Defying gravity

Posted by Cam Hui -

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

 

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

The bull case

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

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

 

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

 

The bear case

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

 

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

 

Dipping my toe in on the short side

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

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXU

 

China is healing

Posted by Cam Hui -

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

 

Real-time signs of recovery

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

 

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

 

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

 

Trade peace ahead?

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

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

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

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

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

 

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

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

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

Chinese weakness? That’s so 2018.
 

Peering into 2020 and beyond

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Gazing into the crystal ball

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

 

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

Short and long-term outlook

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

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

     

    Near term growth scare

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

     

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

     

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

     

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

     

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

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

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

     

    No 2019 recessionary bear

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

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

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

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

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

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

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

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

    The Powell Put is firmly in place.

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

     

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

     

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

     

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

     

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

    Cold War 2.0

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

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

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

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

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

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

    The Great MMT experiment

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

    What is MMT?

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

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

    Here are the policy implications of accepting MMT:

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

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

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

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

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

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

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

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

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

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

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

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

     

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

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

    After the war, inflation eroded the debt away:

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

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

    Here is the key conclusion [emphasis added]:

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

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

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

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

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

    The outlook for 2020″sl

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

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

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

    The week ahead: A market stall ahead

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

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

     

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

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

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

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

     

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

     

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

     

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

     

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

     

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

     

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

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

    Disclosure: Long SPXL

     

    Nearing peak good news?

    Posted by Cam Hui -

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

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

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

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

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

     

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

    Fade the news

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

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

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

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

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

     

    Bearish tripwires

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

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

     

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

     

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

     

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

     

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

    Disclosure: Long SPXL

     

    The Art of the Deal meets the Art of the Possible

    Posted by Cam Hui -

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

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

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

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

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

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

    Intellectual property rights

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

     

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

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

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

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

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

    […]

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

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

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

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

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

    Structural reform

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

    Currency strategist Marc Chandler framed the problem this way:

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

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

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

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

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

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

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

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

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

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

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

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

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

     

    Here comes the growth scare

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

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

    Bullish and bearish over different time frames

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

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

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

     

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

    The growth scare in Europe

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

     

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

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

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

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

     

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

    A US slowdown ahead?

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

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

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

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

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

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

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

     

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

     

     

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

     

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

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

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

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

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

     

    Why I am bullish

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

     

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

    Traversing the valley of weak growth

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

     

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

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

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

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

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

    What could go right

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

     

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

     

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

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

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

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

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

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

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

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

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

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

     

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

     

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

    Bullish tripwires

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

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

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

     

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

     

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

     

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

     

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

     

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

    The week ahead

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

     

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

     

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

     

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

     

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

     

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

     

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

    Disclosure: Long SPXL

     

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

    Posted by Cam Hui -

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

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

     

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

    The necessity of a trade deal

    Both sides desperately need a deal.

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

     

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

     

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

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

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

     

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

     

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

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

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

     

    What gold tells us about stock prices

    Posted by Cam Hui -

    Mid-week market comment: The SPX has risen roughly 400 handles since the December 24 bottom, and it is approaching its 200 dma. Can the market stage a sustainable rally above this key hurdle?

     

    Golden clues

    For some clues, we can turn to the price of gold. The top panel of the chart below shows that gold prices tend to have an inverse correlation with stock prices, and that relationship is especially true now. When stocks rise, gold falls, and vice versa.

     

    Here are some clues to the likely direction of stocks from gold prices. First, the long-term outlook for gold prices looks impressive. It is formed a multi–year saucer shaped base. The objective on an upside breakout is about 1560 based on point and figure charting.

     

    In the short run, however, the golden rally looks exhausted and due for a pullback. Gold prices are testing the underside of uptrend resistance. Similarly, the inflation expectations ETF (RINF) is displaying a similar technical pattern of approaching trend line resistance.

    When I turn to gold equities (GDX), the silver/gold ratio is exhibiting a negative divergence that is not supportive of further strength. Silver is the poor man’s gold, and it tends to have a higher beta than gold. The underperformance of the silver/gold ratio is therefore another short-term cautionary sign for gold bugs.

     

    In addition, Mark Hulbert pointed out that the sentiment of short-term gold timers is an off-the-charts bullish reading, which is contrarian bearish.

     

    Contrast those sentiment readings with Callum Thomas’ weekly (unscientific) Twitter poll conducted on weekends, which still shows respondents to be net bearish even after last week’s advance. Stock prices are climbing the proverbial Wall of Worry.

     

    In conclusion, while the longer term outlook for gold prices is bullish, this precious metal appears overextended in the short-term. The inverse relationship between gold and stock prices implies a bullish outlook for US equities.

    Cautionary tripwires for equities

    However, this does not mean that traders should pile into stocks with abandon. The stock market is highly overbought, and it can either consolidate or correct at any time. Here are a couple of cautionary signs that I am watching for.

     

    1. RSI-14: While the series of overbought readings flashed by the RSI-5 indicator could be signals of “good overbought” conditions, an overbought reading by the longer term RSI-14 indicator has historically been a cautionary sign of an extended market.
    2. VIX below lower BB: In the past, the VIX Index falling below its lower Bollinger Band has also been another cautionary signal for the stock market. Intra-day dips below the lower BB isn’t enough, it’s the closing price that raises the red flag. Watch for it.

    My inner trader went long the market earlier this week. He is bullishly positioned, but he is watching these triggers as signals to exit his long positions.

    Disclosure: Long SPXL

     

    Demographics isn’t destiny = History rhymes

    Posted by Cam Hui -

    As new data has crosses my desk, I thought I would write a follow-up to my bullish demographic analysis published two weeks ago (see A different kind of America First). To recap, I observed that America is about to enter another echo demographic boom as the Millennial generation enters its prime earnings years.
     

     

    A study by San Francisco Fed researchers pointed out that this should raise demand for equities from Millennials. This is especially important as the Baby Boomers reduce their equity holdings as they retire.
     

     

    I then postulated that rising savings from Millennial should usher in another golden age in US equities.

    This is the part where history doesn’t repeat itself, but rhymes.
     

    A generation of slackers?

