Page 60 – Humble Student of the Markets

A 2015 or 2011 style hiccup, or something worse?

Posted by Cam Hui - November 25, 2018

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

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

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

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

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

A smorgasbord recession?

Callum Thomas has a terrific chart depicting the scope of the global stock market weakness. At the end of October, roughly 13% of global indices were above their 200 day moving averages (dma). Such readings are normally seen at intermediate term lows, or as part of a broad based bear market.

If this is indeed an intermediate low like 2015, or even 2011, investors should buy with both hands. On the other hand, if this is the start of a recession-induced bear market, investors should continue to de-risk their portfolios.

At this point, the lights on my panel of long leading recessionary indicators are currently flickering, but not bright red. Paul Krugman recently postulated;

Right now there doesn’t seem to be one big thing setting us up for a crisis – not like the housing bubble before 2008, or the tech bubble of the late 1990s. But there are several smaller things: trouble in emerging markets, some softening of housing, commercial real estate, corporate debt. So we could have a “smorgasbord” recession like 1990-91, with several factors coming together. This could be a problem, because interest rates are still low and there’s not much room to cut.

Could we see a “smorgasbord recession” in the near future?

A wobbly US economy

Certainly, there are numerous signs that the American economy is looking a little wobbly. The cyclically sensitive housing sector appears to have topped out for this cycle.

The much watched 2s10s Treasury yield curve (red line) has not inverted, but the private sector yield curve, defined as the Baa bond yield minus the prime rate, has (blue line).

The 2s10s Treasury yield curve may not flash a recessionary signal this cycle because of the Fed’s quantitative easing (QE) and subsequent quantitative tightening (QT) programs. A study by Benn Steil at the Council on Foreign Relations found that the Fed’s efforts at QT have raised the 10-yield yield by 17 bp. If we were to adjust for the effects of QT, the current spread would narrow to just 6 bp, which is very close to an inversion.

The term premium fluctuates with supply and demand for particular bonds. The Fed’s accumulation of longer-term Treasuries during nearly five years of Quantitative Easing (QE) was a big source of demand, and therefore lowered the term premium on longer-term Treasuries. (Former <Fed Chair Ben Bernanke explains this well in his blog.) Fed economists estimated that yields on 10-year Treasuries at the end of 2017 would have been around 85 basis points higher than their then-level of 2.3 percent had the Fed not bought such bonds.

On the basis of these estimates of the effect of central-bank asset purchases on long-term rates, we calculate that asset run-offs so far—$24 billion per month on average—have boosted 10-year Treasury yields by about 17 basis points.

As well, retail sales may be topping out, though the evidence is not definitive. Retail sales to population made a top five months ago, but New Deal democrat indicated he does not want to call a top until he sees six months of weakness.

In a separate model, New Deal democrat also found that whenever the change in the Fed Funds rate exceeded the change in Non-Farm Payroll employment, a recession has been the result.

While the lines in the above chart are close, they have not crossed as a slowdown warning. However, the weekly reported initial jobless claims may be bottoming. If initial claims continue to rise, the weakness will eventually feed into the monthly NFP reports, and the blue line in the above chart, which represents the change in NFP, could fall enough to produce a recession warning.

Not all the news is dire. The recent credit deterioration in former bellwether GE has led to rising angst about widening yield spreads. Both Scott Minerd of Guggenheim Partners and hedge fund manager Paul Tudor Jones have voiced concerns about turbulence in the credit market. Indeed, credit crunches have always part of past recessions. For now, anxiety over yield spreads blowing out appear overblown, as they are only edging up and levels are nowhere near levels seen in the last two recessions.

Similarly, financial conditions (low is good on the graph) have deteriorated but readings remain benign by historical standards.

In summary, long leading indicators of US economic growth are decelerating. While readings are not indicative of a recession, they are getting close.

China weakness the next smorgasbord course?

There is also evidence that the current risk-off episode could be attributable to Chinese weakness as markets have been moving based on news from China (see Was the market swoon made in China?). In that case, could Chinese weakness be the next course in the smorgasbord recession?

A market analyst would have to be living as a hermit in the last few years not to have heard the warnings about the rising debt levels in China.

Even without the threat of a trade war, there are signs that China is weakening. Business confidence has plummeted to an all-time low.

There are also signs that China’s economy is hitting a debt wall. Fitch warned that China bond defaults are expected to rise despite policy easing:

Chinese corporate bond defaults are likely to continue to rise in 2019 due to high refinancing pressures, the government’s greater tolerance for defaults, and tight credit availability – despite the recent shift in the policy stance towards easing, says Fitch Ratings. Corporate defaults should remain concentrated in the private sector, which has benefitted less from policy easing than state-owned enterprises (SOEs) and local-government financing vehicles.

Bloomberg reported that, in the space of just 11 months, China went from no USD corporate debt to more distressed debt than all other emerging markets. A separate Bloomberg article raised concerns that Chinese companies have been acting like banks by pledging their own assets as insurance for other private companies. Such daisy chain style financing creates possible cascading defaults should any company fail, and the others do not have sufficient capital cushions to sustain the losses arising from default:

Moves by Chinese companies to guarantee each others’ debt have left the world’s third-largest bond market prone to contagion risks — making it all the tougher for officials to follow through on initiatives to sustain credit flows.

Private companies have long had to be innovative in getting financing in Communist-run China, where state-owned enterprises have had preferential access to the banking system. Extending guarantees to each other helped businesses boost some lenders’ confidence enough to extend funding to them.

But now that China is going through a record run of debt defaults, the links pose the risk of a daisy chain of distress. Price moves are reflecting that. Tire-maker China Wanda Group has seen a 16 percent tumble in its notes due in 2021 since end-September, thanks to having provided guarantees to iron-wire maker Shandong SNTON Group Co., one of whose units failed to repay a bank loan two months ago.

Already, we are seeing sporadic defaults in the most vulnerable parts of the market, property development. Caixin reported that the Shenzhen Stock Exchange delisted Zhonghong Holdings Group, a property developer, because of poor share performance owing to a debt crisis.

The latest World Bank statistics show that China has external debts of $1.7 trillion, composed of $1 trillion in short-term debt and the remainder in long-term debt. That figure is quite manageable in light of China’s large foreign exchange reserves. But a recent SCMP article highlights analysis from Daiwa Capital Markets, which indicated that China’s total external debt position, which includes direct and indirect debt, is really $3 trillion.

Massive domestic debt has long been a headache for Beijing, but it is China’s growing external US dollar leverage that is being underestimated and it could possibly trigger a major financial crisis, according to Kevin Lai, chief economist for Asia excluding Japan at Japanese investment bank and securities brokerage Daiwa Capital Markets.

China’s US$3 trillion dollar debt makes it especially vulnerable because of tightening US dollar liquidity, a weakening yuan and the ongoing US-China trade war, said Lai.

Global dollar debt outside America has risen to US$12 trillion today from US$9 trillion in 2013, according to Lai. Of that total, 25 per cent, or US$3 trillion, has been borrowed by China Inc and its subsidiaries in Hong Kong, Singapore and the Caribbean. China’s US dollar cross-border claims have risen faster than any other emerging economy’s despite its partially closed capital account…

The amount of dollar debt raised by China in its offshore centres that has entered its banking system is worrying given the prospect of further depreciation pressure on the yuan’s exchange rate, said Lai.

Such a high level of external debt makes Chinese corporations vulnerable to the Fed’s tightening policy. It also puts the PBOC in a bind. China’s economy is already slowing, even without the trade war. If the PBOC were to ease, the yuan devalues and raises the debt burden of Chinese corporations that borrowed in USD. If it chooses to defend the CNYUSD exchange rate, it risks capital flight, which also puts downward pressure on the exchange rate.

Trade war or peace?

Then we have the trade war wildcard. Trump and Xi are expected to meet on the sidelines of the G20 summit in Buenos Aires on December 1, 2018. Expectations are low going into that meeting.

Mike Pence adopted a highly belligerent tone in an interview with the Washington Post while Pence was on his way to the APEC summit:

Pence told me in an interview that Trump is leaving the door open for a deal with Xi in Argentina, but only if Beijing is willing to make massive changes that the United States is demanding in its economic, military and political activities. The vice president said this is China’s best (if not last) chance to avoid a cold-war scenario with the United States.

“I think much of that will depend on Argentina,” Pence said. “The president’s attitude is, we want to make sure they know where we stand, what we are prepared to do, so they can come to Argentina with concrete proposals that address not just the trade deficit that we face … We’re convinced China knows where we stand.”

In addition to trade, Pence said China must offer concessions on several issues, including but not limited to its rampant intellectual property theft, forced technology transfer, restricted access to Chinese markets, respect for international rules and norms, efforts to limit freedom of navigation in international waters and Chinese Communist Party interference in the politics of Western countries.

If Beijing doesn’t come up with significant and concrete concessions, the United States is prepared to escalate economic, diplomatic and political pressure on China, Pence said. He believes the U.S. economy is strong enough to weather such an escalation while the Chinese economy is less durable.

As a result of the disagreement between the US and China, APEC participants were unable to agree on the wording of a final communique. The dispute is not just over trade, but a conflict over economic and regional dominance that may be the start of a new Cold War. Business Insider reported that China is building another structure in the South China Sea as a sign that tensions are escalating.

On the other hand, there are some hopeful signs of a thaw in relations. China has prepared some concessions ahead of the Buenos Aires meeting (via CNN):

The Chinese government has presented an offer to the United States to try to push forward stalled trade talks before the leaders of the two economic superpowers meet at the end of this month, according to two people briefed on the discussions.

The opening bid falls short of many of the core demands the White House has repeatedly detailed as must-haves in trade talks with Beijing, including addressing technology transfers and intellectual property theft, according to one of the people briefed. Instead, the proposal has been described as a rehash of previous commitments Chinese leaders have publicly announced, like selectively lifting tariffs.

Another sign of a thaw appeared when China approved the visit of American aircraft carrier USS Ronald Reagan and her strike group of escort ships to Hong Kong. This decision stands in contrast to the refusal of the visit of the amphibious assault ship USS Wasp last September.

More importantly, the SCMP reported that trade hawk Peter Navarro has been excluded from the guest list at the Trump-Xi meeting. While the list of aides to accompany Trump is not fully known yet, the most likely candidates are Larry Kudlow, John Bolton, Mike Pompeo, Steve Mnuchin, Wilbur Ross, Robert Lighthizer, and US ambassador to China Terry Branstad. Kudlow and Mnuchin are known to be trade doves, while Lightizer is regarded as a hawk.

It is shaping up to be a battle of trade factions within the Trump administration as the American side heads into the meeting. US Trade Representative Lightizer fired a broadside at China last week. He released a report stating that China has not changed unfair and discriminatory practices that prompted President Donald Trump to impose tariffs on around $250 billion worth of Chinese goods.

