When should you buy gold?

Posted by Cam Hui -

Goldbugs got excited recently when the gold stock to gold ratio turned up sharply after the gold price consolidated sideways subsequent to breaking up from a downtrend. Past episodes have been bullish signals for bullion prices.
 

 

On the other hand, the front page of Barron’s may also be a contrarian magazine cover bearish signal.
 

 

What should you do?
 

Investor or trader?

When analyzing the price of gold, it is important to distinguish between traders and investors as they have different time horizons. From a trading perspective, a long-term track record of some key indicators shows a constructive outlook.

As the chart below shows, the % bullish stocks in GDX is just below 17% (bottom panel), and past readings indicate low downside risk for the price of gold. In addition, a rising GDX/GLD ratio when % bullish was low have coincided with gold rallies. The bad news is GDX/GLD spikes have also thrown off a number of false positives under current circumstances.
 

 

These conditions make me cautiously bullish on gold. While I have no positions in either gold or gold stocks, if I were to try and participate in a potential rally, I would go long with tight stops in case the GDX/GLD spike turns out to be a false one.

There are reasons to be cautious. Gold in Chinese yuan (CNY) has been flat for the last few years. If that relationship were to hold, a rising gold price would imply a rising CNY against the USD. How plausible is that scenario under the current conditions of an incipient trade war?
 

 

The coming week has a number of binary market moving events. The FOMC meeting will conclude on Wednesday with an announcement of a likely rate hike (see FOMC preview: Prepare for the hawkish surprise). As well, Trump will address the UN General Assembly Tuesday, and he will chair the UN Security Council on Wednesday. AP reports that he is expected to reiterate his “America First” policy, which could raise trade or geopolitical tensions and spook markets. The market reactions could be either USD bullish, which would be gold bearish, or vice versa.

If there is a throughline to the still-evolving Trump doctrine on foreign policy, it is that the president will not subordinate American interests on the world stage, whether for economic, military or political gain.

Nikki Haley, the U.S. ambassador to the United Nations, told reporters in a preview of Trump’s visit, that the president’s focus “will be very much on the United States,” its role and the relations it wants to build.

“He is looking forward to talking about foreign policy successes the United States has had over the past year and where we’re going to go from here,” she said. “He wants to talk about protecting U.S. sovereignty,” while building relationships with nations that “share those values.”

Saturday will see a couple of important final deadlines. Ir will be a deadline for a Canada-US NAFTA agreement with a text that the Trump administration can present to Congress for approval. As well, the US federal government will shut down after September 30 if Trump carries out his threat to veto the Continuing Resolution presented to him by Congress, as it does not contain funding provisions for his wall.
 

When investors should buy gold

From a longer term perspective, here is what investors should consider. If gold were to act as a hedge against rising inflationary expectations, when are inflationary expectations likely to rise?

This chart from Goldman Sachs shows the unusual circumstances that we see today, where Washington has enacted a pro-cyclical fiscal stimulus, even as unemployment is falling. In the past, fiscal deficits have coincided with rising unemployment (inverted scale), not falling unemployment. That is likely to be inflationary, right?
 

 

I performed the same analysis and added CPI into the chart. Past episodes where the government has enacted a fiscal stimulus during periods of falling unemployment, such as Johnson’s Guns and Butter policy during the Vietnam War, and Reagan’s tax cuts, have seen inflation rising in the subsequent economic cycle.
 

 

Let that sink in for a minute. Fiscal policy effects on inflation are not likely to show up immediately, but in the next cycle. In that case, investors should be buying gold and other inflation hedges at the bottom of the next recession in anticipation of accelerating inflation.
 

The fiscal outlook under Republicans and Democrats

Historically, the die-hard deficit hawks have been Republicans, but they have been largely silent when the last round of tax cuts, or fiscal stimulus, was enacted. So what would happen under a scenario where the Democrats regain control of the House in 2018, and the White House in 2020?

You will hear a lot more about Modern Monetary Theory, or MMT. Consider this Barron’s interview with Stephanie Kelton, who is a leading advocate of MMT and advised presidential hopefuls like Bernie Sanders.

Stephanie Kelton, an economics professor at Stony Brook University on Long Island in New York, has a radical new way for thinking about the economy: Governments that print and borrow their own currency can’t go bankrupt, she says, and the current U.S. budget deficit is, if anything, too small.

She explained her thinking this way:

Kelton, 48, explained to the room in Kansas City that the government budget is not like a household budget because the government prints its own money. But the problem is that Washington always wants to know how to pay for new programs.

That’s a problem for you, she says she told her listeners, because the conventional wisdom in the capital is that money “grows on rich people” and you pay for nice things by taking it from them.

“Don’t look at me,” she instructed her audience to tell lawmakers. “That’s where the money comes from. And you point at the Treasury. You point at Congress.” And she won the room over.

Insisting that government spending comes from taxes, she says, puts the rich at the center of American policy-making in an unhealthy way. And the very rich, Kelton’s experience shows, are pleased to hear that you don’t have to tax to spend.

Kelton said that you can think of government debt in two different ways, as either a liability or an asset:

Government debt is just the money the government spent into the economy and didn’t tax back. That’s all the national debt is. It’s a historical record of all of the times that they made a net deposit, spent more than they taxed out, and the bonds are the difference between those. One of the greatest cons ever perpetrated on the American people is this notion that the national debt belongs to us, that we are responsible in our individual capacity for a share of it…

When I worked on the Hill, one of my favorite exercises was to find elected officials, staffers, and ask them if you had a magic wand, and you could wave it, and eliminate the national debt tomorrow, would you do it? Of course. Who wouldn’t do that? Yes, I mean, the quickest “yes” you ever got in your life.

OK, what if I gave you a different wand, and I told you, you can wave the magic wand, and you can eradicate the world of U.S. Treasuries. There won’t be Treasury notes anymore. They’ll just all be gone. How many members of Congress, would do that?

Zero.

They looked at me with a total blank stare.

Expect more discussion of MMT in the next few years. Budget deficits are likely to worsen, not improve. Whatever happens, a bullish bet inflationary expectations in the next recession is likely to be a winning one.

 

FOMC preview: Prepare for the hawkish surprise

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

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

Hawkish surprise ahead?

The FOMC is scheduled to meet next week for its September meeting. The market has fully discounted a quarter-point rate hike for the September meeting, and for the upcoming December meeting. Looking ahead to the March 2019 meeting, however, the market isn’t fully convinced the Fed will continue its pace of quarter-point rate hikes every three months.
 

 

Peering further into the future, the CME’s FedWatch tool for the June 2019 meeting shows that the market has only one rate hike penciled in between December and June.
 

 

Will the Fed pause as the Fed Funds rates nears neutral? The market thinks so. But I beg to differ for the following reasons:

  • Inflation pressures are rising, which will force the Fed to focus on its price stability mandate.
  • The Fed governors, including Fed Chair Jerome Powell, have shown little interest in pausing. Other key Fed officials have indicated that they are not afraid of inverting the yield curve.

In other words, prepare for a hawkish surprise from the September FOMC statement.
 

Inflation pressures rising

There are numerous signs of rising inflation pressures. Upside inflation surprise is evident everywhere except for the US.
 

 

The Fed’s own favorite inflation metric, core PCE, is also showing sufficient inflation pressures for a steady upward march in interest rates. In the past, whenever the trailing 12-month count of annualized monthly core PCE above 2% has exceeded six or more, the Fed has embarked on a monetary tightening program. The only exceptions occurred in 2008, which was the onset of the GFC, and 2011, the Greek Crisis.
 

 

What about wage pressure, which is an input into the Phillips Curve that has been a key tool of the Fed? Average hourly earnings (AHE) has been steadily edging up and now stands at 2.8%.
 

 

Forward looking wage measures, such as the NFIB survey, shows that AHE continues to face upward pressure.
 

 

The Atlanta Fed’s Wage Growth Tracker also reveals another dynamic of wage inflation that is not fully captured by some statistical measures. Job switchers have been able to extract higher wage growth because of the tight labor market.
 

 

In addition, the latest Beige Book shows that some employers are using benefits instead of wage increases to cope with the difficulty of recruiting employees. Better benefits may raise compensation costs, but they do not necessarily show up in wage increase metrics [emphasis added].

Labor markets continued to be characterized as tight throughout the country, with most Districts reporting widespread shortages. While construction workers, truck drivers, engineers, and other high-skill workers remained in short supply, a number of Districts also noted shortages of lower-skill workers at restaurants, retailers, and other types of firms. Employment grew modestly or moderately across most of the nation, though Dallas noted robust job growth, while three Districts reported little change that partly reflected a dearth of applicants. Six of the twelve Districts cited instances in which labor shortages were constraining sales or delaying projects. Wage growth was mostly characterized as modest or moderate, though a number of Districts cited steep wage hikes for construction workers. Some Districts indicated that businesses were increasingly using benefits–such as vacation time, flexible schedules, and bonuses–to attract and retain workers, as well as putting more resources into training.

New York
Businesses in most service industries indicated that wage pressures remain fairly widespread, though they have not intensified. A major New York State employer noted success in using non-wage benefits (e.g., vacation, flexible hours) to attract younger workers. Looking ahead, fewer businesses indicated planned wage increases than had been the case in recent months.

Chicago
Employment growth picked up to a moderate pace over the reporting period, though contacts expected gains to slow to a modest rate over the next 6 to 12 months. Hiring was focused on production, sales, and professional and technical workers. As they have for some time, contacts indicated that the labor market was tight and that they had difficulty filling positions at all skill levels. Manufacturers continued to report that they had delayed or turned down projects because of difficulties in finding workers. There were also reports of firms forgoing layoffs to avoid the challenge of finding workers when demand picked up. A staffing firm that primarily supplies manufacturers with production workers reported no change in billable hours. Wage growth remained modest overall, with wage increases most likely to be reported for managerial, professional and technical, and production workers. Most firms reported rising benefits costs.

Dallas
Wage pressures remained elevated, with more than 60 percent of firms saying they were increasing wages and/or benefits to recruit and retain employees.

San Francisco
Wage growth ticked up broadly, and some businesses increased benefits in response to more labor retention challenges. Contacts across the District noted upward compensation pressures for accountants, software engineers, and information technology professionals. In the Mountain West, small businesses moderately raised starting wages and benefit compensation to better compete with larger national employers. In order to retain employees and attract new hires, a few businesses increasingly offered flexible work arrangements.

 

Pause, what pause?

As the Fed continues with its rate hike program, there has been much discussion about the level of the neutral rate, or R-star. Many market analysts have openly pondered if the Fed would pause as the Fed Funds rate nears the neutral rate.

Forget about it. I reiterate my belief that the Fed appears to be determined to keep raising until it sees the signs of a visible slowdown.

Fed chair Jay Powell stated in so many words in his Jackson Hole speech that the Fed is on course to keep raising until something breaks (see Why the Powell speech was less dovish than the market thinks). As well, the WSJ reported that New York Fed President John Williams is not afraid of inverting the yield curve:

Federal Reserve Bank of New York leader John Williams said Thursday the prospect of a yield-curve inversion by itself wouldn’t be enough to stop him from supporting further rate rises if he thought the economy called for them.

“I think we need to make the right decisions based on our analysis of where the economy is and where it’s heading,” Mr. Williams told reporters after a speech in Buffalo. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I find worrisome on its own.”

Fed governor Lael Brainard also stated in an important speech entitled “What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?“. She intimated that the Fed is likely to keep hiking even past neutral by distinguishing between the long-term neutral rate, which is specified in the Summary of Economic Projections (SEP), and the short-term neutral rate, which varies. Fed policy should focus on the short-term neutral rate, which is a function of economic data [emphasis added]:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate. Heightened risk appetite among investors similarly can be expected to push up the shorter-run neutral rate. Conversely, many of the forces that contributed to the financial crisis–such as fear and uncertainty on the part of businesses and households–can be expected to lower the neutral rate of interest, as can declines in foreign demand for U.S. exports.

In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

In conclusion, the question of whether the Fed raises rates at its September meeting is a foregone conclusion. A quarter-point rate hike is baked in. However, investors will be examining the tone of the FOMC statement next to decide whether it was a hawkish or dovish raise.

If you are looking for language in the September FOMC statement hinting that the Fed will pause in the near future, you are likely to be disappointed. In all likelihood, it will be a hawkish raise that will surprise the markets.
 

Deconstructing the pain trade

What would a hawkish hike mean for investors? What’s the pain trade?

Beyond the obvious equity bearish reaction to a hawkish FOMC statement, the real pain trade might be a flattening yield curve. If the Fed were to signal that it is not finished raising rates, it would certainly put upward pressure on short rates. However, don’t expect a parallel upward shift in the yield curve. While I would not necessarily be so bold as to forecast a bond market rally from falling long rates, 10 and 30 are likely to not rise as quickly as the short end.
 

 

Longer term, I am also monitoring the relative performance of bank stocks. Recall that I pointed out that technical breakdowns in the relative performance of this sector has foreshadowed general equity market weakness (see How to watch for signs of another Lehman Crisis). The relative performance of bank stocks has been highly correlated with the shape of the yield curve, and a flattening yield curve would put downward pressure on the financial sector.

As the chart below shows, the BKX/SPX ratio is on the verge of testing a relative support level as it trended downwards while exhibiting a series of lower lows and lower highs. The yield curve is also displaying a similar flattening behavior.
 

 

This will be an indicator to keep an eye on.
 

 

In other words, don’t panic, but don’t get overly complacent either.
 

The week ahead

Looking to the week ahead, there are lots of short-term reasons to turn bearish. Subscribers received an email alert on Friday morning indicating that my trading account had taken profits on its long positions and gone short. There are warnings everywhere:

  • The SPX had advanced above its upper Bollinger Band (BB) on Thursday and Friday, which is an overbought condition.
  • The index was testing its rising trendline Friday before pulling back, which is another overbought warning.
  • The market was exhibiting negative RSI divergences even as it rallied to fresh highs.
  • The NYSE Advance-Decline Line failed to confirm the market`s all-time highs by registering new highs.
  • Even as the market rose last Wednesday and Thursday, there were more new lows than highs on the NYSE.

 

 

A negative divergence in the net highs-lows breadth indicator has historically been a good warning of a major top. The chart below shows both the NYSE and NASDAQ net highs-lows. The only exception occurred in 2000 at the top of the Tech Bubble, when this indicator failed.
 

 

As a solution, I combined the NYSE and NASDAQ net highs-lows into a single metric. As the chart below shows, this combined breadth indicator worked well to warn of pending corrections and bear markets. Currently, the negative divergence in this indicator is another concern for the bulls.
 

 

From a short-term trading perspective, medium term (3-5 day) breadth indicators reached an intraday overbought condition last Friday and turned down, which is a bearish signal of waning momentum.
 

 

As well, longer term (1-2 week) breadth had reached an overbought condition and weakened, which is another bearish trading signal.
 

 

Stock prices are also facing seasonal headwinds. Rob Hanna at Quantifiable Edges found that the week after September option expiry, which is next week, is historically weak. Jeff Hirsch at Almanac Trader also came to a similar conclusion.
 

 

On the other hand, non-US markets are staging a risk-on relief rally. The most impressive was the Japanese market, but the rest of Asia, Europe, and EM currencies also registered gains. This environment should put a floor on stock prices.
 

 

I interpret this market action as only a bounce, as fundamentals remain negative. Starting with Europe, the latest release of eurozone PMI was disappointing, indicating decelerating growth.
 

 

Moreover, the Citi Europe Economic Surprise Index is weakening again, indicating that economic releases are missing expectations.
 

 

In China, almost all of the economic indicators are weakening with the exception of real imports, which could be explained by an import surge to beat new tariffs.
 

 

In the US, the latest update from FactSet shows that while forward 12-month EPS continues to rise, Q3 guidance has weakened to below average. This is a message for equity investors to tone down their expectations for Q3 earnings season, which begins in October.
 

 

My inner investor continues to be cautious and he has reduced his equity weight. My inner trader took profits in his long positions and reversed to the short side on Friday. The initial downside target can be found using the hourly chart, which shows former resistance turned support at 2915, with a potential gap to be filled in the 2910-2920 zone.
 

 

Disclosure: Long SPXU
 

Surprising conclusions from advanced rotation analysis

Posted by Cam Hui -

Mid-week market update: I have been asked to periodically update my sector leadership analysis as a guide to spot up and coming sector strength. The standard approach is to apply the Relative Rotation Graph (RRG) to the market.

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

The sector RRG chart shows that Healthcare stocks remain the leading sector. Up and coming sectors are Financial and Industrial stocks, and defensive sector such as Consumer Staples, Utilities, and REITs are starting to lose steam.
 

 

However, the recent reclassification of stocks into the newly formed Communication Services sector, which moved high octane names such as Alphabet, Amazon, and Netflix into the sector makes RRG analysis somewhat deceptive. Standard RRG analysis on sectors doesn’t tell the entire story. As an alternative, I present a couple of two other ways of rotation analysis for insights for both leadership and market direction.
 

The most powerful signal for stocks

What’s the most powerful technical signal from a stock, sector, or stock market? The answer is to make a new high.

With that in mind, I found a number of sectors that have been showing consistent net new high strength, namely Technology, Healthcare, and Industrials. The chart below shows the net new highs of these sectors, as well as the NASDAQ 100, which is a close cousin to Technology stocks. As a comparison, Financial stocks (bottom panel) are not showing the same degree of net new high breadth as these other sectors.
 

 

Does that mean you should blindly buy into these market leaders? Not so fast. The above RRG sector chart shows that Technology leadership is faltering. The relative performance chart of these sectors tell a slightly different story. While NASDAQ 100 and Technology remain the leaders and their relative uptrends remain intact, they are rolling over on a relative basis. By contrast, Healthcare stocks are showing a constructive relative bottom pattern, and Industrial stocks are in the early stages of a turnaround.
 

 

That’s still not the whole story.
 

A case of bad breadth

The emerging leadership of Industrial stocks made me sit up and take a look more closely, as it was inconsistent with some of my other models. One important macro implication of Industrial stock leadership is a cyclical economic upturn, which is inconsistent with the industrial metal to gold ratio, which is an important global cyclical indicator. In the past the industrial metal to gold ratio has moved coincidentally with the stock to bond ratio, which is a risk appetite indicator.
 