    I had some pushback from readers to the effect that the new generation is a bunch of slackers living in their parents’ basement. But please be reminded that Baby Boomers in the youth popularized the practice of smoking pot, and once believed in “free love”. They eventually grew up, got jobs, and became responsible citizens.

    A recent study by FINRA and the CFA Institute found that the approach that the Millennial generation has adopted to their personal finances are not very different from older cohorts. The study was based on eight focus groups and a 2018 online survey of nearly 3,000 Millennials, Baby Boomers, and Gen Xers. This is an important issue for the financial services industry. Forbes reported that Millennals are poised to inherit $30 trillion over the next 30 years.

    When it comes to financial goals, the assumed overconfidence and ambition of millennials should translate into expectations of early retirement. But the data does not bear this out: Only 3% of millennials with taxable retirement accounts anticipate retiring before age 50, and a sizeable proportion of millennials don’t expect to retire at all. Moreover, the goals of non-investing millennials are exceptionally modest, with 40% of this group saying that their top goal is simply not living paycheck to paycheck. The goals of millennials with taxable accounts line up fairly well with those of Gen Xers and baby boomers who also have such accounts.

    Despite their greater comfort with technology, Millennails are not embracing robo-advisors.

    Indeed, notwithstanding their presumed tech savvy, millennials are not especially well informed or curious about robo-advisors. Of those surveyed, 37% had never heard of robo-advisors, and only 16% said they were very or extremely interested in them. Moreover, when working with a financial professional, more than half of the millennials studied said they’d prefer to do so face to face. They were similarly unimpressed with cryptocurrencies.

    Their trust in Wall Street is not especially high.

    So what about trust? Millennials have had to navigate the most difficult economic landscape of any generation since the Great Depression. The financial crisis has defined their world and shaped their expectations. Surely advisers can expect to have a more difficult time convincing them to take a chance and entrust them with their money, right? Apparently not. Contrary to popular wisdom, the difficult economic times have not made millennials overly skeptical of finance professionals or the finance industry. According to the study, 41% of millennials with retirement or taxable accounts work with an adviser and 72% of these are either very or extremely satisfied with them. Finally, only 15% of those millennials not using an investment professional said it was due to a lack of trust.

    In that respect, demographics does look like destiny.
     

    How history only rhymes

    On the other hand, the Millennial cohort is maturity in an economic environment that is less friendly than the one experienced by Baby Boomers. The competitive environment is more challenging, and they are less likely to out-earn their parents than the Baby Boomers.
     

     

    In addition, I had pointed out a Fed study which concluded student loans are creating headwinds in the rate of home ownership. The same financial burdens are likely to restrain the savings capacity of this generation, which will affect their demand for equity investments.
     

     

    On the other hand, don’t be too surprised if American political discussion shifts to the left over the next decade, just as the 1960’s and 1970’s was a period of leftward drift and political turmoil in the US. As Millennials age and flex their political muscle, the likes of Alexandria Ocasio-Cortes, who is already a Millennial political star, expect economic theories like Modern Monetary Theory to assume a more prominent role in policy discussions. While I have no strong believes as to whether MMT is the correct approach, I do expect a greater fiscal boost should it become adopted. At worse, MMT would be no worse than Arthur Laffer’s supply-side theory which underpinned much of fiscal policy starting with the Reagan years.

    In short, demographics isn’t destiny. Expect some headwinds for Millennials from a tougher competitive environment and higher debt burdens. On the other hand, don’t be surprised at a political blowback as this generation flexes its political muscle.

    History doesn’t repeat, but it does rhyme.
     

    Recession ahead? Fuggedaboutit!

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

    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.
     

    Confident about a slowdown?

    Recently, a number of prominent investors and analysts, including Jeff Gundlach, David Rosenberg, and Ed Yardeni, have warned about an ominous recession signal from the Conference Board’s consumer confidence survey. Ed Yardeni’s analysis of the present situation to expectations spread was especially ominous for equity investors.
     

     

    Fuggedaboutit! The American economy isn’t going into recession. Call me bullish, but with a caveat.
     

    A false signal

    To be sure, there are numerous signs that confidence indices of all stripes are rolling over, starting with the University of Michigan consumer confidence index.
     

     

    NFIB small business confidence is coming off its highs.
     

     

    However, Renaissance Macro pointed out the recession probability signal based on present conditions to expectations spread recession indicator is at 100%, but it has been elevated since mid-2014. This is not a reliable and actionable indicator.
     

     

    The consumer revival

    If you are worried about the American consumer, then ask yourself why real retail sales are continuing to make new highs? Past recessions have usually been preceded by a peak in real retail sales.
     

     

    Over on Wall Street, the relative performance of consumer discretionary stocks have been rising. Most notably, the turnaround even as stock prices plunged in December and continued as the market rallied.
     

     

    In addition, the housing sector, which is the ultimate form of cyclical consumer durable, is showing signs of a turnaround. November new home sales surged and handily beat Street expectations last week. In addition, the relative performance of homebuilding stocks have begun to turn up as long rates have fallen. Similar the pattern of consumer discretionary stocks, this group’s relative uptrend occurred ahead of the stock market selloff last December.
     

     

    Do these charts look the market signals of a weak consumer to you?
     

    Possible growth scare ahead

    This doesn’t mean that equity investors should entirely shrug off downside risk and the bulls won’t have clear path up to all-time highs. Prepare for some volatility as there may be a growth scare ahead.

    I am indebted to the work of New Deal democrat, who has been monitoring high frequency economic data and categorizing them into coincident, short leading, and long leading indicators. This framework is highly useful for understanding the growth outlook in different time frames. His latest update has pointed to persistent readings of short-term weakness that will become evident mid-year, but a long-term (one-year) strength indicating low recession risk.

    The long-term forecast and the nowcast are slightly to the positive side, while the short term forecast is slightly negative for the fourth week in a row. Some of this is due to the government shutdown, so we will have to wait several more weeks to see is the changes are real.

    The signs of short-term weakness into mid-2019 could be mistaken by analysts as the basis for a possible recession. Cue the growth scare going into Q2. Troy Bombardia also observed that the ECRI Weekly Leading Indicator has been consistently negative, which is another worrisome sign.
     