The big picture issues appear to be intractable. In addition to a dispute over the trade deficit, the Americans wants China to change its economic development model. The probability of such an event is as likely as the US adopting a Canadian supply management system for milk and dairy products, which was an issue raised during the NAFTA negotiations.

(As a word of explanation, Canada made a political decision to control the supply of certain food products such as chicken and dairy products, because it believed that it did not want to subject important basics such as the food supply to the market volatility of supply and demand. Better to pay more for food to ensure a steady supply. As a result, farmers cannot just produce chicken, but they need to produce chicken under a government mandated quota. The US has similar supply management system, not in food, but in defense. Otherwise, the Pentagon would considering the purchase of the Eurofighter instead of fighter jets of domestic design.)

Which Trump will show up in Buenos Aires? Will it be the belligerent Trump, who is determined to reduce and eliminate the trade deficit with China, and to contain China’s threat to US dominance in key technologies? Or will it be the Trump who met KJU of North Korea, who decided that he liked the dictator well enough that he could do business with him? Were the rhetoric of the trade doves and hawks just playing a game of good cop-bad cop? While the Chinese and American negotiation teams are said to be in close contact in the period leading up to the summit, Axios reported that Trump was his usual enigmatic self when he discussed his preparations for his meeting with Xi Jinping:

I’m very prepared, I’ve been preparing for it all my life. It’s not like, oh gee, I’m going to sit down and study it. I know every detail. I know every stat, I know it better than anyone who’s ever known it and my gut has always been right.

Realistically, the best outcome would be an American decision to suspend the imposition of the next round of tariffs while both sides talk more. Will that happen?

Stay tuned.

The good news on China

The good news on China is, despite all of the dire reports, there are no signs that the dam has broken. Chinese official statistics are notorious for their creativity, but real-time market signals indicate no signs of a disorderly unwind of the debt bubble.

I have been monitoring the share price of key Chinese property developers, such as China Evergrande (3333.HK), which are highly levered. So far, the shares are holding support.

Alibaba is another useful canary in the coalmine for sentiment on the household sector. BABA skeptic Anne Stevenson-Yang recorded a podcast outlining her skepticism of the company. She believes that foreign investors are buying BABA as a proxy for exposure to the Chinese consumer without fully understanding the company. BABA’s accounts are highly opaque, and disclosure selective. As an example, she cited the case of surging sales, but falling margins. This development has never been fully explained, and indicates either some shift in BABA`s business model, or creative accounting by management. The share price of BABA have been falling, and the breach of support at 170 is disconcerting, but the the stock remains in a relative uptrend compared to other A-Shares, which is an indication of continued investor confidence in the Chinese consumer.

The Smorgasbord Recession verdict

We began this publication with the rhetorical question of whether the market weakness in 2018 is a minor pullback like 2015 or 2011, or something far worse. Is there a smorgasbord recession on the horizon?

The jury is still out on that question.

From a chartist’s perspective, the outlook appears dire. Both global and US equities have flashed long-term sell signals.

On the other hand, the macroeconomic outlook, as well as monetary and trade policy developments remain unclear. While risk levels are rising, they do not justify a recession call yet.

For the last word, I refer readers to the words of Brett Steenbarger at TraderFeed, who wrote the following last Tuesday night at the height of the market selloff:

Yesterday, we saw fewer than 10% of all stocks in the SPX average trading above their three-day moving averages. The market is broadly weak in the short run. Interestingly, when we look at how the SPX stocks are trading relative to their 5, 10, 20, 50, 100, and 200-day moving averages, well fewer than 50% are trading above those benchmarks. So we’re very oversold on a short-term basis in a market that is also oversold on a medium and longer-term basis. (Data from the excellent Index Indicators site).

It turns out that this configuration has occurred 46 times since 2010. Ten days later, the SPX has been up 33 times and down 13 times for an average gain of over +1.63%. Many of the losing instances clustered in the 2011 period when we had some prolonged weakness. Similarly, when we take the data back to 2006, losing instances clustered in 2008/2009, so that there was a positive return over the next day or two from 2006-2009, but actually a negative average return over the following ten days.

So the market is likely to bounce, right? Steenbarger had a more subtle interpretation [emphasis added]:

There is a subtle but important lesson here. The human tendency is to make an assumption about whether we are in a bull or bear market and then extrapolate expectations on that basis. A better use of the data is to recognize that the kind of pullback we’ve seen is historically a very good buying opportunity in all but significant bearish periods. If we do not see a sustained bounce as we walk forward day over day, we can update our thinking to increase the odds that perhaps we’re in the throes of a bear. Conversely, if we see sustained buying, we can question the bear thesis as we walk forward.

In other words, let the market action in the days to come determine the answer of whether there will be a smorgasbord recession ahead.

The week ahead

Looking to the week ahead, all of the intermediate term sentiment and technical indicators are screaming “rally imminent”. Let’s start with the sentiment models. The latest update from AAII shows that the bulls have panicked and stampeded over the bear camp.

Stockcharts has not updated their data, but the bull-bear spread is now -21.8. In the past, such episodes have resolved bullishly, with the exception of the 2008 crash. Even if you believe that this is the start of a bear market, past instances of such bearish excesses saw stock prices rising in 2007.

The NAAIM Exposure Index, which measures RIA sentiment, fell from 35.1 to 30.6 last week. In the past, the market has shown little downside risk and high upside potential whenever the NAAIM reading has fallen below its 26-week lower Bollinger Band. The previous reading of 35.1 was already below the lower BB, and the latest indicates an even more crowded short extreme.

In addition, we are seeing positive RSI divergences across a variety of US equity indices. Here is the SPX.

Here is the NASDAQ Composite.

Here is the small cap Russell 2000.

Lastly, here is the broad based Wilshire 5000.

To be sure, oversold markets can become more oversold. Even if you are bearish, the short-term risk/reward of being short here is not good.

Risk averse traders who don’t want to take a directional bet may find better relative performance in the mid and small cap stocks with a long mid/small cap and short large cap pair trade.

My inner investor has been cautious since late August. My inner trader regrets that he was prematurely bullish, but he remains positioned for a rally.

Disclosure: Long SPXL

Apple: The new Rorschach test

Posted by Cam Hui - November 23, 2018

I normally don’t comment on individual stocks because I don’t have the resources to analyze a zillion companies in detail, but here is a Black Friday thought on Apple, which kicked off a revolution in consumer electronics and created new product categories when it unveiled its iPods, IPads, and iPhones. The share price of Apple have cratered on reports of poor iPhone sales. The chart is a bull’s nightmare. It broke down through the 190 key support level, and violated a long-term uptrend.

In some ways, AAPL is turning out to be a Rorschach test for investors and traders.

Different perspectives on AAPL

Bespoke`s chart depicts the history of the stock’s drawdowns since the inception of the iPhone. Is the current weakness a buying opportunity, or the signs of a busted growth stock that should be sold?

For a longer term perspective, Warren Buffett’s Berkshire Hathaway reported its first purchase of Apple in Q1 2016 when it bought 9.8 million shares. Berkshire has been steadily accumulating Apple shares all the way up, and it now holds roughly 250 million shares. It’s a big bet for Buffett, as the stock represents 26% of the Berkshire portfolio. Buffett initiated his buy program when the stock at its lower weekly Bollinger Band, both on an absolute and market relative basis, which is the same technical position it is in today.

Is AAPL a buy or a sell? How you answer that question reveals more about yourself than the outlook of the stock.

A Thanksgiving Week sector review

Posted by Cam Hui - November 20, 2018

Mid-week market update: In light of the US holiday shortened week, I thought I would do one of my periodic sector reviews to analyze both sector leadership and the implications for stock market direction.

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

The latest RRG chart shows the defensive sectors firmly in the lead, while technology, which were the former market darlings, mired in the lagging quadrant.

While current leadership provides a useful snapshot of the current market, it does not tell the entire story.

The story of faltering leadership

The main problem with the defensive leadership theme is the consistent trend of faltering leadership. The relative performance charts of each of the defensive sectors are all exhibiting negative RSI divergences, which are warnings of fading momentum. Here is the relative performance chart of Consumer Staples.

Here is Heathcare.

Here are Utilities against the market.

Still not convinced? JPM found that the forward P/E spread between low-volatility stocks, which is a proxy for the defensive parts of the market, and growth stocks is at all-time high. In addition, the median P/E of Utilities (17.9x) is higher than the median P/E of Technology (16.8x) and Communication Services (16.5x).

In search of emerging leaders

If defensive stocks are on the verge of giving up their leadership mantle, what will be the emerging leaders? The RRG chart gives us some clues.

One leading candidate are the Financials, which are in the top left “improving” quadrant. However, one key risk is the relative performance of this sector is highly correlated with the shape of the yield curve. These stocks do best when the yield curve is steepening, indicating expectations of better economic growth and a Fed policy that is more dovish than what is currently discounted by the market.

Other possible candidates of emerging market leaders are Materials, Energy, and Communication Services, which mostly represent FAANG. Wait, what?

Here are the relative performance charts of these emerging leadership candidates. Material stocks have already rallied through a relative downtrend line and they are turning up.

Energy stocks represent another possible new sector leader. The relative performance of European energy, whose market internals tend to be highly correlated to the US market, is much better than US energy.

Finally, we have Communication Services, which are exhibiting a positive RSI divergence.

A W-shaped bottom

In conclusion, the picture of faltering defensive leadership is highly suggestive of an imminent rebound in stock prices. I wrote last weekend (see What is Mr. Market saying about Powell’s global slowdown?) that sentiment was becoming excessively bearish, which is contrarian bullish. The combination of panicked RIAs, as evidenced by the latest NAAIM Exposure Index, a tanking Fear and Greed Index, and elevated put/call ratios all point to a market bottom.

The SPX is exhibiting bullish divergence as it tests the October lows. We are seeing positive RSI divergences, the VIX Index cannot exceed its October highs, and the VIX term structure is now inverted, indicating fear.

Panic is now in the air, as evidence by these headlines from the Drudge Report.

In addition, the NYSE McClellan Summation Index (NYSI) is starting to turn up from an oversold condition. There have been 18 instances in the past 12 years when that has happened. In only three of those occasions have the market continued to decline (red vertical lines). (Note that the study period includes the market peak of 2007 and the subsequent bear market.)

My inner investor has already turned cautious because the primary trend is down. On the other hand, my inner trader remains bullish. He believe that you shouldn`t get overwhelmed by the emotion of the moment. Play the odds.

Disclosure: Long SPXL

What is Mr. Market saying about Powell’s “global slowdown”?

Posted by Cam Hui - November 18, 2018

The latest signals of each model are as follows:

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

Global slowdown?

