Page 59 – Humble Student of the Markets

What Trump won’t tell you about the price of a trade war win

Posted by Cam Hui - June 17, 2018

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

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

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

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

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

War is hell

War is hell, even trade wars. The world is again at risk of lurching into a global trade war. Last Friday, Trump announced the imposition of 25% tariffs on $34 billion in Chinese exports, with another proposed list totaling $16 billion that is subject to public comment and review. China has responded with retaliatory tariffs on $34 billion in American exports, mostly in agricultural commodities and automobiles.

Under these circumstances, it is useful to revisit my analysis written in January of the possible fallout under such a scenario (see Could a Trump trade war spark a bear market?). I had highlighted analysis from the Peterson Institute in 2016 modeling the effects of a full blown and abortive trade war on the US economy. The economy would lapse into a mild recession in the former case, but sidestep a recession in the latter case. However, the results did appear anomalous as I pointed that that the observation of (then) New York Fed President Bill Dudley that the economy fell into recession whenever unemployment rose 0.3% to 0.4%, as it would in the modeled result of the abortive trade war.

President Donald Trump tweeted in the past that “trade wars are good, and easy to win”. What if he is right, and trade partners either backed down from retaliatory tariffs, or only imposed limited tariffs?

How would “winning” a trade war look like? Let’s put on our rose colored glasses and take a look.

Vulnerable trade partners

Trump’s trade policy has two main objectives. The long term objective is to bring manufacturing jobs back into the United States, and a shorter term goal is to shrink the trade deficit.

For some perspective, Brad Setser at the Council on Foreign Relations depicted the US current balance in two important ways. The first is in absolute dollar terms.

The second is as a percentage of US GDP.

Setser went on to observe that China and Germany have the lion’s share of the global manufacturing trade surplus:

China’s annual manufacturing surplus is still around $900 billion (for comparison, Germany’s manufacturing surplus is around $350-400 billion depending on the exchange rate and the U.S. deficit in manufacturing is around $1 trillion) and doesn’t show any sign of falling. I don’t see signs that the (modest) real appreciation this year will seriously erode China’s competitiveness—though it should moderate China’s export outperformance (Chinese goods export volumes grew at a faster pace than global trade in 2017).

The accompanying chart from Our World in Data shows trade flows as a share of GDP. The American economy is less sensitive to trade flows than either China or Europe, though the trade sensitive of European countries is exaggerated in the chart as much of the trade represent flows within the EU. Nevertheless, exports make up about 20% of China`s GDP, and Germany is the locomotive of export growth in Europe. These circumstances make them especially vulnerable to trade sanctions.

Fragile China

Moreover, China’s financial conditions are coming under increasing stress. A trade-induced slowdown is the last thing the economy needs. Last week, I had highlighted analysis from Callum Thomas that both fiscal and monetary policy were tightening.

The New York Times reported that China’s credit crackdown raising the risk of tanking its economy:

Beijing has been concerned in recent years about the increased reliance on credit to keep the economy expanding briskly, worrying that it could lead to a financial crisis, or to a long period of stagnation like the one in Japan after the real estate market burst in the early 1990s.

But curbing debt may have significant consequences in China and elsewhere. Countries around the world are much more closely tied to China than ever before, because of its role not just as the world’s biggest manufacturer by far but also, increasingly, as a consumer. An economic slowdown in China — coupled with the knock-on effects of widening trade disputes and slowing growth in Europe — may augur poorly for a global economy that even recently seemed in rude health.

Domestically, China’s credit crackdown has affected smaller businesses hardest. Though the country often appears to be dominated by its vast conglomerates and hulking state-owned enterprises, its economy is, in reality, somewhat more reliant on small businesses than its Western counterparts. And the way Beijing has gone about curbing lending in recent months is unintentionally hitting the most entrepreneurial segments of the economy, the governor of China’s central bank acknowledged in a speech on Thursday in Shanghai.

Beijing is facing the conundrum of trying slow credit growth while sustaining economic growth. They do not the additional headache of a trade war to exacerbate the effects of any slowdown.

Fragile Europe

Europe, on the other hand, faces a different kind of fragility. In addition, to the well known problems of trade openness, the European banking system never solved the excess leverage problems from the last cycle. As a result, ever small wobbles in the EU economy will have an outsized effect on financial stability. The poster boy for Europe`s banking problems is Deutsche Bank, whose share prices is now trading at levels below the lows set during the Great Financial Crisis. Moreover, European financial stocks have dramatically underperformed US financials during the same period.

What if trade partners like China and the EU decided to “eat the loss” and either refrained from trade retaliation, or responded with light, but highly targeted retaliation? That’s because global tariff rates are already very low, especially in the developed economies. Trump’s imposition of a tariff amounts to an import tax that hurts Americans as much as the exporting producer.

An asymmetric trade war?

Why not do nothing and either refrain from retaliation or retaliate in a highly surgical fashion? Let’s consider such a scenario of the short run effects on the exporting country.

Begin with China. Chinese economic growth is highly dependent on trade, and tariffs would bring economic growth to a screeching halt. A Chinese growth slowdown would crater the economic growth of most of Asia, and commodity suppliers like Australia, Canada, and Brazil.

Europe would not fare any better. German exports would tank, and Germany has been the engine of growth in the eurozone. The European banking system would wobble, and financial risk would spike. At a minimum, we would see a magnified repeat of the Greek Crisis of 2011.

How would the markets react? Risk-off would be the order of the day, but with the US economy partly insulated from these offshore troubles, Treasury assets would become the safe haven of choice. The USD would soar, which makes US exports less competitive.

So much winning.

How would the Fed react? Fed watcher Tim Duy gamed the Fed’s reaction from a possible trade war. In a limited trade war, the Fed would do nothing:

Currently, the Fed looks on course for three –and maybe four — rate hikes in 2018 of 25 basis points each. With economic growth sufficient to put downward pressure on an already low unemployment rate, central bankers will seek to push policy rates to a neutral level. Otherwise, the Fed believes the economy faces a risk of overheating.

Escalating trade battles potentially impact this forecast by causing demand to contract and supply shocks. An example of negative demand shocks are retaliatory tariffs on U.S. manufactured goods and farm products. If America’s trading partners focus primarily on tariffs that narrowly target firms in Republican leaning states, such as levies on Tennessee whiskey, Harley-Davidson motorcycles and cheese, the overall impact on economic activity will be fairly minimal.

Narrowly targeted retaliation by our trading partners will thus induce more political and local pain than aggregate weakness. And note that some of the overall damage on manufacturing will be mitigated by the rebound in oil prices and associated increase in drilling activity. If the overall economic impact of such retaliation is minimal, so too will be the Fed’s response. To be sure, if the negative demand shock is stronger than I expect, the Fed will see diminishing risk of overheating and change policy in a more dovish direction.

Another possibility is the Fed continues on its tightening path by looking through the inflationary implications of higher tariffs:

More interesting than demand shocks, which have straight forward implications for policy, is the possibility that the Trump administration’s approach yields an escalating supply shock that restricts the productive capacity of the U.S. Such shocks both constrain economic activity and raise prices. The U.S.-imposed tariffs on steel are a perfect example. Indeed, the possibility of a broad-based disruption from such tariffs is exactly why a nation should be wary of targeting intermediate goods in a trade war.

It is tempting to conclude that the Fed will react to a negative supply shock via tighter policy, especially when central bankers already face the prospect of an overheated economy. This, however, will not be the case as long as the Fed believes inflation expectations remain well-anchored. Rather than shift to a more hawkish stance, the Fed will look through any spike in prices as temporary and instead focus on the negative impacts on economic activity. If they conclude that those negative impacts will continue even after the price shock fades, central bankers might even shift to a more dovish stance.

The final outcome to consider is the Arthur Burns Fed solution of an accommodative Fed, which sets off an inflationary spiral:

The Fed would be driven in the opposite direction if the economy faced a series of negative supply shocks, global trade conflicts escalate and those shocks trigger a change in consumer behavior such that inflation expectations become tilted to the upside. That kind of shift occurred in the late 1960’s, leading to the Great Inflation period. With that episode still looming large in the Fed’s psyche, policy makers would respond with a more hawkish policy stance.

The last case represents a worst-case scenario for financial markets, in that it’s a toxic combination of faster inflation, weaker growth and tighter monetary policy. It would also put the Fed in the Trump administration’s crosshairs. I very much doubt President Donald Trump would sit quietly and respect the Fed’s independence if economic growth faltered. To be clear, this is not my baseline scenario. My baseline is that the scope of the trade impacts in aggregate are too limited to change the direction of policy. But market participants should remain wary of risks to this baseline.

Duy’s analysis suggests that the Fed would continue to tighten in the face of slowing economic growth from abroad. The US economy would then suffer the double whammy of hawkish Fed policy that tightens the economy into a slowdown, and declining demand from abroad.

A recession would ensue. USD assets would rise as Treasuries become the ultimate safe haven, which makes US exports even less competitive. The good news is the trade deficit tends to fall in a recession. So much winning, how can anyone stand it?

It all started when he hit me back!

The above analysis is dependent on the no or limited retaliation from trade partners. What could happen if the worse happened and the war disintegrated into tit-for-tat rounds of rising tariffs? The Washington Post reported that former Trump advisor Gary Cohn stated that a trade war could undo the benefits of the last tax bill [emphasis added]:

Gary Cohn, who served as Trump’s director of the National Economic Council but left amid a rift over the president’s trade policies, said that retaliatory tariffs between countries could drive up inflation and prompt American consumers to take on more debt, possibly pushing the country into another economic downturn.

“If you end up with a tariff battle, you will end up with price inflation, and you could end up with consumer debt,” Cohn, a former Goldman Sachs executive, said at a Washington Post event. “Those are all historic ingredients for an economic slowdown.”

Asked if the trade battle could erase the gains to the American economy from the tax law, Cohn said: “Yes, it could.”

Megan Greene of Manulife Asset Management wrote in the FT that, in the case of a limited trade skirmish, the benign outcomes from macro-economic forecasts don’t tell the entire story.

However, the models largely ignore that the effects of a trade war would hit some industries and regions harder than others. This will become even more of an issue if President Trump follows through on threats to impose 25 per cent tariffs on imported automobiles. The Canadian, Mexican and German auto industries would suffer significantly, even if the overall impact is muted.

These benign predictions are probably flawed in other ways. First, most models are not granular enough to reflect the disruption in global supply chains that would result from tariffs. These are likely to provide the biggest drag on growth from the tension over trade. Some car parts cross the Mexican, Canadian and US borders several times before they end up in a finished vehicle. If Nafta collapses, would carmakers raise prices, absorb additional tariffs or find ways to procure all of their parts in one country?

Second, it is difficult to model the impact of trade-related uncertainty on business sentiment. The stalled Nafta negotiations are starting to affect Canada through lost or deferred business investment.The trade wars could quickly extend into areas that are even harder to quantify. When the US first threatened an additional $100bn in tariffs on Chinese imports, it became clear that China could not respond in kind; it simply does not import enough US goods. But it could hit back by creating more bureaucratic hurdles for US companies operating in China, and interfering with licensing. The impact of such steps would be hard to measure in economic forecasts.

The political blowback is likely to be fierce for Trump. Even in the case of a trade dispute with Canada, CNBC reported that states that supported Trump would get hit the hardest in a Canada trade war.

Further, a report surfaced that Canada floated the idea of sanctioning Trump’s businesses rather than retaliating with more tariffs:

Canadian Foreign Minister Chrystia Freeland said Tuesday that she is open to using a law normally reserved for leaders responsible for human rights violations to impose retaliatory sanctions on the Trump Administration. Those sanctions would target the administration itself rather than the American people.

The Justice for Victims of Corrupt Foreign Officials Act, also known as the Magnitsky law, would allow Ottowa (to impose travel bans and asset freezes on foreign leaders. Regina-Lewvan MP Erin Weir proposed the measure during a Question Period with Freeland earlier this week. Weir noted that the law might be particularly useful because Trump has “made himself vulnerable” by maintaining personal business interests.

The Europeans have been the masters of politically targeted trade retaliation. The Chinese have also learned, by imposing tariffs on American farm exports, whose producing states mainly voted for Trump in the last election.

In short, war is hell. Even if you win, a one-sided trade war is likely to induce a global recession.. A full-blown trade war is likely to cause even greater damage.

The week ahead

If the market had been really spooked about trade policy, stock prices would have been off 1-2%. Instead, the SPX fell only -0.1% on Friday after the White House announced the latest round of tariffs on Chinese exports, though it was off -0.4% for most of the day, and quadruple witching positioning may have accounted for a late day rally.

For now, market internals show relative nonchalance over trade war risks. Domestic large cap companies, which should be relatively insulated from trade tensions, are underperforming the overall index.

In the absence of political and trade policy fears, the fundamentals are strong. Last week’s report of retail sales was unusually strong. In general, the Citigroup Economic Surprise Index seems to have survived the seasonal weakness often seen in H1 and appears to be turning around.

The latest update from FactSet shows that EPS estimate revisions continue to strengthen after the tax bill related surge earlier in the year. Moreover, Q2 earnings guidance is better than average, which points to continuing fundamental momentum that is supportive of higher stock prices.

I wrote last week that the market needed a brief period of correction or consolidation. Since March, the SPX had exhibited a pattern of breakdowns out of a series of rising wedges, and the tops of these formations were coincidentally marked by either a breach or touch of the lower Bollinger Band by the VIX Index. That pattern continues to hold. If history is any guide, these corrective periods tend to last about two weeks, which puts the end of the correction about the end of next week. Bulls can be encouraged by the pattern of progressively shallow corrections, which is an indication of intermediate term strength. Support can be found at about the 2740 level, which represents downside risk of only about 1%.