 

As well, the cyclical strength implied by the outperformance of Industrial stocks is also inconsistent with the growth expectations of institutional investors, as measured by the BAML Fund Manager Survey.
 

 

If the most bullish technical thing that a stock, or stock market can do is make new highs, I have also been concerned about the waning net new highs of NYSE and NASDAQ stocks. Why are new lows so high when the market is within a stone’s throw of its all-time highs?
 

 

In addition, the SPX is flashing a negative RSI confirmation as it tests its highs, which is another cautionary signal.
 

 

Clues from factor rotation

One clue is the RRG chart analysis through a factor, or style lens. One advantage of applying RRG analysis to factor returns is this approach is not subject to the problems of sector reclassification. As the chart below shows, leading factors remain either defensive or value oriented in nature. Leading factors include Dividend Aristocrats (dividend growth), High Quality, Buybacks, and Small Cap Value, though the Low Volatility is surprisingly showing signs of rolling over. Lagging factors remain the high octane plays like Large and Small Cap Growth, IPOs, and High Beta.
 

 

The only exception to the defensive and value theme among the market leaders is buybacks. The emergence of stocks with high buybacks is expected, as the tax bill encouraged the repatriation of offshore cash, some of which went into buybacks (h/t Kevin Muir, the Macro Tourist).
 

 

These results suggest that investors should remain defensive in the portfolio posture. Focus on defensive and leading sectors like Healthcare, and take profits in high beta groups like Technology on strength. From a factor perspective, remain defensive and emphasize dividend growth and high quality stocks.
 

The bulls are still partying

Despite the bearish backdrop, we are likely to see new marginal highs in the major indices in the next couple of days. I recently wrote that the bulls were throwing a quiet little get-together for their friends, but the party was unlikely to evolve into an out-of-control street party, and I stand by those remarks. Short run (1-2 day) breadth indicators from Index Indicators show that momentum is positive, and readings are not overbought, which suggests further upside potential.
 

 

As well, the CBOE option put/call ratio stands at 0.95, which is unusually elevated on a day when the index is advancing as it consolidates above its upside breakout level of ~2870. These readings indicate skepticism, which are signs that the market is climbing the proverbial wall of worry.
 

 

My inner trader remains long the market. He is watching for signs that the market is becoming overbought before taking profits, which will likely occur later this week.

Disclosure: Long SPXL

 

How to watch for signs of another Lehman Crisis

Posted by Cam Hui -

It has been 10 years since the Lehman bankruptcy, which became the trigger for the Great Financial Crisis (GFC). The financial press has been full of retrospective stories of what happened, and discussions from key players.

The GFC was an enormous shock to investor confidence. Ever since that event, many investors have been living with the fear that another tail-risk shock to their portfolios, and they have searched for warning signs that another financial crisis is around the corner.

One of the commonly used indicators to measure financial tail-risk are the financial stress risk indicators produced by the Chicago Fed and St. Louis Fed. Right now, readings are relatively benign, as low and negative numbers indicate low levels of financial stress.

 

New Deal democrat also monitors the Chicago Fed’s National Financial Conditions Leverage Subindex as a more sensitive indicator of systemic stress. The readings of this indicator are also relatively benign (low = low stress).

 

For investors and traders who demand real-time results, there may be even a better way.

The Bank Barometer

The chart below depicts the relative performance of the KBW Bank Index (BKX). In the past, technical breakdowns of relative performance have foreshadowed major market tops with the exception of one false positive in late 2015/early 2016.

 

The BKX/SPX ratio provides a real-time warning of rising financial stress, as well as major bear markets. Right now, the ratio is testing a key relative support level, which, if breached, could be the warning of a major equity market top.

The 2-10 yield curve is also an indicator that tracks the BKX/SPX ratio quite closely. The relationship isn’t a perfect fit. For example, the two diverged in late 2017 when financial stocks surged in anticipation of the tax cut bill. Nevertheless, past instances of BKX/SPX technical breakdowns have coincided with yield curve inversions. The false positive breakdown BKX/SPX occurred when the yield curve was still healthy and positively sloping by over 1%.

 

While the yield curve is not currently inverted, it has been steadily flattening for most of this year. Financial and bank stocks have also been underperforming the market in the same period. Should the Fed continue its course of tightening monetary policy, the yield curve is likely to invert by late 2018 or early 2019. The BKX/SPX ratio may suffer a technical breakdown before that.

Are financial risks high today and the red lights flashing? No, definitely not, but this indicator is starting to flicker red.

Stay tuned!

 

Is China ready for the next downturn?

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

The latest signals of each model are as follows:

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

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

How much runway is left in China’s long landing?

The bears have been warning about China’s unsustainable debt for years. So far, it has been a “this will not end well” investment story, with no obvious bearish trigger and no time frame for a crisis.

 

Michael Pettis is one of the few China watchers who has established a time frame for China to resolve its problems. He outlined a scenario four years ago where China would not crash, but experience a “long landing” where growth gradually decelerates. Pettis elaborated on his best case scenario in an email to me (see Michael Pettis on the risks of the long landing scenario):

My “best-case” rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3-4% over the presumed decade of President Xi’s administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public forum, that this is not my expected “most likely outcome”.

He went on to elaborate that his best guess is the current pace of credit growth was only sustainable until 2017-2018:

My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3-4 years at most, after which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my “orderly long landing” scenario is less likely.

Here we are, four years later. How is China managing its long landing?

Hitting the debt wall

As Pettis had predicted, the cracks are appearing in China’s credit driven growth engine. Remember how Chinese stock prices are tanking? Benn Steil at the Council on Foreign Relations found that the cause is not the trade war.

 

Instead, he attributed stock market weakness to Beijing’s deleveraging policy to reduce credit growth.

 

The cracks are appearing at both the local government and corporate levels. The WSJ reported that a Chinese city was so financially squeezed that it forced parents to send students to private schools:

LEIYANG, China—Long before parents clashed with police and officials over school overcrowding, this southern Chinese city was telegraphing its fiscal squeeze—and exemplifying China’s deep-seated local debt woes.

After the area’s backbone coal-mining industry entered a slump mid-decade, the Leiyang government’s revenue began to slide. By February, the government warned the legislature of challenges in providing education, health care and other social services. Then in May, civil servants went unpaid for more than a week, until emergency funds arrived. Weeks later, a city-owned company that finances construction missed a loan repayment to a nonbank lender.

Problems spilled out into the streets both nights this weekend. The city’s plans to deal with overcrowded public-school classrooms by sending students to more expensive, often inferior private schools drove hundreds of parents and others to protest. On Saturday, some threw bottles, bricks and firecrackers at local officials and police, who, by official accounts, then dispersed the crowds, detaining 46 people.

The SCMP reported that private businesses have trouble getting loans even when the government directed banks to lend to SMEs [emphasis added]:

The Chinese government campaign to get more funding into the hands of small business owners is struggling.

And a solution to the problem is being more urgent as the trade war with the United States starts to weigh on the economy.

Small and medium-sized business (SMEs) account for most jobs in the country – up to 80 per cent by some measures. Each produces a single or a small range of products or services and operates on small profit margins that are far less resilient to economic disruptions than those at larger firms.

The government has pumped money into the banking system to spur lending to smaller business and has recently stepped up its verbal intervention demanding action. Anecdotal evidence suggests the situation has improved, but only modestly.

That is because the push to get banks to lend more to small firms is in direct conflict with the government’s effort to reduce risk in the financial system.

The results of the focus on SME loan growth have been mixed at best:

But, so far, the process is falling short of expectations. At the end of the second quarter, loans to micro and small businesses accounted for 32.3 per cent of the total outstanding corporate loans, 0.4 percentage point lower than at the end of March, according to data from the People’s Bank of China, the central bank.

In the first half of this year, new loans for micro and small businesses made up mere 20.9 per cent of new corporate loans, the lowest rate since the data was first published in 2012.

Small businesses face enormous hurdles in obtaining credit:

Jiang Pengming, chairman of a tech entrepreneurs association in Beijing, said small firms, at least in the green industry, still face egregious requirements to get a bank loan. Banks sometimes demand collateral that not only includes company assets, but also managers’ personal assets.

“Entrepreneurs, their spouses and children over 18 all have to sign loan agreements, businessmen over 60 even need to do psychiatric examinations on the same day of signing,” he told the Post. “Still, firms cannot ensure that they will get a loan by doing so.”

He said that financing difficulties only scratch the surface of the problems facing small businesses in China. Freeing up more money for lending will not resolve these problems facing SMEs, most of which are private enterprises.

Instead, SMEs have been turning to the more expensive shadow banking lenders for credit, which is a sector that the authorities are desperately trying to rein in:

In the past, the shortage of affordable bank credit forced small businesses to turn to other avenues for financing, particularly shadow bank lending. Peer-to-peer (P2P) lending to SMEs soared to 872.3 billion yuan (US$128 billion) in 2017, more than 70 times the 12.4 billion yuan in 2013, according to a report from WDZJ.com, an information platform for the online lending industry, in December last year.

Chinese SMEs, which accounted for more than 60 per cent of the country’s gross domestic product last year, have been underserved by the traditional banking system for years, so the government’s programme to reduce financial leverage and debt by underregulated shadow banking institutions has made their situation worse.

What’s more, the shadow banking sector continues to grow despite Beijing’s efforts.

 

Moreover, Chinese good consumption is in a downward trajectory because of the effects of the government’s deleveraging policy on the economy.

 

Four years after Pettis’ made his guesstimate, it appears that China is beginning to hit a debt wall.

China’s difficult policy choices

Indeed, Pettis acknowledged in his latest commentary that China is coming to the end of its debt runway. Still, he believes that China is unlikely to crash, but it is likely to trade the heart attack for a chronic disease:

China’s debt problems have emerged so much more rapidly and severely this year than in the past that, combined with swirling rumors about the country’s leadership, a growing number of analysts believe that this may be the year that China’s economy breaks. As always, I am agnostic. There is no question that China will have a difficult adjustment, but it is likely to take the form of a long process rather than a sudden crisis.

What if there is a trade war, or a global recession?

If the global trade environment forces a contraction in China’s current account surplus, I argue, by definition it also forces a contraction in the gap between Chinese savings and Chinese investment. This means that either the country’s investment share of GDP must rise or the savings share must decline (or some combination of the two). There are literally only four ways that either of these outcomes can happen. Consequently, there are also only four ways that Beijing can respond, each of which would drive the economy to one of the four possible outcomes (or some combination of them):

  • Raise investment. Beijing can engineer an increase in public-sector investment. In theory, private-sector investment can also be expanded, but in practice Chinese private-sector actors have been reluctant to increase investment, and it is hard to imagine that they would do so now in response to a forced contraction in China’s current account surplus.
  • Reduce savings by letting unemployment rise. Given that the contraction in China’s current account surplus is likely to be driven by a drop in exports, Beijing can allow unemployment to rise, which would automatically reduce the country’s savings rate.
  • Reduce savings by allowing debt to rise. Beijing can increase consumption by engineering a surge in consumer debt. A rising consumption share, of course, would mean a declining savings share.
  • Reduce savings by boosting Chinese household consumption. Beijing can boost the consumption share by increasing the share of GDP retained by ordinary Chinese households, those most likely to consume a large share of their increased income. Obviously, this would mean reducing the share of some low-consuming group—the rich, private businesses, state-owned enterprises (SOEs), or central or local governments.

Notice that all four paths either raise investment or reduce savings, thereby reducing the country’s excess of savings over investment. This is what is meant by a contraction in the current account surplus.

In other words, there are only three realistic policy choices: unemployment, debt, or wealth transfers. While the wealth transfer option appears to be the most logical from a policy viewpoint, Beijing will face the opposition of entrenched and powerful interests of the rich tycoons, the party cadres in the SOEs. Pettis concluded:

For the rest of 2018, I expect that we will see different groups in Beijing try to reconcile the need for slower credit growth with greater growth in economic activity. But because these two things cannot be reconciled, one group or the other must win. So far it isn’t clear whether we will see growth in economic activity continue to slow or credit growth pick up.

While Pettis did not try to forecast specific policy choices, Houze Song at Macro Polo believes that China will continue to prioritize minimizing financial risk through deleveraging at the expense of slower growth. Contrary to market expectations, Beijing will not be panicked into another round of credit-driven investment binge as long as SOE and local government finances are solid:

As US-China trade tensions have escalated, the general consensus has overwhelmingly shifted toward the view that “Beijing is returning to stimulus mode again,” implying that Chinese policymakers are ready to postpone or even reverse its ongoing deleveraging effort. In light of the State Council’s recent dovish signals, such a view has only gained more traction.

But those State Council signals are at odds with the core message of the July 31 Politburo meeting that President Xi Jinping chaired. What came out of that meeting is clear: the overall direction of deleveraging and financial tightening will remain unchanged.

  • The recent Politburo meeting on July 31 reaffirmed Beijing’s priority of containing China’s debt, focusing on state sector and local government deleveraging.
  • Beijing will primarily use administrative measures, and to a lesser extent financial regulation, to contain financial risk for the rest of 2018.
  • While monetary policy will continue to be modestly accommodative, the deleveraging agenda—that is, curtailing shadow banking and local off-budget borrowing—will remain intact and continue to put a drag on growth in the medium term.
  • As long as state firms’ and local governments’ finances are solid, Beijing will hold back on stimulus, stay the course on deleveraging, and accept lower growth.

We don’t know how this story ends. but it sounds like China will undergo some difficult adjustments in the near future, and there are some very obvious bearish triggers ahead.

President Xi, Meet Jay Powell

While the market has focused on Trump’s trade policy as China’s biggest economic threat, I beg to differ. The biggest threat is the Federal Reserve, which appears intent on engineering a recession.

While the market has priced in two more quarter-point rate hikes for the rest of 2018, analysts are starting to focus on when the Fed might pause its rate normalization policy as interest rates near the neutral rate. Unfortunately, the answer is no, it will not pause.

Much has been made of the objection by a number of regional Fed presidents about the prospect of inverting the yield curve. If the Fed were to maintain its current tightening path, the 2-10 yield curve is likely to invert either in late 2018 or early 2019. However, investors have to understand the voting dynamics of the Fed’s monetary policy. The people who really matter (and have the staff to create studies to support their conclusions) are the permanent voters on the FOMC, namely the Fed governors, and the President of the New York Fed.

Indeed, these “important” people have spoken. Fed chair Jay Powell stated in so many words in his Jackson Hole speech that the Fed is on course to keep raising until something breaks (see Why the Powell speech was less dovish than the market thinks). As well, the WSJ reported that New York Fed President John Williams is not afraid of inverting the yield curve:

Federal Reserve Bank of New York leader John Williams said Thursday the prospect of a yield-curve inversion by itself wouldn’t be enough to stop him from supporting further rate rises if he thought the economy called for them.

“I think we need to make the right decisions based on our analysis of where the economy is and where it’s heading,” Mr. Williams told reporters after a speech in Buffalo. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I find worrisome on its own.”

Last week, Fed governor Lael Brainard chimed in with an important speech entitled “What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?“. She intimated that the Fed is likely to keep hiking even past neutral by distinguishing between the long-term neutral rate, which is specified in the Summary of Economic Projections (SEP), and the short-term neutral rate, which varies. Fed policy should focus on the short-term neutral rate, which is a function of economic data [emphasis added]:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate. Heightened risk appetite among investors similarly can be expected to push up the shorter-run neutral rate. Conversely, many of the forces that contributed to the financial crisis–such as fear and uncertainty on the part of businesses and households–can be expected to lower the neutral rate of interest, as can declines in foreign demand for U.S. exports.

In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

And the economy is running hot, which means the short-term neutral rate is above the long-term rate, which Brainard estimated at between 2.5% and 3.5%. The Atlanta Fed’s Q3 GDPNow stands at a sizzling 4.4%, the St. Louis Fed’s nowcast at 4.4%, and the New York Fed’s nowcast is the outlier at 2.2%.

 

Even as the American economy displays signs of strength, the rest of the world is weakening as evidenced by the poor breadth shown by global equity markets.

 

This combination of decelerating non-US growth and a hawkish Federal Reserve is a recipe for a global slowdown of unknown magnitude.

Trade war starting to bite

On top of that, the trade war is starting to bite. AmCham Shanghai and AmCham China conducted a survey of the impact of the US-China tariffs, and the effects of the trade war are starting to bite.

 

China isn’t just retaliating with additional tariffs, but evidence of non-tariff barriers are appearing.

 

The intent of Trump’s trade policy is to force American companies to bring manufacturing back to the US. Instead, most multi-nationals are opting to move to other countries, and only 6% of the survey sample plan on building American facilities.

 

Despite Trump’s belligerent tone, there will be no winners in this trade war.

 

Moreover, there does not seem to be any face saving off-ramps in this trade dispute for without one side enduring the embarrassment of a full capitulation.

The Chinese chickens come home to roost?

How will all this this affect China? Increasingly, there are calls for the Chinese chickens coming home to roost, in addition to Pettis’ analysis of Beijing’s unenviable policy choices. Arvind Subramanian and Joel Felman, writing at Project Syndicate, believes that the era of Chinese exceptionalism is about to end:

After decades of strong and steady growth, China has developed a reputation for economic resiliency, even as it piles up ever more domestic debt. But the prospect of declining exports, alongside a weakening currency, could derail its debt-defying trajectory.

Former UBS strategist George Magnus recently warned about the combination of the unsustainability of China’s debt, and its aging population:

Eventually, the government will have to stabilise and reduce the debt burden and excess leverage in the economy if it is to avoid a painful landing. This will show up in the form of a material reduction in China’s growth rate in coming years. The Yuan is very likely to weaken as a result over the medium-term, in spite of restrictions over capital moving overseas.

Rapid ageing – China is the fastest ageing country on Earth – will tend to both lower growth and sap some of the country’s dynamism. The abandonment of the one child policy in 2015, and the recent removal of the last government diktats over family size are unlikely to be any more successful in raising fertility than other measures have been elsewhere. China will need to find other ways to offset the predicted sharp rise in the old age dependency ratio, which will surpass that of the US in the next 25 years.

In conclusion, China faces both long and short term obstacles. In the long run, its growth is unsustainable and Beijing needs to make adjustments. In the short run, the Fed appears intent on engineering a US recession, which, combined with Trump’s trade war, are headwinds to Chinese growth and policy adjustment process. The risks are rising rapidly, and don’t count on China to sail through the next global downturn as smoothly as the last one.