In a speech last week, Fed chair Jay Powell stated that while the American economy was performing well, he raised concerns about the effects of a global slowdown. His remarks highlights the importance of non-US markets, and it would be useful to take a brief tour around the world to see what Mr. Market thinks of the “global slowdown”.

A comparison of global equity market (top panel) and US equities (middle panel) shows some differences and similarities.

We can make a number of observations from this chart:

Both global and US equities are in downtrends, defined as each index trading below its 200 day moving average (dma), but US stocks are stronger as the SPX is only just below its 200 dma.
Both indices are forming possible inverse head and shoulders formations which may resolve bullishly. As good technicians know, these patterns are not confirmed until the neckline breaks.
One key difference stands out if upside breakouts were to occur. The measured upside target for global stocks is below the January all-time highs, while the measured target for the SPX is over 3000, which would represent a fresh high for that index.
Market leadership may be pausing and waiting for direction. The bottom panel shows that for much of this year, US stocks have been outperforming global stocks, as measured by the MSCI All-Country World Index (ACWI), but relative performance of US, EAFE, and EM equities have flattened out since September.

What follows is a more detailed review of global markets as we take a quick tour around the world.

Inverse head and shoulders everywhere

Let’s begin in Europe. The chart of the Euro STOXX 50 and key core European markets are all in downtrends but displaying similar possible inverse head and shoulders patterns. There are some exceptions, such as Italy and Greece, which are not recovering as strongly , reflecting the special situations that these countries face within the eurozone.

Across the English Channel, the chart below of UK stocks, as measured by the FTSE 100 and smaller cap FTSE 250 tell the story of the special situation in that country. The FTSE 100, which is composed of large cap companies with global reach, is exhibiting a possible inverse head and shoulders pattern typical of other global indices. However, the FTSE 250, which is composed of smaller companies more sensitive to the UK economy, broke down below its February lows, which is reflective of the market angst over the uncertainties of Brexit.

Over in Asia, the stock indices of China’s major Asian trading partners reveal similar downtrends but patterns of nascent inverse head and shoulders formations. The Hong Kong, Taiwan, Singapore, and Australian markets are all exhibiting these patterns in some form. The Shanghai market is an exception, but it seems to be trying to stabilize.

Signs of China weakness

What about oil prices, which have recently cratered? A glance at the price of oil and commodity prices tell a different story.

We can make the following observations from the above chart:

Oil prices were only playing catch-up to commodity price weakness. Non-oil commodities are all resting at key support levels, while oil prices have been on a tear since the summer of 2017. The commodity complex (CRB, second panel), the cyclically sensitive industrial metals (third panel), and gold (fourth panel) have been weak for over a year.
The oil to commodity ratio recently broke a relative uptrend (fifth panel), but the ratio remains well above the levels from which it began its bull run.
Commodity weakness is attributable to weakness in China. The bottom panel shows the relative performance of the China Materials ETF (CHIM) against the Global Materials ETF (MXI). The ratio has been range bound after weakening from early 2018 until July, and it is testing a key relative support level that stretches back to December 2016. This is indicative of a lack of enthusiasm for Chinese raw material stocks, which is a signal of weak Chinese commodity demand.

Chinese weakness can also be observed from the relative performance of EM stocks against ACWI. As the chart below shows, EM equities have broken out of a downtrend against ACWI (top panel). However, positive relative strength can be found everywhere except for China. While Chinese stocks are roughly flat against ACWI (second panel), relative strength is evident in the other EM regions, including the oil price sensitive Russia (bottom panel).

I suggested in a recent publication (see Was the market swoon made in China?) that much of the future market direction depends on China. This brief tour around the world indicates that may still be the case. Under those circumstances, expect further volatility based on newsflow on US-China trade negotiations.

A tactical rally ahead?

That said, the widespread appearance of the possible but incomplete inverse head and shoulders pattern in many global indices suggests that stock prices may be in for a year-end rally (see Time to position for a year-end rally?).

In addition to the sentiment indicators I cited in that post, the NAAIM Exposure Index, which measures the equity sentiment of RIAs, has fallen below its 26-week Bollinger Band indicating excessive bearishness. Historically, such episodes have seen equity prices rise shortly afterwards.

The Fear and Greed Index stands at 10, and these levels are consistent with readings seen at previous complex W-shaped bottoms.

The 21 dma of the CBOE put/call ratio is at levels consistent with past tradable bottoms.

These are all strongly indicative of a stock market rebound lasting until year-end and possibly into January. However, I would not overstay the party. Global markets are all in downtrends, defined as trading below their 200 dma, and the DJ Global Index saw a MACD sell signal on the monthly chart in July. I would therefore expect lower prices after a brief relief rally.

The week ahead

Looking to the holiday shortened week ahead, the SPX is poised to begin its year-end rally. The initial objective will be the neckline of the potential inverse head and shoulders formation at about 2820. Momentum is favorable as the index has exhibited a positive RSI divergence. However, if the market were to surge to test 2820 resistance next week, the rally is likely to fail as the VIX Index would probably fall below its lower BB, which would be the sign of an overbought market.

I would warn that the year-end rally may face some fundamental headwinds. The latest update from FactSet shows that EPS estimate revisions may be stalling. Forward 12-month EPS edged up an estimated 0.01% in the latest week after -0.12% the previous week, which may be a sign that of flagging fundamental momentum. On the other hand, the lack of upward EPS revisions may be a residual effect of the recent stock market weakness, as forward EPS has shown itself to be coincident with stock prices, and its weakness only serves as a fundamental signal of market strength or weakness.

Short-term breadth indicators are coming off an oversold reading and exhibiting positive momentum, which is bullish. I will be watching this next week to see if it reaches an overbought level.

For the last word, I refer you to Jesse Felder. Felder found not one, but two possible head and shoulders formations in the hourly SPX chart. One breaks upwards, and the other breaks downwards. While he characterized it as a Rorschbach test for traders, it also represents an important lesson for technicians. These patterns are not complete until the neckline breaks, so be prepared.

My inner investor remains cautious, and his equity weight is near his minimum risk level. My inner trader covered his shorts last Thursday and went long in anticipation of the start of a seasonal rally.

Disclosure: Long SPXL

Time to position for a year-end rally?

Posted by Cam Hui - November 14, 2018

Mid-week market update: Even as stock prices weakened this week, the market appears to be setting up for a year-end rally. The SPX is exhibiting a number of positive divergences. Both the NYSE and NASDAQ new lows are not spiking even as stock prices have fallen. In addition, the percentage of stocks above their 50 day moving averages (dma) are making a series of higher lows, which are all bullish.

What are the risks and opportunities in positioning for a year-end rally?

The bull case

The tactical bull case is relatively easy to make. Sentiment is becoming washed-out. The latest Investors Intelligence bull-bear spread is at levels seen in recent intermediate bottoms.

SentimenTrader also observed that Rydex traders are panicking, which is contrarian bullish.

I recently highlighted analysis from Mark Hulbert which indicated that market timers have become excessively bearish, which is contrarian bullish. Hulbert wrote that these readings create an equity bullish environment for the next couple of months, which is consistent with the year-end rally theme.

Contrarian analysis isn’t always right, and even when it is it only applies to the short term — no more than the next month or two. So today’s encouraging sentiment picture tells us nothing about where the market might be six months to year from now.

But, for now at least, contrarians are betting that the stock market will higher over the next couple of months.

I also pointed out that we have seen a cluster of corporate insider buying. Even if you are bearish longer term, which I am, such signals resolved themselves with short-term rallies during the period after the 2007 market peak.

Don`t get too bullish

Should a rally into year-end materialize, I would refrain from becoming overly bullish for a number of reasons. First, investors have to contend with the long-term sell signal flashed by the combination of negative monthly RSI divergence and MACD sell signal.

In addition, the market has been reacting to news from China (see Assessing the odds of a US-China agreement). Despite the encouraging signals, it is difficult to believe that any substantive agreement can come out of the Trump-Xi meeting in Argentina at the sidelines of the G20 summit November 30 – December 1. Be prepared for disappointment.

Two tests for the bulls

Nevertheless, the stock market is poised for a relief rally from a technical and sentiment perspective. There is an inverse head and shoulders formation that is forming in the SPX. Good technicians know that these formations are not confirmed until the neckline breaks. If the index were to break through neckline resistance, the measured target would be about 3035, and such an event would likely spark an initial but brief FOMO rally.

Hold your enthusiasm. Here are some challenges for the bulls. First, the longer term weekly chart shows that the SPX broke down through an uptrend. While the market kissed the underside of the trend line last week, it did not break through on a closing basis. One of the key tasks for the bulls will be to break up through the trend line, otherwise any year-end rally would be interpreted as a failed backtest and likely fizzle out with a lower high.

In addition, watch for breadth thrusts. Past rallies have seen breadth thrusts (circled), as measured by the new high-new low % indicators, in one or more of large caps, midcaps, small caps, or NASDAQ stocks.

If the bulls cannot pass these two simple tests, then any upside breakout of the inverse head and shoulders is likely to be disappointing. Rallies will either be weak, abbreviated, or both.

Subscribers received an email alert today that my inner trader had covered his short positions and flipped to long.

Disclosure: Long SPXL

Assessing the odds of a US-China agreement

Posted by Cam Hui - November 12, 2018

In the past week, a number of readers have expressed the conviction that US-China trade tensions are likely to ease in the near future at the upcoming Trump-Xi meeting, which will occur at the sidelines of the G20 meeting November 30-December Bloomberg reported that American farmers are so hopeful that they are storing significant amounts of their soy crop for future sale. What are the odds that will happen?

Certainly, there are some signs of a thaw. The strength of the USD Index indicates that there is more room for CNYUSD to decline further. But the PBOC dropped a pledge to allow the market to play a larger role in setting the exchange rate in its latest quarterly monetary report, which is a signal that the central bank is prepared to intervene to cushion yuan weakness.

While the steps taken by the PBOC is a useful start, here are the challenges facing an agreement on a trade deal.

Devaluation or capital flight?

One of the sources of friction during the trade war is the exchange rate level. Fretting over CNYUSD may not be useful in the current environment. A recent IMF paper, Macroeconomic Consequences of Tariffs, found that tariffs don’t work because the exchange rate devalues to adjust for the effects of tariffs.

We study the macroeconomic consequences of tariffs. We estimate impulse response functions from local projections using a panel of annual data that spans 151 countries over 1963‐2014. We find that tariff increases lead, in the medium term, to economically and statistically significant declines in domestic output and productivity. Tariff increases also result in more unemployment, higher inequality, and real exchange rate appreciation, but only small effects on the trade balance. The effects on output and productivity tend to be magnified when tariffs rise during expansions, for advanced economies, and when tariffs go up, not down. Our results are robust to a large number of perturbations to our methodology, and we complement our analysis with industry‐level data.