In the meantime, short term breadth metrics are weakening across the market cap spectrum. Until the market can start to show some strength and momentum, the correction or consolidation isn’t over yet.

As well, medium term (3-5 day) breadth indicators from Index Indicators are showing negative momentum, but readings are neutral and not oversold. These conditions are suggestive of further downside potential over the next week.

My inner investor remains bullish, and he is not worried about 1% squiggles in the stock market. My inner trader put on a modest short position in anticipation of mild weakness next week.

Disclosure: Long SPXU

Things you don’t see at market bottoms: Giddiness revival edition

Posted by Cam Hui - June 14, 2018

The last time I published a post in a series of “things you don’t see at market bottoms” based on US based investor enthusiasm was in January. That’s because market exuberance had significantly moderated since the January top. Guess, what, the giddiness is baack!

As a reminder, it is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time. My experience has shown that overly bullish sentiment should be viewed as a condition indicator, and not a market timing tool.

Past editions of this series include:

I reiterate my belief that this is not the top of the market, but investors should be aware of the risks where sentiment is getting increasingly frothy.

Junk bond euphoria

Risk appetite is returning to the markets after correction from the January market peak. Lisa Abromowicz at Bloomberg recently pointed out that investors have piled into the lowest rated junk bonds, which are outperforming.

Issuers have taken note of this development, and International Financing Review reported that car finance companies are selling more junky auto loans:

Car finance companies have pushed into fresh territory this year by selling Single B rated debt backed by loans made to sub-prime borrowers.

Selling Double B bonds wInas a bold trade not so long ago but as demand has grown for riskier assets, auto sellers are now able to sell further down the capital structure.

That’s because investors can pick up more yield (even though interest rates are rising):

By migrating to Single B from Double B, investors can pick up a bit of the spread that has vanished from less risky classes.

Last summer Double B spreads sank to a post-crisis low of around 300bp. But by last month, Westlake had cleared its Double B notes at 205bp, according to IFR data.

Its Single Bs fetched 325bp to yield 6.1%.

Still, not all is well. The rush into junk is creating an enormous gap between the relative price performance of junk bonds (blue line), investment grade bonds (red line), and emerging market bonds (green line) against equivalent duration Treasuries. Each sector is behaving according to its own dynamics. IG bond prices may be depressed by the effects of the latest tax bill, where companies that held offshore cash in IG paper have been selling their corporate bond holdings in order to repatriate cash into the US (see this analysis from Convex Capital Management). EM bonds are under stress because of rising rates that is pressuring fragile EM economies with external debt.

Which bond market do you believe?

M&A gone wild

Runaway M&A activity is often seen as a sign of a market top. The court’s approval of the AT&T-Time Warner deal is likely to set of another wave of M&A activity in that sector. Already, we are seeing a bid from Comcast for Fox assets in a challenge to Disney.

Notwithstanding the impact of the AT&T/Time Warner merger, M&A activity is set to hit an all-time high of $5 trillion in 2018, according to Business Insider:

2018 is the most active year for dealmaking on record, according to data from Bloomberg, with nearly $1.7 trillion worth of deals announced across the globe.

That pace puts the market on track for $5 trillion in deals, which would blow away pre-financial crisis level highs when mergers topped $4.6 trillion in value in 2007.

Hernan Cristerna of JPM echoed those sentiments in a Bloomberg TV interview stating that this year is poised to be the “best ever” in M&A activity and “we are in an unprecedented M&A market”.

USA Today piles into FANGs

Here is another indicator of giddy risk appetite. An article in USA Today advised teens that “Investing in Facebook, Amazon, Google stocks could turn summer job pay into a fortune”:

That $10-per-hour summer job slinging eggs or saving lives at the beach could add up to more than pocket change. In fact, it could translate into a nest egg of tens of thousands of dollars if you sock some of the cash away in the stock market.

While the pay isn’t great for teens and college-age workers looking to make a few extra bucks — 87% of employers hiring this summer plan to pay $10 or more an hour, CareerBuilder says — it’s enough seed money to build a small fortune in a short period of time, an analysis by educational investment app Rubicoin found.

Rubicoin calculated how much money a worker earning $10 an hour in a 25-hour workweek for 13 weeks each summer the past four years would have if they invested half of their before-tax pay equally on Aug. 31 each year in four FANG stocks — Facebook, Amazon, Netflix and Alphabet, Google’s parent company. Half of the annual summer pay adds up to $1,625 per summer.

That $6,500 investment since 2014 would be worth $15,899 today, according to Rubicoin, citing closing prices on May 28. And for summer workers who favor big bets, that initial investment would have grown to $22,639 if they funneled all the cash into just Netflix stock, or $19,554 if they bet it all on online retail giant Amazon.

As they say, past performance is not an indication of future returns. That a mainstream publication like USA Today would try to project those kinds of returns based on meager summer job earnings may be a classic example of a contrarian magazine cover indicator sell signal. To be sure, the BAML Fund Manager Survey found that the most crowded trade is long FAANG + BAT (Baidu, Alibaba, and Tencent).

Excuse me, I have to cut this short. I have to run and buy the triple leverage FANG ETF in my kid’s margin account…

How far can this rally run?

Posted by Cam Hui - June 13, 2018

Mid-week market update: Since early May, it has been evident that the bulls have regained control of the tape (see The bulls are back in town). Not much can faze this market. Even today’s hawkish Fed rate hike left the market down only -0.4% on the day. The question for investors then becomes how far this rally can go.

From a technical perspective, the answer was surprising. Applying point and figure chart on the SPX yielded a target of 2609 using the parameters of daily prices, and the traditional box size and 3 box reversal. Extending the time horizon to weekly prices, the target was 2549, and monthly prices, 2579.

This analysis implies that the market has overshot its target. But varying the parameters using a % box size told a different, and more bullish, story.

A point and figure chart using daily prices with a 1% box size and 3 box reversal yielded a target of 3185. The target was the same (3185) using weekly prices, and an astounding 4617 using monthly prices.

What if we used a 0.5% box size? The target using daily prices was 3012, which is similar to the 1% box chart, The weekly chart had a target of 3008, and the monthly chart had a target of 2569(!)

What does this all mean? If we assume that the market has not topped out, a price target of 3000-3100 for this market cycle may be a realistic assumption. On the other hand, the huge variation in point and figure targets is also an indication that the risks to this market is rising.

Market still overbought

In the meantime, the market is still overbought short-term and vulnerable to a correction. The SPX is hitting a resistance band at these levels, and overbought conditions suggest that a brief pullback or consolidation is ahead.

The hourly chart reveals the risks. The market is exhibiting a negative divergence even as it tested overhead resistance.

I would also point out that this week is OpEx week, and Jeff Hirsch at Alamanac Trader observed that the week after June OpEx has been challenging for equity bulls.

My inner trader initiated a modest short position last week, with the first downside target at 2740 and further target at 2700. He is prepared to turn bullish if the index stages a decisive breakout above 2800.

Disclosure: Long SPXU

Can America still lead the world?

Posted by Cam Hui - June 10, 2018

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

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities
Trend Model signal: Neutral (downgrade)
Trading model: Bearish

A question of leadership

A picture is worth a thousand words. In light of the visible divisions at the G7 meeting, the question of whether America can continue to lead the world sounds out of place.

The question takes on a different context from an equity investor’s viewpoint. The chart below shows that US stocks have been the only source of market leadership, which begs the question, “Can global stocks achieve new highs with only US stocks?” The chart below compares US, international developed markets (EAFE), and emerging market (EM) equities to the MSCI All-Country World Index (ACWI). US equities have been tracing out a saucer shaped base on a relative basis. EAFE have been weak in the past year, and they are testing a key relative support level. EM relative performance began to falter in late 2017, and relative strength has been rolling over.

Put it another way, can the other regions recover some of their mojo in order to propel global equities to new all-time highs? To answer that question, we take a tour around the world and analyze the macro and equity market outlooks of the three major trading blocs, the US, Europe, and China.

U-S-A! U-S-A!

The bull case for US equities is easy to make. Valuations are not excessively, as the forward P/E of 16.6 is just above its five year average.

At the same time, fundamental momentum is positive from both a bottom-up and top-down viewpoint. The latest update from FactSet shows that forward 12-month EPS is still rising steadily after the tax cut related surge.

Kevin Muir, writing at The Macro Tourist, observed that bottom-up data is also telling a story of a strong economy:

Recently I had a couple of different interactions with shrewd market watchers that have perked my antenna. When the first occurred, I filed it away – assuming it was a sampling quirk. But when my second buddy unbiddenly told a similar tale, I jumped up from my chair.

Let’s start with the first story. My pal is involved with lending to small business owners. He gets weekly reports that show delinquencies and other metrics that give a great snapshot of the health of America’s small businesses (or at least his thousands of clients). Way back when the 2007-2008 crisis began, he knew it would be worse than Bernanke and the other Pollyannas were indicating as he had a ringside seat to the growing economic stress. His clients simply stopped paying their bills and defaults shot higher. Well, during our meeting last month he said, “Kev, I know the macro numbers are rolling over, but we are not seeing it in our data. I don’t know if it is an anomaly, or if the macro data is wrong, but our data is not reflecting the recent slowing. In fact, many of our credit payment measurements are sitting at near record levels.”

Fast forward to my next buddy. He is an old-school small-cap equity value investor. He gets on planes to visit places most analysts wouldn’t be caught dead at to get a sense of management and see the operation in person. With all of his contacts, he gets a good sense of how small-town America is doing. During our chat over drinks, he passed along his observation that the US economy is “tight as drum.” Phones are ringing off the hook. Trucks leaving the plant with product full to the brim. Business owners can’t find enough staff. Things are hopping.

Top-down momentum looks equally impressive. The Atlanta Fed’s Q2 GDP nowcast stands at an astounding 4.8%, the New York Fed’s GDP nowcast is 3.08%, and the St. Louis Fed’s GDP nowcast is 3.8%. Any way you look at it, that’s strong growth.

The growth acceleration is confirmed by the strength in the Markit Composite PMI.

These strong fundamentals are reflected by a series of buy signals from insider activity, according to Barron’s.

U-S-A! U-S-A!

Europe: The bears’ playground

Across the Atlantic, the eurozone is the region where the bears are coming out to play. There is no shortage of bearish eurozone commentary. Bloomberg reported that Gavekal believes that the next bear market will emerge from the eurozone:

Investors on the watch for a bear market in global equities should keep their eyes on Europe, according to Gavekal Research.

“This animal is the sneaky sort and victims rarely see it coming,” said Charles Gave, founder of the Hong-Kong based asset-allocation consultancy, in a note to clients Wednesday. “If a bear market is to unfold, this will probably start outside of the U.S.”

The likely location would be the euro zone, Gave said, where the single currency system “has now been destroying southern European economies for 20 years and local populations are increasingly unwilling to take the beating.”

As the ECB considers ending its QE program, research from UBS concluded QE is the only thing that is keeping the eurozone economy alive:

But what if the ECB can never normalize policies because tightening financial conditions could end up killing off the recovery? That’s the take-away in not so-many words from a UBS Group AG report led by Pierre Lafourcade. UBS applies the famous Laubach-Williams model on the natural rate of interest to the single-currency bloc. Its conclusion: the central bank’s purchase program has been even-more potent than you might have thought. QE accounts for 75 basis points higher growth per year since 2015 and core inflation by the same clip, while the neutral real rate is a depressing minus 2 percent and potential annual growth just 1 percent, according to the Swiss bank. “Essentially, Europe’s performance has been inflated by ECB action to a greater extent than everyone realized.”

In addition, the latest Composite PMI is telling a story of a growth deceleration.

All these negative have served to put pressure on the Euro STOXX 50, which is tracing out a rounded top (top panel). The relative performance against ACWI (bottom panel) appears equally dismal, with the index weakening and approaching a relative support zone.

That said, these eurozone conditions are a contrarian’s dream. Things can’t get very much worse. Consider, for example, the Europe Economic Surprise Index (ESI), which measures whether economic statistics are beating or missing expectations. The ESI is designed to be mean reverting, and readings at -100 are as bad as they can get.

History shows that investors who bought European equities when ESI falls below -70 would have performed very well.

What about political risk? As I pointed out last week (see Revealed: The market timers’ dirty little secret), Italians overwhelming do not want to leave the euro. Everything else is European theatre. In fact, the FT reported that the German and French positions on greater European integration:

Angela Merkel, Germany’s chancellor, has ended her long silence on the proposals for European reform made by the French president Emmanuel Macron. In an interview with a German newspaper at the weekend, followed by a speech in Berlin on Monday, she laid out her unifying plan for a divided continent. Divisions, it must be said, to which German policies and inaction have contributed.

The chancellor is stretching out a hand not only to France, but also to Europe’s economically beleaguered south. Just as importantly, her plan is one that the more parsimonious and debt-averse northern Europeans can sign up to. With its emphasis on embracing technological change in a way that leaves no one behind, it is crafted to appeal not just to her coalition partners at home, the Social Democrats, but to future partners like the Greens.

Ms. Merkel’s plan is an implicit apology for past German intransigence on economic policy, and signals that Germany wants to return to its old role as a bridge-builder. She promises a “respectful” approach to Italy’s populist governing coalition— a rebuke to earlier criticism of the Italian vote by German EU commissioner Günther Oettinger.

Ms. Merkel accepts that Germany, Europe’s richest economy, needs to contribute more than others, while acknowledging that there is resistance on the part of northern and eastern EU member states to further integration. Her plan, unlike Mr. Macron’s impassioned calls for deeper reform, stands a chance of forming the basis for a new European consensus.

In effect, Ms. Merkel is now fleshing out her announcement in a May 2017 campaign speech that we Europeans needed to “take our fate into our own hands” in the era of a rising China and Donald Trump. Europe, she says now, must “renew the promise of peace and security” to its citizens on three “existential” questions: monetary union, immigration and defence. Only then can it stand firm in defence of a rules-based world order.