     

    Another warning sign for equity investors is the continuing downgrade in forward 12-month EPS estimates. To be sure, stock prices have held up well during a Q4 earnings season whose beat rates are roughly in line with long-term averages, but how long can stock prices defy the gravity of negative fundamental momentum?
     

     

    The chart below depicts quarterly actual and estimated earnings. If New Deal democrat is right about economic weakness in Q2, then equity investors should be prepared for either downward revisions in Q2 EPS estimates, or downside reporting surprises.
     

     

    Waiting for the “you won’t want to buy” moment

    For now, the current newsflow of a dovish Fed and a likely US-China trade deal is tilting sentiment and price momentum bullishly.
     

     

    However, I am concerned that the late December bottom seemed too easy. II sentiment has normalized, and % bears spiked only briefly above % bulls. These readings are inconsistent with past durable intermediate term bottoms.
     

     

    Another worrisome sign evident during this rebound rally is the lack of apparent leadership. The relative performance of NASDAQ and small caps are not showing signs of sustainable leadership. If this rally were to carry itself further, what’s going to lead the way?
     

     

    There is a trader’s adage on Wall Street that when it’s time to buy, you won’t want to. There are too many investors and traders who are too eager to buy the dip.

    It is difficult to see how the market could fall without some bearish catalysts. We have to wait for the “you won’t want to buy moment”, which may occur when the market hits the growth scare speed bump in the coming weeks.

    In conclusion, the US economy is unlikely to enter a recession based on long leading indicators, barring a full-blown trade war. However, investors should expect a growth scare going into Q2. In light of the powerful short-term price momentum in stock prices, timing the inflection point between rebounding optimism and a growth scare will be a tricky task.

    I remain cautiously intermediate term bullish on equities. However, should the growth scare become the dominant narrative in the coming days and weeks, it could become the trigger for a re-test of the December lows. If that were to occur, investors should look through the “you won’t want to buy” fears to step up and load up on equities.
     

    The week ahead

    Looking to the week ahead, the market may be nearing a key technical inflection point. Rather than make a decision on the likely direction, my inner trader believes it would be more prudent to allow the market action tell us the likely short-term direction.

    The intermediate term bull case rests with the continuation of positive price momentum. The SPX exhibited a positive MACD crossover on the weekly chart. The 10-year record of past signals have been mostly bullish (blue vertical lines) with only a small minority that resolved bearishly (red lines).
     

     

    On the other hand, I remain open to the possibility of a W-shaped bottom, especially in light of the likely economic softness starting Q2. A study of market history by Andrew Thrasher concluded that the market needs to clear the 100 and 200 dma in order to reduce the risk of a re-test of the December lows.

    Going back to 1960, after a 15+% decline while the market has remained below its 100-day and 200-day Moving Average, the risk of a retest or a lower high were high. But once we cleared these intermediate and long-term MAs then the risk diminished.

    Troy Bomardia’s historical studies came to a similar conclusion.  Most retracements of “crash and rally” patterns stall either at the 50% retracement or 200 dma. However, they can turn back higher, and strength can persist all the way to all-time highs before retreating.

    So where does that leave us? The SPX rallied through a key downtrend last week, indicating persistent strength, which is bullish. However, the index ended the week just below its 100 dma, as well as the 61.8% Fibonacci retracement level. In addition, the VIX Index (bottom panel) closed Friday just shy of its lower Bollinger Band, which are levels where past stock market rallies have begun a pullback.
     

     

    Breadth indicators offer little clue to direction. On one hand, the market is overbought, but one of the most bullish things a stock market can do is become overbought and stay overbought. On the other hand, readings have pulled back from an extreme overbought condition that is reminiscent of the pattern displayed after the last Zweig Breadth Thrust buy signal in 2015 when the rally stalled and prices pulled back.
     

     

    My inner investor is neutrally positioned at roughly his policy asset weights. My inner trader is stepping aside until the market can flash further clues to market direction.

     

    Dismounting from the market rodeo

    Posted by Cam Hui -

    Mid-week market update: I am publishing the mid-week market update early ahead of the FOMC meeting Wednesday, which can create a high degree of volatility.

    It has been over a month since the December 24 market bottom, and stock prices have rallied strongly since that bottom. Indeed, price momentum has continued to lift prices even after the Zweig Breadth Thrust buy signal of January 7 (see A rare “what’s my credit card limit” buy signal).
     

     

    Marketwatch reported that Morgan Stanley strategist Mike Wilson thinks it’s time to dismount from this stock market rodeo:

    Employing a rodeo metaphor, Wilson on Monday urged his clients to “dismount” as the market’s rally since late 2018 is starting to look precarious.

    “Maybe the bull ride since Dec. 24 has not gone a full ‘8 seconds’ but we’d look to dismount anyway—we’re close enough and bulls can be dangerous animals,” he said in a report, referring to the number of seconds a bull rider is required to stay on to earn a score for a ride…

    “We struggle to see the upside in hanging on just to see how long we can. We think it is better to hop off now and rest up for the next rodeo,” said Wilson.

    I would tend to agree. At a minimum, investors and traders face a number of potential landmines this week.
     

    FOMC surprise?

    The FOMC began a two-day meeting today, and we will see the statement Wednesday. Expectations are building for a dovish tone, with a pause in rate hikes, and a possible taper of the central bank’s balance sheet runoff.

    Bloomberg commentator John Authers quoted TS Lombard U.S. economist Steven Blitz as an example of how market expectations have turned dovish:

    Fed Chairman Powell’s grace note was to float the possibility of tapering the pace of balance sheet reduction (QT). The market grabbed it, took it as gospel, and next week we will see whether the Fed delivers. If they do not, they will probably wish they had, and then taper at the March meeting. They could, of course, skip the QT adjustment half-step entirely and go right to a clean 25bp cut in the funds rate, but the data-dependents on the FOMC would not take kindly to such a leap.

