’t spike sufficiently for a durable bottom. Mark Hulbert wrote this week’s market weakness may not just attributable to the Sino-American trade spat, but excessively bullish sentiment among NASDAQ market timers. His Hulbert Nasdaq Newsletter Sentiment Index (HNNSI) reached an extreme bullish reading. In other words, sentiment had reached a crowded long, and the news of the trade friction was just the spark for the sell-off.
Other sentiment indicators are also showing signs of complacency. The latest CBOE put/call ratio stands at 0.88, which can hardly be interpreted as a high level of fear.
The option market is also relatively sanguine about this week’s pullback. Neither the VIX Index is anywhere near its upper Bollinger Band, nor is the term structure of the VIX inverted. While neither of these signals need to be triggered for me to generate a trading buy signal, indications of spiking fear would supportive signs of a trading bottom.
Stock prices are also facing a seasonal headwind this week. Rob Hanna at Quantifiable Edges found that the week after June OpEx has been weak. On average, stock prices have historically fallen steadily during the week, except for a reflex rally on Wednesday.
In conclusion, the markets appear to be trying to bottom here, but the shape of the bottom is more likely to be a W rather than a V. Nevertheless, the intermediate term outlook remains bullish. The market leaders, the NASDAQ and small cap stocks, made fresh all-time highs today. It is difficult to interpret such developments as anything but bullish.
Subscribers received an email alert yesterday (Tuesday) that I was ready to cover my short position and go long if the SPX tested its support at 2735-2740. It never reached that level, and therefore my inner trader remains short in anticipation of a retest of Tuesday`s lows in the next few days.
Disclosure: Long SPXU
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 the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.
Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.
The latest signals of each model are as follows:
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.
War is hell, even trade wars. The world is again at risk of lurching into a global trade war. Last Friday, Trump announced the imposition of 25% tariffs on $34 billion in Chinese exports, with another proposed list totaling $16 billion that is subject to public comment and review. China has responded with retaliatory tariffs on $34 billion in American exports, mostly in agricultural commodities and automobiles.
Under these circumstances, it is useful to revisit my analysis written in January of the possible fallout under such a scenario (see Could a Trump trade war spark a bear market?). I had highlighted analysis from the Peterson Institute in 2016 modeling the effects of a full blown and abortive trade war on the US economy. The economy would lapse into a mild recession in the former case, but sidestep a recession in the latter case. However, the results did appear anomalous as I pointed that that the observation of (then) New York Fed President Bill Dudley that the economy fell into recession whenever unemployment rose 0.3% to 0.4%, as it would in the modeled result of the abortive trade war.
President Donald Trump tweeted in the past that “trade wars are good, and easy to win”. What if he is right, and trade partners either backed down from retaliatory tariffs, or only imposed limited tariffs?
How would “winning” a trade war look like? Let’s put on our rose colored glasses and take a look.
Trump’s trade policy has two main objectives. The long term objective is to bring manufacturing jobs back into the United States, and a shorter term goal is to shrink the trade deficit.
For some perspective, Brad Setser at the Council on Foreign Relations depicted the US current balance in two important ways. The first is in absolute dollar terms.
The second is as a percentage of US GDP.
Setser went on to observe that China and Germany have the lion’s share of the global manufacturing trade surplus:
China’s annual manufacturing surplus is still around $900 billion (for comparison, Germany’s manufacturing surplus is around $350-400 billion depending on the exchange rate and the U.S. deficit in manufacturing is around $1 trillion) and doesn’t show any sign of falling. I don’t see signs that the (modest) real appreciation this year will seriously erode China’s competitiveness—though it should moderate China’s export outperformance (Chinese goods export volumes grew at a faster pace than global trade in 2017).
The accompanying chart from Our World in Data shows trade flows as a share of GDP. The American economy is less sensitive to trade flows than either China or Europe, though the trade sensitive of European countries is exaggerated in the chart as much of the trade represent flows within the EU. Nevertheless, exports make up about 20% of China`s GDP, and Germany is the locomotive of export growth in Europe. These circumstances make them especially vulnerable to trade sanctions.