On the eurozone, Ms. Merkel still rejects any form of debt mutualization. Instead, she supports banking and capital markets union, as well as a “European Monetary Fund” with special new short-term emergency credit lines. She wants to use the EU budget for investments in growth and innovation in Europe’s more troubled economies.

One of the fatal flaws of the euro is monetary integration without fiscal integration. While the Germans are not embracing full fiscal integration, these steps are nevertheless a positive sign that Europe can be saved.

Watch for the European theatre to continue, but a relief rally to begin in the near future.

China: A growth pause?

While Europe may be a contrarian’s dream, China may turn out to be a growth disappointment. Evidence of a pause is beginning to accumulate, as evidenced by the latest Caixin PMI readings.

Callum Thomas of Topdown Charts observed that both fiscal and monetary stimulus are tightening.

Business Insider reported that Chinese credit growth has also been decelerating.

Chinese defaults also are rising, which is increasing credit risk in an over-leveraged economy. In addition, Bloomberg reported that Chinese banks have been selling their corporate-bond holdings and tightening credit to firms that buy the debt. These steps raise the risk of a doom loop of escalating defaults.

As a result, the stock market of China and her major Asian trading partners have been mixed, characterized by indecisive price trends.

Technicians can measure the pulse of a market by how it responds to news. The partial inclusion of China’s A-shares into MSCI indices barely moved the needle on stock prices. In the short run, that’s bad news for the regional stock market outlook.

Regional opportunities and risks

What can we conclude from our brief tour around the world? I interpret current conditions as strong US economic and equity leadership can provide support for stock prices. I would expect that European equities should recover in the next few months once investors get over their latest jitters.

The wildcard is China. The Chinese economy is entering the downleg of a stimulus/tightening cycle of unknown duration and magnitude. While Beijing has lots of tools to cushion a hard landing, it is unclear how much pain the Chinese economy will have to endure before the authorities act. In short, as long as China doesn’t implode, expect fresh highs in the global market averages in the next few months.

In terms of positioning, I am inclined stay long US equities, accumulate Europe in anticipation of better performance in the months ahead, and underweight China, Asia, and China related plays.

The week ahead

Looking to the week ahead, the intermediate term outlook remains bullish. All versions of the Advance-Decline Lines, whether large cap, mid cap, small cap, or NASDAQ, have recently made all-time highs, indicating a bull trend.

However, we may see some near term weakness. Subscribers received an email alert last Friday that my inner trader was taking profits on all long positions and had put on a small short. The sale of the long positions generated a notional 8.0% profit based on the buy signal flashed on April 23, 2018 (see My inner trader).

Since March, the market had broken down out of a series of rising wedges. Each of those instances was accompanied by the VIX Index either breaching or touching its lower Bollinger Band. The corrective phases of successive rising wedge breakdowns have been increasingly shallow, which is intermediate term bullish. The latest episode occurred Friday, as the market broken down out of the wedge but rallied up to backtest the resistance trend line.

You can better see the break, rally and backtest in the hourly chart. The index tested the old highs and uptrend line while exhibiting a negative RSI divergence. The initial downside target is support and gap at about 2740. Further downside targets can be found at a second gap at about 2712-2718, and a third gap at 2694-2700.

Next week will see a number of sources of event-driven volatility. We will have the US-North Korea summit on Tuesday, and the BoJ, ECB, and Fed will be meeting next week to announce their respective monetary policy decisions. Next week will also be option expiry (OpEx). Historical stuies of OpEx week from Rob Hanna of Quantifiable Edges indicate June OpEx has seen subpar market returns, though the winning weeks still outnumber the losing weeks.

Short-term breadth indicators from Index Indicators show that the market is overbought and due for a pullback.

Andrea Kramer at Schaeffer’s also observed that II Bulls have risen for four weeks in a row, and subsequent market returns have been subpar, though not disastrous.

The peak-to-trough time horizon of past rising wedge breakdowns have lasted about two weeks, and that will be my inner trader’s working hypothesis for how a pullback may play out. He is nevertheless aware that the intermediate term trend is up, and successive corrections have been shallower and shallower. Downside risk at these levels is only 1-2% and therefore his short position does not represent a major capital commitment.

My inner investor is staying long, as he is not interested in playing 1-2% squiggles in the market.

Disclosure: Long SPXU

What June swoon?

Posted by Cam Hui - June 6, 2018

Mid-week market update: Sell in May? June swoon? Not so far! As the SPX convincingly staged an upside breakout above the 2740 resistance level, the bull case is easy to make. We have seen fresh all-time highs this week from the following:

NASDAQ Composite
Russell 2000 small caps
NYSE Advance-Decline Line
NASDAQ Advance-Decline Line

I probably forgot a few, but you get the idea. In addition, the metrics of risk appetite, such as the ratio of high beta to low volatility stocks, is exhibiting a positive divergence.

Hold the celebrations! While I have been bullish throughout this corrective episode, I am very aware that the bulls still have some short-term challenges to overcome.

A bulls’ party

It`s hard not to be bullish. risk appetite indicators such as the relative performance of junk bonds, and price momentum, are pointing higher.

Moreover, sentiment has not reached excessively bullish levels. The Fear and Greed Index is displaying positive momentum, but readings are still in neutral territory. These conditions leave room for stock prices to rise further before becoming overbought.

In the short run, the CBOE equity-only put/call ratio has flashed a number of low extremes, indicating complacency. However, I prefer to focus on the longer term normalized average, which is not at a sell signal level yet.

What about the unfilled gaps below as the market rallied? Could the market weaken to fill those gaps? Rob Hanna at Quantifiable Edges studied what happens when the market rallies to fresh highs while leaving two unfilled gaps in its path (N=47). If history is any guide, positive price momentum has overcome the mean reversion factor of the unfilled gaps.

The challenge for the bulls

Still, there are a couple of short-term worrisome developments beneath the surface. First, breadth momentum, as measured by A-D percent, has been weakening across all market cap bands even as the market ground upwards. Can prices continue to advance even as breadth momentum peters out?

In addition, the market is testing the upper end of a a classic bearish rising wedge. If the market should break down out of that formation, the first logical support would be the 2740 area, with further downside risk down to about 2720. However, an upside breakout would invalidate that potential negative development.

In short, the market needs to exhibit evidence of momentum acceleration in order for this rally to continue.

For now, I am giving the bull case the benefit of the doubt. My inner trader remains bullishly positioned. He is aware of these challenges and he is calibrating his risk control accordingly.

Disclosure: Long SPXL, TNA

2 contrarian trades that will make you uncomfortable

Posted by Cam Hui - June 4, 2018

Do you really want to be a contrarian investor? Most of the time, being contrarian means that your investment views are far from the crowd, and you will feel very isolated and uncomfortable. With that preface in mind, I offer two uncomfortable contrarian trades, based purely on technical analysis. Fading a NAFTA breakdown Let’s […]

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Revealed: The market timers’ dirty little secret

Posted by Cam Hui - June 3, 2018

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

What market timers won’t tell you

Market timers have a dirty little secret that they won`t tell you, “Bottoms are easy to call, but tops are hard.”

Consider the use of the NAAIM exposure index just as a typical example of a contrarian indicator. In the last 10 years, episodes when the NAAIM fell below its Bollinger Band (blue vertical line) have been good trading buy signals. While oversold markets can become more oversold, buy signals have marked periods of low downside risk. On the other hand, sell signals when NAAIM rose above its upper BB have not worked well.

The perspective is totally different from a business viewpoint. What market timers won’t tell you that it’s the doom and market crash narratives that get the clicks and the views. Mark Hulbert revealed that “bear markets and heightened volatility are good for business” of newsletter writers. In the two years leading up to the January top, stock prices went straight up:

Who needs a market timer during conditions like those? One leading stock-market timer I monitor told me that during the market’s blow-off stage between last November and the late-January peak, he lost 18% of his subscribers. He added that he’d never before experienced a drop in subscribers of similar magnitude — much less over so short a period.

Glenn Neely, editor of the NeoWave market-timing service, said 2016 and 2017 were some of the most difficult he’s experienced in a 30-year career.

With those factors in mind, I analyze some of the scare stories that have come across my desk in the last few weeks and show why they should not be reasons for panic:

Eurozone crisis: Italy and Spain
A looming junk bond Apocalypse
A crowded long position in the equity bull trade
Signs of complacency at the Fed

As the Wall Street adage goes, “Bottoms are events, while tops are processes.” Ignore “this will not end well” warnings with no obvious bearish trigger. Don’t be fooled by the clickbait stories of doom.

Eurozone crises are the best crises

The markets were spooked last week by fears of another looming eurozone crisis, first from Italy, then from Spain. But investors were in reality just served with another act of European theater.

Just keep in mind opinion polls show that most Italians would like to remain in the euro. In the absence of eurozone breakup risk, we know how this plays out. The eurocrats will cobble a solution in the end.

The latest act of European theater parallels the events of last Greek crisis. The initiatives of the latest Italian government is highly reminiscent of the ideals of the SYRIZA government in Greece when it first achieved power. We know how that play turned out too.

As for Spain, just remember that Spain is not Italy. Its economic growth is about 3%. Madrid will comply with EU budget rules for the first time in years. In addition, any realistic alternatives to Rajoy will be pro-Europe.

I recently read the best perspective on the latest eurozone fright stories: Eurozone crises are the best crises! Let’s get the band back together!

“This will not end well”

While a eurozone banking crisis has the potential to crater the global financial system, a number of other “this will not end well” warnings have crossed my desk, indicating elevated risk levels but with no obvious bearish trigger.

John Mauldin recently warned about a potential high yield train wreck. He observed that the size of the US high yield and loan markets has been rising rapidly.

Mauldin also highlighted analysis from David Rosenberg of danger posed by deteriorating credit quality. Even within the investment grade (IG) category, nearly half of IG bonds are rated BBB, which is the lowest rating above junk.

Moreover, covenant lite issues are hitting the market, which leave investors with little protection should financial conditions deteriorate significantly.

In a separate piece of analysis, Callum Thomas of Topdown Charts pointed out that leveraged long equity ETFs have surged to all-time highs, while leveraged short ETFs have been falling.

Thomas also found that stock market leverage, defined as net margin debt + net leveraged ETFs + net speculative futures positioning, is also at an all-time high.

The bullishness has also migrated to Federal Reserve policy makers. Textual analysis of Fed minutes revealed that words about a strong economy have reached an all-time high.

At the same time, the level of disagreement at the Fed is very low. In effect, the Fed is becoming complacent about strong growth and groupthink is taking over.

What could possibly go wrong?

What’s the bearish trigger?

Keynes famously said that the markets can stay irrational longer than you can stay solvent. In my experience, “this will not end well” narratives can continue as risk levels stay elevated and markets rally. Such conditions are more indicative of heightened downside risk in a bear phase, but they are silent on the bearish trigger.

As a reminder, in my series “Things you don’t see at market bottoms”, I have stated repeatedly that, “My experience has shown that overly bullish sentiment should be viewed as a condition indicator, and not a market timing tool.” This series began in June 2017, about a year ago, and an equity bear hasn’t begun yet:

As an example, analysts have recently pointed to the lack of positive response to EPS beats. The latest update from FactSet reveals that companies that beat consensus EPS by 20% or less did not perform well.

Is that a reason to be bearish? Further analysis shows that stocks have been behaving this way for about a year. At the same time, stock prices are higher than they were a year ago.

At the same time, the latest update from FactSet shows that forward 12-month EPS continues to rise. FactSet also reported that Q2 guidance is better than the historical average. Both of these factors are indicative of positive fundamental momentum.

Moreover, Q2 EPS estimates are rising, which is unusual. Historically, EPS estimates tend to start high because of overly optimistic analysts, and they drift down as reality sets in. As we close the book on Q1 and look ahead to the Q2 reporting season, EPS estimates are edging upwards.

Are you sure you want to be bearish?

Recessions = Equity bear markets

Ultimately, markets will not fall without a bearish trigger. History has shown that recessions have been bull market killers, and my approach is to combine fundamental and macro analysis with technical analysis to control downside risk. Once I have determined that recession risk is high, my inner investor uses the moving averages to define the levels where he de-risks his portfolio.

Here is what I am worried about. The first is Fed policy. The unemployment rate, as indicated by the May Jobs Report, fell to 3.8%. Jim O’Sullivan of High Frequency Economics observed that the current unemployment rate is already at the Fed’s projected year-end 2018 levels, indicating an increasingly tight labor market. Can the Fed really take its foot off the monetary brakes under such conditions?

Fed Governor Lael Brainard’s recent speech is equally concerning, where she downplayed the risks from a flattening yield curve. Brainard, who had been a dove, has turned more hawkish, and her views also highlight a growing schism between the Fed governors (who have permanent votes, more staff, and therefore greater power in determining monetary policy), regional Fed Presidents, who have voiced concerns about inverting yield curve.

It is important to emphasize that the flattening yield curve suggested by the SEP median is associated with a policy path calibrated to sustain full employment and inflation around target. So while I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.

At the current rate of deterioration, my monetary policy indicators will flash a recessionary warning in late 2018.

My second worry is the growing risk of a trade war (see Could a Trump trade war spark a bear market?). The latest Fed Beige Book shows that respondents are increasing concerned about a potential trade war.