    Authers believes that expectations becoming a little too unrealistic:

    In other words, Powell will enter Wednesday with the market braced for him to make a U-turn for the ages, a complete 180-degree turn from his views on the balance sheet as expressed only last month. There is substantial risk of disappointment, but whatever he says after the FOMC meeting, it will matter more than Ross’s admission that trade peace with China remains “miles and miles” away.

    Kevin Muir, or The Macro Tourist, thinks that Powell is ready to cave on the question of balance sheet adjustment, or quantitative tightening, in the wake of the recent WSJ article entitled “Fed Officials Weight Earlier Than Expected End to Bond Portfolio Runoff”:

    Which leads me to three different possibilities:

    1. Powell somehow believes that surprises are bad and that it is important for the information to be eased out into the market. I guess that might be the case if you are talking about bad news, but it seems to me that good news should be ripped off like a band-aid. But hey – I don’t have an army of PhD economists telling me the optimal method of communicating my waffling, so I don’t know. Maybe this is just messed-up Fed thinking at work.
    2. Maybe the WSJ has gone rogue and this story is not a leak but merely the “connecting of dots” from previous Fed communication. If you look carefully, there is little new information.
    3. Someone – either another faction at the Fed or maybe even the White House – planted the story in an attempt to force the Fed to change QT policy.

    I know the last two options seem a little extreme.

    Here is the more sober interpretation of the Fed’s likely actions this week from Tim Duy:

    The Fed will hold steady this week. I anticipate that barring any evident inflationary pressures, the Fed will be content to stay on the sidelines through at least the middle of the year. I think the underlying data will still prove too strong for central bankers to signal that they are at the end of the rate cycle. They will though want to communicate that regardless of their expectations, actual policy will be made with patience and flexibility. They will also want to communicate that the ultimate size of the balance sheet remains a technical issue at this point.

    If the market expectations have built up for an abrupt dovish shift from the FOMC, then prepare for disappointment from the market. For what it’s worth, Rob Hanna at Quantifiable Edges highlighted the historical record of positive equity market returns on FOMC days between the Powell Fed and his predecessors.
     

     

    Trade talks wildcard

    The second potential market landmine that the market faces are the upcoming US-China trade talks. A senior Chinese delegation is arriving in Washington on Wednesday to meet with American officials for two days of scheduled talks. Treasury Secretary Steve Mnuchin stated that the main issues are market access, making sure there aren’t forced ventures, not forced transfers of technology, and a monitoring mechanism if and when they reach an agreement.

    The WSJ highlighted the really difficult issue of the domination of China’s SOEs in key industries:

    China’s state firms dominate industries that U.S. firms want to enter, including telecommunications, energy, banking and insurance, and have made inroads into industries Mr. Xi is staking out as top priorities for the future. Beijing and local governments, for instance, have announced more than $100 billion in financing, mainly to state-owned firms, to develop a domestic semiconductor industry.

    State-owned construction firms are building Mr. Xi’s ambitious Belt-and-Road infrastructure projects across Asia and Africa, while state-owned banks are often called on to ramp up credit to keep the Chinese economy from slowing too rapidly.

    One Chinese economist calls state businesses “the legs of the Communist party.”

    In effect, the Americans are asking the Chinese to abandon their industrial strategy. It would be the equivalent of asking the US to abandon English style system of jurisprudence and adopt the Napoleonic Code.

    The Trump administration insists that Beijing cut tariffs and regulations that benefit state firms and block U.S. competition. It also wants China to reduce subsidies, preferential loans and other help that give state-owned firms an added advantage.

    Mr. Xi and his allies see state firms as a source of employment and thus social stability and a way for China to compete internationally through national champions in steel, aluminum, construction and other fields. They are also an important lever to manage the economy, in part because the Communist Party plays a big role in selecting top managers.

    In addition, the official US request for the extradition of Huawei CFO Meng Wanzhou is likely to put a damper on negotiations. CNN summarized the key points of the US indictments in the extraction request:

    1. Huawei’s founder lied to the FBI: Huawei founder Ren Zhengfei, who has played a prominent role in defending the company in recent weeks, repeatedly lied about its business dealings in Iran, US prosecutors say.
    2. Bonuses for employees who stole trade secrets: US prosecutors say Huawei had a policy in place that gave bonuses to employees who successfully stole confidential information from competitors.
    3. The ‘home’ team pressured colleagues to steal: Aside from a cash incentive, Huawei employees were allegedly under enormous pressure to obtain trade secrets.
    4. US investigators accessed Meng Wanzhou’s electronic device: Prosecutors allege that Meng, the Huawei CFO, was part of a decade-long conspiracy to evade American sanctions on Iran and dupe Congress and US investigators.

    Despite all the soothing American talk about the Huawei case being separate from the trade discussions, it really is not. The indictments are part of a broader effort of economic warfare against emergent Chinese 5G technology. The belligerent tone will make it difficult for both sides to back down during the trade talks.

    Ultimately, the decision on whether to cut a deal will be political. Is Trump sufficiently pressured by stock market instability to sweep these bigger issues under the rug for another day? The best case that we can hope for out of these meetings is an agreement for an ongoing process to keep talking. The worst case is the talks break down.

    Even though my base case scenario still calls for a deal to be made, the risks are asymmetric and tilted to the downside.
     

    Earning season volatility

    In addition, there is the earnings season wildcard. There are a lot of large cap bellwethers reporting this week, and the market reaction is likely to add volatility.
     

     

    Subscribers received an email alert this morning (Tuesday) that my inner trader had taken profits on his long positions and reversed to the short side. Just don’t ask me what the downside target is, I have no idea. All I know is risk/reward is tilted to the downside. One thing at a time.

    Disclosure: Long SPXU
     

    A buying opportunity for Chinese stocks?

    Posted by Cam Hui -

    I had a number of bullish comments on China in the wake of my last post (see How worried should you be about China?). Jeroen Blokland pointed out that the market is discounting a lot of weakness in the Chinese economy.
     

     

    On the other hand, Caterpillar shares cratered today on jitters of a China slowdown. This brings up the question, “Are Chinese stocks a contrarian buy opportunity?”
     

    Valuation support

    Indeed, there is valuation support for Chinese stocks. Callum Thomas highlighted the low P/E ratios of the China A-Share market. Historically, such valuations have been good low-risk entry points.
     