The canaries in the Chinese coalmine

What should investors do? In light of the heightened risks, I suggest that investor monitor two key stocks as real-time indicators of the health of the Chinese economy.

The first is China Evergrande Group (3333.HK), which is China`s biggest property developer. Real estate firms like Evergrande are sitting on about 120 billion in offshore USD debt, nearly double 2016 levels. Reuters reported that “Morgan Stanley estimates that every 1 percent depreciation of the yuan could shave an average of about 3 percent off developers’ 2018 earnings per share.” Should the yuan weaken for any reason, the stresses are going to show up quickly in the property sector.

 

In addition, investors can also monitor Alibaba as a gauge of the health of the household sector.

 

My New (consumer) China/Old (finance and infrastructure) China pair trades, which consist of long Golden Dragon China (PGJ)/short iShares China (FXI) and long Global X Consumer China ETF (CHIQ)/short Global X China Financials ETF (CHIX), are also showing similar levels of household sector stress.

 

Currently, the price of Evergrande has remained stable, while Alibaba has been rolling over, even before the announcement of CEO Jack Ma`s retirement. Bottom line, don`t panic just yet until both indicators really tank.

The week ahead: Don’t overstay the party

The bulls held a little get together for their friends last week, but don`t expect it to become a wild party. Much of the strength can be attributable to a relief rally as bearish sentiment got overdone. EM currencies rallied last week, including the beleaguered Turkish lira, and that was enough to spark an EM led risk-on relief rally. US high yield (HY) joined the party, as HY bond prices surged against equivalent duration Treasuries.

 

The S&P 500 pulled back and tested its breakout level. As well, the pullback formed a bull flag, which is a continuation pattern indicating higher prices. The index appears poised to test its previous highs, and possibly break out to another all-time high. Even then, an S&P 500 fresh high is still a sideshow compared to the market action of the DJIA.

 

The major technical test is a key resistance level above the DJIA. The Transports has already made an all-time high. Should the DJIA stage an upside breakout, it would mark a Dow Theory buy signal.

 

Short-term breadth indicators from Index Indicators show that readings are neutral, and the market is exhibiting positive price momentum. These conditions suggest that a short-term top is still ahead next week.

 

Next week is also option expiry week (OpEx). Rob Hanna at Quantifiable Edges found that September OpEx has tended to be bullish for equities.

 

However, I would not stay on the bullish bandwagon for too long. The FOMC meeting is scheduled for the following week. While a September raise is already baked-in, the market will be looking for hints of when the Fed might pause its pace of rate hikes. I don`t believe that the market has sufficiently discounted the hawkish tone from the likes of Powell, Williams, and Brainard. Their message is very clear. The Fed will keep raising rates until the economy shows signs of slowing.

Mark Hulbert also pointed out that his sample of NASDAQ market timers are getting overly exuberant, which is contrarian bearish:

Consider the average recommended equity exposure among a subset of short-term market timers who focus on the Nasdaq market in particular (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). Since the Nasdaq responds especially quickly to changes in investor mood, and because those timers are themselves quick to shift their recommended exposure levels, the HNNSI is my most sensitive barometer of investor sentiment in the equity market.

This average currently stands at 64.9%, having risen in recent sessions to as high as 70.1%. On the occasion of my early-August column on stock market sentiment, in contrast, this average stood at minus 2.7%. This represents a significant shift towards irrational exuberance.

Accordingly, instead of the “wall of worry” that prevailed in early August, the current stock market mood is more akin to the “slope of hope” the market descends.

It’s interesting to note that this 70.1% recent reading is almost identical to the HNNSI level that prevailed on the day of the stock market’s late January high, when the HNNSI closed at 70.6%. The Nasdaq Composite fell almost 10% over the two weeks following its January high, and the S&P 500 lost even more.

 

My inner investor remains cautious. My inner trader is short-term bullish, but he recognizes that his positioning is only of a short-term nature.

Disclosure: Long SPXL

Short-term bullish, long-term cautious

Posted by Cam Hui -

Mid-week market update: There are a number of signs that the pullback that began in late August has run its course. These conditions makes me short-term bullish, but I remain longer term cautious on equities.

The market’s recent action of a correction to test its breakout level turned support is constructive. The index pulled back to form a bull flag, which is a bullish continuation pattern. It staged an upside breakout out of the flag this week, which suggests that the index may be poised for a test of its previous highs.
 

 

Imperfect buy signals

The market also flashed a number of imperfect buy signals, where various indicators neared buy signal levels, but never quite got there. As an example, the VIX Index breached its upper Bollinger Band on an intra-day basis, which would be an oversold condition for the stock market, but never closed there. Nevertheless, the market began to advance after that near-oversold condition.
 

 

Short-term breadth indicators from Index Indicators tell a similar story. The % of stocks above a 10 dma neared an oversold reading and began to mean revert and turn up.
 

 

Selected sentiment indicators flashed oversold buy signals. The CBOE Index Put/Call ratio reached an extreme level indicating fear late last week. Past episodes have seen limited downside equity risk.
 

 

Credit market risk appetite is also supportive of a risk-on tilt. Not only is US high yield leading the market upward, emerging market debt seems to be finding a bottom and have begun to turn up as well.
 

 

The combination of these conditions has turned my inner trader bullish.
 

Long-term cautious

Despite the appearance of these short-term bullish signals, my inner investor remains uneasy. One key question is how long the US market can decouple from the rest of the world. Even as the major US equity indices are within striking distance of their all-time highs, all of the major European and Asian stock market indices have retreated below their 50 and 200 day moving averages.

The chart below illustrates my inner investor’s dilemma. The monthly MACD on the Dow Jones Global Index (DJW) recently flashed a sell signal. Past buy (blue) and sell (red) signals in the last 20 years have marked effective entry and exit points. Moreover, the S&P 500 has tracked DJW closely. This time, however, the S&P 500 has diverged from DJW and surged. Will the divergence end with US weakness, or a rally from the rest of the world?
 

 

Other breadth indicators are flashing cautionary signals. My former Merrill Lynch colleague Fred Meissner of The FRED Report recently expressed concerns over the new high-new low indicator this way:

The indicator that most concerns us is the New Highs/New Lows indicator, which has seen two out of the last four weeks with more new lows than highs. This is unusual at new highs in the market, unless those highs are reversed. This is a concern for the same reason we like this indicator. We believe this indicator is the best institutional “footprint” of what the big mutual funds are doing.

Many of these funds have to remain invested in stocks even if they see a bear market coming. What they do then is to sell “junk” and buy “quality”. If you define
junk as stocks near lows that are not prominent in the big indexes, one can see that an expansion of new lows indicates selling by these funds. This, then, is the reason for our concerns – although the indicator itself is still flat to up.

 

Another way of expressing Fred Meissner’s thesis of “buying quality and selling junk” is price momentum. As the chart below shows, price momentum has breached a relative uptrend line and the performance of the factor has been consolidating sideways. At the same time, I had identified Tech as one of the key leaders in the market’s advance (see Tech as the canary in the coalmine). The relative performance of Tech stocks remain in an uptrend, but it has also been consolidating sideways in the same time frame as price momentum. Unless momentum can decisively stage an upside breakout from its relative trading range, the bulls will face significant obstacles.
 

 

Further, the Citi Panic/Euphoria Model is at an exuberant level. Going back to 1987, such readings have seen the market retreat over the following 12-months about 70% of the time.
 

 

How you navigate these cross-currents is a matter of time horizon. My inner investors remains cautious, and he is lightening up his equity positions on market strength.

My inner trader believes that a Last Hurrah scenario is in play, where the market is poised to rally and test or possibly exceed the recent highs. Subscribers received an email alert this morning indicating that my trading account had covered all short positions and gone long the market.

Disclosure: Long SPXL

 

Tech as the canary in the coalmine

Posted by Cam Hui -

Technology stocks have been on a tear in the last couple of years. Indeed, both the Tech sector and the Tech heavy NASDAQ 100 has been market leaders.
 

 

Tech earnings have surged in this cycle. By contrast, non-Tech earnings appear to be at or near a cyclical peak.
 

 

Can it continue?
 

Morgan Stanley’s warning

Business Insider recently highlighted a Morgan Stanley warning on the Tech sector.

All good things must come to an end.

It’s an age-old proverb — and one Morgan Stanley says applies to the tech sector.

This is an alarming prognostication when you consider that tech stocks have been indispensable in pushing indexes to record highs. But Morgan Stanley is adamant that tech is due for a reckoning, and it boils down to two major reasons.

First, the firm says weakness in the formerly red-hot semiconductor sector is crystallizing. This is due to a decline in memory pricing, which has put pressure on margins in the industry.

Morgan Stanley traces these issues to increasing inventory stockpiles for chipmakers. The firm says they’ve been unable to turn over their existing inventory, severely undercutting their pricing power.

Second, the tech space is facing the possibility of new regulation, especially following a second round of congressional hearings with top executives.

While there’s nothing immediately threatening about these types of events, that could change quickly. After all, so many tech stocks are already priced for perfection, which means even a faint threat to the status quo could result in deep losses.

Indeed, the relative performance of semiconductor stocks appear to be rolling over.
 

 

As for the sector’s rising regulatory problems, Tyler Cowen at Marginal Revolution put together a list of reasons of why Tech has so many political problems. Cutting to the chase, Silicon Valley is populated by too many engineers with poor people skills.

1. Most tech leaders aren’t especially personable. Instead, they’re quirky introverts. Or worse.
2. Most tech leaders don’t care much about the usual policy issues. They care about AI, self-driving cars, and space travel, none of which translate into positive political influence.
3. Tech leaders are idealistic and don’t intuitively understand the grubby workings of WDC.
4. People who could be “managers” in tech policy areas (for instance, they understand tech, are good at coalition building, etc.) will probably be pulled into a more lucrative area of tech. Therefore ther is an acute talent shortage in tech policy areas.
5. The Robespierrean social justice terror blowing through Silicon Valley occupies most of tech leaders’ “political” mental energy. It is hard to find time to focus on more concrete policy issues.
6. Of the policy issues that people in tech do care about—climate, gay/trans rights, abortion, Trump—they’re misaligned with Republican Party, to say the least. This same Republican party currently rules.
7. While accusations of deliberate bias against Republicans are overstated, the tech rank-and-file is quite anti-Republican, and increasingly so. This limits the political degrees of freedom of tech leaders. (See the responses to Elon Musk’s Republican donation.)
8. Several of the big tech companies are de facto monopolies or semi-monopolies. They must spend a lot of their political capital denying this or otherwise minimizing its import.
9. The media increasingly hates tech. (In part because tech is such a threat, in part because of a deeper C.P. Snow-style cultural mismatch.)
10. Not only does tech hate Trump… but Trump hates tech.
11. By nature, tech leaders are disagreeable iconoclasts (with individualistic and believe it or not sometimes megalomaniacal tendencies). That makes them bad at uniting as a coalition.
12. Major tech companies have meaningful presences in just a few states, which undermines their political influence. Of states where they have a presence — CA, WA, MA, NY — Democrats usually take them for granted, Republicans write them off. Might Austin, TX someday help here?
13. US tech companies are increasingly unpopular among governments around the world. For instance, Facebook/WhatsApp struggles in India. Or Google and the EU. Or Visa and Russia. This distracts the companies from focusing on US and that makes them more isolated.
14. The issues that are challenging for tech companies aren’t arcane questions directly in and of the tech industry (such as copyright mechanics for the music industry or procurement rules for defense). They’re broader and they also encounter very large coalitions coming from other directions: immigration laws, free speech issues on platforms, data privacy questions, and worker classification on marketplaces.
15. Blockchain may well make the world “crazier” in the next five years. So tech will be seen as driving even more disruption.
16. The industry is so successful that it’s not very popular among the rest of U.S. companies and it lacks allies. (90%+ of S&P 500 market cap appreciation this year has been driven by tech.) Many other parts of corporate America see tech as a major threat.
17.Maybe it is hard to find prominent examples of the great good that big tech is doing. Instagram TV. iPhone X. Amazon Echo Dot. Microsoft Surface Pro. Are you impressed? Are these companies golden geese or have they simply appropriated all the gold?

Bernie Sander`s Stop BEZOS act, which targets Amazon`s pay practices, is a manifestation of the Tech backlash. In addition, Donald Trump is no fan of Jeff Bezos, who is also the owner of the Washington Post. If Trump were smart, he would target Amazon the way the Justice Department targeted Microsoft for its cross-subsidization practices. The chart below demonstrates the operating margins of Amazon`s retail business compared to Amazon Web Service (AWS). If Amazon were to be forced to spin off AWS as a separate business, its retail business would face considerable operating headwinds.
 

 

In short, Tech has been leading the market for a couple of years. Morgan Stanley believes that the sector is vulnerable to a setback from both a cyclical and regulatory viewpoint. If the stock market is deprived of Tech leadership, what would be left?

Watch Tech. If its performance starts to crack, then it would be a signal to batten down the hatches.
 

Red sky in the morning

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

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

Global slowdown in progress

There is an adage among the nautical set:

Red sky at night, sailor`s delight
Red sky in the morning, sailors take warning

In the global economy, there are signs of a red sky in the morning. Last week, IHS Markit highlighted falling global manufacturing PMI.
 

 

Stagnant growth can be attributed to a slowdown in export orders in every major region of the world. In particular, the export order components of the UK, Japan, China, and much of Asia are below 50, indicating negative growth.
 

 

The global trade slowdown is confirmed by the OECD, which is a sign that the trade war is starting to bite.
 

 

Let’s take a tour around the world and see how the global economy is progressing.
 

The US: From tailwinds to headwinds

Starting our tour in the US, the snapshot shows a picture of strong growth, but forward-looking indicators are pointing to deceleration. The upside surprise from the ISM Manufacturing PMI appeared anomalous.
 

 

Chris Williamson, chief economist at IHS Markit, attributed the strength in ISM to a likely bias towards larger companies, while the Markit survey focuses more on SMEs.
 

 

Another explanation is companies undertaking a precautionary inventory build ahead of tariffs that are being implemented later in the year. The share of respondents in the ISM survey saying that inventories are up jumped up to levels not seen since 2013.
 

 

Looking ahead to Q3 earnings season, expectations are starting to get racheted downwards from the torrid EPS growth rates of Q1 and Q2. FactSet reported that the pace of Q3 guidance is normalizing, as 75% of companies have issued negative guidance, which is slightly above the 5-year historical average of 71%. The rate of Q3 EPS downgrades are now roughly consistent with history.
 

 

The strong ISM and August jobs numbers will give support to the Fed`s course of tightening monetary policy. As well, last week’s Fedspeak revealed a Federal Reserve that is determined to keep raising rates until something breaks. In an interview, Minneapolis Fed President Neel Kashkari, who is one of the most dovish members of the FOMC, revealed that the Fed’s institutional memory is still biased towards fighting inflation. By implication, Fed officials are likely to err on the side of caution should growth and inflationary pressures become evident.

There’s scarring from the financial crisis, yes. But there’s scarring, bigger scarring from the inflation of the 1970s. And I think that that is persuading us more than anything else and why we’re so biased towards … you know we say that we are we have a symmetric view of inflation. We don’t mind if it’s 2.1 or 1.9 but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.

At the same time, John Williams, who is one of the highly influential triumvirate of the Fed chair (Powell), vice-chair (Clarida), and the New York Fed President (Williams), stated that he is not afraid of inverting the yield curve (via the WSJ):

Federal Reserve Bank of New York leader John Williams said Thursday the prospect of a yield-curve inversion by itself wouldn’t be enough to stop him from supporting further rate rises if he thought the economy called for them.

“I think we need to make the right decisions based on our analysis of where the economy is and where it’s heading,” Mr. Williams told reporters after a speech in Buffalo. “If that were to require us to move interest rates up to the point where the yield curve was flat or inverted, that would not be something I find worrisome on its own.”

Reuters reported that even the former dove, Charles “don’t hike until you see the whites of inflation’s eyes” Evans of the Chicago Fed, turned hawkish. He now believes that the Fed should not pause its rate hike program until the Fed Funds rate rises beyond the neutral level:

The Federal Reserve will likely have to raise interest rates past the neutral rate to keep the economy on a sustainable growth path and inflation around target, according to Chicago Federal Reserve Bank President Charles Evans.

“Given the outlook today, I believe this will entail moving policy first toward a neutral setting and then likely a bit beyond neutral,” Evans said in a speech originally intended to be delivered to a conference earlier this week in Argentina and released on Thursday.

Longer term, the outlook is far more cloudy. The Goldman Sachs Bull/Bear Risk Indicator is not looking very pretty.
 

 

While this indicator is not intended to be a tactical market timing indicator and more effective at forecasting five-year returns, it nevertheless represents a warning for long-term investors.
 

 

Business Insider reported that the Leuthold Group issued a similar warning for stock prices.
 

 

In short, the tailwinds are starting to turn into headwinds.
 

Jittery Europe

Across the Atlantic, IHS Markit reported that the Eurozone PMI was steady, but the expectations component was deteriorating.

The levels of new work continued to increase during August, with the rate of growth improving slightly on July, but business confidence regarding future activity continued to weaken. Latest data showed expectations were at their lowest level for 23 months as global trade tensions and the unknown impact on future activity continued to undermine confidence. Most notably, sentiment amongst Italian and Spanish companies fell to around five-year lows. Expectations in France were at their weakest in over a year-and-a-half.

 

Recent analysis from Goldman Sachs shows that recent outperformance in European equities has been driven mostly by foreign sales, indicating a lack of enthusiasm for local exposure. This begs the question of what might happen if non-European economies wobble.
 

 

The Euro STOXX 50 has been behaving badly in response. The index has fallen below its 50 and 200 day moving averages, indicating a downtrend as begun. Tactically, it is now testing a key support level.
 

 

Across the English Channel, the FTSE 100 is exhibiting a similar downtrending pattern of trading below its 50 and 200 dma. The prospect of a no-deal Brexit is not helping matters.
 

 

Deflating Asia

The weakness in the FTSE 100 is not surprising. A ranking of Manufacturing PMI export orders shows that the UK was in contraction. Moreover, the two major Asian economies, China and Japan, were also in contraction. Other countries at the bottom of this ranking were also mainly Asian.
 

 

China’s Caixin PMI slowed to 50.8 in August, which is an 14-month low. Equally surprising was the performance of Guangdong province, China’s economic powerhouse, which saw PMI drop from 50.2 in July to 49.3 in August, indicating contraction.
 