For now, it’s only a trade skirmish. The only question is how these conditions affects business confidence, and the pace of hiring and investment. Here is Mark Zandi of Moody’s (via Marketwatch):

“If all of the announced tariffs are actually implemented, it will [cut] 0.2% from real GDP growth. If that’s all it is, it won’t cause much of a slowdown,” Moody’s Analytics chief economist Mark Zandi said. “However, if the trade war is back on, and the Trump Administration slaps 25% tariffs on all Chinese and Mexican exports to the U.S., as [Trump] promised during the campaign, then yes, it would do serious economic damage. NAFTA would likely fall apart, and financial markets would begin discounting much worse. A recession would be a real possibility.”

The month ahead: A test for the bulls

The stock market went on a wild ride last week, and I was fortunate to have nailed my two short-term forecasts (see Offbeat Thursday and Friday forecasts). I took the “over” in the May Jobs Report, which came in well ahead of expectations. Moreover, good (economic) news continues to be good (stock market) news.

As well, last Thursday saw a significant QT day, where about $28b rolled off the Fed’s balance sheet. Past significant QT days in 2018 has seen stock market weakness and last Thursday was no exception. The jury is still out on QT day weakness as a trading indicator. Arguably, equity prices fell in reaction to the imposition of aluminum and steel tariffs on major American allies. On the other hand, the tariff news was known before the open, but stock prices did not significantly weaken until later in the trading day, which argues for a QT market effect. For readers following along at home, data from the New York Fed shows that the next significant QT day will be June 30, 2018.

I also wrote last week that an analysis of the market using MACD using daily, weekly, and monthly time frames was revealing (see The hidden MACD message from the market). The MACD weakness on the daily chart appears to be resolving itself with only downside risk. We continue to see positive divergence from the Advance-Decline Line, with the next SPX resistance at 2640.

The coming week will be a test for bullish momentum. Risk appetite remains healthy. Market fears of a junk bond selloff is dissipating (top panel), and the price momentum factor remains in a relative uptrend.

The Fear and Greed Index is rising, has a intermediate term momentum tailwind, and readings are only neutral and have room to increase further before it becomes overbought.

The signal from the DJ Transports is equally encouraging. Even as the DJIA struggles, the DJTA has broken out to fresh recovery highs and the DJTA/DJIA ratio is tracing out a saucer shaped bottoming pattern (bottom panel).

That said, the bulls need to get the job down in the next month or so. The NYSE McClellan Summation Index (NYSI) is becoming overbought, and the window for achieving new highs before the index rolls over is narrowing.

My inner investor remains bullish in anticipation of fresh index highs this summer. My inner trader added to his long positions on market weakness last week.

Disclosure: Long SPXL, TNA

The hidden MACD message from the markets

Posted by Cam Hui - May 30, 2018

Mid-week market update: Callum Thomas conducts a regular weekly (unscientific) Twitter poll of equity market sentiment, and the latest results show that both fundamental and technical bullishness are falling. These readings suggest that bullish momentum is waning.

Indeed, daily MACD has been decelerating and turned negative this week, indicating that the bears are taking control of the tape. However, I would point out that many past episodes of negative MACD in the last year has seen little market downside, so an aggressive bearish trading stance may not be warranted.

That`s not the whole story.

Fun with MACD

The weekly chart has a different message. MACD is rising, indicating that any market weakness is likely to be temporary and should be bought.

The narrative of short-term market weakness and intermediate term market strength is confirmed by the behavior of the VIX Index, which closed above its Daily Bollinger Band on Tuesday, indicating an oversold condition for stock prices. While the market did recover today (Wednesday), I expect some chop before stock prices can fully recover and the bull regain the upper hand. If QT related weakness should strike the markets on Thursday (see Offbeat Thursday and Friday forecasts), trader should be regarded that as a buying opportunity.

Longer term, the monthly chart shows a falling MACD.

Confused? Not really. I interpret the weekly chart as a market ready to test or exceed the old highs this summer, but the negative divergence on the monthly chart suggests that any highs will not hold and may ultimately turn out to be the cyclical high for this bull market. We can see a similar effect on the monthly RSI of the Wilshire 5000. If this index were to break out to new highs in the next few months, it will likely exhibit a negative divergence that is a warning for the market.

A similar pattern can be found in the DJ Global Index,

My inner investor remains bullishly positioned for the potential new highs, as he has a policy of not trying to anticipate model readings before they actually appear. My inner trader has decided to ignore the temporary weakness on the daily chart and bet on intermediate term strength.

What you do depends on your own time frame.

Disclosure: Long SPXL, TNA

Offbeat Thursday and Friday forecasts

Posted by Cam Hui - May 29, 2018

Brett Steenberger recently warned that traders about trading on noise, which is advice to which I wholeheartedly agree:

In other words, before we can determine whether or not we have an edge (in systematic or discretionary trading), we need to establish knowledge. A theory explains how and why something occurs. Testing of historical data can help us conduct limited, targeted tests to determine whether our theory holds up in practice. Before we test, we must formulate a plausible hypothesis. There is no theoretical or practical rationale why many strategies in technical analysis, fundamental analysis, or random combinations of quantitative variables should be valid.

With that caveat, I offer two offbeat forecasts for the markets for this coming Thursday and Friday.

A QT warning?

Kevin Muir at The Macro Tourist observed that stock prices seem to take a tumble whenever the Fed wound down its balance sheet.

It’s hard to find a direct reason for the stock market weakness during QT days. The Fed does not sell its bond holdings as part of its Quantitative Tightening (QT) program, but it decided to allow issues to mature and roll off its balance sheet. Therefore there are no market transactions, and the maturity of its security holdings should have no direct market impact, either on the bond, forex, or stock market.

Despite my skepticism, I made a quick study of my own using weekly data and found a weak negative influence on stock prices in 2018, though the sample size is small.

Nevertheless, a market effect has been observed. The New York Fed publishes the details of the Fed’s security holdings, and the next big day is Thursday, May 31, 2018, when about $28 billion rolls off the balance sheet.

Will we see a significant market downdraft on Thursday? That’s what out-of-sample model testing is for.

A blowout Jobs Report?

Friday’s forecast is based on more reliable evidence. The markets had interpreted the latest FOMC minutes in a dovish fashion because of the focus on a symmetrical inflation objective, indicating that the Fed is willing to tolerate some inflationary overshoot of its 2% target. How would the market react if we were to see a significant upside surprise in the May Jobs Report scheduled to be released this Friday?

The chart below shows a simple heuristic that plots the 4-week moving average of initial jobless claims (blue line, inverted scale) with headline NFP. Initial claims for the week ending May 12, 2018, which corresponds to the survey period of the Jobs Report, set a low that was exceeded only back in the 1960’s. This suggests that we should see a blowout May NFP figure this Friday.

Expectations is for an increase of 185K jobs. I would take the over.

If I am correct, then the bond market won’t like the results. On the other hand, the stock market reaction will be a key test of investor psychology. Will good (economic) news be interpreted as good (stock market) news, or bad news? The Citigroup Economic Surprise Index has shown a pattern of weakness early in the year and then a strong recover midyear. Could the NFP kick off that strength?

The Atlanta Fed’s GDPNow is flashing an astounding 4.0% level for Q2 growth.

Stay tuned for possible fireworks Friday.

Could a weak consumer stall the economy?

Posted by Cam Hui - May 26, 2018

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

Rising household stress

The headlines look dire. CNN proclaimed that “40% of Americans can’t cover a $400 emergency expense”, according to the Fed’s annual Report on the Economic Being of US Households. Further research from Google Trends showed that interest in consumer items is tanking.

In addition, searches for bankruptcy and financial reorganization spiked recently, indicating rising stress in the household sector.

Last Friday’s release of consumer sentiment missed expectations and readings are continue to deteriorate.

The economy is at or near full employment. Is this as good as it gets? Is this what prosperity looks like? What does this mean for policy makers?

For investors, the key question are:

How stressed is the household sector; and
Is this precursor to a bull market killing recession?

A household sector report card

To assess the financial status of the American household, let us first consider real retail sales, which is an important driver of economic growth. History shows population adjusted real retail sales has topped out before past recessions, and the latest data shows a possible plateau, but the jury is still out on that score. In the past, it takes about six months to confirm an actual peak in retail sales. The last peak occurred in November 2017, and the May 2018 data has not been reported yet.

If consumer spending were to weaken, it would show up in the cyclically sensitive consumer durable sector. The report is also mixed. On one hand, auto sales appear to be rolling over after the most recent hurricane replacement spike.

On the other hand, the housing sector appears to be still healthy. This cyclically sensitive sector has topped out ahead of past recessions, though it is enjoying a start of a demographic tailwind as millennials begin to enter the market and raise housing demand.

That said, the weak performance of the homebuilding stocks relative to the market has to be regarded as disappointing for the housing outlook.

Score retail sales and consumer durable sales growth as neutral. Real retail sales are trending up but may be plateauing, but the jury is still out. Auto sales are rolling over, but the housing sector remains strong, buoyed by positive demographics. The dire stories about a tanking consumer may be overblown.

The anatomy of consumer finances

Still, there is an element of truth that household finances are becoming more fragile. My analysis of consumer spending considers its underlying elements. It all begins with wage growth. While average hourly earnings have been rising steadily and annual growth now stands at 2.6%, the level of wage growth has been extraordinarily muted by historical standards. The unemployment rate is 3.9%, which was last seen in 2000, and before that, the 1960`s.

One of the puzzle that has bedeviled economists and policy makers is the lack of wage growth in the current tight labor market. A number of explanations have been advanced, such as demographics, where retiring well paid Baby Boomers are replaced by younger and less well paid Millennials. Another is the rise of an employer monosony holding down wages. The following chart from the San Francisco Fed shows “wage rigidity”, or the percentage of employees who have received no wage increases. Even with the unemployment rate at 3.9%, the current level of wage rigidity is higher than the peak seen in the last cycle.

Wage growth is the primary driver of consumer spending. As this chart from Political Calculations shows, median real household income has been flat since 2000.

Still, households have other ways of coping in the face of stagnant pay increases. The first avenue of coping is to spend more by saving less.

After drawing down savings, consumers could borrow to finance spending. The Fed’s flow of funds data shows that households are funding virtually all of their marginal expenditures with debt, up from 40% in 2013.

Rising debt raises financial risk for households. An analysis of the credit card delinquencies shows that as interest rates rise, delinquencies are likely to rise to recessionary levels by next year.

Despite the dire picture, household finances are not that dire as they seem. The latest update from JPM Asset Management shows that household debt ratios are still low, and their balance sheets are in good shape (annotations are mine). In other words, they have plenty of room to borrow if they want to.

Liz Ann Sonders at Charles Schwab has created a Consumer Stress Index to measure the state of household finances. The latest readings indicate that consumer stress is rising, but readings are not in the danger zone yet.

Oh, and the headline about 40% of American households who can`t cover a $400 emergency expense? While the absolute level is still worrisome, the same Fed survey shows that the trend has been steadily improving.

Moreover, the percentage of survey respondents who report that they are “finding it difficult to get by” has been falling as well.

A growing financial divide

Does this mean the ominous headlines about deteriorating consumer finances are overblown and it’s time to sound the all clear? Not so fast!

Detailed analysis an picture of bifurcated consumer finances and rising household fragility that will haunt the economy in the next downturn. The Atlanta Fed’s wage growth tracker captured this effect. People with high skill sets consistently enjoyed higher wage growth compared to the rest of the population. Remember your math, a consistently higher wage growth will lead to an acceleration in wealth differences over a lifetime.

While the relationship is less clear, skill sets can be proxied by education levels.

The Fed’s annual Report on the Economic Being of US Households tells a similar story of a financial divide is by education. Survey respondents were asked if they were “doing okay financially” and results increased steadily as education levels rose.

The flip side of the coin shows the respondents who were unable to fully pay the current month’s bills. We can observe a marked deterioration by education, and within each educational grouping, by race.

What about the American Dream and the idea of America as the land of opportunity? If education is the great equalizer, then the future looks problematical. Survey results show that parental educational attainment affect their children’s education levels.

In conclusion, aggregate statistics of household finances indicate that while consumer stress is rising, they do not constitute a danger signal of looming recessionary conditions. However, aggregates don’t tell the entire story, and further detailed analysis shows a bifurcation of household finances that will exacerbate the magnitude of the next downturn, and create longer term political problems in the United States.

The week ahead

Looking to the week ahead, positive macro momentum is holding up this market. The latest update from FactSet shows that forward 12-month EPS continues to surge upward.

Other nowcast indicators are flashing bullish readings. The Philly Fed coincident state indices rose in 45 states, and the three month diffusion index was up in 49 states out of 50 (via Calculated Risk). Other elements of the Philly Fed indices are also upbeat (see Bear markets simply don’t start this way).

From an intermediate term technical perspective, the outlook is bullish. This chart from OpenInsider shows that insider selling usually exceeds insider buying and rarely do the two lines cross. In the last two instances where the two lines have intersected, downside equity risk was minimal.

The OpenInsider buy signal was confirmed by the weekly summary of insider activity from Barron`s.

Shorter term, the SPX remains in a short-term no-man’s land between Fibonacci retracement levels of 2700 and 2740, with further resistance at 2800. Until either the bulls or bears can demonstrate sufficient resolve to break either of these levels, my inner trader is leaning slightly bullish but he is playing a waiting game.

Small cap stocks, as measured by the Russell 2000, remains the market leaders as they staged upside breakouts to fresh highs and the index has held above the breakout level. However, the relative performance chart (bottom panel) shows that small caps are in the middle of an upward sloping relative uptrend channel and have little information about short-term direction. My inner trader is still watching for a test of the channel as a possible buy signal.

Stock prices are likely to grind higher into the summer months, and my inner investor is bullishly positioned. My inner trader has partial long market positions, and he is prepared to add to them on pullbacks.

Disclosure: Long SPXL

Cue the fiscal and inflation fears

Posted by Cam Hui - May 24, 2018

Was the recent big tax cut not enough? CNBC reported that President Trump is proposing further tax cuts before November. He went on to pressure Congress to enact funding for his budget priorities on Twitter.