     

    Near-term fundamental momentum

    Another reader (thank you, Ken) pointed out that the OECD leading economic indicators are bottoming for China, while they are still falling for the US and eurozone. These are signals that worst of the slowdown in China has already been seen.
     

     

    I also outlined my tactical view of China was “Apocalypse Not Yet” (see How worried should you be about China?). The latest stimulus package is likely going to buy them another 2-3 quarters of growth, and my base case scenario calls for a trade agreement to be made:

    My base case scenario is no crash in 2019. The limited stimulus package announced by Beijing will have some effect, and it will likely buy the country another two or three quarters of growth. At the same time, China is desperate to reach a trade agreement with the US.

    The Trump administration has also shown that it is highly sensitive to stock market movement, and it is also eager to reach an agreement. As one simple example, after stock prices weakened on Tuesday, January 22, National Economic Council director Larry Kudlow appeared on CNBC to sooth markets and deny reports that a planned meeting between Chinese and American negotiators had been canceled. This is a signal that American negotiators are sensitive to pressure from Wall Street to make an agreement.

    Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to be signed. But that will not be the end of the story. The next battle will be over review, enforcement, and verification of reform initiatives.

    However, expect trade tensions to rise again in 2020:

    The fundamental nature of the Sino-American relationship is changing. Years of negotiation with past administrations have led to a sense of promise fatigue from both sides of the aisle. A consensus is emerging that China is becoming a strategic competitor. Cold War 2.0 has begun, and 2020 will be a difficult year for US-China relations as aspiring candidates will try to show how tough they are on China.

    In conclusion, current levels present a relatively low-risk entry point into Chinese equities. The outlook should be positive until late 2019, but don’t overstay the party.
     

    How worried should you be about China?

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

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

    The elephant in the room

    I pointed out recently that the latest BAML Fund Manager Survey shows that institutional managers have been stampeding into emerging market (EM) stocks exclusive of the other equity markets around the world (see An opportunity in EM stocks?). However, some EM countries are more equal than others. The chart below shows that while EM stocks have begun to outperform global equities (bottom panel), China continues to lag compared to other major markets like Brazil and India.
     

     

    For investors, China is becoming the elephant in the room. The country accounts for roughly one-third of global GDP growth, and its economic growth rate is decelerating. Ken Rogoff stated in Davos that he thinks China is hitting the debt wall:

    Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

    “People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

    “China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

    “There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

    How worried should you be about China?
     

    China weakness everywhere

    For global investors, the only question that matters for global growth is China. Right now, all signs point to a slowdown. I won’t bore you with Chinese economic statistics, which can be made up. However, we can consider other China-related free market indicators:

    • Commodity prices
    • Australian property market
    • Korean exports
    • German industrial production, whose capital goods are exported to China
    • Chinese auto sales

    China has shown itself to be a voracious consumer of raw commodities. For commodity prices, the industrial metal to gold ratio is a cyclically sensitive indicator of industrial demand, net of commodity price inflation (red line). This indicator has also shown itself to be highly correlated to risk appetite, as measured by the US equity to UST ratio (grey bars). Current readings indicator continued demand deceleration.
     

     

    We have all heard about how China’s great big ball of liquidity leaked out and went into real estate in Australia, Canada, the US, and other places with golden visa programs, like Portugal. Property prices in Australia, which has been an outsized recipient of Chinese hot money, has been tanking. I can also personally attest to similar conditions in Vancouver, and Toronto.
     

     

    South Korea is one of China’s closest trading partners. The latest figures show that its exports, which are also correlated with global EPS growth, have collapsed.
     

     

    The same could be said of German industrial production, and M-PMI.
     

     

    What about the Chinese consumer? Hasn’t Beijing been trying to rebalance growth away from credit driven infrastructure spending to China’s household sector? The weakness in Chinese auto sales tell a story of a stressed out consumer.
     

     

    In addition to these signs of short-term weakness, another source of concern is the Sino-American trade war, which remains unresolved.
     

    China’s long-term challenges

    While these short-term worries are spooking the markets, it is impossible to understand China without first analyzing her long-term challenges before drilling down to the shorter term policy responses to those problems. As I see it, China’s long-term challenges are:

    • A looming middle-income trap
    • An overleveraged economy
    • The rising tension between Xi Jinping’s desire to retain tight political control and the urgency to address the challenges of excess leverage and slowing growth

    A fast growing EM country hits the middle-income trap when its growth slows after reaching middle- income levels as they encounter developmental roadblocks to achieving high-income status. According to World Bank estimates, only 13 of 101 middle-income economies have achieved the transition to high income for the period from 1960 to 2008. Antonio Fatás of INSEAD summarized China’s challenge with falling growth rates using South Korea’s development path as an example.
     

     

    Fatás added the following caveat:

    In summary, the deceleration of GDP growth rates in China can be seen as a natural evolution of the economy as it follows its convergence path, in particular if we use recent decades in South Korea as a benchmark. Let’s not forget that South Korea is one of the best performer for countries in the range below 50% of the US GDP per capita. So using South Korea as a benchmark we might be providing an optimistic benchmark for Chinese growth.

    China is following the well-trodden development path followed by South Korea, Taiwan, and other Asian Tiger economies. China is running out of cheap labor fast, and its import substitution strategy of producing cheap imitation goods has also near the end of its useful life. Beijing’s policy response is to raise development by migrating up the value-added chain with an industrial strategy intended to achieve dominance in STEM research (see How China could dominate science from The Economist). One major leg of this is the China 2025 initiative, which is running into US and other Western objections about intellectual property theft and market access by Western companies (more on that later).

    In addition, as the China bears’ favorite chart shows, China’s policy response in the wake of the GFC of a shock-and-awe campaign of credit driven infrastructure stimulus has left in its wake a risky debt buildup.
     

     

    Additional efforts at credit driven stimulus are becoming less and less effective. Additional credit creation is resulting in less and less GDP growth.
     