Everything else being equal, the Chinese yuan would naturally fall to adjust for the effects of the Trump tariffs. Indeed, there is a considerable interest rate divergence between the US and China, which puts downward pressure on the exchange rate.

Benn Steil at the Center for Foreign Relations pointed out that the poor performance of Chinese equities puts additional downward pressure on CNYUSD.

Over the past two years, as our left-hand figure above shows, foreign portfolio investors have piled prodigiously into Chinese assets, helping to support the RMB. But history suggests this trend is about to reverse. While inflows have been rising, Chinese stocks have been tumbling—they are down over 20 percent from their January peak. Dreadful performance like this typically drives funds out of emerging markets. We may be seeing the beginning of such outflows in China.

Steil concluded with an ominous warning for Beijing should it decide to prop up its currency:

So in spite of President’s Trump’s repeated charges that China is manipulating its currency for competitive advantage in trade, all evidence suggests that it will continue to do the opposite. But if China were to sell reserves at the same pace as in 2015, its reserve levels would, by mid-2020, actually fall below the safety threshold implied by the IMF’s framework for reserve adequacy—as shown in the right-hand figure above.

The prospect of a balance-of-payments crisis, in which China would struggle to pay for imports and service foreign debt (a prospect considered outlandish a decade ago), highlights the urgency with which China must begin addressing the problem of high and rising corporate and local-government debt levels. The PBoC has no easy fix for these problems.

In the meantime, capital flows are continuing, albeit at a reduced rate, even before the deletion of the PBOC’s to allow the market to play a larger role in the exchange rate.

If the Chinese decide to prop up its exchange rate, it will have to choose between a market driven devaluation, or capital flows.

Preparing for the Trump-Xi summit

Ahead of the Trump-Xi meeting in Buenos Ares, here is what each side had to say. Bloomberg reported that Xi Jinping criticized “law of jungle” in veiled swipe at Trump at the inaugural China International Import Expo on Monday that “the practices of beggar-thy-neighbor” would lead to global stagnation.

Marc Chandler outlined the American position this way:

In a recent article in the Wall Street Journal, former Treasury Secretary Paulson seemed to express the views of many. If neither the US nor China changes its course, an “iron curtain may soon descend.” Pssst…the future has happened.

It can be debated when the Rubicon was crossed. Perhaps it was when Chinese officials had thought a deal had been struck with Treasury Secretary Mnuchin to buy more US goods to reduce its bilateral surplus with the US, only for President Trump to have torpedoed the agreement. That taught China that power does not lie with the US Treasury. Chinese officials also took that to mean that issue was not really the bilateral imbalance, but part of a larger attempt to stymie China’s rise. The Rubicon has been crossed.

Trump’s speech a couple of months ago should have left no doubt about what is happening: “When I came we were heading in a certain direction that was going to allow China to be bigger than us in a very short period of time. That is not going to happen anymore.”

Vice-President Pence was crystal clear in a recent speech. China was trying to shape the world in ways that are contrary to the US values and interests. Past administrations that sought to integrate China into the US-led order, like Paulson, in effect were co-conspirators to the violations of the rules to the detriment of America. Pence claimed that China was interfering with domestic policies. This is a strong claim.

Chandler took the gloves off in outlining the issues in this trade conflict:

Let’s be frank. Even before the Trump’s election, some Chinese officials thought that the US was trying to contain the PRC’s rise. It may or may not have been the case previously, but there can be little mistake now. The US is not just preparing for a fissure, it is fostering it.

NAFTA 2.0 is not much different than NAFTA 1.0 plus some of the measures agreed to in the Trans-Pacific Partnership negotiations and some domestic content changes. It also contained two other modifications, which mean very little for Canada and Mexico, but significant as a template for future agreements. The first is about intervention in the foreign exchange market and making it transparent and rare. The second is the gem. It essentially says that having trade agreements with non-market economies can end the bilateral deal with the US. “Non-market economies” is diplomatic-speak for China.

It can force countries who want privileged access to the US market to limit their trade with countries it judges unfit. Paulson fears that the US will be isolated because few will want to be locked out of the rapid growth that China continues to enjoy, even if not as fast as a few years ago. This seems to be an expression of defeatism among many of globalist camp.

Ahead of the summit, Xinhua reported that Xi Jinping met foreign policy guru Henry Kissinger. Xi stated after the meeting:

Adhering to the path of peaceful development, China remains committed to developing Sino-U.S. relations featuring non-conflict, non-confrontation, mutual respect, and win-win cooperation. We are willing to properly resolve the problems between the two countries through friendly consultations on the basis of equality and mutual benefit. At the same time, the U.S. side should also respect China’s right to choose its own way of development and China’s legitimate interests. [The United States should] walk along with China to jointly safeguard the healthy and stable development of Sino-U.S. relations.

Kissinger responded:

Under the current situation, U.S.-China cooperation is crucial to world peace and prosperity. I highly appreciate China’s efforts… The United States and China must better understand each other, strengthen strategic communication, continuously expand common interests, properly manage differences, and show the world that the common interests of the two countries are far greater than the differences.

Translation: Xi met Kissinger because of his reputation for strategic realism. Xi’s message to the old foreign policy warhorse is China is willing to sacrifice some of China’s interests, as long as it doesn’t harm Beijing’s long-term development strategy.

Is there enough daylight between the two sides for some kind of agreement? Marc Chandler doesn’t think so:

China initially appeared content to bide its time and Xi is positioned to outlast Trump. It tried offering concessions to ease the bilateral imbalance. These were ultimately rebuffed. The rhetoric on both sides has become more hostile. China has few friends in the US. Environmentalists, labor, human rights activists, businesses frustrated with the discrimination, and nationalists (President Trump’s self-identification) are vocally critical. Antipathy toward China is one of the few bipartisan issues in America, where the electorate and officials are exceptionally polarized. Democrats, who were often criticized by Republicans for being “soft on Communism” after the Kennedy-Johnson era, are not going to be similarly vulnerable in this new cold war.

This means that Chinese officials cannot in anyway count on the changes of the US electoral cycle to dial back the confrontation. While many in the US see a contradiction between China modernizing economy and an archaic political system, China experiences US government as unstable.

Consider that the US impeached one president who lied about a having slept with a consenting woman while electing another man president who appeared to have bragged about taking advantage of other women. Or consider that US political elite had sponsored a multilateral system of free mobility of goods and capital, but in one election in which the winner did not receive a majority of the popular vote, the strategy has been turned on its head. The vagaries of America’s electoral system and the gerrymandering that helps preserve it is not a stable foundation upon which China’s development strategy can reliably depend.

He concluded:

The situation is likely to get worse in the period ahead. It seems unlikely that China will make the concessions the US is looking for later this month when Trump and Xi meet. Trump then is likely to begin the formal process of putting tariffs on the remainder of Chinese goods. That process will take a couple of months and could be halted or modified before implementation, but in the meantime, it is consistent with the maximum pressure tactics the Art of the Deal requires. Moreover, on January 1, the 10% tariff on $200 bln of Chinese goods will be raised to 25%.

I agree. Both sides are dug in. It is difficult to see how either could back down given their respective positions. In particular, it will be difficult for Trump to conclude a NAFTA 2.0 style deal and “declare victory” without accusations of having caved to the Chinese.

Prepare for a minor risk-on rally on the hopes of a thaw ahead of the summit, and disappointment afterwards.

Insiders are buying, should you jump into stocks?

Posted by Cam Hui - November 11, 2018

The latest signals of each model are as follows:

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

Insiders are buying

Regular readers will know that I have been sounding cautionary technical warnings because of a negative monthly RSI divergence and a MACD sell signal for US equities. This combination has been uncanny in the past at warning of major market tops.

On the other hand, the latest report from Open Insider shows that corporate insiders, who are known as “smart investors”, have been buying the latest dip. Historically, sales (red line) exceed buys (blue line) by a significant margin. A funny thing happened during the latest correction. Sales dried up, and buys exceeded sales, which is an indication that insiders are showing confidence in the share price outlook of their own companies.

How can we square the circle of these two contradictory signals? Should investors be buying or selling equities?

The valuation bull case

Here is how corporate insiders are probably seeing the market. Simply put, valuations are attractive. The latest update from FactSet shows that the market is trading an undemanding forward P/E ratio of 16.0, which is below the 5-year average of 16.5, and above the 10-year average of 14.5.

From that point of view, the recent price dip was a gift from the market gods. Stock prices just went on sale. Why shouldn’t insiders be buying?

What are the risks?

As a group, insiders are generally known to have better knowledge about their companies and the industry conditions their companies operate in, they are not always prescient about the future. As an example, we saw several clusters of insider buying on dips after the market top in 2007. In fact, insiders were buying all the way down to the 2009 bottom.

I believe that the bullish signal from insider buying should be offset by the risks of rising economic policy uncertainty.

The bear case

Here is the bear case to the valuation thesis. What if conditions changed sufficiently that tanked earnings? I offer two possible scenarios.

First, the US and China appear to be headed towards a full-blown trade war. In the past, recessions have caused world exports to fall. Could the tail wag the dog this time? Could falling global trade cause a recession, and a decline in earnings expectations?

The IMF has estimated that a full-blown trade war would reduce US real GDP growth by about 1%. China’s GDP would fall by 1.6%, and the rest of Asia would also get sideswiped by trade tensions.

The latest FOMC Summary of Economic Projections (SEP) shows that the median estimate of real GDP growth is 2.5% in 2019 and 2.0% in 2020. If IMF projections are correct, then we could see those figures fall to 1.5% and 1.0% respectively.

Indeed, the Fed is projecting already a significant slowdown in 2021, as the unemployment rate rises 0.2% from 3.5% in 2020 to 3.7% in 2121. The 0.2% rise in unemployment is very close to the recession threshold outlined by the (then) New York Fed president Bill Dudley who observed that the economy fell into recession whenever the unemployment rate rose more than 0.3% to 0.4%,

A particular risk of late and fast is that the unemployment rate could significantly undershoot the level consistent with price stability. If this occurred, then inflation would likely rise above our objective. At that point, history shows it is very difficult to push the unemployment rate back up just a little bit in order to contain inflation pressures. Looking at the post-war period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points.

What’s the downside risk under such a scenario? Supposing we were to pencil in a 10-20% fall in EPS estimates from a trade war. In the past, forward P/E ratios have experienced compression during economic slowdowns.

History shows the minimum forward P/E compression has been 2-3 points, and it has been considerably higher during more severe recessions. However, I don’t believe that P/E ratios are likely to fall very much, as institutional investors have largely already de-risked their portfolios. Assuming that forward P/E ratios fall by 2-3 points, and estimates decline by 10-20%, equity downside risk is 20-30%.

What if matters were to get worse? The Fed has made it clear that it is embarked on a slow but steady rate normalization policy. There has been no discussion of when it might pause its rate hikes, and many analysts have concluded that the Fed will continue to raise until something breaks. What if the Fed were to make such a policy mistake and react too slowly to signs of a slowdown?