These actions prompted Steve Collender (aka @thebudgetguy) to declare in a Forbes article that Trump May Be The Most Fiscally Reckless President in American History:

But think about why Trump is asking for rapid action on the 2019 appropriations: He wants even more spending. Even though his policies have spiked the annual budget deficit to a new normal of a $1 trillion (with $2 trillion definitely within view) and interest rates are now starting to go up in large part because of his out-of-sync-with-the-economy stimulative fiscal policy, Trump is demanding that federal spending and the government’s red ink be increased even further.

There was no hint in this or any other subsequent tweet that Trump is going to propose offsetting spending cuts (or, heaven forbid, revenue increases) to compensate for the additional spending he’s demanding.

Trump’s recently-announced rescission package (which is already in a great deal of political trouble with congressional Republicans) doesn’t come close to offsetting the new spending Trump said he wants. It also won’t come close to being an offset even if the first package is followed with that second rescission plan Trump has said is coming, but which so far seems to be totally imaginary.

Here at Humble Student of the Markets, I believe that the determination of the proper path of fiscal policy is above our pay grade. Instead, my focus is on positioning portfolios for any changes in government policy.

Plenty of concerns

Steve Collender is not the only one to raise the alarm about the US fiscal position. The IMF also expressed concerns, as the US is the only major industrialized country projected to see increases in its debt-to-GDP ratio.

Goldman Sachs also recently raised questions about the fiscal outlook.

Federal debt is just the tip of the iceberg. Bridgewater Associates recently published a chart of out of control IOUs.

Rising inflation fears

The usual solutions to runaway debt are either default or inflation. For a country whose currency is a major global reserve currency, the easy answer is inflation. Already, the latest update from Markit shows rising inflationary pressures.

The latest FOMC minutes added fuel to the inflation fire by affirming the symmetry of the inflation target at 2% and signaling a tolerance for an overshoot [emphasis added]:

With regard to the medium-term outlook for monetary policy, all participants reaffirmed that adjustments to the path for the policy rate would depend on their assessments of the evolution of the economic outlook and risks to the outlook relative to the Committee’s statutory objectives. Participants generally agreed with the assessment that continuing to raise the target range for the federal funds rate gradually would likely be appropriate if the economy evolves about as expected. These participants commented that this gradual approach was most likely to be conducive to maintaining strong labor market conditions and achieving the symmetric 2 percent inflation objective on a sustained basis without resulting in conditions that would eventually require an abrupt policy tightening…It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.

What to buy?

Regardless of my personal beliefs about the correct path for US fiscal and monetary policy, I believe investors in an era of rising fiscal tension and rising inflationary expectations should be buying inflation hedge vehicles for protection.

I have two suggestions. The classic inflation hedge is gold. From a technical perspective, gold has been basing since 2013, and in an uptrend that began in early 2016. More remarkable is the resilience of gold in the face of recent USD strength, which has shown an inverse correlation to bullion.

Absolute return oriented investors may wish to consider buying inflation breakeven in the credit markets. Kevin Muir, otherwise known as the Macro Tourist, explains it this way:

Although my short-term forecast is uncertain, I have a long-term one. Eventually, the Federal Reserve will lose control of inflation expectations. When that happens, owning TIPS might not be a winning trade in absolute terms, but rather simply offer relative protection versus traditional bonds from a rising inflation environment. If you want to profit from this widening, you need to have the other side of the trade on too. You have to be long TIPS, but also short Treasuries. Owning TIPS outright is not good enough.

Muir went on to outline two ways of trading inflation expectations. One is to buy TIP and short a Treasury ETF (IEF or TLT) at the right hedge ratio. The other is to buy an illiquid inflation expectations ETF (RINF) with a high (3.87%) gross expense ratio. Please note that the accompany chart showing a long TIP and short IEF position is for illustrative purposes only as it takes duration risk and therefore not interest rate neutral.

None of these hedges are perfect. You pay your money and take your chance.

Bear markets simply don’t start this way

Posted by Cam Hui - May 23, 2018

Mid-week market update: There remains a fair amount of stock market skittishness among my readers and on my social media feed. Let me assure everyone that bear markets simply don`t start this way.

SentimenTrader has an intermediate to long-term sentiment model called AIM “which averages the momentum of the four major sentiment surveys”. This model is not perfect at calling the exact bottoms or spotting exact turning points. Nevertheless, it has done a good job of defining the risk and reward of owning stocks when readings are at bearish extremes, which is contrarian bullish. The model is currently on a buy signal.

From a top-down macro perspective, Bespoke recently pointed out that the Philly Fed General Conditions Index hasn’t been this high for some time. Despite the mutterings of permabears (I’m looking at you Rosie), recessions simply do not start this way.

BTW, the Philly Fed New Orders component surged to an all-time-high, and the last time it rose this much in a single month was October 2005.

These conditions are all pointing to further intermediate term equity strength. Expect a test of the old highs in the major equity indices this summer, and probably new all-time highs.

However, stock prices don’t go up in a straight line. The short run equity outlook is a little different.

Trust the bull, but verify the trend

In the short-term, the bulls face a number of challenges. While the upside breakout through the downtrend line is constructive, the SPX failed at 2740 resistance while exhibiting a negative RSI-5 divergence. These conditions suggest some consolidation or pullback over the next few days. Likely support can be found at the partially filled gap at about 2700.

The hourly chart is also supportive of the minor pullback thesis. The index breached an uptrend line that began on May 8, 2018. Under these conditions, minor weakness is likely, and it will be up to the bears to see if they can take control of the tape.

In light of the recent resurgence of small cap leadership and likely short-term market weakness, my main working hypothesis calls for either a successful SPX test at 2700, or a test of the small cap relative uptrend as signals that the pullback is over.

My inner trader remains partially long the market. He trusts the bull, but he is verifying the short-term trend.

Disclosure: Long SPXL

The struggling Canadian canary

Posted by Cam Hui - May 21, 2018

Back in March, I wrote about the new Fragile Five, which were five highly leveraged developed market economies that were undergoing property booms. The five countries are Australia, Canada, New Zealand, Norway, and Sweden.

As a reminder of how insane property prices are in Vancouver, which is one of the epicenters of the real estate boom, I highlighted this little gem that was listed for about USD 1 million.

Here is the same beauty from the back.

For some perspective. This chart depicts the debt bubble in Canada and Australia. If you are worried about runaway debt in China, then you should be equally concerned about the property bubble in the other Fragile Five countries.

So far, this has been a “this will not end well” investment story with no obvious bearish trigger. Now, there seems to be signs of a turning point in the Canadian economy.

The canary in the coalmine

The Financial Post reported last week that the long end of the Canada yield curve had inverted.

The yield on Canada’s 10-year government bond briefly rose above the nation’s 30-year securities for the first time in more than a decade Thursday. The shorter-maturity notes have sold off in the last few days, pushing yields above 2.5 per cent for the first time since 2014. Canada is the only developed economy with that part of its yield curve inverted, according to data compiled by Bloomberg.

While I recognize that most investors monitor the yield curve at the short end, because central bankers control the short rate and short-to-long yield curve inversion is a signal of the central bank’s monetary policy. An inversion at the long end is equally disturbing, because it is reflective of the market’s growth expectations.

By week’s end, the yield curve had steepened and the 30-year Canada was trading 1bp above the 10-year. Whew!

Nevertheless, the Canada yield curve is very flat starting from the 10-year mark. This is a sign that the Canadian canary in the economic coalmine is struggling.

To be sure, the yield curves of the other Fragile Five countries continue to be upward sloping and there are no other danger signals. Here is Australia as an example.

How bad can it get?

While property bubble in Canada has begun to spread to a number of Canadian cities, it has largely been concentrated in Vancouver and Toronto. The rise in prices began with the leakage of excess liquidity from China into overseas property markets (see How China’s Great Ball of Money rolled into Canada). Locals joined the buying stampede, fueled by cheap and easy credit.

Not all bubbles are the same, but the Canadian experience is reminiscent of the Spanish experience with Costa del Sol before the Great Financial Crisis. Foreign (European) money poured in the region, attracted by the warm climate, and the location within the EU. Fueled by cheap credit, a buying and construction stampede followed. We know how these bubbles all end.

The historical experience shows that prices fell by between one-third and one-half over the course of several years. Expect a similar price adjustment process for Vancouver and Toronto real estate.

While a 30-50% price decline is painful, it can wipe out late buyers, as many bought in with 5-10% down payments. Moreover, the local papers was full of stories of homeowners who borrowed at 2-3% with home equity lines to fund mortgage lending pools that were lending at 5-8%. It was free money! What could possibly go wrong?

I have been asked for ways to short Canadian real estate, but there are no obvious plays. Much of the pain will be borne by the Canada Mortgage and Housing Corporation, which is a federal government entity that sells mortgage insurance. In that case, one way to play a collapsing Canadian property bubble would be to short the Canadian Dollar. The risk to that trade is CADUSD has historically been correlated to oil prices, which has been trending upwards.

The carnage will also be felt by much of the financial sector. Canadian financial stocks underperformed the market by 25% in the last crisis, but banks had adhered to far more prudent lending standards compared to America in 2007. This time, Canadian institutions have been piling into property lending like drunken sailors, and expect loan losses to exceed the experience in the last cycle. The key risk to this trade is timing. While Canadian financials have begun to roll over relative to the market, the sector remains in a multi-year relative uptrend.

Rather than try to profit from a bursting Canadian property bubble, I prefer to take a global view and monitor the situation. Should Canada be the first of the G-7 markets to roll over into recession, it will serve as a warning to the other Fragile Five economies – and the rest of the world.

Disclosure: As a Canadian resident, I am naturally long CAD

Deconstructing the institutional pain trade

Posted by Cam Hui - May 20, 2018

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

Institutions and the pain trade

The BAML Fund Manager Survey (FMS) is one of the most interesting surveys around, as the frequency is regular (monthly), extensive, and it has a long history. For readers who are unfamiliar with the survey, it reflects mainly the views of fund managers with global investment mandates.

Reading between the lines of the latest FMS results, I found that institutional managers are positioned for a late cycle inflation surge, but they are starting to de-risk their portfolios in anticipation of weaker growth. To summarize, institutional managers believe that:

Growth momentum is slowing, but
Inflation expectations are rising, but
The day of reckoning, as defined by either a recession or even a yield curve inversion, is still a long way in the future.

Fund managers have positioned their portfolios:

In commodities, which I interpret as positioning for a late cycle inflation surge, but
They are de-risking by selling equities,
Selling their emerging market (EM) positions, and
Buying bonds, but
Portfolio risk appetite remains above average.

The highlights of the consensus portfolio bets amount to long energy, short USD, and short bonds. This analysis is highly speculative, but if I were the market gods and I wanted to inflict the maximum level of pain on market participants, here is what I would do.

What institutions believe

Let`s start by unpacking the FMS results. Institutional investors believe that the economic cycle is in the late phase of an expansion. Growth momentum is slowing.

Inflation expectations are rising and they have been steadily increasing for several years.

Here is a possible anomaly. Even though managers believe that they are seeing classic signs of a late cycle expansion, the median manager believes that a yield curve inversion, which has preceded past recessions, will not occur until some time in 2019. How late cycle can the markets be if a yield curve inversion is that far off?

As well, the median manager expects the next recession will not occur until late 2019.

Buying inflation hedges, but de-risking

In accordance with the belief in rising inflation expectations, institutional managers are overweight late cycle inflation hedges such as commodities, though positions are not excessive.

Similarly, energy stocks have staged an upside relative breakout from a multi-year base. Managers are also overweight, but positions are not extreme.

Risk on? Not so fast. Managers have begun to de-risk their portfolios by unwinding their extreme underweight bond positions, though they remain deeply underweight.

At the same time, they have begun to lower their equity weights, though their positioning remains risk-on and above average.

The de-risking starts with a sale of their high-beta EM positions.

The equity weights in most developed regions have been falling.

The only major exception is the UK, which enjoyed a rebound. However, the weight of the UK in the MSCI All-Country World Index (ACWI) is only 5.8%.

The weight of US stocks, which has a 52% weight in ACWI, has been mixed. While US portfolio weights have been trending up for the past few months, it ticked down in the latest month.

How can managers be selling stocks while you espouse a belief in rising inflation, and overweight commodities? Shouldn’t they be buying beta instead of selling beta under these circumstances?

How the pain trade could develop

One of the clues to the pain trade comes from the recent EM weakness. What was unusual about the sale in EM positions is that that rush for the exits was not accompanied by other signs of risk appetite pullback. The chart below shows the price performance of US high yield debt relative to their duration equivalent Treasuries, and that of EM bonds. Note the yawning price gap that began in early April.

The weakness in EM debt can be attributable to the strength in the USD. As the USD rises, the risk of a crisis in overly indebted EM countries with USD denominated debt rises. The bottom panel of the following chart shows that the history of EM debt relative performance is negatively correlated with the US Dollar.

Here is how a pain trade might develop. What if the US Dollar were to strengthen further? Continued intermediate term USD strength makes sense from a technical perspective. The RRG chart, which is used to measure group rotation, shows that the USD is the only currency that is in a leadership position. All other currencies, which includes gold, are either in the weakening or lagging quadrants.

The recent USD strength caught most market participants by surprise. The USD is currently overbought, and a minor pullback or consolidation would be no surprise. What if it paused briefly here and continued to rally?

Commodity prices are historically inversely correlated with the USD, and further USD rally would cause managers with overweight positions in commodities and energy stocks considerable pain.