Moreover, China’s financial conditions are coming under increasing stress. A trade-induced slowdown is the last thing the economy needs. Last week, I had highlighted analysis from Callum Thomas that both fiscal and monetary policy were tightening.
The New York Times reported that China’s credit crackdown raising the risk of tanking its economy:
Beijing has been concerned in recent years about the increased reliance on credit to keep the economy expanding briskly, worrying that it could lead to a financial crisis, or to a long period of stagnation like the one in Japan after the real estate market burst in the early 1990s.
But curbing debt may have significant consequences in China and elsewhere. Countries around the world are much more closely tied to China than ever before, because of its role not just as the world’s biggest manufacturer by far but also, increasingly, as a consumer. An economic slowdown in China — coupled with the knock-on effects of widening trade disputes and slowing growth in Europe — may augur poorly for a global economy that even recently seemed in rude health.
Domestically, China’s credit crackdown has affected smaller businesses hardest. Though the country often appears to be dominated by its vast conglomerates and hulking state-owned enterprises, its economy is, in reality, somewhat more reliant on small businesses than its Western counterparts. And the way Beijing has gone about curbing lending in recent months is unintentionally hitting the most entrepreneurial segments of the economy, the governor of China’s central bank acknowledged in a speech on Thursday in Shanghai.
Beijing is facing the conundrum of trying slow credit growth while sustaining economic growth. They do not the additional headache of a trade war to exacerbate the effects of any slowdown.
Europe, on the other hand, faces a different kind of fragility. In addition, to the well known problems of trade openness, the European banking system never solved the excess leverage problems from the last cycle. As a result, ever small wobbles in the EU economy will have an outsized effect on financial stability. The poster boy for Europe`s banking problems is Deutsche Bank, whose share prices is now trading at levels below the lows set during the Great Financial Crisis. Moreover, European financial stocks have dramatically underperformed US financials during the same period.
What if trade partners like China and the EU decided to “eat the loss” and either refrained from trade retaliation, or responded with light, but highly targeted retaliation? That’s because global tariff rates are already very low, especially in the developed economies. Trump’s imposition of a tariff amounts to an import tax that hurts Americans as much as the exporting producer.
Why not do nothing and either refrain from retaliation or retaliate in a highly surgical fashion? Let’s consider such a scenario of the short run effects on the exporting country.
Begin with China. Chinese economic growth is highly dependent on trade, and tariffs would bring economic growth to a screeching halt. A Chinese growth slowdown would crater the economic growth of most of Asia, and commodity suppliers like Australia, Canada, and Brazil.
Europe would not fare any better. German exports would tank, and Germany has been the engine of growth in the eurozone. The European banking system would wobble, and financial risk would spike. At a minimum, we would see a magnified repeat of the Greek Crisis of 2011.
How would the markets react? Risk-off would be the order of the day, but with the US economy partly insulated from these offshore troubles, Treasury assets would become the safe haven of choice. The USD would soar, which makes US exports less competitive.
So much winning.
How would the Fed react? Fed watcher Tim Duy gamed the Fed’s reaction from a possible trade war. In a limited trade war, the Fed would do nothing:
Currently, the Fed looks on course for three –and maybe four — rate hikes in 2018 of 25 basis points each. With economic growth sufficient to put downward pressure on an already low unemployment rate, central bankers will seek to push policy rates to a neutral level. Otherwise, the Fed believes the economy faces a risk of overheating.
Escalating trade battles potentially impact this forecast by causing demand to contract and supply shocks. An example of negative demand shocks are retaliatory tariffs on U.S. manufactured goods and farm products. If America’s trading partners focus primarily on tariffs that narrowly target firms in Republican leaning states, such as levies on Tennessee whiskey, Harley-Davidson motorcycles and cheese, the overall impact on economic activity will be fairly minimal.