Since the effects of monetary policy operate with a lag, the 2020 SEP median GDP growth rate of 1.0% under the IMF’s trade war scenario is at risk of turning negative. Already, cyclically sensitive industries such as housing appears to be peaking out. In the past, growth has slowed whenever housing inventory has spiked. Will the current episode tip the economy into recession?

Monetary indicators, such as real money growth, are decelerating and on the verge of turning negative, which would represent another recession warning.

The price downside risk for equities under the conditions of a double whammy of a Fed policy error and full-blown trade war would be considerably more than 20-30%.

Resolving the macro and technical outlook

So how can we resolve the apparent bullish outlook shown by corporate insiders and the poor technical outlook shown by the charts? Here is what the market is saying.

The monthly MACD sell signal for US equities is actually late. World equities already flashed a MACD sell signal in July. Non-US stock markets have been discounting a global slowdown for several months.

The message from the market is, “We are worried about policy risk.”

Here is what I would watch for. I recently wrote about the rise of recession risk (see A recession in 2020?). While my long leading indicators are not flashing red, they are flickering. Investors need to monitor the evolution of recession risk.

In conjunction with conventional macroeconomic analysis, we also need to pay attention to global growth risks posed by rising trade tensions. Should the US impose a further round of tariffs on Chinese imports in January, the anticipated effects will be far more consequential to US growth than the previous round because the new tariffs will be on intermediate goods, which are production inputs into American products. A new IMF paper, Macroeconomic Effects of Tariffs, shows the negative effects on economic output and productivity if tariffs are imposed on inputs (top panels) compared to outputs (bottom panels).

In addition to any progress between the scheduled Xi-Trump talks at the G20 meeting in late November, investors may be well-served to monitor any changes in the Trump administration during the post-election period. Cabinet secretaries and administration officials often turn over after the midterms. For example, if Steve Mnuchin at Treasury or Wilbur Ross at Commerce were to leave, but the Peter Navarro and Robert Lightizer were to stay, it would signal a more protectionist turn in American policy. In a late breaking development, CNBC reported Friday that Trump is considering replacing Wilbur Ross with former WWE executive Linda McMahon as Commerce Secretary by the end of the year.

As I pointed out in the past (see Was the market swoon made in China?), the effects of the Trump tariffs are just starting to show up in Q4. If there is no further progress in the trade talks, more sanctions will hit the Chinese economy starting January 1, 2019.

In conclusion, while corporate insider buying presents a possible opportunity to buy stocks, the valuation appeal of stocks is offset by the risks of macro policy uncertainty. Investors should assess recession risk, and the evolution of the Sino-American trade policy risk before following the risk-on policy adopted by corporate insiders.

The week ahead: Waiting for clarity

In my last post (see Bullish or bearish? What’s your time horizon?), I wrote that the market appears to be undergoing a bottoming pattern. However, it is unclear whether a final bottom has been made. We should get more clarity in the week ahead. Intermediate sentiment such as the normalized equity-only put/call ratio indicates a market that is poised to rally.

Mark Hulbert also pointed out that his survey of market timers are more bearish than they were at the February bottom, which is contrarian bullish.

As well, an examination of the 4-8 week market reaction to insider buying clusters during the 2007 top shows that the market has tended to rally after such episodes. Even if you believe that the top is in, you should still expect a reflex rally.

If the stock market were to strengthen, the challenge facing the bulls is to break uptrend resistance after its violation.

However, a number of indicators suggest that stocks may have to decline first before prices can rally in a sustainable manner. The latest update from FactSet was somewhat disturbing. Despite the above average results from Q3 earnings season, forward 12-month EPS fell last week. As forward EPS estimates are coincidental with stock prices, it is unclear whether this is just a data blip or something more concerning.

Further analysis shows that the decline in forward EPS was attributable to cuts to 2019 earnings. 2018 EPS estimates remain steady. If this trend of 2019 downgrades continues into next week, the market may be spooked by the outlook for next year.

Traders should also watch the USD. While this is not a perfect relationship, USD rallies in the past year have coincided with stock market weakness. The USD Index bounced off trend line support last week and it is advancing. If recent history is any guide, this should translate into further equity weakness.

The post-election rally last Wednesday qualified as an Investors Business Daily Follow Through Day (FTD), which is evidence of a breadth thrust. Such breadth thrusts are interpreted to be bullish, but Rob Hanna`s study of FTD found only a success rate of 55% after such episodes. As a reference, the market tends to rise 56% of the time on a weekly time frame, and 61% of the time monthly. Therefore a 55% success rate is nothing to get overly excited about.

Last week’s SPX rally stalled at a key Fibonacci retracement level, and ended the week with two unfilled gaps below. Whether the gaps get filled is an open question. What is constructive is the index closed about its 200 day moving average (dma). However, the equal-weighted SPX was unable to rally above its 200 dma, which represents a minor negative breadth divergence.

Short-term breadth market indicators is retreating from an overbought reading, which is a classic sell signal for traders. I am inclined to wait for this indicator to fall to at least a mild oversold condition before reversing to the long side.

My inner investor has de-risked his portfolio and he is at his minimum equity weight. My inner trader was caught short during last week’s rally, but he remains short in anticipation of lower prices next week. He will re-evaluate his positioning once he gets greater clarity from next week’s market action.

Disclosure: Long SPXU

Bullish or bearish? What’s your time horizon?

Posted by Cam Hui - November 7, 2018

Mid-week market update: The midterm election performed roughly as expected. The Democrats regained control of the House, and the Republicans held the Senate and even made some gains. Is this bullish or bearish for equities? It depends on your time frame.

Here is my outlook from a strictly chartist’s viewpoint, starting with the long-term to the short-term.

From a very long-term perspective, the negative monthly RSI divergence and MACD sell signal is too worrisome to be ignored. These conditions suggest that the market is making a broad-based top.

The latest MACD sell signal is unlikely to be resolved with a minor 2015 style correction. The technical breach of the relative performance of bank stocks, which was accompanied by a similar relative support violation of the regional banks, is another warning that a major decline is under way.

That said, nothing goes up or down in a straight line.

Prepare for the year-end rally

However, intermediate-term indicators are sufficiently oversold to expect a relief rally into year-end. The normalized equity-only put/call ratio was highly stretched and it has begun to mean revert, which is a classic buy signal.

There are other signs that risk appetite is recovering. Emerging market stocks, which have been badly beaten up in the latest downturn, have begun to show some signs of life. EM equities (EEM) compared to the MSCI All-Country World Index (ACWI) have rallied through a relative downtrend. The performance of the other major components show that all regions, except for China, are showing signs of relative strength.

There is much evidence that stock prices perform well after midterm elections. Here is one example of the historical pattern from CNBC.

However, I would temper those expectations by pointing out that there are many ways of analyzing the historical data. The same CNBC report showed that Fundstrat found equities perform well only when House control remains unchanged, which is not the case in 2018.

In the last 100 years, Ned Davis Research found that the combination of a Republican president and a split Congress occurs about 10% of the time, and the DJIA’s annualized return is -6.1% during those instances.

Short-term overbought

In the very short-term, the market was already at overbought extremes as it approached election night Tuesday. Conditions are going to be even more extended after Wednesday’s rally.

Rob Hanna at Quantifiable Edges did not find a short-term trading edge after the midterm elections, except for a one-day rally after the election.

The most likely short-term scenario for the market is it chops around a bit more, as the Fear and Greed Index did during past W-shaped bottoms.

In conclusion, how you should behave is a function of your time horizon. The stock market appears to be making a broad-based top, but it is also in the process of making an intermediate bottom, and a year-end rally is likely. Tactically, however, stock prices are highly overbought and will probably pull back and possibly test the recent lows. At a minimum, expect one or both of the gaps below to be filled first before the the market can mount a sustainable rally.

Disclosure: Long SPXU

How fat tails could mean fat profits

Posted by Cam Hui - November 5, 2018

The CBOE Short-Term Volatility Index (VXST) measures volatility over a 9-days. In effect, it’s the 9-day VIX, which measures 1-month volatility.

VXST closed at 21.17 last week. indicating that the market expects an annualized volatility of 21.17% over the next 9-days. When I translate that to a weekly volatility by taking the 52nd root (52 weeks in a year), it comes to 1.1%. That figure seems low for several reasons. First, the SPX rose 2.4% last week and its low to high range was 5.9%. The midterm elections on Tuesday could pose an unknown event risk. As well, we have an FOMC meeting on Wednesday and Thursday, which could also shake up markets.

The higher than normal probability of disruptive events creates fat tails for market returns. Fat tails could mean fat profits for traders.

What the market expects

I ran two (unscientific) polls on the weekend asking respondents what they would do in the event of a Red or Blue wave. A Red Wave is perceived as unabashedly equity bullish, while a Blue Wave is equity bearish, though there was no clear consensus as to what asset class they would like to hold.

Even a deadlocked Congress, with a Democrat House and Republican Senate, may not be very equity bullish. This analysis from Nordea Markets puts it much better than I could:

The medium-term risk appetite is more at risk from a hung Congress than usual due to the pro-cyclicality of Donald Trump’s policy wishes. The road to more tax cuts and more pro-cyclical spending will be much longer if Trump must navigate a Republican Senate and a Democrat House. We argue that Trump’s policy is associated with i) protectionist inflationary impulses, ii) less immigration and accordingly increasing wage pressures and iii) excessive pro-cyclical spending / fiscal easing by now.

The third factor has been key for the positive US equity story so far this year. The prospect of additions to factor iii) will be very slim in a hung Congress scenario, which should substantially limit the market appetite to bet on further cyclical upside, unless Trump pulls off a miracle and keeps the double majority intact on Tuesday. Trump will be able to continue his aggressive trade rhetoric even with a hung Congress, as the president have widespread prerogatives on trade. So, this means that we will likely get a policy mix of more aggressive trade rhetoric and protectionist policies and less fiscal stimuli. This is a not a medium-term positive equity cocktail.

Indeed, stock prices have been fallen steadily even as the probability of a Congressional Gridlock increased.

Now that we have some understanding of market expectations, what might happen if we get a fat-tailed event such as a Red or Blue Wave?

A surge in early voting

According to Michael McDonald of Elect Project, there has been a surge in early voting in 2018, which is indicative of an energized voter base. Here is the early voting turnout in some key battleground states compared to the last midterm in 2014 as of November 4, 2018:

Arizona 125%
Florida 160%
Georgia 194%
Indiana 130%
Montana 135%
Nevada 206%
Texas 236%

While the consensus is a Democrat-controlled House of Representatives and a Republican-controlled Senate, the surge in early voting raises the probability of a “wave” election where one party wins both chambers of Congress.