 

A scan of the stock indices of China and her major Asian trading partners reveals a bearish picture. With the exception of the Taiwanese market, all other markets are either in downtrends, or recently suffered a technical breakdown (Australia).
 

 

The commodity markets are also signaling a global slowdown. Commodity prices are more sensitive to Chinese economic growth, as China represents the bulk of the demand in many instances. Both industrial metals and the CRB Index are in downtrends.
 

 

What the world tour is telling us

So what is the tour around the world telling us?

It tells us that the global economy ex-US is slowing. The slowdown is most evident in Asia, and Trump’s trade policies are likely exacerbating the downturn. Softness is also beginning to appear in Europe, and the prospect of a no-deal Brexit is not helping the UK outlook.

In the US, the nowcast remains robust, but tailwinds are starting to turn into headwinds. Both the Goldman Sachs Bull/Bear Market Risk Indicator and the Leuthold Stock Market Utilization Rate, which are composites of macro and equity valuation indicators, are flashing late cycle signals. The Leuthold indicator has begun to roll over, which is a more definitive bearish warning, while the Goldman Sachs indicator has not, and it is just signaling a high risk environment.

At the same time, policy direction is charting a bearish course. The Fed is determined to continue to tighten monetary policy. At the current pace, the yield curve is likely to invert in late 2018 or early 2019. The Trump administration appears to be determined to go all-in into a trade war (see my January 2018 publication Could a Trump trade war spark a bear market?).

In short, the clouds are gathering. Observant investors are seeing the metaphorical “red sky in the morning”. How many will take heed of this warning?
 

The week ahead

Tactically, traders should not be worried about a crash. While bottoms may be events, market tops are processes, and stock prices normally don’t fall in a straight line.

Here are the tactical bull and bear cases.

Starting with the bull case, the chart below shows the difference between actual and announced buybacks. Should the market decline further, expect that the buyback desks to become busier, and the additional buying should put a floor on stock prices, at least for now.
 

 

The S&P 500 retreated last week to test the breakout turned support level, and so far, support is holding. Moreover, the technical pattern appears to be a bull flag, which is a continuation pattern indicating higher prices. Moreover, the VIX Index is nearing the top of its Bollinger Band. A rise above the upper BB is an oversold signal that is a setup for a relief rally.
 

 

On the other hand, market internals of equity risk appetite are failing. The NASDAQ 100, which had been one of the market leaders, breached an uptrend line last Thursday. In addition, the high beta/low volatility factor ratio has broken down through a relative support level. These kinds of technical damage cannot be ignored, at least on an intermediate term basis.
 

 

Short term breadth indicators from Index Indicators show that the S&P 500 is nearing an oversold extreme, but may need one more down day before a bottom can be found. This is consistent with my observation that the VIX is just below its upper BB, which is also an oversold condition.
 

 

Breadth readings for the NASDAQ 100, which has bore the brunt of last week’s weakness, tell a similar story. However, this index may be sufficiently oversold to start a relief rally now.
 

 

Next Monday is Rosh Hashanah. Jeff Hirsch of Almanac Trader found the “sell Rosh Hashanah, buy Yom Kippur” trading pattern still works, and historically the DJIA has been weak the day before Rosh Hashanah, and strong on the day itself. If history were to be any guide, we may see a bounce on Monday before a final flush mid-week as the final trading low is achieved.
 

 

My inner investor is taking advantage of market strength to selectively lighten up his equity positions. My inner trader remains short, and he is waiting for the oversold signal to cover.

Disclosure: Long SPXU

 

The Dollar tail wagging the market dog

Posted by Cam Hui -

Mid-week market update: Here at Humble Student of the Markets, we believe that investors can gain great insight through the use of inter-market, or cross asset market, analysis. During this period of heightened trade tensions and emerging market stress, it is the US Dollar that is driving risk appetite, and the direction of stock prices.

Indeed, the stock market has weakened whenever the year/year increase in the USD Index has reached 5% or more. If the index were to rally up to about the 96 area this week from Wednesday`s closing level of 95.06, the 5% tripwire will be triggered.

 

Here are the bull and bear cases.

USD bull case

Currency strategist Marc Chandler summarized the case for rising trade tensions on the weekend:

Trade tensions are set to rise. The public comment period for the new tariff that the Trump Administration wants to levy on $200 bln of imports from China ends on September 6. The US President has made it clear that he intends to move forward as China has not signaled its willingness to change its behavior. China has responded by announcing that it will retaliate with tariffs on $60 bln its imports from the US. Even if the tariffs are not implemented immediately, it will cast a pall over the investment climate.

Trump also indicated that he will get around to addressing Europe’s unfair trade practices too. He dismissed as insufficient Europe’s offer, according to reports, to drop all auto tariffs. Europe is chaffing under a series of actions that the US has taken over the past two years, including pulling out of the Paris Agreement, slapping its steel and aluminum with tariffs justified on national security grounds, and the unilateral withdrawal from the treaty with Iran. Trump encouraged the UK to leave the EU and has offered France “a better deal” if it left too. At the end of last week, Trump again threatened to leave the WTO, “if it does not shape up.”

Meanwhile, NAFTA negotiations were not concluded at the end of last week. Talks will resume the middle of next week. Canada appears willing to cede some market share to the US dairy industry, but it cannot accept the steel and aluminum tariffs and the weakening of the conflict resolution mechanism. However, the White House has gone ahead and notified Congress that it planned to sign a deal with Mexico in 90-days and Canada can “join if it is willing.” By informing Congress on August 31, it allows the current president of Mexico to sign the agreement before AMLO takes office on December 1.

Since Congress had authorized the President to negotiate a trilateral agreement and he has submitted a bilateral agreement, the stage is set for a battle between the two branches. Also, if the lame duck Congress does not return to take up the measure, the duty will fall to the next Congress. The composition of the next Congress is not known, polls suggest the historical pattern in which the party that controls the executive branch loses seats in the legislative branch, will likely remain intact.

I would also add that the US-Mexico trade agreement would be a catastrophe if Trump decided to exclude Canada. The centerpiece of the agreement is a new set of rules on auto production, with tightened Rules of Origin for auto parts, as well as a higher level of US-Mexican content than NAFTA. Manufacturers would be hard pressed to adhere the higher North American content under NAFTA with Canada in the agreement. Without Canada, there would be no car produced in North America that would qualify for tariff free treatment. Think of what a disaster that would be.

At the same time, EM currencies are taking a hit from the combination of rising stress in the offshore USD market, and greenback strength. The cracks began in Turkey. They then migrated to Argentina, and now to South Africa and Indonesia. EM currencies and EM bonds are tanking as the USD strengthens.

 

Remember the yield curve? While everyone was watching the 2-10 Treasury curve, which incidentally steepened this week, Jeffrey Snider of Alhambra Investments pointed out that the eurodollar curve has slightly inverted. This is another indication of rising stress in the offshore USD market.

 

As bad as it gets?

The bear case for the dollar is more difficult to make, other than to point out that a bottom may be forming. Even as the USD Index strengthened yesterday (Tuesday), the natural expectation was the Chinese Yuan would weaken. Instead, the PBoC intervened to strengthen CNY overnight, indicating that China was not interested in a currency war.

Oh, and remember soybeans? Soybeans was a major target of Chinese tariff retaliation. Soybean prices have cratered, but they appear to be finding a bottom at these levels. This may be an indication that trade tensions have reached their height.

 

Another wildcard is the Trump administration’s position on the greenback. Here is a timeline of past statements, which has been both bullish and bearish. Will Trump say anything? If so, what?

 

The technical picture of the USD Index can be viewed from either a glass half-full, or half-empty perspective. On one hand, the hourly chart of the USD ETF (UUP) shows that greenback weakened today (Wednesday) after rallying yesterday, which can be thought of as risk appetite and equity bullish. On the other hand, the index may be in the process of tracing out an inverse head and shoulders, which is risk appetite bearish. (Just remember that the caveat to a head and shoulders formation is not complete until the neckline is broken.)

 

As well, the fact that the SPX is consolidating above its breakout level from the January highs can be interpreted as constructive.

 

I don’t pretend that I can predict the near-term path of the USD, but its trajectory will be a short-term “tell” of where risk appetite, and stock prices will go.

Stay tuned.

 

American confidence with Chinese characteristics?

Posted by Cam Hui -

Ed Yardeni recently highlighted the surge in small business confidence, earnings and employment plans as part of a scenario of what could go right.

 

Beneath the surface, there were a number of contradictions that were evocative of official Chinese economic statistics.

A confidence bifurcation

The first problem is how consumer and business confidence is measured. Jim O’Sullivan observed a significant partisan divide in the Bloomberg consumer comfort figures.

 

There was a similar partisan divide in University of Michigan consumer expectations.

 

Opinions vs. hard data

The NFIB small business population sample is skewed heavily small-c conservative and Republican. It is therefore no surprise that small business confidence and investment plans are surging. But how reflective is that of reality?

Instead of focusing on survey opinion data of how respondents felt, I analyzed hard figures of actual small business employment from Paychex, which processes payroll data for a wide swath of American small businesses. To my surprise, the Paychex Small Jobs Index was actually declining. Wait, what?

 

The wage data was nothing to write home about. The pace of wage gains was decelerating, despite the widespread complaints from the NFIB survey about finding qualified applicants. Weekly hours have been rising, but pace was not significantly different from levels during the Obama years.

 

Are these American business confidence statistics with Chinese characteristics? You tell me.

The macro risks that keep me awake at night

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

The latest signals of each model are as follows:

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

What keeps me up at night

Last week, I outlined the technical reasons for my cautious investment outlook (see 10 or more technical reasons to be cautious on stocks), and I promised that I would write about the macro and fundamental headwinds facing the economy and the stock market. These concerns fall into three main categories:

  • The Fed’s monetary policy;
  • Trade policy; and
  • Policy fallout from the midterm elections.

The combination of these factors have the potential to really tank economic growth. The latest Fathom Consulting forecast shows recession risk is rising dramatically.

 

Equally important is the analysis of New Deal democrat, who monitors economic statistics by splitting them into coincident, short leading, and long leading indicators. NDD reported that his set of long leading indicators have turned negative for the second time in three weeks. While he allowed that the data can be noisy, he is not sounding the recession alarm just yet.

[I]n the last month three of the long leading indicators have deteriorated enough to change from positive to neutral or neutral to negative, and a fourth is less than 0.1% away. The sole remaining positives are the Chicago Fed Adjusted Financial Conditions Index and Leverage subindex, and real estate loans. Corporate bonds remain neutral. Several weeks ago they were joined by the yield curve. Treasuries, refinance applications, mortgage rates, and real M2 all remain negative, plus purchase mortgage applications for the third week in a row, and joined for the first time this week by real M1…

I will require two events before this translates into a “recession watch” for over 12 months later: (1) The weekly reports must remain negative consistently for at least one full month, and (2) they must be reflected in a reliable monthly measure where available.

 

Rising recession risk from Fed policy

Forget all the noise about how Powell’s speech believes the uncertainty of the stars (u*, r*, pi*, also see Why the Powell Jackson Hole speech is less dovish than the market thinks), the Fed is on a preset course to raise rates.

One of the Fed’s dual mandate is price stability, or fighting inflation. It has also made it clear that its preferred inflation metric is core PCE. The dark line in the chart below shows the number of instances when the annualized monthly core PCE has exceeded 2%, which is the Fed’s inflation target. Whenever this metric reaches six or more, the Fed has embarked on a hawkish course of raising the Fed Funds rate.

 

The upward pressures on inflation is confirmed by the New York Fed’s Underlying Inflation Gauge (UIG), which stands at 3.3% and rising. As long as inflation is rising, expect the Fed to maintain its steady pace of rate hikes until something breaks.

 

We can already see the monetary consequences of the Fed’s tight money policy. One widely observed indicator is the flattening yield curve, which flirted with the cycle low of 0.20% last week but stands at 0.21%. The St. Louis Fed reported that the 2-10 yield curve as most popular series on FRED. As so many people are focused on the 2-10 yield curve, I would tend to discount its message, especially in the QE era where the Fed`s unconventional monetary policy may have affected the yield curve. One alternative is to move out to the far end of the yield curve and focus on the 10-30 year spread, which has worked just as well in the past as the 2-10 spread.

 

Much ink has been spilled about the message from the flattening yield curve. A good summary comes from Edward Harrison of Credit Writedowns:

What a flattening curve says is that the Fed’s policy is tightening. It says that the Fed has less scope for more rate hikes in the near future because it has already tightened so much. It doesn’t mean recession. And it’s not a harbinger of recession.

However, when the curve inverts, then it says that the tightening has gone so far that the Fed must eventually reverse course. Lower long rates are a signal that bond markets expect the Fed to be forced to cut rates in the medium term. And that only happens when the macro outlook deteriorates. We are 15 basis points from that happening. And unless long rates increase from here, two rate hikes in September and December or September and March get us to inversion.

New Deal democrat found that while a flattening yield curve doesn’t signal a recession, it does foreshadow a slowdown in employment:

In other words, even if the Fed stops raising rates now, and the yield curve does not get tighter or fully invert, my expectation is that monthly employment gains will decline to about half of what they have recently been — i.e., to about 100,000 a month — during the next year or so.

Regardless of how the market or policy makers interpret the message from the yield curve, both the 2-10 and the 10-30 spreads are likely to invert with one or two more rate hikes. As long as inflation pressures like UIG keep rising, it will be difficult for the FOMC to pause its pace of policy normalization.

A more worrisome monetary indicator is the deceleration in money supply growth. In the past, real year/year money supply growth, measured as either M1 or M2, has turned negative ahead of recessions. While the weekly data series is noisy, real M1 growth fell negative last week, and while real M2 growth remains positive, it is decelerating and on track to turn negative in the near future.

 

The risks of the Fed’s tightening policy is not just restricted to the US. FT Alphaville highlighted analysis from Neels Heneke and Mehul Daya of Nedbank that global USD liquidity is drying up.

 

The Nedbank team pointed out the risks of a reversal in USD liquidity, particular in light of some *ahem* less than prudent risk taking among investors. We have already seen the fallout in Turkey and Argentina. What happens when the Fed really squeezes?

The reversal in dollar liquidity is particularly worrisome for some emerging markets, because during the post-crisis years of cheap money, investors piled into these markets to make up for the lower returns available in developed economies. Heneke and Daya chart this shift in capital allocation despite the less than stellar fundamentals

 

In short, the combination of a Fed tightening policy with no obvious pause in sight, and deteriorating monetary indicators are red flags that suggest a recession is likely to begin in late 2019 or early 2020. Moreover, Fed policy is likely to increase the risk in the offshore USD market, and could precipitate another EM crisis.

Rising trade war risk

While conventional macro analysis indicates heightened recession risk beginning in Q4 2019, there are a number of developments that could either pull forward the timing of a recession, or exacerbate the downside effects. The most glaring risk is that of a trade war.

Agustín Carstens of the Bank of International Settlements (BIS) presented a paper at Jackson Hole outlining the likely consequences of a trade war. The globalized nature of supply chains presents a vulnerability for the global economy. Carstens pointed out that “global trade in intermediate goods and services is now almost twice as large as trade in final goods and services”. Many of Trump’s tariffs are now hitting intermediate goods, which raise the cost of production, which “could inflate prices, hurting both US consumers and US exports”.

 

Carstens also observed that rising tariffs could force the Fed`s hand to react with even more monetary tightening, and raise the risks of a currency war. This would be especially true if inflation expectations start to rise in sympathy to the price of goods.

Tariffs could therefore push up US prices, possibly requiring monetary policy to react through more rapid increases in interest rates. Such a response would widen the interest rate premium to the rest of the world and could drive the dollar higher. This would hit US exporters with a double whammy, and emerging market economies with a triple whammy. For emerging markets, a stronger dollar tightens financial conditions, triggers capital outflows and slows growth. As you can see in Graph 4, the dollar is already much stronger against emerging market currencies, other than the renminbi, than it is against those of other advanced economies. An additional twist is that US dollar strength could tempt authorities to impose even higher tariffs or even additional protectionist policies. Can the first salvoes in a currency war be long in coming?

The disruption from a trade war isn’t just limited to the trade channel, but through the banking channel because of the financial complexity of global value chains (GVCs):

Another source of vulnerability lies in the financial links that have increased with new trading relationships and production chains. Trade in commodities and finished goods requires only simple financial services, such as cross-border payments and foreign exchange. But complex trading relationships like GVCs need complex financial services to glue production processes together. The far-flung operations of multinational firms, which account for an increasing share of trade, require lots of working capital and entail lots of exposure to foreign currency risk. More complexity is added by the financial transactions needed to manage these positions, including derivatives and hedging strategies to offset currency risk.

All these links rely on the dollar, which remains dominant in trade transactions or bank loans for working capital, and in international banking or securities markets more generally. Indeed, in currency markets, the dollar prevails even more in the swap and forward markets than in the spot market.

There’s that offshore USD shortage rearing its ugly head again. Carstens went on to lay out a dire “perfect storm” scenario of a financial crisis set off by global trade war through the offshore USD banking system, which is heightened by an enormous US$11.5 trillion in offshore USD debt:

Today, we must recognise the potential for real and financial risks to interact, to intensify and to amplify each other. Protectionism could set off a succession of negative consequences. If all the elements were to combine, we could face a perfect storm.

Consider that non-US banks provide the bulk of dollar-denominated letters of credit, which in turn account for more than 80% of this source of trade finance. The Great Financial Crisis highlighted the fragility of this setup, since non-US banks depend on wholesale markets to obtain dollars. Ten years on, we should not forget how the dramatic fall in trade finance in late 2008 played a key part in globalising the crisis. Any dollar shortage among non-US banks could cripple international trade.

On top of that, trade skirmishes can easily escalate into currency wars, although I hope that they will not. As we saw earlier with Mexico, imposing tariffs on imports tends to weaken the target country’s currency. The depreciation could then be construed as a currency “manipulation” that seemingly justifies further protectionist measures. If currency wars break out, countries may put financial markets off-limits to foreign investors or, on the other side, deliberately cut back foreign investment, politicising capital flows.