Narrowly targeted retaliation by our trading partners will thus induce more political and local pain than aggregate weakness. And note that some of the overall damage on manufacturing will be mitigated by the rebound in oil prices and associated increase in drilling activity. If the overall economic impact of such retaliation is minimal, so too will be the Fed’s response. To be sure, if the negative demand shock is stronger than I expect, the Fed will see diminishing risk of overheating and change policy in a more dovish direction.
Another possibility is the Fed continues on its tightening path by looking through the inflationary implications of higher tariffs:
More interesting than demand shocks, which have straight forward implications for policy, is the possibility that the Trump administration’s approach yields an escalating supply shock that restricts the productive capacity of the U.S. Such shocks both constrain economic activity and raise prices. The U.S.-imposed tariffs on steel are a perfect example. Indeed, the possibility of a broad-based disruption from such tariffs is exactly why a nation should be wary of targeting intermediate goods in a trade war.
It is tempting to conclude that the Fed will react to a negative supply shock via tighter policy, especially when central bankers already face the prospect of an overheated economy. This, however, will not be the case as long as the Fed believes inflation expectations remain well-anchored. Rather than shift to a more hawkish stance, the Fed will look through any spike in prices as temporary and instead focus on the negative impacts on economic activity. If they conclude that those negative impacts will continue even after the price shock fades, central bankers might even shift to a more dovish stance.
The final outcome to consider is the Arthur Burns Fed solution of an accommodative Fed, which sets off an inflationary spiral:
The Fed would be driven in the opposite direction if the economy faced a series of negative supply shocks, global trade conflicts escalate and those shocks trigger a change in consumer behavior such that inflation expectations become tilted to the upside. That kind of shift occurred in the late 1960’s, leading to the Great Inflation period. With that episode still looming large in the Fed’s psyche, policy makers would respond with a more hawkish policy stance.
The last case represents a worst-case scenario for financial markets, in that it’s a toxic combination of faster inflation, weaker growth and tighter monetary policy. It would also put the Fed in the Trump administration’s crosshairs. I very much doubt President Donald Trump would sit quietly and respect the Fed’s independence if economic growth faltered. To be clear, this is not my baseline scenario. My baseline is that the scope of the trade impacts in aggregate are too limited to change the direction of policy. But market participants should remain wary of risks to this baseline.
Duy’s analysis suggests that the Fed would continue to tighten in the face of slowing economic growth from abroad. The US economy would then suffer the double whammy of hawkish Fed policy that tightens the economy into a slowdown, and declining demand from abroad.
A recession would ensue. USD assets would rise as Treasuries become the ultimate safe haven, which makes US exports even less competitive. The good news is the trade deficit tends to fall in a recession. So much winning, how can anyone stand it?
The above analysis is dependent on the no or limited retaliation from trade partners. What could happen if the worse happened and the war disintegrated into tit-for-tat rounds of rising tariffs? The Washington Post reported that former Trump advisor Gary Cohn stated that a trade war could undo the benefits of the last tax bill [emphasis added]:
Gary Cohn, who served as Trump’s director of the National Economic Council but left amid a rift over the president’s trade policies, said that retaliatory tariffs between countries could drive up inflation and prompt American consumers to take on more debt, possibly pushing the country into another economic downturn.
“If you end up with a tariff battle, you will end up with price inflation, and you could end up with consumer debt,” Cohn, a former Goldman Sachs executive, said at a Washington Post event. “Those are all historic ingredients for an economic slowdown.”
Asked if the trade battle could erase the gains to the American economy from the tax law, Cohn said: “Yes, it could.”
Megan Greene of Manulife Asset Management wrote in the FT that, in the case of a limited trade skirmish, the benign outcomes from macro-economic forecasts don’t tell the entire story.
However, the models largely ignore that the effects of a trade war would hit some industries and regions harder than others. This will become even more of an issue if President Trump follows through on threats to impose 25 per cent tariffs on imported automobiles. The Canadian, Mexican and German auto industries would suffer significantly, even if the overall impact is muted.