In effect, the surge in early voting heightens the probability of a Red or Blue wave, and fat tails in market returns.

Red or Blue Wave?

If there is to be a wave, will it be Red or Blue?

Here is how to make some educated guesses. We can get some glimpses of early voter demographics, as they are reported by some states. What is astonishing is the surge in participation by young voters, according to The Hill:

The number of voters between the ages of 18 and 29 who have cast ballots early has surpassed turnout levels from the last midterm election in just about every state, according to several sources tracking early vote totals.

In some states, especially those with hot races, the increase in turnout is staggering. In Texas, 332,000 voters under the age of 30 have cast ballots already, up nearly fivefold from the 2014 midterms. In Nevada, the 25,000 young voters who have cast a ballot is also five times higher than in the same period four years ago.

Georgia’s young voter turnout is four times higher than it was in 2014. In Arizona, three times as many younger voters are turning up.

“Voters under the age of 30, relative to their ’14 turnout, are outperforming every other group,” said Tom Bonier, a Democratic strategist whose firm TargetSmart tracks the early vote. “It’s not just like a presidential year surge where you’re getting younger voters who only vote in presidentials coming out in a midterm. A lot of these young people are voting in their first election period.”

The surge in young voters give the Democrats the edge. Pew Center Research found that Millennials tilt Democrat, while the older generations tilt Republican.

If, and that’s a big if, there were to be a wave, the early voting data suggests that it will be Blue, and that will be bearish for equities.

Don’t forget the Fed

As well, we also have the FOMC meeting this week. Fed watcher Tim Duy believes that the Fed will interpret the strong October Jobs Report as a reason to continue tightening, and they will keep tightening until something breaks:

I don’t know yet how this will play out. What I do know is that central bankers are very comfortable with the flat Phillips Curve story, almost complacent. Essentially, they have been surprised so many times by how low they can push unemployment that they don’t really trust their ability to estimate the natural rate of unemployment and are now defaulting to a dovish scenario that allows them to maintain a gradual pace of rate hikes despite fairly hot growth. There don’t appear to be many skeptics left among central bankers. My experience is that when everyone believes the same story, it’s time to get a new story.

Bottom Line: Jobs data gives no reason for the Fed to think their job is done; rate hikes will continue.

In conclusion, both the midterm election and the FOMC meeting could pose to be a source of market volatility this week. The surge in early voting raises the odds that one party could dominate both chambers of Congress, which is contrary to the market consensus and further raise market volatility. Traders should be positioned for big market swings, either by reducing their position sizes, or by taking an active bet on volatility.

Disclosure: Long SPXU

Was the market swoon made in China?

Posted by Cam Hui - November 4, 2018

The latest signals of each model are as follows:

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

A made in China selloff?

There is a family joke in our household that Santa Claus doesn’t live at the North Pole, but in China. That’s because everything he bring says “Made in China”.

There have been many explanations for the recent market swoon, such as rising rates, earnings disappointment, or earnings growth deceleration from the fading effects of the tax cuts, and so on. John Authers, who is now at Bloomberg, pointed out that the recent sell-off may have been made in China.

Volatility returned to U.S. stocks again Monday afternoon. This is still, I think, largely about forced sellers as speculators such as hedge funds get used to the reality of having to operate with less leverage. But it would be wise to note that there is obviously a Chinese component to this. Since 2016, the more a company was exposed to China, the better it had done. But that has all changed in recent weeks, and those companies are doing worse.

It’s starting to look that way. After Trump tweeted about his “good conversation” with Xi Jinping, and Bloomberg reported that he asked his cabinet to draft a possible deal with China (what have they been doing all along?), global markets went full risk-on Thursday night. Stock prices reversed themselves Friday after White House officials denied that there were any cabinet preparations for a trade plan with China. The market partially recovered when Trump contradicted his staff and stated that he thinks the US will reach a trade deal with China.

If the Made in China thesis is correct, investors need to adjust the macro, fundamental, and technical analytical framework from a purely domestic focus to one more global in nature. This week, I explore the underpinnings of this hypothesis, and the steps to take should it be correct.

Risk levels rising

I have been writing about how risk levels are rising in China, and I don’t want to repeat myself (see The brewing storm in Asia and Is China ready for the next downturn?). Here are some additional data points of vulnerability that I haven’t covered in the past.

The WSJ reported on IMF analysis which concluded that Chinese bond trading is so acutely dependent on repos that changes in interbank rates have dramatic impact on volume and liquidity. In effect, liquidity could dry up just as market funding seizes:

According to the IMF’s October 2018 Global Financial Stability Report, trading volumes of Chinese government and corporate bonds have been far more volatile than in the U.S.

That is likely because most bond purchases in China were financed with borrowed money. In 2017, repo borrowing was 15 times the size of average daily trading volumes in the Chinese bond market, twice as high as the peak level recorded in the U.S.

Over the past few years, Chinese bond trading slumped whenever the cost of short-term borrowing rose. Activity surged when interest rates fell. Bond-trading volumes have fluctuated by as much as 200% in a year, according to the IMF report, following that pattern.

“This procyclical link between bond trading and financial conditions represents a significant vulnerability in China’s financial markets,” wrote IMF financial-sector expert Henry Hoyle. The concern is that bond-market liquidity could rapidly dry up if interest rates shift quickly, making it difficult for financial institutions to sell assets or roll over their repo loans to fund themselves.

A vicious circle could result if higher demand for short-term borrowing pushes rates higher and further reduces liquidity, according to Mr. Hoyle.

This heightened fragility is occurring against a backdrop of rising leverage among China’s banks.

Analysis from Morgan Stanley also indicated that China’s credit creation may be slower than headline figure suggests – there’s more short-term bill financing, less medium and long-term lending. This represents the classic asset-liability mismatch that is the root of virtually all banking crises.

I outlined in the past how property developers have been discounting unsold units, which has led to protests by buyers who bought in at higher prices. Deutsche Welle reports that the phenomenon is so widespread it now has a name, “Fang Nao”:

The property protests have not been limited to Shanghai and, in some instances, have even turned violent. In Xiamen, in China’s southeastern Fuijian province, anger spilled out on the streets after the price of one luxury villa was cut by 2 million yuan, having sold for more than 5 million a year earlier.

Such was the bitterness at the price drop, the developer — China’s largest residential real estate company, Vanke — was pressured to pay out a million yuan in compensation to some 100 existing owners.

Similar protests in Shangrao, Xiamen, Guiyang, and Hangzhou saw property owners demand the return of their money from construction firms, amid fears their losses could be much larger than in a previous downturn in 2014.

Property protests are becoming so regular in China that a new term has emerged on social media. “Fang Nao” literally means property trouble-making.

Enter property developer and debt behemoth China Evergrande, whose profile was documented by FT Alphaville:

It boasts an enterprise value of $145bn. In the first half of the year it generated $44bn of revenues and $4.5bn of profits, paying out half in dividends. It has $98bn of debt, $44bn of it due within the next twelve months.

The answer is China Evergrande, a real estate kraken with tentacles stretching across China. It does all things property including development, investment, management and construction, along with a host of smaller ventures in technology, finance and healthcare.

That reach makes some of the numbers mind boggling, particularly when it comes to the company’s debt. For instance, it paid $4.2bn of interest over the first six months of 2018 — more than the revenues of 259 of the S&P 500’s constituents in the same period, according to S&P Capital IQ.

According to this Bloomberg article, its debt profile is…interesting. It has about US$100b in debt, but it is highly reliant on trust loans derived from the shadow banking system.

Trust financing accounted for about 45 percent of Evergrande’s total borrowing at the end of June, the largest chunk since at least 2010. That’s led to an “uneven capital structure,” according to S&P Global Ratings analyst Matthew Chow.

Most of Evergrande’s publicly traded peers are much less reliant on such funding. Longfor Group Holdings Ltd. and China Resources Land Ltd. say they don’t use trusts, while China Vanke Co. gets about 18 percent of its financing from sources other than banks and bonds.

In a separate article, Bloomberg reported that the company’s chairman bought $1b of a $1.8b bond issue to signify “support and confidence in the Group”:

China’s most indebted property developer made an unusual move to buy $1 billion of its new $1.8 billion notes priced on Tuesday, as he seeks to lend support to the group.

Hui Ka Yan, chairman and executive director of China Evergrande Group, purchased $250 million each of its 2022 and 2023 bonds, while his wholly-owned Xin Xin (BVI) Ltd. bought another $250 million each of those two notes, according to a statement to Hong Kong stock exchange on Wednesday.

Hui followed through with the purchase after expressing interest to buy the notes on Tuesday. “The purchase is being undertaken to signify Mr. Hui’s support to and confidence in the Group,” the company said in the filing on Wednesday. The terms of the purchase of the notes by Hui and Xin Xin are the same as other investors in the debenture that was issued Tuesday, according to the statement.

Evergrande’s latest bond offering comes amid government effort to rein in property prices in China, which has made funding more expensive for developers. The company has relied more on high-cost trust funding recently, which accounted for about 45 percent of its total borrowing at the end of June, the most since at least 2010.

A vote of confidence, or signs of a company under stress?

Widespread weakness

In the meantime, the signs of economic weakness are widespread. The release of the latest PMI and its components tell the story. More importantly, new export orders and employment are dropping and below 50, indicating contraction.

Even worse, satellite imagery indicates that manufacturing output may be faring even worse than the official PMI figures. While the official PMI reading of 50.20 was soft and below market expectations, satellite data suggests the manufacturing sector may be in outright decline.

Estimates from Bloomberg Economics indicate that economic conditions are weakening across the board, and sentiment is very poor, especially among smaller firms.

The weakness was confirmed by the PMIs of Asian trading partners Taiwan, Malaysia and Thailand, which also fell below 50 in October, indicating contraction.

The stock indices of major Asian trading partners are all trending downwards, indicating a weakening regional economy.

Tariffs: They have not begun to really bite

What about the trade war? The effects of the tariffs have not fully hit the economy. The chart below shows the differences between the scope and size of the announced and implemented tariffs.

The 10% tariff rate on $200 billion is set to rise to 25% on January 1, 2019. In addition, news reports indicate that the US is prepared to slap tariffs on an additional $257 billion on Chinese exports should the Trump-Xi meeting fail at the G20 meeting in late November. The new tariffs are expected to be implemented in January. The IMF estimates that a full-blown trade war would reduce China’s GDP growth by 1.6%, the US by about 1%, and the effects would be felt throughout Asia.

China Beige Book’s Leland Miller stated on CNBC that the effects of the trade war haven’t fully hit China’s economy yet:

China’s economy could be facing a tough winter as economic growth slows and the effects of a trade war with the United States begin to take hold, data analyst Leland Miller told CNBC on Monday…

“The tariff situation has created a very bad potential problem for [the] China fourth quarter of this year, potentially in a big way first quarter” next year as well, Miller said on “Squawk Box.”