In addition, we must be mindful of long-observed knock-on effects from tighter US monetary conditions, given the large stock of dollar borrowing by non-banks outside the United States, which has now reached $11.5 trillion. Policymakers in advanced economies should not shrug off the growing evidence that abrupt exchange rate depreciations reduce investment and economic growth in emerging market economies. This has implications for everybody, in that weaker economic activity reduces demand for exports from advanced economies. That would close the circle of trade tensions affecting the real economy via the financial channel of exchange rates.

Already, there are signs of a deceleration in global trade growth. It is difficult to judge at this point whether the cause is cyclical, or the result of US tariffs.

 

Tom Orlik at Bloomberg also found that global port volumes are decelerating.

 

What’s worse, Politico reported that American political considerations suggest that a Sino-American trade war is more or less baked-in:

Trump’s hard-line tactics and hardheaded determination to exhaust Chinese President Xi Jinping’s resolve has led some analysts and trade experts to doubt whether a negotiated outcome is Trump’s true aim — or whether he simply wants to forge a new economic status quo marked by higher tariffs on trade between the world’s two largest economies.

“By not having an agreement, Donald Trump really looks good and tough,” said Robert Lawrence, a Harvard University trade and investment professor. “He can say, ‘Look, we’re imposing all these tariffs.'”

“Once you get an agreement, people are going to look at it and say, ‘Did you really solve our problem?'” Lawrence added. “So, I actually believe the Chinese will make offers and it most likely will never be enough — and we’re going to sit with these tariffs in place for a very long time.”

In the short time he has before the midterm elections, Trump can either blame China or Mexico for the trade deficit, and lost manufacturing jobs. Those circumstances make China the more convenient political culprit:

Since Trump has blamed both Mexico and China for lost manufacturing jobs, it would be politically difficult for him to reach a deal with both countries at the same time and still convince his political base that he is looking out for their interests, said Derek Scissors, a resident scholar at the American Enterprise Institute.

“My argument is not that the president absolutely wants higher tariffs on China. But he’s not going to defend a trade deal with Mexico and go through the NAFTA wringer and then say, ‘OK, I also got a trade deal with China,'” Scissors said. “One of the ways you defend a trade deal with Mexico is you say the real problem here is with China.”

Even a US-Mexico trade deal is no panacea. Jeffrey Schott at the Peterson Institute believes the auto deal could backfire on Trump:

If implemented, these changes would raise the cost of cars and trucks produced in North America and possibly reduce the sale of cars assembled in North America, the opposite of the intended effect.

If this proposed change to NAFTA seems illogical and counterproductive, you’re right. Raising the cost of producing a car or truck in North America is not a good recipe for commercial success. Foreign producers don’t have to follow the convoluted NAFTA requirements to sell their cars in the US market; instead, US auto importers merely pay a 2.5 percent tariff—which doesn’t require them to meet any domestic or regional content criteria. So if the proposed NAFTA content rules force North American automakers to switch to higher priced local suppliers, and the added cost is more than the current import tariff, NAFTA will actually benefit importers by giving them a price advantage over North American production.

The only way to mitigate the negative effects of rising prices of American autos is to start another trade war:

The only way the NAFTA revision would not hurt US-based automakers is if the United States were to raise the cost of imported cars by imposing a stiff new tariff on imported cars from Europe, Japan, and South Korea above the maximum rate of 2.5 percent set by US obligations under the World Trade Organization (WTO). This could be done presumably by invoking the authority of Section 232 of the Trade Expansion Act of 1962 to restrict imports that threaten to impair US national security. Using Section 232 authority is the only way that US officials arguably can raise tariffs without violating the letter of WTO obligations and/or paying compensation to affected exporting nations.

In the face of persistently rising prices, how would the Fed react? Would regard these developments as a transitory effect on inflation, or would they push harder on the monetary brakes?

Now do you see why I lay awake at night?

The election effects that no one talks about

In addition, there is an electoral effect that I have not seen any analyst or strategist talk about. The polls indicate that the Democrats are likely to regain control of the House, though the Senate is likely to still see a Republican majority.

What are the likely effects of such a political transformation, and how would the market react?

If the Democrats were to become the majority in the House, they would have control of the committee chairmanships. Axios reported that the Republicans have compiled over 100 subpoenas and probes that would make life at the White House a living hell. These probes would range from Trump’s tax returns, to Jared Kushner’s ethics law compliance, to classified discussions at Mar-a-Lago, just to name a few.

While the first order market effects are likely to be minor, and regarded as more inside-the-Beltway fights, it would paralyze the government and tie the President’s hands on any legislative initiatives. The risk is Trump may use his other executive powers to assert his authority, such as to escalate a trade war, or to start a shooting war somewhere.

As well, Bloomberg reported that the Democrats have already laid out their tax plans should they retake the House. These initiatives include:

  • Raising the corporate tax rate;
  • Raising the capital gains tax rate;
  • Repeal the carried interest tax break;
  • Revise small business taxes; and
  • Undo the SALT limit.

While the carried interest tax break and SALT limit provisions are relatively small potatoes, there is consensus among Democrats about the issue of corporate taxes:

Democrats are finding success — particularly among blue collar workers over 50 — by tying the corporate tax cuts to future reductions in Medicare, Medicaid and Social Security, Lake said.

Slashing the corporate tax rate to 21 percent from 35 percent is estimated to cost $1.3 trillion over the next decade, according to estimates from the nonpartisan Joint Committee on Taxation. Increasing the rate, by at least a few percentage points, is likely to figure in Democrats’ sights as a way to offset the costs of other investments.

In an infrastructure plan released in March, Senate Democrats called for a 25 percent corporate rate. More moderate House Democrats, including Neal, have said they’re supportive of a rate in the mid-to-high 20s. Representative John Delaney, a Maryland Democrat who is running for president in 2020, has called for increasing the corporate rate to 23 percent and to use additional revenue to fund infrastructure.

It is unclear at this point what the midterm elections are, and how big a Congressional vote margin the Democrats can muster to push through a corporate tax hike. One risk for investors is the market is not pricing in the chances of a corporate tax increase, however modest. In addition, the Congressional Budget Office has projected that the stimulative effects of the tax cuts are likely to start fading they take effect after two years, or 2020, the addition of any corporate tax increases would create a potent ingredients for a fiscal induced slowdown just as the full effects of monetary tightening are being felt in late 2019 and early 2020.

As we approach the midterm elections, expect analysts to begin to focus on the ramifications of a Democrat victory. Fiscal policy is likely to become either unchanged or slightly tighter in 2019. The combination of a tight fiscal policy and tight monetary policy is likely to tank the economy into a slowdown – which is a scenario that is not discounted by the market.

In conclusion, there are a number of macro headwinds that equity investors face. The combination of a tight monetary policy, aggressive trade policy, and the possible post-midterm election tighter fiscal policy are likely to tank the economy into a recession. As history shows, recessions are bull market killers. The only question is the degree of downside risk (see How far can stock prices fall in a bear market?).

 

The week ahead

Looking to the week ahead, the market action last week appeared to have been climactic. In the last 12 months, the market has ridden the top of its Bollinger Band (BB) 10 times, not including the most current episode. The market has pulled back in 7 out of the 10 occasions (blue circles). The only three exception (red circles) were marked by continued overbought readings on RSI-5, defined as RSI staying above 70, during those episodes. The RSI-5 reading as of Friday’s close was 68.8, which is below the 70 overbought line. This suggests that we are due for a period of short-term weakness.

 

While this may be a case of torturing the data until it talks, the minimum target for a pullback in 6 of the 7 upper BB breaks was the 20 day moving average (dma). Since the 20 dma has been rising, that makes the 2860-2880 zone the initial downside target.

Short-term breadth indicators from Index Indicators confirms the bearish trading outlook. Price momentum is negative, and readings are nowhere near oversold territory.

 

The Citi panic/euphoria index is firmly in euphoric territory, which is contrarian bearish. The last time this happened was January, when the market peaked out and shortly began a corrective period.

 

Despite my intermediate term bearish bias, one of the challenges for my inner trader is the recent achievement of fresh all-time highs in several major US equity indices. All-time highs are generally bullish and should be respected and not be ignored. I will be watching how the market behaves during the upcoming period of likely weakness. One of the challenges for the bulls is whether we can see a Dow Theory buy signal, marked by fresh highs in both the DJ Industrials and Transports. The DJTA staged an upside breakout to new highs during the latest rally, and the DJIA is roughly 650 point from a new high.

 

Another indicator to watch should the market pull back is the behavior of equity risk appetite, as measured by the high beta vs. low volatility pair. The ratio recent breached a key relative support level, but rallied back above support turned resistance. Will relative support hold this time if stock prices weaken?

 

My inner investor has been taking advantage of the recent rally to scale back his equity holdings. My inner trader remains short the market.

Disclosure: Long SPXU

 

The risks to Trump’s NAFTA gambit

Posted by Cam Hui -

There has been a lot of excitement over a possible breakthrough on NAFTA based on a handshake agreement between the United States and Mexico. The White House has also positioned the deal as a take-it-or-leave-it offer to Canada to join the agreement by Friday, which has also raised the anticipation level on the prospect that trade tensions are going to ease.

However, I would characterize the US-Mexico deal as a useful step towards a comprehensive NAFTA agreement, but the characterization that a deal as imminent is a high risk strategy for Trump that may backfire on him.

 

Here are the main risks to a comprehensive agreement.

Trump does not have the authority to negotiate a bilateral deal with Mexico, and therefore he cannot just unilaterally cut Canada out of a revised NAFTA deal.

The negotiation over a revised NAFTA treaty was done under fast track authority, which is explained this way:

The Constitution gives Congress exclusive authority to set tariffs and enact other legislation governing international trade. The President has the Constitutional authority to negotiate international agreements. If the President negotiates a trade agreement that requires changes in U.S. tariffs or in other domestic laws, that trade agreement’s implementing legislation must be submitted to Congress — or the President must have Congress’ advance approval of such changes.

Fast track is an expedited procedure for Congressional consideration of trade agreements. It requires Congress to vote on an agreement without reopening any of its provisions, while retaining the ultimate power of voting it up or down. The three essential features of any fast track authority are:

(1) extensive consultations and coordination with Congress throughout the process;
(2) a vote on implementing legislation within a fixed period of time; and
(3) an up or down vote, with no amendments.

Ultimately, fast track gives the President credibility to negotiate tough trade deals, while ensuring Congress a central role before, during and after negotiations. The authority puts America in a strong position to negotiate major trade agreements and maintains a partnership between the President and Congress that has worked for more than 20 years.

In other words, Congress gives the President the authority to negotiate trade agreements under fast track, and it can either approve or refuse to ratify the agreement with no changes. Trump received fast track authority to negotiate a trilateral agreement with Canada and Mexico, not just Mexico. If he wants a bilateral agreement, he needs to ask for Congressional authority first before Congress can approve it.

In contrast to the White House’s messaging of a possible bilateral agreement, Mexican President Enrique Pena Nieto was far more cautious in characterizing any possible deal as a three-way agreement between the Canada, the US, and Mexico.

What are the issues facing the negotiations with Canada?

As with any negotiation, presenting a third partner with an interim agreement is problematical for a number of reasons. First, Canadian Foreign Affairs Minister Chrystia Freeland expressed optimistic noises about a possible three-way agreement, her team had not even received the text of the deal until Wednesday, and therefore there is little time to react. There may be some parts of the US-Mexico agreement that have unforeseen effects that neither American nor Mexican negotiators may not have considered.

The Washington Post has outlined the three major hurdles for Canada to join an agreement:

1. Dairy. “There’s a word Canada has trouble with. It’s M-I-L-K,” Larry Kudlow, Trump’s top economic adviser, said Tuesday on “Fox & Friends.” Canada keeps milk prices high by using supply management, a system that restricts how much milk is sold in Canada and how much foreign milk can come into the country. Canada has done this for 50 years, and it’s beloved in some parts of the country because Canadian dairy farmers enjoy high and steady incomes. But it has prevented U.S. producers from selling much milk (or cheese) to Canada, since any dairy products that aren’t part of the supply management quota are socked with tariffs of 200 percent to 300 percent.

On the flip side, Canada accuses the United States of giving massive subsidies to dairy (one study claims 73 percent of U.S. dairy farmer returns came from support programs, although U.S. producers argue they mainly get insurance payments from the government when prices are low).

Canada has struck a compromise with other trading partners, including Europe, to allow foreign producers to have a bigger share of sales in Canada. That could work for the NAFTA update, trade experts say, but Trump is fixated on getting the tariffs down. (Dairy was excluded from the original NAFTA deal that removed tariffs on most other items moving across the border.)

2. Dispute resolution. Known as “Chapter 19,” this original NAFTA provision allows one country to challenge another country over tariffs or dumping cheap goods below market value. It’s basically a fast-track version of going to the World Trade Organization and complaining about unfair trading practices. Instead of waiting years for a WTO case (or U.S. court case), a NAFTA Chapter 19 board decides quickly.

The United States would love to rip that chapter out, but Canada wants to save it. Two sources familiar with the trade deliberations, who spoke on the condition of anonymity since discussions are ongoing, said this is the thorniest issue. The Canadian government has been using Chapter 19 to go after the Trump administration, and Trudeau has wide support across the aisle in his country to keep Chapter 19 intact, but Trump wants greater ability to use protectionist measures when he thinks U.S. workers and firms are being harmed.

This issue goes hand-in-hand with Chapter 11, known as investor-state dispute settlement. Chapter 11 gives companies a mechanism to sue foreign governments for changing rules on them and hurting their profits. The United States and Mexico struck a compromise on this: It will still apply in full to some industries, especially energy, where companies are worried that the new Mexican government might tear up their government drilling contracts, but it will be lessened for other industries. It’s unclear what Canada will do on Chapter 11; Trudeau and his team have spoken far more fervently about protecting Chapter 19.

3. Trump’s tariffs on steel, aluminum and possibly cars. The bad blood over trade really started when Trump put tariffs on Canadian steel and aluminum, arguing that Canadian metals are a “national security threat” to the United States. Trump used a law, known as Section 232, that has rarely been used since NAFTA was created. Trudeau blasted the 232 tariffs as “insulting” and nonsensical, citing the two countries’ longtime alliance and generally balanced trade.

Canada wants the steel and aluminum tariffs removed if a new NAFTA deal passes. Even more important, the Canadians don’t want Trump turning around in a few months and hitting Canada with tariffs on autos, a massive industry for the Canadians. So far, the Trump administration is hesitant to agree. A senior White House official said the 232 negotiations are “on their own track separate from NAFTA.”

Trump wants options to hit harder later on, and his administration has argued the United States should have a right to protect itself, although many trade experts find it hard to justify that bringing SUVs in from Canada is a national security threat.

What are the chances that these issues will be resolved in just a few days?

What does Trump have to do to make good on his threats to cut out Canada?

Trump has threatened to impose a 25% tariff on autos if Canada does not sign on the dotted line by the Friday deadline. Consider what he would have to do to make good that threat.

He could declare Canadian autos a “national security threat” under Section 232. Implementing such a measure will not be easy in this era of global supply chains where auto parts move back and forth freely on the Ambassador Bridge between Detroit and Windsor. How do you define a “Canadian car”?

Remember how difficult it was to implement Trump’s travel ban when he first moved into the White House?

A more formal and heavy-handed way to retaliate against perceived Canadian intransigence is to withdraw from NAFTA. Here is how the process would work.

  • Trump must give six months’ notice to Canada and Mexico, which would put the exit date around March 2019.
  • Trump must give Congress 90 days notice of withdrawal from NAFTA. (Is this a good idea just ahead of a midterm election? The auto industry is a major employer. As well, Canada is the biggest customer of many states. How would the Republican Party react to such a measure?)

 

  • NAFTA was implemented by acts of Congress, and Congress will have to repeal those provisions (in 2019). As the Democrats are likely to control the House after the midterm election, what are the chances that NAFTA will get repealed? This sets up a possible constitutional crisis, where the executive branch and the legislative branch both assert authority over trade, and the implementation of trade laws.
  • Even if the US were to withdraw from NAFTA, the US-Canada trading relationship would then revert to the old Canada-US Free Trade Agreement which was signed by the leaders of both countries in 1988. The old FTA addresses the same issues as dispute settlement, dairy supply management, and so on. Is Trump going to withdraw from that agreement as well? What acts of Congress will have to be passed in order to unscramble that omelette?

 

What will Trudeau do?

Canada’s Globe and Mail reported that Prime Minister Justin Trudeau stated that he won’t be rushed into a deal:

Prime Minister Justin Trudeau is signalling that Canada won’t be rushed into a bad deal just to meet Donald Trump’s Friday deadline for preserving the North American Free Trade Agreement.

“We recognize there is a possibility of getting there by Friday, but it is only a possibility because it will hinge on whether or not there is ultimately a good deal for Canada, a good deal for Canadians,” Trudeau said at an event in northern Ontario on Wednesday.

“I’ve said from the beginning no NAFTA deal is better than a bad NAFTA deal. And we are going to remain firm on that principle because Canadians expect us to stand up for them.”

Donald Trump is tremendously unpopular in Canada, and Trudeau may calculate that he could play the Captain Canada role by resisting American pressure, despite the risks of tariff retaliation.
 

Declare victory and go home?

There is one final possibility for all sides to declare a victory and go home. Canada’s National Post reported that the Friday deadline may not be an actual hard deadline and everyone could agree to keep negotiating:

Outside experts say the American law governing how Congress approves trade deals, the oft-cited reason for the time crunch permits much more flexibility. Talks with Canadian negotiators could actually continue into late September, while still enabling Mexico’s outgoing president to sign the accord before Dec. 1, considered a crucial objective, they say…

The U.S. Trade Promotion Authority (TPA) requires the White House to give Congress 90 days’ notice that it plans to sign a trade deal. On its own, that would make Saturday the deadline for concluding things. The White House has said it would give notice Friday.

But the TPA also says the final text of the deal doesn’t have to be released until 60 days before signing.

That means Canada could have as much as another 30 days to hammer out its part in the agreement, trade experts say.

Given all the hurdles, it is hard to see that negotiators could come to an agreement by the Friday deadline, and dot all the i’s and cross all the t’s, even if there was an earnest intentions on all sides.

How this all plays out, I have no idea. But there are considerable risks to the Trump NAFTA gambit. Don’t get so excited and be prepared for more twists and turns.

 

On the verge of a “good overbought” rally, or market stall?