     

    Beijing’s policy response is to try and gradually let the air out of the credit balloon through a deleveraging initiative. The idea isn’t to crash the economy, but to slow credit growth to manageable levels, to the unregulated shadow banking credit market back under the formal banking umbrella so that credit can be more easily controlled, and to use specialized tools to target stimulus when necessary.
     

    The shrinking private sector

    The rise of Xi Jinping as Party Secretary has given rise to a number of difficult policy trade-offs. Xi ascension was followed by an anti-corruption campaign, which was done to both root out corruption, and to consolidate power. Slowly but surely, Xi has consolidated power and control of the economy with the Party. That’s where the policy trade-offs come in. Xi’s power concentration is creating headwinds for the growth engines of the Chinese economy.

    First, the change in regime has given greater power to the State Owned Enterprises (SOEs) at the expense of Small and Medium Enterprises (SMEs). The government recognizes that SMEs represent the engine of economic growth, but a desire for Party control is stifling their growth outlook.
     

     

    Xi’s power consolidation is squeezing out the private sector to the benefit of the SOEs. A recent Forbes article entitled “Friends Don’t Let Friends Become Chinese Billionaires” tells the story:

    China Daily reported Friday that unnatural deaths have taken the lives of 72 mainland billionaires over the past eight years. (Do the math.)

    Which means that if you’re one of China’s 115 current billionaires, as listed on the 2011 Forbes Billionaires List, you should be more than a little nervous.

    Mortality rate notwithstanding, what’s more disturbing is how these mega wealthy souls met their demise. According to China Daily, 15 were murdered, 17 committed suicide, seven died from accidents and 19 died from illness. Oh, yes, and 14 were executed. (Welcome to China.)

    I don’t know about you but I find it somewhat improbable that among such a small population there could be so many “suicides,” “accidents” and “death by disease” (the average age of those who died from illness was only 48). I’m only speculating but the homicide toll could really be much higher.

    Is it any surprise that a recent Barron’s article reported that about half of high net-worth Chinese individuals have either emigrated or want to emigrate?

    About 53% of high-net-worth individuals surveyed said they had no plans to emigrate to other countries, while 38% said they were considering a move abroad. Nearly 9% said they had non-Chinese citizenship or were in the process of application.

    The top destination for rich Chinese to emigrate was Europe, with 30% of respondents picking the region. Australia and the U.S. tied on the second spot (28%), followed by Canada (27%) and Singapore (11%).

    At the same time, the PBOC’s efforts to slow credit growth are also hitting SMEs much harder than SOEs. In general, SOEs are more creditworthy because they have the implicit backing of the government, while SMEs have to survive on their own, which is creating a credit crunch for smaller Chinese businesses. Bloomberg reported that some companies have resorted to creative financing techniques to tap credit markets:

    The practice is one of several strategies for debtors to enhance their appeal to creditors, including one where borrowers guarantee each others’ debt. Use of stock as collateral for loans has also sown the seeds for volatility in stocks.

    Another even more imaginative technique is to use the structured finance tactic which sparked the GFC of slicing up a bond into different credit tranches, where the issuer buys the most junior “equity” tranche in order to secure financing. With all this inventiveness at work in Chinese finance, what could possibly go wrong?

    Lower rated private companies and local government financing vehicles, or LGFVs, have been the main users of structured issuance, observers say. One popular method is for the borrower to put up the money for the subordinated tranche — the first to absorb losses — of the asset-management vehicle that buys the bonds.

    Another key plank of Beijing’s policy response is to refocus growth towards the Chinese consumer. As Michael Pettis has pointed out in many past occasions, the success of such an initiative requires the redistribution of income away from the entrenched interests of Party cadres in the large SOEs to the household sector, which is a difficult task in the best of times.

    This cannot be said to be the best of times for the Chinese consumer. A weak job market is pointing to weak income growth.
     

     

    At the same time, households have been raising their debt levels in order to consumer, and to invest (mostly in property). Bloomberg highlighted how Chinese consumers have been piling on debt, and their debt capacity is well on its way to reaching their limits.
     

     

    In short, don’t expect too much help from the Chinese consumer.
     

    Short-term policy response

    In response to the latest slowdown, Beijing has responded with a small stimulus package of tax cuts, and targeted top-down credit growth aimed at SMEs. However, don’t expect the latest round of stimulus to have the same effect as previous efforts. China’s total tax intake is relatively low, which puts a limit on the effects of a tax cut.
     

     

    On the credit front, banks are caught between top-down directives of lending to small businesses and maintaining the credit quality of their loan portfolios. Reports are emerging that many SMEs simply do not qualify for bank loans, and they must turn to the shadow banking system for loans at much higher rates. Instead, banks are instead lending money to subsidiaries of SOEs incorporated to qualify as small businesses.
     

    The trade war wildcard

    In addition, China is trying to conclude a trade deal in order to alleviate the negative effects of the trade war. The latest Bloomberg report the discussions as recounted by Wilbur Ross indicates that both sides are talking, but they are “miles and miles” from reaching a resolution. China has reportedly offered to eliminate the trade deficit within several years, but the issue of China’s industrial strategy and intellectual property protection remains a sticking point. The WSJ reported that American businesses raised the China 2025 strategy as a concern:

    In a joint report to the U.S. Trade Representative, the U.S. Chamber of Commerce and the American Chamber of Commerce in China say Beijing’s ambitious plan to become a global technology leader is being widely implemented, casting doubt on efforts by Chinese officials to play down its significance.

    There is evidence of “a deep, concerted and continuing effort” by provincial officials to pursue the central government’s Made in China 2025 plan, which seeks to make China a leader in electric vehicles, aerospace, robotics and other frontiers of manufacturing, the two business groups say.

    Reuters reported that American negotiators have demanded regular reviews of Chinese trade reform practices, much in the manner of an arms control treaty:

    The United States is pushing for regular reviews of China’s progress on pledged trade reforms as a condition for a trade deal – and could again resort to tariffs if it deems Beijing has violated the agreement, according to sources briefed on negotiations to end the trade war between the two nations.

    A continuing threat of tariffs hanging over commerce between the world’s two largest economies would mean a deal would not end the risk of investing in businesses or assets that have been impacted by the trade war.