Even if the U.S.-China trade dispute were resolved Jan. 1, “the Chinese economy will be hurting very badly” despite some other “growth engines not doing as poorly,” Miller said.

What about the news that Trump asked his cabinet to prepare for a trade deal with China, which was later denied by White House officials?

Call me skeptical, but short of a major breakthrough in talks, which have been nonexistent, the underlying issues remain unresolved. The dispute is about the reversal of a trade deficit, and the reversal of China’s industrial strategy. The idea that a “trade peace” will suddenly break out is far-fetched, especially in light of the Commerce Department’s decision to restrict Chinese chipmaker Fujian Jinhua from buying American electronic components. In all likelihood, the talk is nothing more than a stunt to position the Trump administration in a favorable light ahead of the midterm elections.

Beijing to the rescue?

Bloomberg reported that a Politburo meeting signaled that China is planning more stimulus as a response to the widespread signs of economic weakness:

China’s leadership signaled that further stimulus measures are being planned, as disappointing economic data showed that the current piecemeal approach isn’t working.

The nation’s economic situation is changing, downward pressure is increasing, and the government needs to take timely steps to counter this, according to a statement from a Politburo meeting Wednesday chaired by President Xi Jinping.

The signal of increasing urgency came just hours after purchasing manager reports showed an across-the-board deterioration that risks spilling into a broader drag on global growth. The world’s second largest economy is being damaged by its trade war with the U.S. and a domestic debt cleanup.

With those pressing constraints, officials have added modest policy support so far, ranging from tax cuts to regulatory relief, rather than repeating the fiscal firepower seen after a previous slowdown. Investors seem unpersuaded by the drip-feed approach with the yuan hovering around a decade low and stocks sliding.

Caixin reported that “deleveraging” has been left off the agency of the Politburo meeting. This may be a sign of panic, as the authorities are throwing out their playbook on controlling debt.

It may not be enough. I had previously highlighted analysis by Michael Pettis that China may be hitting a debt wall. He concluded that China has four unenviable policy choices:

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.

Left unsaid is the devaluation policy lever. John Authers recently pointed out that the Chinese yuan (CNY) is more closely tied to the USD, and it has become less competitive on a trade-weighted basis compared to other currencies. One of the policy levers that Beijing can employ is competitive devaluation, which has the potential to spark a global currency war, capital flight, and a disorderly unwind of China’s debt bubble.

Global contagion risk

How does China’s policy dilemma affect the rest of the world? Here are the stakes. According to the IMF, Chinese growth comprises about one-third of global GDP growth.

Its currency is weakening even as US real rates are rising. Something has to give.

What to watch

The risks to China and the possible spillover risks to the global economy appear to be formidable. While I don’t know whether Beijing can successfully navigate through these stormy seas, I can offer some real-time indicators that investors can watch in order to monitor the evolution of risk levels.

First is the behavior of the stock markets of China’s major Asian trading partners. Since almost all global markets are in retreat, monitoring absolute prices may not be an effective technique for spotting trouble. Instead, I would advocate watching the relative performance of the regional markets against the MSCI All-Country World Index (ACWI). The chart below shows the returns of US-listed country fund ETFs against ACWI. All returns are in USD, therefore currency effects are already reflected in the charts. While the performance of Chinese stocks have begun to stabilize against ACWI, the same could not be said of Taiwan and South Korea, which are disturbing developments. This is something to keep an eye on over the coming weeks leading up to the meeting between Trump and Xi at the G20 meeting.

I have also suggested in the past to monitor the share prices of key Chinese property developers such as China Evergrande (3333.HK). So far, Evergrande has not breached its key support level.

However, the apparent strength may be artificial as the Chinese authorities recently took steps to stabilize the stock market:

After a faster-than-usual revision to existing law, companies can now repurchase shares with approval from at least two-thirds of the board if deemed necessary to protect shareholders’ interests, or to fund convertible bond exchanges, the National People’s Congress said last Friday.

Firms were previously only allowed to buy back shares for more limited purposes, and had to get shareholder approval.

China will encourage buybacks by listed companies, its securities regulator said yesterday. The new law allows companies to react much faster during market corrections, China Galaxy Securities wrote in a report on Monday, adding that long processing times made it less common for firms to conduct buybacks compared with those overseas.

Should the shares of Evergrande and other developers crater through key technical levels, I would regard such a development as the breach of the last redoubt of Beijing’s market support policies. It would be a signal that the dam has broken, and events are spiraling out of control.

The week ahead

Looking to the week ahead, the market will be focused on the midterm elections on Tuesday. While the expectation is for the Democrats to control the House, and the Republicans to control the Senate, anything is possible. One outlier forecast from Rachel Bitecofer of the Wason Center for Public Policy is predicting a Democrat pickup of 47 House seats, which would mean a Blue Wave that puts the Democrats’ control of the Senate within reach. On the other hand, Dilbert creator Scott Adams, who correctly called the Trump win, believes that the Republicans could see a surprise victory by keeping control of both the Senate and House.

In addition, the FOMC meeting on November 7-8 could be a source of volatility. It is difficult to believe that the Fed would stray from its steady course to raise rates in light of last week’s solid October Jobs Report. The Fed will also have the JOLTS report as a source of guidance.

From a technical perspective, the primary trend for stock prices is now down. I had highlighted the marginal monthly MACD sell signal on the Wilshire 5000 in my last post (see Tricks or treats for equities). As MACD is a momentum indicator, advancing the calendar by even an incomplete month starkly shows the effects of momentum deceleration. The MACD histogram reading is far more visibly negative, and it would take a powerful rally in the month of November to negate the October sell signal.

Urban Carmel also observed that, as of October 31, the SPX had fallen below its 10 month moving average, which triggers Meb Faber’s signal to de-risk and sell equities. Here is what happened next.

Using data from the last 38 years, there is an even chance that SPX reverses direction and moves higher from here over the months ahead. But the October low – or very close to it – appears likely to be retested in November…

Watch out for the short term – is this: the recent low at 2603 on October 29 is likely to get retested.

In our SPX charts above, note the green highlights in 1985 and 1986. These are the only two dates [out of 21 instances] when the “sell month’s” low was not revisited within 1%. In 1985, the next month’s low was 1% higher and in 1986 it was 1.4% higher. In 91% of these 21 instances, the next month either closed lower or the intra-month low was within 1% of the “sell month’s.” Ignoring contrary evidence (described most recently here), that implies a very high likelihood of SPX trading back down to at least 2640 in the weeks ahead (1.4% above 2603), perhaps even lower. That is 2.7% below today’s close.

Subscribers received an email alert indicating that my trading account was shorting the market Friday morning. The AAII sentiment survey, which was published on Wednesday, saw a surge in bullish sentiment, which is too far, too fast.

Tactically, the index should decline to fill the gap at 2685-2705. If it were to fall further and test the previous lows, as per Urban Carmel’s analysis, then I would watch for an upside penetrate of the upper Bollinger Band by the VIX Index. As well, monitor the level of new 52-week lows (bottom panel) as a sign of breadth confirmation or divergence on a test of the October lows.

In the short run, breadth indicators are turning down from an overbought condition, which is a sell signal.

My inner investor has already de-risked his portfolio. My inner trader went short the market near the open on Friday, and he is anticipating further downside ahead.

Disclosure: Long SPXU

Tricks or treats for equities?

Posted by Cam Hui - October 31, 2018

Mid-week market update: Will investors get tricks or treats this Halloween?

Here is the good news. The sentiment backdrop was sufficiently washed-out for a reflex rally to occur. For some perspective, I refer readers to Helene Meisler’s recent Real Money article:

Long time readers know I am not known for my sunny disposition when it comes to markets. I am a contrarian; when we’re going up, I look for what can take us down and when we’re going down I look for what can reverse us back up.

But it struck me when I took the mute off the television on Monday how really bearish everyone was. All of a sudden no one is interested in buying the dip. No one is even interesting in “picking.” All of a sudden everyone is talking about at least a revisit of the February lows or more.

Remember when there were targets on the upside of 3,000 or 3,200? Now I see 2,300 or 2,200 coming out. We might get there but I find it fascinating that many of the new found bears all of a sudden want to buy the market lower.

SentimenTrader also observed that flows into inverse Rydex mutual funds have gone off the charts, and such readings have tilted heavily bullish historically.

Here is the bad news. Despite the two-day snapback rally, my models have flashed two long-term sell signals.

MACD sell signal

I warned about a negative monthly RSI divergence in August (see Market top ahead? My inner investor gets cautious). At the time, I did not notice that past negative divergences were accompanied by MACD sell signals. As we close the book on the month of October, the MACD sell signal has arrived.

I prefer to use the Wilshire 5000 as it represents a broad index of the US equity market, but the monthly SPX also flashed a MACD sell signal.

Don’t forget that we already saw a MACD sell signal for global stocks in July.

This is the first indication that the cyclical top is in for this equity bull. If history is any guide, the market is unlikely to rally back to a new high after the combination of a negative monthly RSI divergence and a MACD sell signal.

Bank Index sell signal

As well, I identified another bearish tripwire in the form of the relative performance of bank stocks (see A correction, or the start of a bear market?). The KBW Bank Index (BKX) broke a key relative support level at the end of September, but recently rallied back to test the breakdown level. The relative performance of the regional banks (KRX) has fared far worse.

This chart shows the longer term historical context of this technical breakdown. In the past, KRX relative returns have either been coincident or led BKX returns, and such episodes have been ominous signals for stock prices in the past.

I initially viewed this signal with some skepticism. The poor performance of bank stocks is not showing up in measures of financial stress. Neither the Chicago Fed National Financial Conditions Index nor the St. Louis fed Financial Stress Index are very elevated and readings remain relatively benign. However, the analysis of past technical breaches of the BKX/SPX ratio shows that bank stock relative performance has led deterioration in the regional Fed’s financial condition indices.

Joe Wiesenthal at Bloomberg also recently highlighted the high degree of correlation of the relative performance of Utilities compared to the Goldman Sachs Financial Conditions Index, whose stress levels are rising.

The combination of these signals indicate that we have likely seen the stock market top for this bull cycle, and a bear market is about to begin.

What’s next?

How individuals react to such a signal depends on their time horizon. Bear markets are volatile, and stock prices don’t go down in a straight line. The market remains oversold and it appears to be undergoing a relief rally.

Investors with long horizons should be lightening up their equity positions on rallies, and target a minimum equity weight in their portfolios. Traders, on the other hand, should be positioning themselves for the inevitable bounce.

It may be instructive to see how the market behaved when stock prices began to roll over during the last two market tops. Consider the 2000 market top. The market rallied about 7% after flashing the MACD sell signal. It continued to rise in a choppy fashion and tested the old high before falling back to exhibit an oversold condition. The subsequent rally took the index back up to the 40 week moving average (wma), which is roughly equivalent to the 200 dma.