Posted by Cam Hui -

Mid-week market update: As the market broke out through the round number 2900 level, I am indebted to Urban Carmel and others for pointing out that the index is testing a key uptrend line.
 

 

There are a number of common elements of the current market conditions to past tests of the uptrend:

  • By definition, all episodes either tested or approached trend line resistance.
  • Most were at or above their upper Bollinger Bands (BB). Each upper BB ride lasted between 1 and 4 days. Today is day 3 of the upper BB ride.
  • All were overbought on RSI-5, with readings of 80 or more.

The key difference between the rallies in 2018, and the melt-up advances that began in late 2017 is the degree of positive breadth participation. The 2017 episodes were marked by strong breadth and momentum that exhibited themselves in a series of “good overbought” RSI-5 readings. The strong display of momentum enabled stock prices to rise even further and in a steady manner.

The key question for traders is whether the current rally turn into a “good overbought” advance, or will it stall at trend line resistance?
 

I vote for stall

I vote for the stall scenario. Here are a number of reasons why.

First, the lack of breadth surges is disconcerting. The chart below shows the difference between the 2017 rallies and the 2018 rallies. Where are the breadth surges, especially when the market is testing trend line resistance, and the upper BB? In addition, recent upper BB tests have lasted 1-3 days. Today is day 3. How much further can the market rise from here without a breadth surge?

 

Medium term (1-2 week) breadth from Index Indicators tell a similar story. The rallies in 2017 were marked by stronger overbought readings compared to the ones in 2018. The current episode is similar to other 2018 rallies where the market became mildly overbought, reached trend line resistance (grey rectangles), and retreated. Unless the market can exhibit even stronger follow through, the odds favor weakness here.
 

 

Short term (1-2 day) breadth from Index Indicators also shows that the market is overbought and ripe for a pullback. In effect, both short (1-2 days) and medium term (1-2 week) breadth are highly extended, indicating that market weakness can occur at any time.

 

As well, the Fear and Greed Index was within a whisker of its overbought target of 80-100 as it now stands at 79. Is that close enough to call the top to this rally? Even if you are bullish, do you really want to be buying here instead of waiting for a pullback?

 

Finally, this coming Friday is QT day, when roughly $21b of Treasury securities roll off the Fed’s balance sheet (via NY Fed). Such events have tended to be equity negative in 2018.

 

Admittedly, I was a little early (wrong) in turning bearish on a tactical basis, these conditions strongly suggest that a bearish reversal is at hand. My inner trader is holding to his short position, and he is considering adding to it on a downside break.
 

Disclosure: Long SPXU
 

Why the Powell Jackson Hole speech was less dovish than the market thinks

Posted by Cam Hui -

I am late on this analysis, but I spent some time on the weekend reading, and re-reading Powell’s Jackson Hole speech. Contrary to the market’s interpretation, I concluded that his speech was not as dovish as the market thinks.

There is much at stake for equity investors. The stock market is already risen to its highest level compared to past Fed rate hike cycles.
 

 

Dovish at first glance

At first glance, the speech appeared to be dovish. Powell outlined how the FOMC mis-judged the stars. namely the natural unemployment rate, the neutral real Fed Funds rate, and, to a lesser extent, the inflation objective. In doing so, the Fed made a number of policy errors in the past.
 

 

Then there was the paeon to Alan (let’s wait another meeting) Greenspan in the late 1990’s:

The FOMC thus avoided the Great-Inflation-era mistake of overemphasizing imprecise estimates of the stars. Under Chairman Greenspan’s leadership, the Committee converged on a risk-management strategy that can be distilled into a simple request: Let’s wait one more meeting; if there are clearer signs of inflation, we will commence tightening. Meeting after meeting, the Committee held off on rate increases while believing that signs of rising inflation would soon appear. And meeting after meeting, inflation gradually declined.

 

What the market missed

I believe one key market mis-interpretations is the Fed’s neutral position and analytical framework. During the Greenspan era, the neutral position was to do nothing until the FOMC saw evidence of rising inflation. By contrast, Powell staked out his neutral position at the beginning of the speech as gradual policy normalization:

As the economy has strengthened, the FOMC has gradually raised the federal funds rate from its crisis-era low near zero toward more normal levels. We are also allowing our securities holdings–assets acquired to support the economy during the deep recession and the long recovery–to decline gradually as these securities are paid off. I will explain today why the Committee’s consensus view is that this gradual process of normalization remains appropriate.

The remainder of the speech addressed the question of risk management and how to navigate the risks of tightening too quickly and choking off growth against reacting too slowing and allowing inflation to get out of control:

1. With the unemployment rate well below estimates of its longer-term normal level, why isn’t the FOMC tightening monetary policy more sharply to head off overheating and inflation?

2. With no clear sign of an inflation problem, why is the FOMC tightening policy at all, at the risk of choking off job growth and continued expansion?

 

Policy error risk

Powell’s predecessor Janet Yellen was a labor economist by training, and she had a deep abiding faith in the Phillips Curve in the formulation of policy. It is evident from Powell’s speech that he has less trust in the Fed’s models and estimates of the stars, namely u* as the natural rate of unemployment, r* as the neutral real rate of interest, and Π* (“pi star”) is the inflation objective.

The risks from misperceiving the stars also now play a prominent role in the FOMC’s deliberations. A paper by Federal Reserve Board staff is a recent example of a range of research that helps FOMC participants visualize and manage these risks. The research reports simulations of the economic outcomes that might result under various policy rules and policymaker misperceptions about the economy. One general finding is that no single, simple approach to monetary policy is likely to be appropriate across a broad range of plausible scenarios. More concretely, simulations like these inform our risk management by assessing the likelihood that misperception would lead to adverse outcomes, such as inflation falling below zero or rising above 5 percent.

The paper that Powell referenced is called Some Implications of Uncertainty and Misperception for Monetary Policy. Here is the abstract [emphasis added]:

When choosing a strategy for monetary policy, policymakers must grapple with mismeasurement of labor market slack, and of the responsiveness of price inflation to that slack. Using stochastic simulations of a small-scale version of the Federal Reserve Board’s principal New Keynesian macroeconomic model, we evaluate representative rule-based policy strategies, paying particular attention to how those strategies interact with initial conditions in the U.S. as they are seen today and with the current outlook. To do this, we construct a current relevant baseline forecast, one that is constructed loosely based on a recent FOMC forecast, and conduct our experiments around that baseline. We find the initial conditions and forecast that policymakers face affect decisions in a material way. The standard advice from the literature, that in the presence of mismeasurement of resource slack policymakers should substantially reduce the weight attached to those measures in setting the policy rate, and substitute toward a more forceful response to inflation, is overstated. We find that a notable response to the unemployment gap is typically beneficial, even if that gap is mismeasured. Even when the dynamics of inflation are governed by a 1970s-style Phillips curve, meaningful response to resource utilization is likely to turn out to be worthwhile, particularly in environments where resource utilization is thought to be tight to begin with and inflation is close to its target level.

In other words, even in the face of uncertainty, the Fed should tighten if unemployment is below r*, or the natural rate of unemployment. That is the first subtlety that many market analysts appear to have missed.
 

Risk management at the Fed

The second mis-interpretation by many analysts is how the Fed practices “risk management”. A simplistic interpretation of the following paragraph created confusion, because it did not outline the exact metrics that the FOMC will use in formulating monetary policy [emphasis added]:

Experience has revealed two realities about the relation between inflation and unemployment, and these bear directly on the two questions I started with. First, the stars are sometimes far from where we perceive them to be. In particular, we now know that the level of the unemployment rate relative to our real-time estimate of u* will sometimes be a misleading indicator of the state of the economy or of future inflation. Second, the reverse also seems to be true: Inflation may no longer be the first or best indicator of a tight labor market and rising pressures on resource utilization. Part of the reason inflation sends a weaker signal is undoubtedly the achievement of anchored inflation expectations and the related flattening of the Phillips curve. Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.

Powell answers the question of how to view inflation in a couple of ways. The first led to a dovish interpretation, because inflationary expectations are well anchored, which allows the Fed to run the economy a little hot:

When longer-term inflation expectations are anchored, unanticipated developments may push inflation up or down, but people expect that inflation will return fairly promptly to the desired value. This is the key insight at the heart of the widespread adoption of inflation targeting by central banks in the wake of the Great Inflation. Anchored expectations give a central bank greater flexibility to stabilize both unemployment and inflation. When a central bank acts to stimulate the economy to bring down unemployment, inflation might push above the bank’s inflation target. With expectations anchored, people expect the central bank to pursue policies that bring inflation back down, and longer-term inflation expectations do not rise. Thus, policy can be a bit more accommodative than if policymakers had to offset a rise in longer-term expectations

For investors, this means monitoring the breakeven rate and the 5×5 forward inflation expectation rate, both of which have been very stable. If they were to break to the upside, then the FOMC is likely going to stomp on the monetary brakes.
 

 

However, the 30-year breakeven rate is rising and less “well-anchored”.
 

 

Which should you focus on, the 5-year rate, which has been stable, or the 30-year rate, which has been rising? The answer is probably a bit of both, but it is difficult to know how much weight the Fed puts on either metric.
 

When does the Fed pause?

Prior to Powell’s speech, Fed watcher Tim Duy penned a commentary asking when the Fed is likely to pause. In particular, Duy was looking for clues from the Powell speech for the signposts that the Fed is looking for in pausing its tightening policy:

Danger lurks, however, in this stage of the business cycle. Due to long and variable lags in monetary policy, activity might not slow sufficiently quickly to deter the Fed from hiking rates. Moreover, they may still be witnessing a lagged impact of higher inflation from prior economic strength. This combination could push the Fed to hold rates higher for longer than is appropriate for the economy. Indeed, this is an error I believe the Bernanke Fed made at the height of its tightening cycle.

My sense is that the Fed will resist pausing until the data suggests enough slowing to put the economy on a sustainable path. If true, this is where the risk of recession rises as policy transitions from “less accommodative” to “neutral” to “restrictive.” That said, should Powell’s comments at Jackson Hole be relevant for the near-term policy path, I am watching for signals that he is looking to raise policy rates another 50 or 75 basis points into the range of estimates of the neutral rate and then be willing to pause even if the data flow remains strong. This will take of a leap of faith on the part of the Fed that their estimates of neutral are more correct than not and that continuing strong data simply reflects a policy lag.

To Duy’s disappointment, there were no hints. There were no discussions of a “pause”, or how the FOMC might “re-assess” its policy when metrics reached a certain milestone. Instead, Powell concluded:

I see the current path of gradually raising interest rates as the FOMC’s approach to taking seriously both of these risks. While the unemployment rate is below the Committee’s estimate of the longer-run natural rate, estimates of this rate are quite uncertain. The same is true of estimates of the neutral interest rate. We therefore refer to many indicators when judging the degree of slack in the economy or the degree of accommodation in the current policy stance. We are also aware that, over time, inflation has become much less responsive to changes in resource utilization.

While inflation has recently moved up near 2 percent, we have seen no clear sign of an acceleration above 2 percent, and there does not seem to be an elevated risk of overheating. This is good news, and we believe that this good news results in part from the ongoing normalization process, which has moved the stance of policy gradually closer to the FOMC’s rough assessment of neutral as the expansion has continued. As the most recent FOMC statement indicates, if the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate.

The economy is strong. Inflation is near our 2 percent objective, and most people who want a job are finding one. My colleagues and I are carefully monitoring incoming data, and we are setting policy to do what monetary policy can do to support continued growth, a strong labor market, and inflation near 2 percent.

In other words, all the considerations of risk management, wait-one-more-meeting Greenspan, and managing policy in the face of uncertain stars were smokescreens. Those discussions related to how the Fed is likely to behave in the face of rising tail-risk. Right now, tail-risk is not evident.

The neutral course is to keep raising one-quarter point every three months, and to gradually unwind the balance sheet. In other words, while the Fed is becoming more data dependent and less policy dependent, the preset policy is to keep raising until something breaks. That is why I believe the Powell speech is less dovish that the market consensus – in the absence of substantive Fedspeak discussions of the pausing conditions.
 

10 or more technical reasons to be cautious on stocks

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

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

What I am cautious on stocks

I continue to get resistance to my recent bearish calls (see Major market top ahead: My inner investor turns cautious), and that was even before the major indices broke out to fresh record highs. To reiterate, the cautiousness was triggered by both technical and macro considerations. Most importantly, the Wilshire 5000 is exhibiting a negative divergence on the the monthly chart, which has foreshadowed important market tops in the past.
 

 

As well, a number of my Recession Watch long leading indicators are rolling over. While the current snapshot forecast for the next 12 months remains neutral, at the current pace of deterioration, they would become sufficiently negative to flash a recession warning later this year. This would indicate that a recession would occur in Q4 2019. As stock prices tend to be forward looking, the combination of bearish technical readings and weakness in long leading indicators suggest that a market top is forming about now.

In addition to the bearish technical indicators I cited three weeks ago, a number of other warnings have appeared indicating intermediate term cautiousness for equity investors.
 

Technical breaks everywhere

In the wake of that post three weeks ago, I have encountered numerous examples of technical breakdowns which warn of a developing market top. Firstly, American investors have been spoiled because US equity markets have been the global market leaders, which may have created a false sense of security for American investors.
 

 

Technical deterioration has been evident to non-US equity investors for most of 2018. Callum Thomas of Topdown Charts found that the number of equity markets experiencing a death cross has been steadily rising. (A death cross occurs when the 50 dma falls below the 200 dma, indicating the onset of a downtrend).
 

 

In the US, evidence of technical deteriorating is starting to appear. Consider the stock/bond ratio (SPY/TLT), which includes the total return. As the S&P 500 broke out to an all-time high last week, why did SPY/TLT behave so poorly? This ratio staged an upside relative breakout to fresh highs in early August, pulled back to test the breakout level, and it has been unable to strengthen back above relative resistance. Is that telling us something about risk appetite?
 

 

The ratio of high beta to low volatility stocks (SPHB/SPLV) is also flashing a cautionary message about risk appetite. This ratio had been consolidating sideways for most of this year, and recently broke a key relative support level. While risk appetite has tactically improved and the ratio has rallied back above the relative resistance line, the technical damage done by the relative support breach is something investors should be paying attention to.
 

 

Clues from leadership rotation

Market internals of sector leadership based on RRG charts is also showing that the bears are taking control of the tape. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

The latest RRG of style, or factor, leadership shows that the leading groups have become defensive and value in nature, while high-octane groups, such as IPOs, high beta, and price momentum are either weakening or lagging. This shows how the character of stock market internals have shifted in the past 10 weeks from growth to value, and from high beta to defensive factors.
 

 

The RRG chart of US sector leadership tells a similar story. Defensive sector such as Consumer Staples, Healthcare, REITs, and Utilities are all either improving or leading sectors. The appearance of heavyweight sectors such as Financials and Technology in the lagging and weakening quadrants is also creating headwinds for the major cap and float weighted indices.
 

 

On an absolute basis, this chart of VNQ, which represents REITs, is undergoing a bullish cup and handle upside breakout. Leadership from such a defensive sector is another technical warning of a potential market top.
 

 

The heavyweight financial stocks are current in the “lagging” quadrant, and appear to be on the verge of rising to the “improving” quadrant, but even that recovery may be suspect. As the chart below shows, the relative performance of this sector is highly correlated to the shape of the yield curve. They outperform when the yield curve is steepening, and lag the market when it is flattening. The yield curve underwent a brief steepening episode, but it appears to have reverted to its flattening trend as the Fed has signaled a steady pace of rate increases.
 

 

Another clue from sector leadership can be seen in the performance of cyclical stocks compared to defensive stocks. Callum Thomas of Topdown Charts observed that cyclical stocks have been one of the key drivers of this equity bull, but the cyclical to defensive stock ratio is starting to roll over.
 

 

Globally, the BAML Fund Manager Survey found that consensus profit expectations are also deteriorating, which usually foreshadows weakness in the cyclical/defensive stock performance.
 

 

The copper/gold ratio is another way that we can see how the global cycle is rolling over. Both copper and gold have commodity and inflation hedge characteristics, but copper is more sensitive to industrial production and therefore its price is more cyclically sensitive. As the chart below shows, the copper/gold ratio is declining, and this ratio has historically been correlated with the stock/bond ratio, which is a measure of risk appetite.
 

 

Warnings from trend following models

In addition, trend following models are starting to flash warnings of market weakness. I first encountered Chris Ciovacco’s work in 2016 when his trend following models proclaimed [A] Stock Market [buy] Signal Has Occurred Only 10 Other Times In Last 35 Years. This YouTube video explained his decision process. Ciovacco uses a trend following model which applies a 30, 40, and 50 week moving average to the NYSE Composite. A bullish condition occurs when each of shorter MAs are above the longer MAs, and vice versa. A warning signal is flashed when the short (30 week) MA falls below the medium (40) week MA (vertical lines). By design, trend following models will not pinpoint the exact top or bottom, but they spot the trend, and they are usually late in their buy and sell signals. As the chart below shows, the 30 WMA of the NYSE Composite just fell below the 40 WMA, which is a bearish warning*.
 

 

As well, consider how the 30, 40, and 50 WMA trend following model is telling us about market conditions when we apply the model to the Value Line Geometric Average, which is another broad measure of the stock market.
 

 

How about the equal weighted S&P 500, as a measure of the average large cap stocks, as opposed to the more conventional float-weighted index?
 

 

Of the broadly based indices, only the Wilshire 5000 is on a buy signal, though the 30 wma is showing signs that it is rolling over.
 

 

I interpret these conditions as failing price momentum, which is another warning for the bulls.

* Ciovacco remains bullish on equities today, but his bullishness is justified by moving his original goalposts. A recent article, These Facts Do Not Support Major Top Theory, presented evidence by comparing the behavior of stocks, bonds, and gold in 2008 to today.
 

Faltering price momentum

Indeed, the performance price momentum factor has been rolling over, which is worrisome.
 

 

A team of academic researchers at the Cass Business School found in 2012 (see The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation) that traders can optimize their results by combining trend following with price momentum. Price momentum works best when the stock market is an uptrend, and performs badly in a downtrend. In other words, when the market is rising, buy the hot story stocks of the day.

My own study reproducing the results at the sector level, instead of the stock level momentum observed in the original study, found a similar effect. I calculated the returns of a basket of high momentum sectors under different trend conditions. The accompanying chart shows that price momentum returns were astoundingly positive in uptrends, negative in downtrends, and had minimal effect in neutral trends.
 