    “The threat of tariffs is not going away, even if there is a deal,” said one of three sources briefed on the talks who spoke with Reuters on condition of anonymity.

    CNBC reported that George Soros went even further and labeled Xi Jinping the “most dangerous enemy” of open societies. He went on to warn that the US and China are in a “cold war that could turn into a hot one”.
     

    Apocalypse Not Yet?

    For investors, the critical question is what happens next in China. The biggest issue China faces is that it is running out of bullets. FT Alphaville characterized China’s dilemma as “cakeism”, or the desire to have your cake and eat it too.

    Alphaville sat down with economist George Magnus, a former senior adviser to UBS Investment Bank and the recent author of “Red Flags: Why Xi’s China is in Jeopardy.” He describes what’s happening in China this way: “At the moment, we’ve got an incoherence of policy. It’s confusing to us looking at it from the outside. It must be incredibly confusing if you are an entrepreneur or small business on the inside.”

    China’s version of “cakeism,” he says, centers around the leadership’s conflicting commitments to de-risking the financial system on one hand and on the other, hitting elevated growth targets north of 6 per cent. “You can’t really have a determined effort to deleverage the economy and not expect it to have a material impact on economic growth,” points out Magnus.

    Its debt-driven growth model is reaching the limits of usefulness. Tightening put the brakes on growth. Without large scale credit growth, which will exacerbate their real estate bubble, the economy will crash. The tools available to tinker at the margins, such as rebalancing to household consumption, and an industrial policy to escape the middle-income trap may have long-term benefits, but will not help in the short run.

    Will China crash? The current policy response is another effort to kick the can down the road yet one more time, though this round of stimulus will be less effective than past efforts.

    So Chinese officials have been presented with a choice: play the long game and work towards shifting the economy towards a more sustainable path, or sidestep short-term pain and prop up growth now.

    Of course, China wants its cake. And just like the Brits, it wants to eat it, too.

    So blame “cakeism” for why the stimulus measures that China has rolled out since the summer have done little to boost the economy. Rather than a full-scale stimulus programme, China has favoured a more piecemeal approach this time around, including liquidity injections into the financial system, cuts to the amount of cash banks have to hold as reserves and infrastructure spending.

    But by asking banks to lend more to private and small companies (by cutting the reserve requirement ratio), and simultaneously urging banks to raise more capital and pay attention to their bad debts, officials are “not speaking with the same tongue,” says Magnus. Ultimately, this could lead China to fail on both fronts.

    My base case scenario is no crash in 2019. The limited stimulus package announced by Beijing will have some effect, and it will likely buy the country another two or three quarters of growth. At the same time, China is desperate to reach a trade agreement with the US.

    The Trump administration has also shown that it is highly sensitive to stock market movement, and it is also eager to reach an agreement. As one simple example, after stock prices weakened on Tuesday, January 22, National Economic Council director Larry Kudlow appeared on CNBC to sooth markets and deny reports that a planned meeting between Chinese and American negotiators had been canceled. This is a signal that American negotiators are sensitive to pressure from Wall Street to make an agreement.

    Expect difficult negotiations to last right up to the March 1 deadline, but a limited deal to be signed. But that will not be the end of the story. The next battle will be over review, enforcement, and verification of reform initiatives.

    The fundamental nature of the Sino-American relationship is changing. Years of negotiation with past administrations have led to a sense of promise fatigue from both sides of the aisle. A consensus is emerging that China is becoming a strategic competitor. Cold War 2.0 has begun, and 2020 will be a difficult year for US-China relations as aspiring candidates will try to show how tough they are on China.

    Apocalypse Not Yet. Though the short-term policy solutions doesn’t address the longer term problems.

    While this is my base case scenario, other more bearish outcomes are possible, I can offer two sensitive real-time barometers that can warn of an impending crash in China. The first is the AUDCAD exchange rate. Both Australia and Canada are similar sized economies with high exposure to resource extraction industries with some key differences. Australia is more sensitive to China, and its exports are mainly in bulk commodities such as coal and iron ore. The Canadian economy is more sensitive to the US, and its exports are tilted towards energy. A disorderly breakdown in the AUDCAD exchange rate would be an early warning signal that something is breaking in China.
     

     

    In addition, the stability of the Chinese financial system is highly sensitive to the health of its property market. Should highly levered property developers such as China Evergrande (3333.HK) break long-term support, it may be a signal of a Lehman-like moment in China’s banking system.
     

     

    The share price of Alibaba, which is a key barometer of Chinese consumer spending, is also performing well relative to the Chinese market.
     

     

    Should any of these key real-time indicators weaken significantly, it would be time to run for the hills.
     

    The week ahead

    Looking to the week ahead, the bulls can celebrate as the market seems to be sailing through earnings season well. The latest update from FactSet shows that the EPS and sales beat rates are coming at roughly their historical averages, though forward 12-month EPS are still being revised downwards.
     

     

    That said, the market is not reacting to bad news. The stock price of companies that beat are being rewarded, but misses are not being punished.
     

     

    The partial government shutdown has hampered the release of many key economic statistics. However, much was made about the sub-200,000 print last week of initial jobless claims representing a 50-year low, I would remind readers that the population adjusted initial claims has already been making fresh lows for quite some time.
     

     

    In the very short run, stock prices may be due for a pause. The market is nearing key resistance levels while exhibiting a negative divergence in RSI-5. Friday’s lack of bullish reaction to the news of a legislature truce which re-opened government is another warning sign that the market may be about to stall.
     

     

    Short-term breadth is back at or near overbought levels. While the market could stage a minor advance early next week, the combination of near overbought readings, negative divergence, and the proximity of key resistance levels argue for a pullback of unknown magnitude.
     

     

    My inner investor is neutrally positioned at about target asset weight levels. My inner trader is long the market, but he is getting ready to reverse course next week.

    Disclosure: Long SPXL
     

    How far can this pullback run?

    Posted by Cam Hui -

    Mid-week market update: The Zweig Breadth Thrust buy signal occurred a little two weeks ago. For those who jump onto the bullish bandwagon, it has been an exhilarating ride. This week, the inevitable pullback has arrived. The SPX breached a key uptrend on the hourly chart yesterday (Tuesday), and it could not hold the morning good news rally induced by the positive earnings reports from Comcast, IBM, and United Technologies.