But first, a USD pullback

To be sure, the market gods are tricksters who like to draw their victims in so that they can suffer maximum pain. The USD rally is probably unsustainable in the short run, as the spike in US yields have pushed the greenback up against other currencies. The differential between the 10-year Treasury note and other global yields has reached 1%, which is extreme by historical standards. Something has to give, and expect some pullback in Treasury yields, which would weaken the USD.

At the same time, there is ample evidence that inflationary pressures are rising. Inflation expectations, as measured by the 5-year breakeven rate, is back to 2013 “taper tantrum” levels.

The combination of near-term USD softness and rising inflation expectations should draw in buyers into inflation hedge vehicles. In that case, watch for gold prices to stage an upside breakout from a multi-year base should the USD decline. In the interim, gold’s ability to remain in an uptrend in the face of USD has to be regarded as constructive for the precious metal.

A summary of the latest Commitment of Traders from Hedgopia shows that large speculators are bailing out of their long gold positions. This is a sign of capitulation, and counter-trend USD weakness that buoys gold prices will be another source of trader pain.

At the same time, the erosion in large speculator long positions in crude oil even as prices advanced is a sign that oil prices are climbing the proverbial Wall of Worry.

All we need is one or more catalysts, such as a falling USD, or tighter supply from Iranian oil embargoes, to spike the oil prices. CNBC reported that Paul Hickey of Bespoke indicated that the current combination of rising oil prices and rising USD, while unusual, has historically been bullish for oil prices:

When we looked back at these prior periods in the market when you see these simultaneous rallies, crude oil has had a little bit better-than-average returns. The energy stocks have done really well going forward as well as the overall stock market.

A separate CNBC article indicated that expectations are building for $100, or possibly even $150 oil prices:

The geopolitical risk premium in oil has driven crude prices to nearly four-year highs and shows no signs of abating.
The U.S. exit from the Iranian nuclear deal, the rocket attacks between Iranian and Israeli forces and the general belief among the U.S., Saudi Arabia and Israel that Iran’s regional expansion needs to be stopped all argue for a continued rise in the price of crude.
President Trump’s position on Iran has emboldened both Israel and Saudi Arabia, together, to challenge Iran more openly than at any time in the last four decades.

I have pointed out before that one-year changes in oil prices of 100% or more have tended to coincide with stock market peaks, largely because of a combination of the recessionary effects of higher oil prices and the Fed reacting to the leakage of commodity inflation into core inflation statistics. All that is needed is a WTI price of $85-90 by this summer.

Under such a scenario of near-term USD weakness, and upside breakouts in gold and oil price spikes, it would draw in the FOMO traders in a bullish stampede. Evidence of rising inflation and inflation expectations would likely result in a Fed-induced tightening cycle that puts upward pressure on the USD.

That’s how the ultimate pain trade would develop. One particular point of vulnerability are the EM economies. Bloomberg reported that Carmen Reinhart stated that EM countries are highly exposed in the current environment:

While money managers from Goldman Sachs Group Inc. to UBS Wealth Management still tout investing opportunities in emerging markets, the asset class has one notable critic: Harvard professor Carmen Reinhart.

The Cuban-born economist points to mounting debt loads, weakening terms of trade, rising global interest rates and stalling growth as reasons for concern. In fact, developing nations are worse off than during their two most recent moments of weakness: The 2008 global financial crisis and 2013 taper tantrum, when equities endured routs of 64 percent and 17 percent respectively.

“The overall shape they’re in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis,” Reinhart said from Cambridge, Massachusetts. “It’s both external and internal conditions.”

Edward Harrison at Credit Writedowns suggested that Fed chair Powell is prepared to throw the EM economies under the bus. These countries are on their own if there is a crisis. In a recent speech, Powell stated:

Monetary stimulus by the Fed and other advanced-economy central banks played a relatively limited role in the surge of capital flows to EMEs in recent years. There is good reason to think that the normalization of monetary policies in advanced economies should continue to prove manageable for EMEs.

It also bears emphasizing that the EMEs themselves have made considerable progress in reducing vulnerabilities since the crisis-prone 1980s and 1990s. Many EMEs have substantially improved their fiscal and monetary policy frameworks while adopting more flexible exchange rates, a policy that recent research shows provides better insulation from external financial shocks.

Translation: The Fed is only responsible for the American economy. EM countries are on their own.

In addition, some Fed researchers published a rather timely discussion paper on the effects of Fed tightening cycles on foreign economies [emphasis added]:

This paper analyzes the spillovers of higher U.S. interest rates on economic activity in a large panel of 50 advanced and emerging economies. We allow the response of GDP in each country to vary according to its exchange rate regime, trade openness, and a vulnerability index that includes current account, foreign reserves, inflation, and external debt. We document large heterogeneity in the response of advanced and emerging economies to U.S. interest rate surprises. In response to a U.S. monetary tightening, GDP in foreign economies drops about as much as it does in the United States, with a larger decline in emerging economies than in advanced economies. In advanced economies, trade openness with the United States and the exchange rate regime account for a large portion of the contraction in activity. In emerging economies, the responses do not depend on the exchange rate regime or trade openness, but are larger when vulnerability is high.

Ouch! As a reminder. Even though the FMS shows that institutional managers are de-risking, their portfolios remain in a risk-on mode.

Should the pain trade scenario develop as I outlined, the fake-out begins with inflation exposure in institutional portfolios growing as the USD initially weakens and commodities rise, drawing the momentum players. Once it becomes an unbearable crowded long, interest rates would rise, the USD rally, and the trade would reverse itself, causing much pain and misery.

Near-term bullish

In the meantime, the near-term outlook is still bullish. The 4-week moving average of initial jobless claims, which is inversely coincident to stock prices, fell to another cycle low and to levels not seen since 1969. Population adjusted initial claims is already at another all-time low.

Forward 12-month EPS estimates is another indicator that is coincident to stock prices. The latest update from FactSet shows that forward EPS continues to rise, and Q2 guidance is better than the historical average.

Drilling down further, the evolution of Q2 EPS estimates is encouraging for the growth outlook. Historically, Street analysts tend to be overly optimistic about earnings. Initial estimates tend to be high, and they slowly deteriorate over time. Q2 2018 EPS breaks that pattern. After an initial ramp because of the tax cut, estimates have stayed flat instead of degrading.

The week ahead

Looking to the week ahead, it’s hard to discern likely market direction despite my bullish intermediate term outlook. The bulls can be encouraged by the recent upside breakout from the downtrend (solid line), and stock prices appear to be in a rising channel (dotted lines). As well, last week’s weakness was halted at the 50% retracement level.

The latest CoT data shows that large speculators have moved from a net long to a net short position in VIX. Complacency is returning to the markets, but readings are not extreme and rising VIX shorts can be interpreted as a sign of positive equity price momentum.

On the other hand, the current rally off the bottom has been led by small cap stocks, and the small cap move looks extended and due for a pause.

In addition, breadth indicators from Index Indicators show that the market is working off an overbought condition and exhibiting negative momentum, which is short-term bearish.

These kinds of market conditions call for a careful assessment of risk and reward. While my inner trader is leaning bullish, this is not the time to take excessive risk, and he prefers to step back and he is prepared to be not fully invested should the market rally from these levels. At the same time, he is keeping dry powder to buy the dips should they materialize.

My inner investor remains constructive on equities.

Disclosure: Long SPXL

Market waves and ripples

Posted by Cam Hui - May 16, 2018

Mid-week market update: Charles Dow once characterized the stock market`s price movement as being composed of tides, waves, and ripples. We can see a mini version of this thesis by the market’s action in the past week. The major indices had staged an upside breakout through a downtrend and sentiment had turned bullish.

This week, the narrative became more cautious:

10-year bond yields had spiked significantly above 3%.
The US-North Korea summit is at risk of going off the rails.
The anti-migrant Lega Nord and anti-establishment Five Star Movement are on the verge of forming the next Italian government.
The Sino-American trade talks are undergoing their own roller coaster. Trump’s weekend “rescue ZTE” tweet was followed by a White House clarification that walked back some of rhetoric.

Which is the wave? Which is the ripple?

Intermediate term trend is up

From a technical perspective, the intermediate term trend remains constructive. Breadth, as measured by the NYSE Common Stock only McClellan Summation Index, has broken out to the upside, and stochastics are not overbought.

Another constructive data point comes from Mark Hulbert. Hulbert’s sample of NASDAQ market timers have turned bullish, indicating positive momentum, but readings are neutral and not extreme yet.

Risk appetite, as defined by HY relative price action, and price momentum, remain in uptrends.

The high beta small caps are breaking out to the upside. The S&P 600 had already broken out to all-time highs, and the Russell 2000 just made a new high today.

Watch the ripples

I had suggested that there was support for the SPX at about the 2700. An open gap was partially filled, and the area is also the site of the downtrend line which the market could test on a pullback.

Short-term breadth (1-2 day time horizon) from Index Indicators is sloping downwards and have not reached oversold levels, which suggest that the pullback may not be over.

This week is OpEx week, and Rob Hanna’s study found that the historical pattern for May OpEx had no edge, with 17 up weeks and 17 down weeks.

I interpret the current market action as the stock prices undergoing a minor pullback in an intermediate uptrend. Short-term indicators are not oversold, and history suggest further choppiness. The path of least resistance is up, but the correction has probably not fully run its course.

My inner trader is long the market and he is buying the dips.

Disclosure: Long SPXL

Tame inflation? Don’t get too complacent!

Posted by Cam Hui - May 14, 2018

The Treasury market rallied last week when the 10-year Treasury yield tested the 3% level and pulled back.

The decline in yields (and bond prices rally) was not a big surprise for a number of reasons:

10-year yields (TNX) was exhibiting a negative RSI divergence
A tamer than expected Consumer Price Index
Hedge funds were in a crowded short in the 10-year T-Note and T-Bond futures

While the bond market rally is likely to have a bit more leg over the next few weeks, my inclination is to enjoy the party, but don’t overstay the festivities.

A crowded bond short

The latest Commitment of Traders readings from Hedgopia shows that large speculators, or hedge funds, were in a crowded short in the 10-year Treasury Note.

Their positioning in the long Treasury bond also shows a lack of bullishness.

The combination of nervousness over a surge in a fiscal deficit induced Treasury issuance, which tactically put upward pressure on yields, a crowded short, and a positive inflation surprise were enough to spark a bond market rally.

Don’t get too complacent

However, I would advise against getting overly complacent about inflation. Here is the big picture. Inflation expectations (blue line) have been steadily rising, and the Fed has been tightening in response. The spread between inflation expectations and the Fed Funds rate (red line) has been falling, indicating an increasingly tight monetary policy.

In the short run, inflation surprise began to tick up in early 2018 globally and readings have flattened out. Inflation momentum may be taking a hiatus, but the underlying dynamics still call for more upward pressure.

How pervasive is inflation pressure? The New York Fed’s Underlying Inflation Gauge stands at 3.2%, which is well above the Fed’s 2% inflation target.

The inflation “tell” from small business

Aside from the top-down analysis, the bottom-up view also shows a story of escalating price pressures. Eric Cinnamond pointed out a long list of 64 companies talking about inflation.

The latest NFIB survey also provides a fascinating window on inflationary pressures. These results are important because they come from small businesses, which are mainly price takers and have little bargaining power, and therefore provide a highly sensitive gauge of the economy.

First, small businesses are seeing upward pressure on prices.

What about the labor market and wages, which is closely watched by Federal Reserve officials? Job openings have been rising steadily since the Great Financial Crisis.

As a consequence, small businesses are seeing increasing wage pressure. Unfortunately, the NFIB survey readings are a diffusion index (net up vs. down), we cannot quantify the actual level of wage increases.

Even though the unemployment rate has been falling steadily during this expansion and now stands at a cycle lows for both the headline and U6 unemployment rates, the lack of wage growth has been a puzzle for many policy makers.

Moreover, this chart from the WSJ is remarkable as the JOLTS report shows that there is one job for every job seeker.

One theory advanced for the lack of wage growth is a labor monopsony, where the number of employers are highly concentrated in labor markets and therefore have greater bargaining power. Marshall Steinbaum at the Roosevelt Institute plotted the average HHI across occupations (and quarters) in each commuting zone. Commuting zones shaded orange and red have HHI greater than 2500, based on the CareerBuilder data. He found that the only labor markets that are unconcentrated by the standard of the Horizontal Merger Guidelines are the largest metropolitan areas.

Noah Smith, writing in Bloomberg, agreed with Steinbaum’s assessment:

New evidence is showing that employers have more market power than economists had ever suspected. Two papers — the first by José Azar, Ioana Marinescu, and Marshall Steinbaum, the second by Efraim Benmelech, Nittai Bergman, and Hyunseob Kim — find that in areas where there are fewer employers in an industry, workers in that industry earn lower wages. The two papers use very different data sources, look at different time periods and different geographical units, and use different statistical methodologies. But their findings are completely consistent.

I have no strong opinion as to whether the monopsony labor market thesis is correct. But if it is accurate, then we should be able to find evidence of wage pressure from small business surveys, as small businesses have minimal bargaining power.

One of the key indicators that I am watching is the spread between labor compensation (thin line) and prices (thick line). Both have been rising steadily for about two years, and the gap between the two have been stable. This indicates that small businesses have been able to pass through their labor cost increases, which puts upward pressure on inflation.

We are not at the point in the cycle where the two lines are converging, which would indicate a margin squeeze and downward pressure on earnings growth.

Asset inflation on the rise

For the last word, consider this chart showing the ratio of the CRB Index to the US long Treasury bond as a way of measuring the inflation/disinflation trend. The ratio bottomed out in early 2016 and it has been rising slowly, and it recently breached a downtrend line that began in 2011. The downtrend breach also coincides with the downtrend violation of the 10-year Treasury yield. This is an indication that the cycle has turned. Asset inflation is on the rise and disinflation is in retreat.