These benign predictions are probably flawed in other ways. First, most models are not granular enough to reflect the disruption in global supply chains that would result from tariffs. These are likely to provide the biggest drag on growth from the tension over trade. Some car parts cross the Mexican, Canadian and US borders several times before they end up in a finished vehicle. If Nafta collapses, would carmakers raise prices, absorb additional tariffs or find ways to procure all of their parts in one country?
Second, it is difficult to model the impact of trade-related uncertainty on business sentiment. The stalled Nafta negotiations are starting to affect Canada through lost or deferred business investment.The trade wars could quickly extend into areas that are even harder to quantify. When the US first threatened an additional $100bn in tariffs on Chinese imports, it became clear that China could not respond in kind; it simply does not import enough US goods. But it could hit back by creating more bureaucratic hurdles for US companies operating in China, and interfering with licensing. The impact of such steps would be hard to measure in economic forecasts.
The political blowback is likely to be fierce for Trump. Even in the case of a trade dispute with Canada, CNBC reported that states that supported Trump would get hit the hardest in a Canada trade war.
Further, a report surfaced that Canada floated the idea of sanctioning Trump’s businesses rather than retaliating with more tariffs:
Canadian Foreign Minister Chrystia Freeland said Tuesday that she is open to using a law normally reserved for leaders responsible for human rights violations to impose retaliatory sanctions on the Trump Administration. Those sanctions would target the administration itself rather than the American people.
The Justice for Victims of Corrupt Foreign Officials Act, also known as the Magnitsky law, would allow Ottowa (to impose travel bans and asset freezes on foreign leaders. Regina-Lewvan MP Erin Weir proposed the measure during a Question Period with Freeland earlier this week. Weir noted that the law might be particularly useful because Trump has “made himself vulnerable” by maintaining personal business interests.
The Europeans have been the masters of politically targeted trade retaliation. The Chinese have also learned, by imposing tariffs on American farm exports, whose producing states mainly voted for Trump in the last election.
In short, war is hell. Even if you win, a one-sided trade war is likely to induce a global recession.. A full-blown trade war is likely to cause even greater damage.
If the market had been really spooked about trade policy, stock prices would have been off 1-2%. Instead, the SPX fell only -0.1% on Friday after the White House announced the latest round of tariffs on Chinese exports, though it was off -0.4% for most of the day, and quadruple witching positioning may have accounted for a late day rally.
For now, market internals show relative nonchalance over trade war risks. Domestic large cap companies, which should be relatively insulated from trade tensions, are underperforming the overall index.
In the absence of political and trade policy fears, the fundamentals are strong. Last week’s report of retail sales was unusually strong. In general, the Citigroup Economic Surprise Index seems to have survived the seasonal weakness often seen in H1 and appears to be turning around.
The latest update from FactSet shows that EPS estimate revisions continue to strengthen after the tax bill related surge earlier in the year. Moreover, Q2 earnings guidance is better than average, which points to continuing fundamental momentum that is supportive of higher stock prices.
I wrote last week that the market needed a brief period of correction or consolidation. Since March, the SPX had exhibited a pattern of breakdowns out of a series of rising wedges, and the tops of these formations were coincidentally marked by either a breach or touch of the lower Bollinger Band by the VIX Index. That pattern continues to hold. If history is any guide, these corrective periods tend to last about two weeks, which puts the end of the correction about the end of next week. Bulls can be encouraged by the pattern of progressively shallow corrections, which is an indication of intermediate term strength. Support can be found at about the 2740 level, which represents downside risk of only about 1%.
In the meantime, short term breadth metrics are weakening across the market cap spectrum. Until the market can start to show some strength and momentum, the correction or consolidation isn’t over yet.
As well, medium term (3-5 day) breadth indicators from Index Indicators are showing negative momentum, but readings are neutral and not oversold. These conditions are suggestive of further downside potential over the next week.
My inner investor remains bullish, and he is not worried about 1% squiggles in the stock market. My inner trader put on a modest short position in anticipation of mild weakness next week.
Disclosure: Long SPXU