     

    How far can this pullback run?

    The bear case

    There is a case to be made for a deeper correction, perhaps all the way to test the December lows. OddStats posted some bear porn, based on the historical behavior of the VIX. The forward returns look downright ugly.

     

    Andrew Thrasher also made the case for a re-test of the December lows, based on the extreme overbought condition flashed by the % of stocks above their 20 dma.

     

    A “good overbought” condition?

    On the other hand, a market doesn’t go down just because it is overbought. The stock market has historically experienced “good overbought” conditions when it continued to grind upwards.

    This chart of stocks above their net 20-day highs-lows shows the market recently reached an off-the-charts overbought extreme. Further examination of the historical experience shows that similar past episodes has seen prices rise further before topping out. The ZBT signal of 2015 was one such example.

     

    Market internals unhelpful

    If the market were to blast off to new highs or weaken to re-test the old lows, we should see some evidence from market internals. However, many of the internals are flashing ambiguous signals.

    As an example, this chart of market cap and group relative performance is unhelpful to determining leadership. Mid and small cap stocks remain in relative downtrends and cannot be considered market leaders. NASDAQ stocks, which had been the high beta leaders, remain mired in a relative trading range.

     

    The behavior of price momentum is equally puzzling. While it is constructive that price momentum did not break down during December downdraft, but they did not recover and lead the market as prices rebounded.

     

    Mixed sentiment

    Sentiment models are also flashing mixed signals. On one hand, Callum Thomas has been conducting a weekly (unscientific) Twitter poll, and sentiment remains bearish despite the powerful stock market rebound since the December 24 bottom, These readings should be seen as contrarian bullish, and as a sign that the market is climbing the proverbial wall of worry.

     

    On the other hand, the latest Investors Intelligence poll shows that the spike in bearish sentiment has normalized after the December panic. I would interpret this as long-term complacency and contrarian bearish.

     

    A re-test, but not yet

    Trading the market with these cross-currents can be treacherous. Moreover, the market has been moving on fundamental and macro news, which are inherently unpredictable. Under these circumstances, technical analysis is likely to have diminished importance.

    However, sentiment analysis does give us some clues, and my working hypothesis is the market is likely to see a re-test of its December lows, but not yet. Short-term sentiment such as the Callum Thomas Twitter poll is too bearish and likely a signal that the market is climbing a wall of worry. As well, the strong price momentum displayed by the ZBT suggests that the market is likely to see further near-term upside. On the other hand, long-term sentiment from the II survey indicates complacency, and points to a re-test of the December lows in the next few months.

    Tactically, the SPX is pulling back after a two-week rally, and initial support is at the current levels coinciding with the 50 dma and 61.8% Fibonacci retracement. Further support can be found at the 50% retracement of about 2580.

     

    My inner trader is still bullish. He is opportunistically adding to his long positions at current levels, He plans to add more should the index decline to 2580, with a tight stop set just below that level.

    Disclosure: Long SPXL

     

    An opportunity in EM stocks?

    Posted by Cam Hui -

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

     

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

     

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

     

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

     

    Should you follow suit into EM stocks?
     

    What cyclical rebound?

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

     

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

     

    What cyclical rebound?
     

    Some EMs are more equal than others

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

     

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

     

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

     

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

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

     

    A different kind of America First

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

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

    A bright tomorrow

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

     

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

    An overvalued market?

    Hulbert’s six valuation metrics can be categorized as:

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

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

     

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

     

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

     

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

     

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

     

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

     

    A demographic dividend ahead

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

     

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

     

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

     

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

     

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

     

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

     

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

     

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

    America First, medium term

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

     

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

     

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

     

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

     

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

     

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

     

    Key long-term risks

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

     

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

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

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

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

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

     

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

     

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

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

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

     

    Key medium-term risks

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

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

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

     

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

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

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

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

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

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

     

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

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

    The week ahead: Waiting for direction

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

     

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

     

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

     

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

     

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

     

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

     

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

     

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

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

     

    Disclosure: Long SPXL

     

    There is no magic black box to profits

    Posted by Cam Hui -

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

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

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

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

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

     

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

    Market implications

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

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

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

    The risk of small sample sizes

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

     

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

     

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

     

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

    No free lunch

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

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

    Disclosure: Long SPXL

     

    A State of Emergency for the markets too?

    Posted by Cam Hui -

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

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

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

    Few limits on emergency powers

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

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

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

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

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

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

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

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

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

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

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

    Presidents can even send troops into the streets:

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

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

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

    P/E multiple contraction ahead?

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

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

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

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

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

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

     

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

    Here is Egypt.

     

    Here is Hungary.

     

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

     

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

     

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

     

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

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

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

    George Washington`s last stand

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

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

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

    Ursus Interruptus

    Posted by Cam Hui -

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

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

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

     

    The latest signals of each model are as follows:

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

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

    Why I turned bullish

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

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

     

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

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

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

     

    What is the market discounting?

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

    More importantly, earnings are already discounting a mild recession:

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

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

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

     

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

     

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

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

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

    Bullish breadth thrusts

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

     

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

     

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

     

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

    Negative fundamental momentum

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

     

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

     

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

     

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

     

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

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

     

    Watch China!

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

     

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

     

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

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

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

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

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

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

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

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

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

    Political risk premium

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

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

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

    Stress in the credit market

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

     

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

     

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

     

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

     

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

     

    Investment implications

    To sum up, what does this all mean?

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

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

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

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

     

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

    Possible roadmaps

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

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

     

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

     

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

     

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

    Model readings

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

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

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

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

     

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

     

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

     

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

     

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

    Disclosure: Long SPXL
     

    The Animal Spirits are stirring

    Posted by Cam Hui -

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

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

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

     

    The ZBT signal clarifications

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

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

     

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

     

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

     

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

    A high beta revive

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

     

    Investors looking for emerging market leaders might consider Communication Services.
     

     

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

     

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

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

    Disclosure: Long SPXL