From a tactical perspective, Goldman Sachs recently pointed out that 13 out of 24 commodity contracts that they monitor is in backwardation (red). As a reminder, backwardation is the condition where the near-term futures contract is trading above the long-dated contract. This is usually an indication of a supply shortage which puts upward pressure on prices.

Now tell me that there is no inflationary pressure.

In conclusion, bond yields are tactically falling because of market positioning and a short-term inflation surprise. Recognize these circumstances as a trading opportunity, but don’t mistake it for a long-term trend.

How I learned to stop worrying and love rising rates

Posted by Cam Hui - May 13, 2018

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

Yellow flags galore, but no red flags

In the wake of last week’s publication (see Why I am not ready to call a market top), I had a number of discussions with investors that amounted to, “What about _________ (insert the worry of the day)”.

The main themes discussed, in no particular order, were:

Rising rates and the flattening yield curve;
Trade war;
Oil price spike; and
Fed policy error as they tighten into a decelerating economy.

I conducted an (unscientific) Twitter poll, and respondents were mostly concerned about a Fed policy error, while the oil price spike was the least of their worries.

While I believe that all of these risks are legitimate, they can be characterized as yellow flags, but there are no red flags that signal an imminent recession or equity bear market.

Fed policy error risk

Let’s consider each of these risks, one at a time. The greatest fear cited by investors is a Fed policy error, where the Fed tightens monetary policy into a weakening economy and pushes it into a bull market killing recession. I have expressed concerns in the past about such a scenario, and there are signs that monetary policy is starting to bite.

The effects of monetary policy normalization can be seen in money supply aggregates. In the past, either negative real M1 or M2 growth has been recession warnings. The latest readings show that real M2 growth is steadily decelerating and below 1%, and it is on pace to turn negative later this year. Call it another yellow flag, but no recessionary red flag warning.

In addition, New Deal democrat constructed a simple recession forecasting model based on Non-Farm Payroll and the Fed Funds rate:

1. a YoY increase in the Fed funds rate equal to the YoY% change in job growth has in the past almost infallibly been correlated with a recession within roughly 12 months.

2. the YoY change in the Fed funds rate also does a very good job forecasting the *rate* of YoY change in payrolls 12 to 24 months out.

As the chart below shows, YoY jobs growth (blue line) is converging with YoY Fed Funds rate changes (red line). While the two lines are close, they have not crossed yet.

New Deal democrat went on to interpret the data in a cautionary, but benign fashion:

Because the Fed funds rate has been hiked by 0.75% in the last year, that suggests that a further YoY% decline in payrolls growth is already “baked in the cake” over the next 12-24 months, to a level of roughly +0.8% YoY.

That suggests that if the Fed makes 3 more 0.25% interest rate hikes in the next year, the “red flag” will be triggered at some point in that 12-24 month window.

In other words, the risk of a Fed policy error is a yellow flag, not a red flag.

Rising rate risk

One of the most often cited worry is the combination of rising rates and a flattening yield curve. Indeed, 10-year Treasury yields have been rising, and they have breached a multi-decade downtrend. Moreover, both the 2-10 and the 10-30 yield curves are flattening to 43bp and 13bp respectively. Past instances of yield curve inversions have been sure fire recession signal.

There are two issues here. Let us first consider the problem of rising yields, which I addressed in a past post (see How much does 3% matter to stocks?). I had pointed out that the historical data from JPM Asset Management showed that rising yields have not been a problem for equity prices until yields reached 5%.

The key to the relationship between yield and stock prices is a tradeoff between rising growth expectations, which is bullish, and rising rates, which is bearish. Early in the Fed’s tightening cycle, the market tends to focus more on growth expectations. At some point, psychology switches to the bearish effects of rising rates. The simple question is, “Is good (economic) news good (equity) news, or bad news?”

So far, good news is still good news. Call rising rates a yellow flag, but the red flag of “good news is bad news” has not appeared yet.

Too early to worry about a flattening yield curve

Once investors recognize the evolution of market psychology of the Fed’s tightening cycle, it should naturally follow that they should not worry about a flattening yield curve. True the yield curve tends to flatten as the Fed’s begins its tightening cycle. But flattening yield curves are not danger signals for equity prices – yet.

Liz Ann Sonders at Charles Schwab found that stock prices tended to risen as the 2-10 yield curve flattened below 50bp. The 2-10 curve currently stands at 43bp, and if history is any guide, there is still upside in stock prices.

Kent Petersen at Insights From A Quant also studied the past history of yield curve inversions, as measured by the spread between the 2-year and 3-month Treasury Bill for the period starting from 1960. He found that US stock prices were flat to up 3-4 months after an inversion before falling. The current spread is a positive 63bp, which is a far way from an inverted condition.

Even an inverted yield curve may not be a bear market signal. Even though the sample size is small (N=3), the historical evidence suggests that investors may be better served by holding stocks until after the 2-10 yield curve inverts, and then selling when it steepens back above positive.

In effect, a flattening yield curve can only be characterized as a yellow flag, not a red flag for equity prices.

Can a trade war sink the economy?

Before the election of 2016, when the prevailing consensus called for a Clinton presidential, my scenario for the next bear market was based on a Fed induced recession. The emergence of Trump’s America First policy raises the risk of a trade war that tilts the global economy into a synchronized slowdown.

A recent CNBC report highlighted the risks of how a trade war could tip China into a hard landing.

Nearly 20 percent of China’s exports go to the U.S.
If a trade war ensues with the U.S., China’s GDP growth would drop 0.5 percent and could continue to fall as things heat up, the IMF warns.
China’s debt-to-GDP has ballooned to more than 300 percent from 160 percent a decade ago.
Chinese officials now warn of a financial-sector debt bubble that’s waiting to burst.

The risks are high. China has accounted for most of the global credit growth since the Great Financial Crisis. A trade induced slowdown has the potential to tip the Chinese economy into a hard landing, and drag down the economies of its trading partners.

The American economy is not immune to a slowdown in China. As an example, Ford’s recent temporary decision to suspend production of their most top producing F-150 light truck because of a fire at a supplier plant in Michigan is an eerie reminder of the catastrophic consequences of even small disruptions in the supply chain. Multiply those results by a hundred or thousand-fold in the event of a full trade war, and we can see the resulting production havoc from the current era of global supply chains. If Trump wants the trade deficit to fall, he can achieve those results with a trade war induced recession.

Geoffrey Gertz at Brookings characterized Trump’s adventures into the arena of trade and foreign policy as more bark than bite:

There is one fundamental rule for making sense of trade policy over Trump’s first 16 months in office: Do not overreact to new announcements. Indeed, with the benefit of hindsight, we can observe a growing list of at-the-time seemingly newsworthy policy announcements that ultimately went nowhere. For instance, back in January 2017, Trump suggested that he would pay for a border wall by imposing tariffs on Mexico. That never happened. In an April 2017 interview, Trump suggested he was interested in a “reciprocal tax” on imports, meaning the U.S. should tax imports from other countries at the same rates as those applied to American exports. In February of this year, he resurrected the same idea, declaring that the United States would “soon” announce a reciprocal tax, with more information forthcoming “as soon as this week.” Meanwhile, we’re still waiting. In late January, U.S. Trade Representative Robert Lighthizer suggested that “before very long” the administration would select an African country to begin new free trade agreement talks. The pro-trade U.S. Chamber of Commerce enthusiastically nodded its head. So far nothing seems to have happened.

Former Korea CIA analyst Sue Mi Terry characterized Trump’s negotiating style as transparent. While her remarks were in the context of American negotiations with North Korea, her comments are applicable to trade policy as well. She characterized Trump as someone who is looking for the affirmation of “a win”, regardless of whether the deal is substantive. Foreign leaders have figured out to flatter and praise him, while offering only token concessions but give the impression of “a win” (use this link if video is not visible).

We saw this pattern in the KORUS negotiation. The revised agreement was hailed as a great victory by the Trump administration, but the tweaks were only cosmetic in nature. The South Koreans agreed to two concessions. In return for an indefinite exemption from the steel and aluminum tariffs, Seoul agreed to a steel export quota to the US, but the quotas are toothless because they are contrary to WTO rules and could be challenged at anytime. In addition, South Korea doubled the ceiling on American cars which could imported into that country. The ceiling increase was meaningless because American automakers were not selling enough cars under the old ceiling. In other words, the KORUS free trade deal was a smoke and mirrors exercise and a face saving out of a potential trade war.

The trade negotiations with China appear to conform to a similar template, according to this CNBC report:

Commerce Secretary Wilbur Ross said China appears open to some of the White House’s requests.
“I think they agreed to the concept of a trade deficit reduction,” Ross said.
The U.S. requested the majority of China’s deficit reduction come from purchases of U.S. goods — an idea Ross reiterated Thursday.

In short, the risk of a trade war induced recession is a yellow flag. Until a trade war actually erupts, it cannot be regarded as a red flag for the stock market.

Oil spike risk

Now that oil prices have spiked, concerns are appearing that rising oil prices could derail the economy. James Hamilton has been a pioneer in researching the link between oil shocks and recessions, and he found that 10 out of the 11 last US recessions were associated with oil price spikes. For more details, see his testimony before the Joint Economic Committee of Congress on May 20, 2009, and his study of historical oil shocks.

A 2014 Federal Reserve study agrees with Hamilton`s conclusion:

Although oil price shocks have long been viewed as one of the leading candidates for explaining U.S. recessions, surprisingly little is known about the extent to which oil price shocks explain recessions. We provide a formal analysis of this question with special attention to the possible role of net oil price increases in amplifying the transmission of oil price shocks. We quantify the conditional recessionary effect of oil price shocks in the net oil price increase model for all episodes of net oil price increases since the mid-1970s. Compared to the linear model, the cumulative effect of oil price shocks over the course of the next two years is much larger in the net oil price increase model. For example, oil price shocks explain a 3 percent cumulative reduction in U.S. real GDP in the late 1970s and early 1980s and a 5 percent cumulative reduction during the financial crisis. An obvious concern is that some of these estimates are an artifact of net oil price increases being correlated with other variables that explain recessions. We show that the explanatory power of oil price shocks largely persists even after augmenting the nonlinear model with a measure of credit supply conditions, of the monetary policy stance and of consumer confidence. There is evidence, however, that the conditional fit of the net oil price increase model is worse on average than the fit of the corresponding linear model, suggesting much smaller cumulative effects of oil price shocks for these episodes of at most 1 percent.

Should investors be concerned about rising oil prices tanking the economy and the stock market? Not yet. As the chart below shows, the historical evidence suggests that stock prices do not top out until the 12-month rate of change in oil prices reach 100%. They are only at about 50% right now.

This does not mean, however, that the market is out of the woods. WTI oil bottomed out last June in the low 40s. The combination of base effects, tight supply from collapsing Venezuelan production, and a looming Iranian oil embargo could produce an oil price spike. If prices rise to the $85-90 level this summer, then the 100% rate of change rule will be triggered. Such a level for oil prices is well within the realm of possibility. Bloomberg reported that BAML is forecasting that oil could hit as much as $100 next year.

For now, rising oil prices represent a yellow flag that needs to be monitored, and it is not a red flag sell signal.

Risks are rising, but too early to get overly bearish

In conclusions, warning signs are appearing for the stock market but there are no sell signals. The equity bull that began in 2009 is mature, but it is still alive and snorting.

Accounts with long term horizons could respond to these conditions with a neutral stance by re-balancing their portfolios back to their target asset mix. Investors with greater tactical orientation should remain bullish, as the final price top is likely still ahead.

The stock market will get bumpy, but the outlook is still bullish.

The weeks ahead

Looking to the weeks ahead, the intermediate term equity outlook looks encouraging. The latest update from FactSet shows that Q1 earnings season is mostly over and results have been solid. Both the sales and EPS beat rates are well above historical averages, and Street estimates continue to rise. Moreover, the negative guidance rate for Q2 is better than average, indicating further near-term fundamental upside.

Another way of thinking about the earnings outlook is to monitor the evolution of quarterly earnings estimates. Historically, Street analysts have tended to be overly optimistic in their EPS estimates, and estimates tend to degrade slowly over time. In this instance, Q2 estimate rose sharply due to the effects of the corporate tax cuts, and they stayed flat instead of falling slowly. I interpret this lack of EPS deterioration as equity bullish.

From a technical perspective, breadth indicators are flashing bullish signals. Even though the S&P 500 is below its highs, both the NYSE Advance-Decline Line and S&P 500 Advance-Decline Line, which is an apples-to-apples breadth indicator, have achieved all-time highs.

The S&P 600 Small Cap Index also reached an all-time high last week, though the Russell 2000 is just a hair below fresh highs. The troops are leading the charge, the generals (major large cap indices) are likely to follow soon.

Risk appetite indicators from both the credit and equity markets appear to be healthy, which is bullish.

To be sure, short-term breadth (1-2 day) indicators from Index Indicators shows that the market is overbought, and some minor pullback or consolidation is to be expected.

The market has broken a downtrend that began from the January highs, though it remains range-bound between 2560 and 2800. RSI(5) is overbought, and initial support on a pullback can be found at trend line and gap at about 2700. If stock prices were to begin grinding up from these levels, the challenge for the bulls will be to sustain a series of “good”overbought readings as prices rise. I had also previously highlighted a condition where the VIX falling below its lower Bollinger Band (BB) indicating a short-term overbought reading for the market (see The bulls are back in town).

Steve Deppe conducted a study where the S&P 500 closes above its daily BB, and above its 200 dma, combined with the VIX below its BB. Returns are flat to slightly negative near term, but going out 10-20 days.

My base case scenario calls for some minor weakness or consolidation into mid-week, with a likely pullback to the 2700 area, followed by further strength for the remainder of May. My inner investor remains constructive on stocks. My inner trader lightened up his long positions late last week, and he is waiting for either the pullback or a breakout to buy more.