 

The lackluster performance of price momentum for most of 2018 has to be regarded as a warning sign that the market trend may be faltering as well.

In summary, there are at least ten separate and distinct technical warning signs that a major market top is forming. One of the adages of technical analysis is while bottoms are events (because of emotionally laden panics seen at bottoms), tops are processes (as complacency and technical deterioration set in). I interpret current conditions as the US equity market undergoing a topping process. While stocks are unlikely to crash tomorrow, investors should be prepared for the bears taking control of the tape in the not too distant future.

In a future post, I will also detail the macro and fundamental headwinds for equity bulls.
 

The week ahead

Even as many of the major stock indices staged upside breakouts to fresh highs last week, the lack of a breadth thrust is worrisome. Compare the strength of the breadth thrusts shown in the market melt-up that began in late 2017 across all market cap bands and in NASDAQ stocks to 2018. One of these market advances is not like the other, which puts into question the sustainability of the current rally.
 

 

In the short run, short-term (3-5 day time horizon) breadth from Index Indicators is back at or near overbought levels. While overbought markets can become more overbought, the risk/reward is tilted to the downside, especially in light of an absence of breadth thrusts that make the likelihood of a series “good overbought” conditions less likely.
 

 

Short-term risk appetite may be a function of the USD. A rising USD has the undesirable effects of weakening the Chinese Yuan, which exacerbates trade tensions, puts pressure on vulnerable EM currencies, and depress the earnings of US large cap multi-nationals. The USD Index staged an upside breakout through the 95 key resistance level in early August, but weakened on the back of Trump’s comments on monetary policy, and the perceived dovish tone of Powell’s Jackson Hole speech. What happens next? Your guess is as good as mine.
 

 

My inner investor is taking advantage of market strength to selectively lighten up on his equity positions. My inner trader remains short the market.
 

Disclosure: Long SPXU
 

Why positive breadth won’t help the bull case

Posted by Cam Hui -

Mid-week market update: There was a lot of skepticism in response to my last post (see How many pennies left in front of the steamroller?). Much of it was related to comments relating to positive market breadth.

I am in debt to Urban Carmel who pointed out back in May that the Advance-Decline Line tends to move coincidentally with the major market indices. Here is an updated five-year chart of the 52-week highs-lows, and the NYSE Advance-Decline Line. The peaks in both of these indicators have either been coincidental, or lagged the stock market peak.

Other breadth indicators, on the other hand, have been less kind to the bull case. The chart below shows NYMO , or the NYSE McClellan Oscillator, % bullish, and % above the 200 dma. NYMO has been trending down even and exhibited a series of lower highs even as stock prices recovered. Both % bullish and % above 200 dma failed to confirm the recent test of the all-time high, as they failed to achieve new highs in the last month.

The market shrugged off the Manafort and Cohen news and closed roughly flat today, but the index flashed a bearish graveyard doji candle yesterday as it unsuccessfully tested its all-time highs while exhibiting a negative RSI-5 divergence.

In addition, the latest breadth readings from Index Indicators show that the market is retreating after reaching an overbought reading on a 3-5 day time horizon.

…and on a 1-2 week time horizon.

Regardless of whether you agree with me on my bearish intermediate term outlook, these conditions argue for a short-term pullback.

My inner trader remains short the market.

Disclosure: Long SPXU

How many pennies are left in front of the steamroller?

Posted by Cam Hui -

A reader commented on the weekend, “TBH, being long here sure feels like picking up pennies in front of a steamroller”. I agree. While I have been steadfast in my belief of a “Last Hurrah rally” before a significant market top, that scenario is looking far less likely.

As the market tests a key resistance level, it is displaying both a negative RSI-5 divergence, which is tactically bearish, and faltering internals, which is intermediate term bearish.
 

 

There is a distinct possibility that we may be seeing a final market top in the major US equity indices this week. While the market may rally to new marginal highs, I believe that the risk/reward ratio is turning unfavorable for the bulls, and there may not be many pennies left on the road in front of the steamroller.
 

Risk appetite is deteriorating

Here are some of the worrisome signs that the bulls are losing control of the tape. The ratio of high beta to low volatility stocks breached a significant relative support level, indicating a significant deterioration of equity risk appetite.
 

 

In the credit market, the relative price performance of high yield (junk bonds) to their duration equivalent Treasuries is not confirming the recent equity rally. Needless to say, the relative performance of EM bonds has been terrible.
 

 

Equally disturbing is the inability of the SPY/TLT (stock/bond) total return ratio to rise after its upside breakout and pullback to test the relative resistance turned support level. This is another negative divergence that is bearish sign for risk appetite.
 

 

My inner investor has been opportunistically lightening up his equity exposure since my market warning two weeks ago (see Market top ahead: My inner investor turns cautious). My inner trader sold his long positions, and reversed to the short side today.
 

Disclosure: Long SPXU
 

Could China take the baton if US growth falters?

Posted by Cam Hui -

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

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

 

My inner trader uses 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 hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

The latest signals of each model are as follows:

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

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

What if I am wrong?

Good investors always examine their assumptions. What if I am wrong? What are the risks to my forecasts?

I had lunch with a friend where he pushed back on my bear case for a major market top (see Major market top ahead: My inner investor turns cautious and How far can stock prices fall in a bear market?). The macro scenario goes something like this. The Fed is on track to steadily raise rates by a quarter-point every three months. Monetary indicators, such as money supply growth and the yield curve, are on a trajectory to flash recessionary signals by year-end, if not before. The US sneezes and slows into a mild recession, China catches a cold and collapses into a hard landing because of its excess leverage. Global contagion spreads into a global synchronized recession whose magnitude could be as bad as the last financial crisis.

Already, the global outlook is precarious. US equities seem to be the only game left in town as everyone piles into them.

 

To be sure, the US is the last source of growth left standing. LPL Financial found that while US earnings expectations are still rising, they are flat for non-US developed markets (EAFE), and falling in the emerging markets. Sure, America is leading the world, but if the US slows, what happens then?

 

My lunch companion’s key objection to the bearish scenario is the China linkage. It is unclear whether a slowing American consumer will trigger a significant slowdown in China. Even if Chinese economic growth were to slow, Beijing still has lots of policy levers to cushion a downturn. This is an important question. China remains the big swing factor in global growth. What if China doesn’t collapse? The downside risk to my bearish scenario would be very mild by comparison.

 

If US growth were to falter, could China pick up the baton?

How resilient is China?

One source of Chinese resilience is their large foreign currency reserves. Louis Gave of Evergreen Gavekal recently outlined his recession scenario, based on a contraction in the World Monetary Base (WMB).

 

Gave wrote the following before the onset of the Turkish crisis, He observed that a WMB growth slowdown tends to create a shortage in the offshore USD market, and such shortages tend to show up in EM countries with large current account deficits and external debt. The resulting collapse in offshore USD liquidity then slows global trade flows, even without an American recession.

The first effect to watch out for is a contraction in international trade as a consequence of the US dollar shortage. Every time in the past that there has been a contraction in the WMB, six or so months later there has been a steep decline in the volume of world trade (at least since 1994—I only have the data back that far). These declines have almost always led to a recession, either in the OECD, or outside the OECD, as in the case of the Asian crisis. I see no reason why the same should not happen again this time around, especially as I am starting to detect a range of other signs that typically accompany the march towards a recession.

Gave went on to state that he believes that China and other Asian countries are more insulated from the slowdown because of large foreign exchange reserves built up at the PBOC, the HKMA, and by other Asian central banks after they learned the lessons of the Asian Crisis of 1997.

China has foreseen the danger of a US dollar shortage, and has tried to arrange things in Asia to allow the region to ride out a dollar squeeze. As a result, Asia is likely to be a zone of relative stability in the coming turmoil.

 

Modeling an American slowdown

My lunch companion also brought up another point. If the mechanism for a Chinese hard landing is through the trade channel, does a slowdown in trade necessarily crash the Chinese economy?

Let’s do some back of the envelope numbers. China’s exports account for roughly 20% of its GDP. Add in services, and the current account effects rise to about 30% of its GDP. Merchandise trade with the US is about 20% of its exports, but if we were to add back exports to Hong Kong and Vietnam, whose export volumes are greater than exports to Germany, as US exports, these re-exports account for 30% of its trade. Putting it all together, Chinese exports to the US in goods and services account for just under 1% of GDP. Even if trade flows were to diminish, the effect won’t be the full 1% of GDP. How can a slowdown in US trade collapse the Chinese economy?

For a big picture perspective, consider these comments from Chris Balding, who spent nine years teaching at the HSBC Business School of Peking University Shenzhen Graduate School:

As I continued lecturing I noticed an attentive student in the front tentatively appearing almost embarrassed, raise their hand just enough for me to see. Hoping to salvage a situation I could not understand I called on them hoping to elicit conversation about the implications of the unfolding events. I prepared to unleash upon this unwitting graduate student the depth of my knowledge and preparation demonstrating my profound wisdom. In a cautious almost trembling voice they asked a seemingly benign question:

“Professor, where did you get this data?”

I knew the answer. The only question to a professor discussing quantitative easing concerned data provenance? The question seemed beneath a man of my stature.
“I downloaded the Chinese data from the National Bureau of Statistics and the People’s Bank of China.”

The student paused. Hunched forward. Thought carefully how to choose their next words.

“Professor, do you believe the data?”

To make a long story short, Balding concluded that his students, some of whom were Party members and comprised the elite of China, didn’t believe the Chinese data:

What struck me most, the doe eyed innocent students within the machinery of an elite university, many of them Party members, took skepticism of government data for granted. There were no caveats. They ignored the typical academic hedging. Their message clear: do not believe the data.

Chris Balding went on to explain the *ahem* squishy nature of Chinese statistics:

Adding complexity to the morass of conflicting information, despite the widespread perception that China systematically overstated its data, Chinese statisticians and accountants over and understated outcomes depending on their specific incentive. A 2015 official report by the national auditor found that state owned enterprises both over and under stated profit, revenue, assets, and liabilities. At first it seems paradoxical that SOE’s would both over and under state key financial metrics. However, their motivation stems from their incentives. Profitable companies want to understate their profit, so the government grabs a smaller share of their free cash. Conversely, unprofitable companies overstate their profitability to gain additional funding or keep cadres employed at good positions. Call it the Goldilocks theory of data manipulation: officials wanted outcomes neither too good or too bad but just right.

He went on to give a personal example:

One day I needed to turn in some small travel receipts and took them with the appropriate form to the accounting office. Still trying to figure out the forms in China and all the regulations, I took my taxi and meal receipts to the staff accountant. Looking at them concerned, they informed me the school could not reimburse my receipts for reasons I am still not clear on. Ready to forgo the money, as it was a relatively minor amount of money, I got ready to leave. Asking what the receipts were for, I turned to explain. Content with my explanation, the accountant opened up a bottom desk drawer filled with official looking red stamped receipts, very important for Chinese public accounting, and proceeded to find a few that approximated my requested amount. They asked if I could accept the small discrepancy in my requested amount and the amount of the magical receipts. Standing mouth agape at the accountant with drawer full of receipts used to outwit public auditors, I quietly nodded my acquiescence and slipped out both thankful and concerned for my reimbursement with a lesson learned about system manipulation in China.

 

One of the problems for the China analyst is the opaque nature of Chinese statistics. Even if you were to trust the figures,it may be relatively easy to quantify the first order effects of a trade slowdown. However, measuring the full effects is more problematical. A recent (wonkish) paper by Baqee and Farhi, The Macroeconomic Impact of Microeconomic Shocks: Beyond Hulten’s Theorem, found that losses from trade shocks and tariffs are several orders of magnitudes higher than previously thought [emphasis added].

We provide a nonlinear characterization of the macroeconomic impact of microeconomic productivity shocks in terms of reduced-form non-parametric elasticities for efficient economies. We also show how structural parameters are mapped to these reduced-form elasticities. In this sense, we extend the foundational theorem of Hulten (1978) beyond first-order terms. Key features ignored by first-order approximations that play a crucial role are: structural elasticities of substitution, network linkages, structural returns to scale, and the extent of factor reallocation. Higher-order terms magnify negative shocks and attenuate positive shocks, resulting in an output distribution that is asymmetric, fat-tailed, and has a lower mean even when shocks are symmetric and thin-tailed. In our calibration, output losses due to business-cycle fluctuations are an order of magnitude larger than the cost calculated by Lucas (1987). Second-order terms also show how shocks to critical sectors can have large macroeconomic impacts, almost tripling the estimated impact of the 1970s oil price shocks.

There are opaque linkages everywhere. In an era of global supply chains where components are manufactured in different countries with inputs from all over the world, and then exported and assembled and re-assembled in many different plants all over the place, does trying to quantify the bilateral effects of a slowdown in one major consumer country make any sense?

 

The unknown effects of hidden linkages

There are hidden linkages everywhere, not just through the trade channel from a globalized supply chain, but through the finance channel. I had outlined the financial risks in a past post (see How a China crash might unfold).

To briefly recap, in early 2016, the SCMP reported how the shares of Hang Fat Ginseng, which was a well-established HK-based ginseng broker, collapsed about 90% in a single day with no warning:

This is a classic tale of what has and would happen to the dozens of newly listed companies in the past two years. It is a tale of greed.

Yeung is no stranger to the game.

The so-called “King of American Ginseng” loved to talk about his clever bets on apartments, currencies as well as derivatives…

As Hang Fat’s price shot up, so has the borrowing of Yeung and his family, as suggested by records with the Central Clearing System(CCASS)…

In the meantime, Yeung and his brother like many of the bosses of newly listed companies have made bets with all sorts of investment schemes proposed by their private bankers with money from margin finance. It was jolly good.

By summer, it was all over. The A share market crashed; the yuan depreciated; and Hang Fat’s price dropped 30 per cent.

The brothers pledged more shares to pay up the margin call and to support Hang Fat’s price.

They spent at least HK$220 million buying up Hang Fat between August and December, according to company announcements. They had no choice because the lower the price, the worse the margin calls.

It was futile. The market headed south with the renminbi…

They were forced to sell 6.17 per cent at a 50 per cent discount for a meagre HK$23 million. To who? Surprisingly, it’s the clients of CIS. Yeah it is bloody.

Bloomerg reported that the rescuer was Yang Kai, the chairman of China Huishan Dairy:

The Yeungs announced they were selling 1.23 billion of their own shares to a company run by China Huishan Dairy Holdings Co. Chairman Yang Kai in an off-market deal for HK$23.4 million. Yang sold almost all the shares a day later for HK$77.1 million, exchange filings show. A Huishan Dairy spokesman declined to comment on the transaction.

Fast forward to a year, the shares of Huishang Dairy collapsed 85% in one day without warning, as roughly USD 4 billion in market cap evaporated overnight. Bloomberg reported that money had gone missing:

A muddled tale of corporate woe has since emerged involving a missing company treasurer, a leverage-happy chairman and serious doubts about the company’s future.

Who went missing?
 The executive director who managed Huishan’s treasury and cash operations. The company said on March 28 that its last contact with the director, Ge Kun, was a March 21 letter to Chairman Yang Kai explaining that work stress — heightened by Block’s critical report — had taken a toll on her health and that she didn’t want to be contacted.

So not a good day for the chairman?
It got worse, according to Huishan’s account. That same day, Yang realized Huishan had been late on some bank payments. By March 23, Huishan had arranged an emergency meeting with creditors and government officials in Liaoning province, where the company is based. Huishan said its major lenders, including Bank of China Ltd., expressed confidence at the meeting. But that was before the stock collapsed.

 

Huishan Dairy eventually went bankrupt. But these sorry tales are stories of hidden leverage, opaque reporting, and leverage piled on top of leverage. It also highlights the risks inherent in the Chinese financial system (and what happens when staff accountants regularly keep official looking stamped receipts in desk drawers to fool the auditors and other authorities).

Despite Beijing’s admonishments against excess debt, the excesses haven’t stopped. Reuters recently reported that Evergrande, China’s biggest property developer with USD 84 billion in net debt, is investing 1.65 billion in six high tech projects by the Chinese Academy of Sciences, including one to build the world’s fastest supercomputer. Makes total sense, right?

In the meantime, the Australian Financial Review reported that Sydney property, which has been one of the epicenters of Chinese fund flows, is melting down:

Selling agents are starting to reveal the truth behind recent listings in Sydney’s west with Belle Property Strathfield’s Jimmy Kang saying up to 50 per cent of his clients were asking him to sell their homes in Sydney’s western suburbs because they can no longer afford their new principal-and-interest mortgages.

In Hong Kong, SCMP reported that buyers are choosing to forfeit deposits and walking away from purchases:

Some buyers are so edgy about the Hong Kong property market that they are pulling out of deals, despite losing big deposits.

A buyer who agreed to buy a unit at Sun Hung Kai Properties’ St Martin II two weeks ago cancelled the purchase on Thursday. The U-turn on the HK$7.25 million studio unit in Tai Po in the New Territories meant the buyer had to forfeit the 5 per cent deposit – about HK$362,700 (US$46,200).

That followed five instances on Wednesday at Sun Hung Kai’s Park Yoho Milano in the northern Yuen Long district. A total of nearly HK$2 million will be charged for the sales terminations. The project debuted last month and was seen as the cheapest residential project this year.

Nothing to see here, move right along…What happens when an operational slowdown, such as a mild US recession or a trade war, hits a highly leveraged economy?

What about the policy response?

To be sure, the Chinese economy is still in many ways a command economy and Beijing still has deep pockets. In the wake of the Great Financial Crisis, China rescued the world with a shock-and-awe stimulus program. Beijing ordered its local authorities and SOEs to spend, and its state-owned banks to lend. In may ways, China saved the world in the same way that Japanese resilience in the aftermath of the 1987 Market Crash saved the global financial system.

Could China do it again?

There are a couple of problems with a repeat of the 2008-2009 episode. First, the degree of financial leverage in China is much higher than it was then.

 

In addition, China’s RRR already stands at post-crisis levels. While they have been historically lower, those rates occurred during an era of financial repression and interest rates fell below inflation. The Chinese economy will not be able to rebalance its growth in an environment where the household sector is repressed through negative real rates.