Disclosure: Long SPXL

The bulls are back in town

Posted by Cam Hui - May 9, 2018

Mid-week market update: In my last mid-week market update (see Still choppy, still consolidating), I highlighted the weekly (unscientific) sentiment survey conducted by Callum Thomas. The poll showed fundamentally oriented investors to be very bullish, while technical survey was bearish. I suggested at the time that one of the signs that the sideways consolidation may end was an agreement between the fundamental and technical survey, indicating either positive or negative momentum.

The latest survey shows that such an event has occurred as technicians have flipped from bearish to bullish.

While this is not an unqualified trading buy signal, there are plenty of indications that the bulls are back in town.

Bullish indicators

I can point to a number of constructive technical and sentiment indicators with bullish implications. From a short-term tactical perspective, the SPX has staged both an upside breakout through a downtrend, and broken out of an inverse head and shoulders (IHS) pattern. In addition, the market shrugged off a rise in the 10-year Treasury yield up to the 3% level. Remember how stock prices reacted the last time this happened?

If the bulls gain control of the tape, then price momentum is likely to become dominant again. This factor remains in an relative uptrend and it is poised for an upside breakout to new highs.

To be sure, I don’t pretend that this is an unqualified buy signal. There is plenty of overhead resistance that could stall this rally, starting with an initial resistance zone at about 2865. There is also a second declining trend line, which will act as secondary resistance. Beyond that, the IHS measured target of about 2715 also coincides with the upper Bollinger Band. The rally could stall at any of these levels in the near future. In addition, the VIX Index has breached its lower Bollinger Band, which is often the sign of either a short-term top, or a brief consolidation period.

Nevertheless, these developments are signals that the bulls are slowly gaining the upper hand and a summer rally may be just starting. My inner trader has been bullish for much of the consolidation period, but he is not so blind as to believe that stock prices are going to go up in a straight line. He is likely to take some partial profits should the market hit some of these resistance levels, and buy back in on the pullbacks.

Disclosure: Long SPXL

Why you shouldn’t get wedded to any market indicator

Posted by Cam Hui - May 7, 2018

Over the years, I have had a number of discussions with traders who have religiously embraced specific trading systems and investment disciplines. This is a cautionary tale of how systems fail.

Charlie Bilello won the NAAIM Wagner Award for his work on the lumber/gold ratio:

Lumber’s sensitivity to housing, a key source of domestic economic growth in the U.S., makes it a unique commodity as it pertains to macro fundamentals and risk-seeking behavior. On the opposite end of the spectrum is Gold, which is distinctive in that it historically exhibits safe-haven properties during periods of heightened volatility and stock market stress.

When you look at a ratio of Lumber to Gold, it is telling you something about the risk appetite of investors and the relative strength or weakness in economic conditions. When Lumber is leading Gold, volatility in equities tends to fall going forward. When Gold is leading Lumber, the opposite is true, and equity volatility tends to rise.

History shows that the lumber/gold ratio has been an excellent indicator of risk appetite. The bottom panel of the accompanying chart shows the rolling correlation of the lumber/gold ratio (cyclical indicator) to the stock/bond ratio (risk appetite indicator). The lumber/gold ratio is rising, which is a buy signal for risky assets.

Does that mean that you should bullish on stocks? Maybe.

Consider the copper/gold ratio, which is another cyclical indicator based on a similar theme. The copper/gold ratio is telling a story of economic softness.

Should you be buying or selling? Which indicator should you believe?

Analyzing the indicators

I have long been an advocate of understanding the assumptions behind indicators and models. Let’s analyze the lumber/gold indicator and unpack its message. The lumber price being measured is an American lumber price that is affected by local conditions. Lumber prices started to take off when the US imposed tariffs on Canadian softwood lumber as part of a long running dispute between the two countries. Over time, homebuilding stocks have weakened relative to the market and breached a long term relative support level. Does the behavior of the homebuilders look like a sign of cyclical strength?

While lumber prices constitute a useful cyclical indicator because of it is mainly an input into housing, the housing sector has specific demographic characteristics that could affect its effectiveness. This chart shows prime age population demographics, and its correlation to housing starts.

Copper as China indicator

Copper has its own idiosyncrasies too. Long before China became the dominant global growth engine, copper was regarded as a good indicator of global cyclicality. Now that China has become the largest consumer of commodities, copper prices are reflective of Chinese economic activity. The chart below shows the ratio of China Materials ETF (CHIM) to Global Materials (MXI) in the top panel, and the copper/gold ratio in the bottom panel. The coincident weaknesses of the CHIM/MXI and copper/gold ratios are probably reflective of softness in China.

Slowing Chinese growth is also reflected in Beijing’s policy response to lower bank reserve ratios.

KOSPI: The global cyclical barometer

In addition to copper and lumber, the South Korean stock market has been regarded as a global cyclical barometer because of the significant weight of electronics giant Samsung in the KOSPI index. Moreover, the weight of Samsung`s suppliers in the Korean KOSPI index only serves to raise the weight of the “Samsung factor” to about half of the index.

The chart below shows the KOSPI (top panel), along with the relative returns of South Korean stock market to MSCI All-Country World Index, or ACWI, (second panel, all returns in USD), the copper/gold ratio (third panel), and the lumber/gold ratio (fourth and bottom panel). One of these indicators is definitely not like the other.

I began this post with the rhetorical question of which indicator investors should believe, the lumber/gold ratio or the copper/gold ratio? An analysis of the two ratios, as well as the Korea/ACWI ratio, shows that the bullish cyclical conclusion of the lumber/gold ratio as the outlier. The lumber/gold ratio has been affected by specific factors relating to US building materials market.

Further analysis of the Korea/ACWI ratio and the copper/gold ratio also reveals some differences. Both the Korea/ACWI and copper/gold ratios have been range bound for the last year. However, while Korea/ACWI has been trendless, copper/gold has entered a minor downtrend, but recovered in the last month. I interpret these conditions as copper/gold signaling some softness in the Chinese economy, but the global cycle Korea/ACWI remains trendless. Neither is signaling weakness that could lead to a recession.

The moral of this story? Models and indicators are not magic black boxes. Look under the hood before you make any investment conclusions.

Why I am not ready to call a market top

Posted by Cam Hui - May 6, 2018

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:

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

Market top is still ahead

As stock prices chopped around in an indecisive fashion in past few weeks, the traders in my social media feed have become increasingly nervous and bearish. The bull can point to the SPX repeatedly testing its 200 day moving average (dma), which has held as technical support. However, the market’s inability to rally despite what has been good earnings news during a Q1 earnings season with solid results is worrisome.

My review of intermediate and long-term technical market conditions, as well as the macro backdrop reveals that no pre-conditions of a bear market are in sight. While there are concerns that the American economy is undergoing the late cycle phase of an expansion, which is typically followed by a bear phase. I am not ready to make the investment call that stock prices have topped out just yet.

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

The latest RRG chart depicts a stock market with the emerging leadership of late cycle inflation sectors (gold and oil), which is the result of late cycle inflationary pressures, along with interest sensitive sectors (REITs and utilities) as the result of a dovish Fed.

This combination suggests that the market is setting up for one last inflationary blow-off before the Fed steps on the monetary breaks to cool the economy into a bull market killing recession.

Listen to the market

When I listen to the message from market leadership, inflation hedge sectors appear poised to assume the mantle of new market leadership, which is an indication that the economy is in the late cycle phase of an expansion.

Three weeks ago, I rhetorically asked if it was time to buy gold for the late cycle inflation surge. Even as I acknowledged that the bull case for gold was easy to make, a rising US Dollar or tight Fed policy could derail any surge in gold prices.

From a technical perspective, the gold was making a multi-year rounded saucer bottom. The silver/gold ratio, which is a measure of precious metal risk appetite, was at historically washed out levels. However, the USD Index, which is inversely correlated to gold, was rallying and creating a headwind for gold prices.

Here is a shorter term version of the chart. Gold has been range bound and technical support is holding. The silver/gold ratio is bottoming, indicating rising risk appetite, but the USD broke out of a short-term range. The combination of emerging equity group leadership, rising risk appetite, and ability to hold support in the face of a rising USD is constructive for gold prices going forward.

In conjunction with nascent leadership from gold, crude oil, which is another inflation hedge, may be poised to rise in the near future. The chart below depicts the price of oil (top panel), and the difference between the December 2018 futures price and the June 2018 futures prices. Under “normal” conditions, the long-dated contract (December) trades at a higher price than the short-dated contract (June) and the difference reflects the cost of storage and carrying costs. When the short-dated contract trades above the long-dated contract, the commodity is said to be in “backwardation” and such conditions usually reflect tight supply conditions. Current conditions show that oil prices have staged an upside breakout to new highs, and the futures contract is in backwardation, indicating a supply shortage.

The supply shortage can be attributable to two factors. First, American fracker production is discouraging conventional oil producers from investing in new production. But the frackers are already producing at their production limits, and the combination of better global growth and restricted conventional production are bullish tailwinds for oil prices. As the chart below shows, the price spread between Midland (Permian) oil and Brent is now plunging because pipeline capacity is full and there is an abundance of Permian oil with nowhere to go.

As well, Reuters reported that Trump has all but decided to repudiate the nuclear agreement with Iran, and the Guardian reported that the Trump WH may have hired Israeli private investigators to dig up dirt on the former Obama Administration officials who negotiated the deal. The Trump White House is scheduled to announce its Iranian decision on May 12. The re-imposition of sanctions on Iran has the potential to spike oil prices, either ahead of the announcement, or on the announcement date.

In addition, a slightly more dovish Fed is providing a tailwind for inflation hedge vehicles. Last week’s FOMC announcement of a symmetric inflation target was a signal of a slight dovish tilt to monetary policy. The Powell Fed is ready for the economy to run a little “hot” and tolerate a little more inflation before reacting with an aggressive rate hike policy.

Bond yields retreated in response to the dovish message, but interest sensitive sectors such as REITs and utilities had already reacted in anticipation. The accompanying chart shows the relative market returns of REITs overlaid on top of 7-10 year Treasury returns. While the two had tracked each other closely, the divergence in the last couple of weeks may be attributable to a market reaction to excess supply from Treasury auctions.

The relative returns of utilities are also showing a similar pattern of a relative bottom, and close correlation with Treasury prices.

In short, the combination of rising inflation and a slightly more dovish Fed are recipes for a last hurrah melt-up in asset prices. Gavyn Davies‘ assessment of the interaction between rising oil prices and bond yields is probably the correct one:

It may be driven mainly by the perception of a demand shock in the US economy, stemming from the fiscal easing and confirmed by robust activity data in latest nowcasts for the economy. This is leading to an acceleration in expected Fed tightening, but not to any change in long-run inflation expectations or in terminal interest rates at the end of the cycle.

Although this shift in expected monetary tightening is not exactly good for risk assets, it might not be fatal either.

Fundamental conditions are still strong

From a macro and fundamental perspective, conditions are strong. The latest April Jobs Report showed that both the headline and U6 unemployment rates below the lows set in the last expansion. There are no signs of economic weakness here.

As well, initial jobless claims have been shown a close inverse correlation to stock prices. Initial claims are making 40+ year lows. These lows are setting up a bullish divergence with stock prices.

Q1 earnings season is mostly complete. Both the sales and EPS beat rates have been solid, and forward guidance is better than average. The Street has responded with upward estimate revisions, indicating positive fundamental momentum.

Long-term technical trends are bullish

For a longer term technical perspective, I present a number of 20 year charts from around the world. Starting in the US, Chris Ciovacco uses a series of moving averages to spot changes in price trends. The trend following system flashes warnings (shown in boxes) when the moving averages turn down and converge. The latest readings indicate that the shortest moving average is still rising and hasn’t even begun to decline. Does this look like a bear coming out of hibernation?

Across the Atlantic, the STOXX 600 remains in a solid uptrend. While the index may pause as it tests overhead resistance, this pattern does not appear bearish.

Regular readers know that my analytical framework calls for dividing the world into three trade blocs composed of North America, Europe, and China/Asia. The Chinese stock market remains a casino and its price signals are not always reflective free market forces. However, we can get some clues from the stock indices of China’s Asian trading partners. Here is the Hong Kong market, which recently staged an upside breakout to new highs and pulled back. The index remains in minor (dotted line) and major (solid line) uptrends. Does this look bearish to you?

Here is the Taiwan market, which broke out to new highs.

The South Korean market, which is regarded by many investors as a global cyclical barometer, also staged an upside breakout and held its highs.

Do the technical patterns in any of these global market indices look bearish to you? I didn’t think so. So why get so worried?

In short, there are no signs that a bear market has begun in any major equity markets around the world. Moreover, an analysis of sector leadership points to a classic late cycle inflationary blow-off. Fundamentals are also positive and supportive of stock prices.

Unless we see signs of fundamental weakness or long-term technical deterioration, I can only conclude that equity markets are undergoing a short-term correction. Weakness should therefore be viewed as a buying opportunity.

The week ahead

Looking to the week ahead, the stock market remains in a choppy consolidation phase. The ability of the market to hold at its 200 dma is constructive, but my inner trader is not ready to get all-in bullish just yet.

Short-term (1-2 day) breadth indicators have moved from a mildly oversold to a mildly overbought condition. The bulls need to follow through in the days ahead with further strength before this consolidation period can be declared over.

Medium term (3-7 day) breadth indicators are in neutral. If the bulls are truly in control of the tape, then the market needs to move this indicator into the target overbought zone.

Until we see either some sustained upside momentum or a downside support break, my inner trader’s base case scenario is a continuation of the choppy consolidation where he buys the dips, and sells the rips. My inner investor remains bullish on equities.

Disclosure: Long SPXL