 

Houze Song at Macro Polo believes that Beijing’s priorities have changed, and the imperative to deleverage and reduce financial risk ranks higher than growth priorities:

Another stimulus requires the creation of debt, which is widely viewed as a key vulnerability in the Chinese economy. In this instance, the economic vulnerability also aligns with political vulnerability, since a stimulus would be interpreted as abandoning Xi Jinping’s signature deleveraging agenda. Backing away from deleveraging would likely prove more politically damaging than most expect, particularly as Xi has banked his personal credibility on ensuring financial stability and reducing debt. Having made numerous announcements publicly himself, Xi would likely be criticized internally for deviating from such a priority at the first sign of uncertainty. In fact, Chinese state media has already sent unambiguous messages that China needs to hunker down and absorb some near-term pain to get through the deleveraging process.

The authorities have mainly imposed the deleveraging directive on what they can control, namely local governments and SOEs:

Given the severe constraint the deleveraging mandate imposes on local governments, they cannot easily fall back on capital investments to offset a potential economic shock. At the same time, state-owned enterprises (SOEs) are now also subject to the same stringent mandate. Since local governments and SOEs together account for at least one-third of China’s investment, this means that a significant part of the Chinese economy probably won’t increase borrowing even if more credit is made available.

This is the political context in which the People’s Bank of China (PBOC) recently cut the reserve requirement ratio (RRR). Although this cut was widely interpreted as a precursor to China pivoting to stimulus mode, the PBOC took this action primarily in consideration of the uncertainty trade tension has created. This was hardly a stimulative move, but should really be interpreted as an accommodative action to provide a bit more liquidity to fend off the anxiety created by the tariff that took effect on July 6.

While Song interpreted the RRR cuts as a response to the rising US tariffs, they also represent an administrative measure in support of the deleveraging effort. The PBOC has been trying to rein in the excesses of the shadow banking system (as an example, see the NY Times account Bejing Struggles to Defuse Anger Over China’s P2P Lending Crisis) by bringing the funds parked there back to the formal banking system. The RRR cuts therefore represent an accommodative measure for the banks to take on more of the burdens that were in the shadow banking system onto their balance sheets.

Song believes that Xi Jinping is willing to tolerate a slower rate of growth in order to reduce the risk in the economy:

Another aggressive stimulus akin to the 2008-2009 program is no longer an appealing policy option when the associated costs are considered. Such steroidal stimulus will only exacerbate China’s vulnerabilities and increase the likelihood of a financial crisis, something Xi is adamant about preventing. Since Xi will rule China for at least another decade, he is likely more willing to tolerate short-term economic pain without jeopardizing his signature policy on curbing financial risk. Time is on his side.

Another contributing factor is the *ahem* famous fudge in Chinese growth statistics:

Beijing can actually meet its 2020 doubling of GDP goal even if it tolerated a slowdown. According to the 13th Five-Year Plan, China needs to average 6.5% growth from 2016-2020 to achieve a doubling of GDP from the 2010 level. But that target was set before the fourth General Economic Survey and GDP accounting method revision, which will likely lead to an upward revision of China’s GDP by at least 5% in 2019 What this means is that Beijing can achieve its 2020 target with a growth rate of around 5% through the next 2.5 years.

In conclusion, while the possibility exists that China could stabilize global growth in the event of an American recession, the lack of transparency in China’s statistical data raises the risk of a disorderly unwind, especially among the more vulnerable small and medium enterprises (SMEs). As well, don’t count on China to save the world again through another shock and awe policy response. Its latest projections show that it is willing to tolerate a growth slowdown from 6.5% to 5.0% over the next couple of years, which gives the economy plenty of wiggle room to decelerate if necessary.

The week ahead

Looking to the week ahead, I can easily make both a bull and bear case. On one hand, the cup and handle breakout is still in play. Barring a pullback below the 2800 level, the upside target of 2925-2960 remains open.

 

In addition, the large and mid cap advance-decline percentage readings last week are supportive of higher prices. Similar positive breadth episodes in the past six months have resolved themselves with price advances.

 

As well, the Fear and Greed Index has pulled back to neutral and it has not hit my overbought target, indicating further upside price potential. Last week’s market action highlights the jittery and headline driven nature of the market. The market was sufficiently oversold that just the hint of a further discussions in the US-China trade dispute was enough to send stock prices soaring. On the NAFTA front, the US may be on the verge of coming to a bilateral deal with Mexico next week, which has the potential to spark another risk-on rally.

 

On the other hand, much depends on the fate of the USD. The historical evidence over the last 12 years shows that whenever the one-year change in the USD Index exceeds 5%, stock prices have struggled, Notwithstanding the fears caused by the Turkish Tantrum, a rising USD puts downward pressure on the Chinese yuan, and raises the risk of American accusations that China is devaluing its currency in response to tariffs. Even if the Dollar were to stabilize at these levels, the base effects of a falling exchange rate last August and September means that the one-year rate of change could easily exceed 5% in the next few weeks, which represents a danger signal for equity prices.

 

However, the USD Index doesn’t tell the entire story of currency strength. While the USD has been strong overall, its strength can be especially seen against EM currencies.

 

This brings up the question of whether the risk-off tone in EM is likely to continue. Notwithstanding the Turkish drama, the Citi EM Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is sliding after recently rising to the zero line. This will be something to keep an eye on.

 

My inner investor is de-risking his portfolio by slowly and methodically cutting back his equity exposure as prices rise. My inner trader is nervously long equities, and he is giving the bull case the benefit of the doubt.

Disclosure: Long SPXL

Three reasons to ignore the Turkish Apocalypse hype

Posted by Cam Hui -

Mid-week market update: Earlier in the week, Mark Hulbert wrote that “U.S. investors should see this Turkish crisis as a buying opportunity”. Hulbert went on to cite the historical record of past currency crises:

And it’s not just 20-20 hindsight for me to point this out now, with a strong bull market under our belts. On the contrary, in a series of columns beginning in March 2010, I regularly pointed out that the stock market usually takes currency and sovereign debt crises very much in stride.

I based my confidence on how the stock market had reacted previously to other such crises over the prior two decades. The crises on which I focused were the 1994 Mexican peso devaluation and associated crisis; the Thai government debt crisis 1997 (which led to the term “Asian contagion”); the 1998 Russian ruble devaluation in August 1998 (which led to the bankruptcy of Long-Term Capital Management), and the 2001 Argentine government debt/currency crisis.

The accompanying chart shows how the U.S. stock market—on average—reacted to these four crises. For both data series, 100 represents the stock market’s level when those crises first broke onto the world financial scene. Notice that equities’ reaction over the four years following the Greek crisis was remarkably close to the average of its behavior in the wake of the previous crises.

 

 

I agree. In addition to Hulbert`s points, there are two other reasons why the Turkey Tantrum will blow over.
 

Central bankers have not begun to fight

The first line of defense for central bankers in a currency crisis is the currency swap. When American banks find themselves in a liquidity crisis, they borrow at the Fed window, as the Fed is the lender of last resort. If foreign banks and governments encounter a liquidity crisis because of a shortage of US dollars, they cannot borrow at the Fed window. However, the Fed can establish swap lines to lend USD to other central banks, which can in turn lend those dollars to the banks in their country.

Here is how the Fed describes liquidity swaps on their website:

Because bank funding markets are global and have at times broken down, disrupting the provision of credit to households and businesses in the United States and other countries, the Federal Reserve has entered into agreements to establish central bank liquidity swap lines with a number of foreign central banks. Two types of swap lines were established: dollar liquidity lines and foreign-currency liquidity lines. The swap lines are designed to improve liquidity conditions in dollar funding markets in the United States and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress. Likewise, the swap lines provide the Federal Reserve with the capacity to offer liquidity in foreign currencies to U.S. financial institutions should the Federal Reserve judge that such actions are appropriate. These arrangements have helped to ease strains in financial markets and mitigate their effects on economic conditions. The swap lines support financial stability and serve as a prudent liquidity backstop.

When the foreign central bank loans the dollars it obtains by drawing on its swap line to institutions in its jurisdiction, the dollars are transferred from the foreign central bank’s account at the Federal Reserve to the account of the bank that the borrowing institution uses to clear its dollar transactions. The foreign central bank remains obligated to return the dollars to the Federal Reserve under the terms of the agreement, and the Federal Reserve is not a counterparty to the loan extended by the foreign central bank. The foreign central bank bears the credit risk associated with the loans it makes to institutions in its jurisdiction.

If the Fed believes that the risk of global financial contagion is too high, it can choose to establish a swap line with the Turkish central bank in order to stabilize markets. Remember, the Fed can create USD out of thin and and extend as much liquidity as it chooses. So far, it hasn’t done so for because either it believes that the situation will resolve itself, political considerations such as the belligerence of Erdogan towards the West, or other reasons.

The extension of swap lines is usually the first step that central bankers take to stabilize markets. It is usually followed by the negotiation of an IMF directed economic program to return that country to a more sustainable long-term path.

When the news of a swap line extension hits the tape, the markets usually respond with a rip your face off relief rally.
 

Geopolitical pressure for a deal

The Washington Post featured an article yesterday entitled “Trump’s trade spat with Turkey has little downside with the U.S.”.

But even as decisions from Washington have helped fuel the mess, it presents only limited danger to American business interests. The United States trades a relatively skimpy amount with Turkey, and U.S. banks likewise don’t have much exposure there.

That gives President Trump a freer hand escalating his confrontation with Turkish President Recep Tayyip Erdogan over the jailing of Andrew Brunson, an evangelical American preacher.

Unlike Trump’s other trade showdowns, in which he’s aiming to extract economic concessions, his fight with Turkey centers on the preacher’s case — suggesting the president is increasingly willing to use trade leverage to accomplish diplomatic goals. And in Turkey’s case, there appears to be little immediate downside for the U.S. to doing so.

In the short run, that analysis is correct. In the long run, however, Jim Edwards wrote in Business Insider that Turkey is very important to the West from a geopolitical viewpoint.
 

 

As this map shows, Turkey may not be important economically— in terms of contagion to the rest of the global economy — but it sure is important strategically and militarily.

Turkey is the bridge between the democratic, peaceful West and the war-ridden dictatorships of the East.

How strong do we want this bridge to be?

Turkey has important strategic importance to the West [emphasis added]:

On its Western flank, Turkey borders Greece and Bulgaria, Western-facing members of the European Union. A few years ago, Turkey — a member of NATO — was preparing the join Europe as a full member.

Turkey’s other borders face six nations: Georgia, Iran, Iraq, Syria, Armenia, and Nakhchivan, a territory affiliated with Azerbaijan. Five of those are involved in ongoing armed conflicts or outright war.

Turkey is the thing that has physically prevented the Islamic State terrorist group from rolling into Greece. It keeps the Syrian war inside Syria. It prevents the Russians from rolling back into Bulgaria. And it deters the Iraqis, Iranians, and Kurds from escalating their various conflicts northward into Europe.

That’s the reason Turkey has the largest standing army in Europe. We need Turkey to be strong and stable, in other words.

The Turkish air base at Incirlik serves as a major jumping off point for US and NATO forces to intervene in the Middle East. A policy of isolating Turkey risks not only the loss of this important NATO base, but it could drive Ankara into the arms of Iran, Russia, or worse, towards Islamic fundamentalism. It is only a matter of time before the conversation turns from Turkish intransigence to national security and foreign policy considerations. Will future historians be debating the question of who lost Turkey to Russia, Iran, or ISIS?

For Europe, the worst banking exposure to Turkey comes from the Spanish banks and amounts to about 6% of Spain’s GDP. While that sounds bad, the eurozone has sufficient resources contain the losses. The bigger question for the EU is NATO unity and the fate of the migrant deal. Recall that in March 2016, Turkey concluded a deal with the EU where it would stop the flow of refugees in return for a €6 billion refugee fund, visa-free travel and a fast-tracked EU membership. The latest crisis puts that deal into jeopardy, and the prospect of another Syrian refugee surge into Europe would turn the politics of the region upside down.

Don’t get me wrong, I believe that Erdogan’s policy responses to the crisis is wrongheaded. Capital controls will not solve the problem. Neither will tariffs on imports, or an import substitution policy. However, the geopolitical price for allowing the Turkish economy to go down in flames is just too high. Despite the rhetoric, I would expect that there are backstage discussions occurring where a compromise solution will eventually be found. Indeed, there was a note of optimism when Reuters reported that “Problems with the US will be resolved”.

If you are bearish and think that the Turkish crisis is the signal for a major global risk-off episode, think again. and don’t get too short. There are too many institutional factors arrayed against you, and when they are unleashed, they will rip the face off any short seller.
 

Stock market outlook

In the meantime, the outlook for US equity prices is constructive for the bulls. The market flashed a buy signal yesterday when the VIX Index rose above its upper Bollinger Band on Monday, mean reverted below Tuesday, and tested the upper BB again Wednesday but closed below.
 

 

The breadth chart from Index Indicators shows that the short-term (1-2 day) outlook is oversold and poised for a relief rally.
 

 

My inner trader dipped his toe into the long side last Friday, and he is holding his position in anticipation of higher prices.

Disclosure: Long SPXL
 

How far can stock prices fall in a bear market?

Posted by Cam Hui -

One of the most frequently asked questions from last week’s post (see Major market top ahead: My inner investor turns cautious) was my downside objective for stock prices. While technical analysis could highlight a possible trigger for a bear phase, it is less reliable for quantifying downside risk.

Assuming the trigger for a bear market is a recession, one way to guesstimate downside risk is to examine how the historical record of stock prices behaved in past recessions. Beginning in 1981-82, that bear market was particularly nasty because it lasted over a year, and it was triggered by the Volcker tight money era. The 1990 bear market and recession, which was ostensibly triggered by the Iraqi invasion of Kuwait, was mild. The Tech Wreck in the aftermath of the NASDAQ Bubble in 2001-02 was also painful, but was preceded by an unprecedented surge in stock prices. The bear market of 2008 was short and sharp, but stock prices fell roughly 50%. In conclusion, the historical record indicates that downside risk is in the 20-50% range.
 

 

But that’s not the whole story.
 

A fundamental perspective

That 20-50% figure is wide enough to drive a truck through. Another way of estimating downside risk is to analyze two components.

  1. How much will earnings fall in a downturn, and 
  2. How will the capitalization rate, or the inverse of the P/E ratio, behave in the same period?

History gives us some guidance. Earnings fell roughly 20% in the “mild” 1990 recession, and fell considerably more in the post-NASDAQ Bubble and the GFC, in the order of 40-50%.
 

 

Recessions tend to be periods in which the excesses of the past cycle are unwound. Arguably, there are few excesses evident in the American economy outside of sky high unicorn valuations in Silicon Valley. Even if the likes of Uber were to blow up in the next downturn, their demise is unlikely to sink the economy. That argues for a mild Fed-induced recession, where earnings fall 20% for purely cyclical reasons, such as a downturn in housing, and so on.

However, if we were to cast our eyes around the world, the excesses are not to be found within US borders, but abroad. I don’t need to repeat the story of how high debt levels in China represent an accident waiting to happen. Imagine the following scenario, the Fed induces a mild slowdown in the US, which could be exacerbated by a trade war. Falling American consumption craters Chinese exports, and drags the Chinese economy into a slowdown through the combination of falling trade, and defaults from excessive debt. The Chinese slowdown tanks most of Asia, such as Hong Kong, South Korea, Taiwan, and Japan, as well as the resource extraction economies of Australia, New Zealand, Canada, Brazil, and South Africa. Germany, which is the growth engine of the eurozone and a major exporter of capital equipment to China, slows, which drags down European growth and exposes the banking leverage problems that were not fixed from the last crisis.

On top of that, shrinking USD liquidity in the offshore market pressures EM economies (see Turkey). In short, these are the ingredients for another Great Financial Crisis.

To quantify downside risk, we modeled different scenarios, where earnings fall 20% in a mild recession, and 40-50% in a deeper crisis. I have combined that with projections of how the P/E ratio might behave under different interest rate scenarios. CNBC reported that Jamie Dimon believes the 10-year note should be yielding 4%, and 5% is not an unrealistic outcome.

Though the bank chief previously theorized that the yield on the benchmark 10-year Treasury note could reach 4 percent in 2018, his comments Saturday at the Aspen Institute’s 25th Annual Summer Celebration Gala appeared to reflect his belief in a stronger economy.

“I think rates should be 4 percent today,” Dimon said. “You better be prepared to deal with rates 5 percent or higher — it’s a higher probability than most people think.”

In a similar vein, Josh Brown recently highlighted some anecdotal analysis from Larry Jeddoloh in Barron’s:

A couple of weeks ago, I drove exactly the same route I did two weeks before the elections in 2016—through Winston-Salem and Raleigh-Durham and Charlotte, N.C., up into the Shenandoah Valley in southwestern Virginia and then up to Washington, D.C. One reason I thought Trump would win was that almost every lawn had a Trump sign. It went on for miles. Now it has completely flipped—there are no Trump signs, but there are large numbers of Help Wanted signs. We are going to get some wage pressure. The Fed will be pushed to raise interest rates. The natural rate for 10-year Treasury yields is more like 4% to 4.25%, not 3%. The last time the 10-year took a run to 3%, in January and March, the markets started to wobble. The speed of the move is just as important as the level. So the market can drive the economy in my view.

According to FactSet, the forward P/E ratio stands at 16.6, which is not significantly different from its 5-year average, indicating valuations are not overly excessive. We can then calculate an equity risk premium based on the 10-year yield of 2.9%, where ERP = E/P (1/16.4) – 2.9% = 3.1%. Everything else being equal, if the forward P/E were to decline to the 10-year average of 14.4, the ERP would be 4.0%.
 

 

Scenario analysis

I conducted scenario analysis to arrive at a downside target using differing assumptions:

  • Earnings fall between 20%, 40%, and 50% for one-year.
  • The 10-year Treasury yield remains at 2.9%, rises to 4.0%, and 5.0%.
  • ERP either remains unchanged, or rises to a level equivalent to a current de-rating of forward P/E to the 10-year average.

The results are summarized in the table below.
 

 

Downside risk varies between -20% to -63% in the worst cases. The unweighted downside average target of all these scenarios is -47%. Even if we were to assume a mild downturn where earnings fall -20%, it is not difficult to arrive at a 30-40% drawdown if the 10-year yield were to rise to 4%.

In conclusion, a reasonable estimate of peak-to-trough downside US equity risk in a recession next year is in the 35% to 45% range. In a rosy scenario, downside risk is limited to 20%, but that would be the most optimistic scenario.