The 2007 top was slightly different. The market made a 5% rally after the monthly MACD sell signal. Unlike the 2000 experience, it did not rally up to test the old high, but cratered to flash an oversold signal, made a feeble rally, fell further, but eventually rose up to the 40 wma.

As they say, history doesn’t repeat itself, but rhymes. Current market conditions are somewhat unusual inasmuch as stock prices fell rapidly and in a short time after the market made an all-time high. The SPX is now exhibiting an extreme oversold condition, as defined by its 5-week RSI, and a breach of its weekly Bollinger Band. In the past, such oversold conditions did not coincide with MACD sell signals, but generally occurred afterwards.

Assuming that a bear market has begun, a reasonable initial upside target for an oversold rally is the 200 dma, which stands at about 2765. If the index were to reach that level, I would then re-evaluate market conditions before taking further action.

Reflex rally = Bull trap?

There are a number of other warning signs that the reflex rally is unsustainable. Marketwatch reported that technical analyst Jeff deGraaf is unimpressed with the current rally:

Technical analyst Jeff deGraaf is unimpressed with the current attempt by stocks to punch higher after a sharp rally on Tuesday an apparent follow through in early Wednesday action.

The chairman of research firm Renaissance Macro Research suggests that a lack of real volume and breadth, or more sectors getting involved in the recent turn higher, has left him wanting more after a withering October…

“A sigh of relief fell over the street as the losing streak for equities abated near support at 2600 on the SPX. We’d classify the rebound as ‘uninspiring’ where TRIN was a useless .61 and breadth a mediocre 2.2:1,” he wrote in a Wednesday research note. TRIN refers to a short-term technical trading indicator, developed by the late Richard Arms in the 1970s, that tracks volume in advancing and declining stocks.

In other words, where`s the breadth thrust?

As well, OddStats ran historical analysis showing what happened when a negative month but the last two days are up least 1%.

Finally, Knowledge Leaders Capital suggested that the market may be insufficiently washed out for a durable bottom. Even if this is a minor pullback and not a major bear market like 2011 or 2015, breadth indicators need to become more oversold indicating liquidation before the market can mount a sustainable rally to new highs.

My inner investor has already de-risked his portfolio to his minimum equity portfolio weight. My inner trader took profits on his long positions and went to cash today. He expects to re-enter his long position after a pullback later this week.

Contrarian ideas for a relief rally

Posted by Cam Hui - October 29, 2018

There are good reasons to believe the market is poised for an oversold rally. As I pointed out in my last post (see How this Bear could be wrong: Exploring the bull case), the SPX is testing a key uptrend line that began in the market bottom of 2009. Initial trend line tests rarely fail, which is supportive of the bounce scenario. In addition, the market is exhibiting oversold conditions on both the 5-week RSI (top panel), and the NYSE McClellan Summation Index (NYSI, bottom panel). Such conditions have resolved themselves with relief rallies, outside of major bear legs. Even the initial downlegs of the 2007-08 bear market saw oversold rallies after the market reached such oversold conditions.

Here are a few contrarian suggestions of beaten up investment themes for an oversold rally, should it occur on a sustainable basis.

The Trump trade

As the US approaches the midterm elections, the consensus is that the Democrats take control of the House while the Republicans retain control of the Senate. The latest FiveThirtyEight forecast shows that the Democrats have a 6 in 7 chance of controlling the House.

While the Senate forecast shows that the Republicans have a 5 in 6 chance of retaining control.

While a Democrat controlled House will make political life impossible for the Trump administration, as there will be endless hearings and subpoenas, starting with Trump’s tax returns, such political waves in Washington are unlikely to have significant market impact.

At the same time, as the Republicans’ political hopes of controlling Congress faded over time, the Trump trade has steadily underperformed the market, as measured by the MAGA ETF. While I am not a fan of highly specialized ETFs, the Point Bridge GOP Stock Tracker ETF (MAGA) serves to highlight some important points on the market views about political sentiment. The ETF holds equal-weighted positions in the top 150 stocks “within the S&P 500 that are highly supportive of Republican candidates for federal office including President, Vice President, Congress and other Republican Party-affiliated groups as determined by a rules-based methodology.”

The chart shows the market relative performance of MAGA, which has been steadily underperforming since May. Further analysis of MAGA’s sector exposures reveal large overweight positions in industrial and energy stocks, and a severe underweight in technology.

The chart below shows the relative weight of the ETF by sector. Industrial and energy stocks are overweight by roughly 10%, while the ETF had a zero weight in technology, which led to an underweight position of slightly over 20%.

While this is highly speculative, could the MAGA trade see a relief rally after the midterm election? While I would not recommend buying the ETF because of its illiquid characteristics, as its market cap is only $40 million and it only trades about 2,000 shares a day, its overweight positions in industrial and energy stocks hold some promise.

The chart below depicts the market relative performance of US industrial and energy stocks (black lines), as well as the market relative performance of European industrial and energy stocks (green lines). Historically, US and European equity factor performance has been closely correlated, but divergences are appearing in both of these sectors. European industrial and energy stocks are performing much better against their market compared to the American counterparts.

One explanation of the relative performance differential could be the Trump factor. In that case, could the midterm election be a trigger for a convergence?

A small cap revival?

A less controversial idea is the revival of small cap stocks. The small cap Russell 2000 is testing a key relative support level, while exhibiting a positive RSI divergence. If the market were to rally, small cap stocks represent a high-beta group that has the potential to outperform.

In conclusion, the US equity market is poised for a rally. Should the strength be sustainable, industrial, energy, and small cap stocks may be sufficiently washed out to see above average rebounds.

The S&P 500 lost ground today but it continued to exhibit a positive RSI divergence. These conditions are constructive for a rebound and therefore these contrarian buy themes remain in play.

How this Bear could be wrong: Exploring the bull case

Posted by Cam Hui - October 28, 2018

The latest signals of each model are as follows:

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

How I could become bullish

Three weeks ago, I explored the likelihood of a recession in 2020 and concluded that while my panel of recession indicators were not bright red, they were flickering (see A recession in 2020?).

I have been increasingly cautious about the equity outlook since August (see 10 or more technical reasons to be cautious on stocks and The macro risks that keep me awake at night). My call for caution has been correct so far. The latest update from John Butters of FactSet shows that the market is not responding to good news during Q3 earnings season. Stocks that beat expectations saw their prices fall at a level that was last seen in 2011. This is all occurring when the EPS and sales beat rates are either average or slightly average compared to their 5-year averages.

The negative stock price response to EPS beats cannot be attributable to a negative overall tone to the market. As the chart below shows, companies that have beaten expectations performed slightly worse than ones that reported in-line, while companies that disappointed were punished.

Here is what’s bothering me. A recent Bloomberg article indicated that two-thirds of business economists expect a recession by the end of 2020. .A 2020 recession is becoming the consensus call, and being in the consensus makes me highly uncomfortable. While I recognize that recessions have historically been bull market killers, what if the consensus is wrong?

Here are some possibilities that could turn me bullish. While I remain cautious on stocks and these do not represent my base case scenarios, any of these outcomes could make me more constructive on equities.

The Fed achieves a soft landing

Here is one way that stocks could avoid a bear market. What if the Fed were to achieve its fabled soft landing? Indeed, the Fed is nearing its dual goal “sweet spot” of low inflation and unemployment.

New Deal democrat, who monitors high frequency economic release and categorizes them into coincident, short leading, and long leading indicators has been calling for a slowdown next summer, though he is not forecasting a recession (see Is a summer 2019 slowdown beginning to show up in the short leading forecast?). He confirmed that outlook in his latest weekly monitor of high frequency economic indicators and found weakness in all coincident, short leading, and long leading indicator time frames [emphasis added]:

We now have weakness showing up in all timeframes. The long leading forecast has been fluctuating recently, and for the second week is neutral…The weakness has now spread to the short-term forecast, which as of this week I’m downgrading from positive to neutral…Finally, I’m also downgrading the nowcast to a weak positive, due mainly to the impact of tariffs, which has shown up in a swift decline in rail loads. An economic slowdown looks baked in the cake, with the issue of whether it leads to outright recession in a year or so still outstanding.

As well, the price trend of 3M, which is a global conglomerate bellwether, has acted as a good leading indicator for both ISM and Markit M-PMI, and it is suggesting a slowdown in growth.

While the current median dot plot is penciling in three more rate hikes in 2019, the market is expecting between two and three hikes.

What if the Fed were to recognize the incipient weakness and pause its rate hikes? What if we were to see only one or two hikes in 2019? Historically, the Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, has a seasonal tendency to be weak in the first half, and usually in Q1. If this pattern were to repeat itself in 2019, the Fed could see the growth outlook decelerate sharply early next year, and begin to react by Q2 or Q3.

So far, inflation expectations are very stable and well-anchored, which would give the Fed comfort that an easier monetary policy would not see inflation and inflation expectations spiral out of control.

While this is not my base case scenario, such an outcome is possible – if the Fed were to react in time to a slowing economy.

More fiscal stimulus: Tax Cut 2.0?

I am indebted to Kevin Muir, otherwise known as The Macro Tourist, for the following idea. What if we were to see another round of fiscal stimulus around the world? Wouldn’t that reduce the likelihood of a recession in 2020?

In the US, the stimulus effect from the last round of fiscal stimulus is fading.

That doesn’t preclude another round of fiscal stimulus. President Trump has trumpeted the possibility of another tax cut during the midterm election campaign. Steve Collender (@thebudgetguy) has laid out how the Republicans could pass another tax cut:

When House Republicans passed their tax 2.0 last week and then recessed until the lame duck session that begins this November, the presumption was that this latest GOP descent into bigger budget deficits was nothing more than a pre-election ploy that would never go any further.

And with Majority Leader Mitch McConnell (R-KY) saying that the Senate had no plans to take up whatever the House passed before the election, that seemed like a safe bet.

But contrary to what’s currently being assumed, 2.0 could definitely become law this year.

The legislative road to another tax cut is difficult, but not impossible during the lame duck session of Congress:

First, the House and Senate would quickly have to adopt a fiscal 2019 budget resolution with reconciliation instructions that require the 2.0 tax changes.

Second, the House-passed 2.0 would have to be designated as the legislation required by the just-adopted budget resolution’s reconciliation instructions or the House would need to re-pass 2.0.

Third, with a simple majority, the Senate could either pass its own 2.0 or…and much more likely…pass the House-adopted bill.

Fourth, the 2.0 bill now adopted by the House and Senate would then go to the president for his signature and enactment.

I am not holding my breath for tax cut 2.0 to be enacted, but I would not dismiss the possibility either.

European fiscal stimulus: Italy leads the charge?

In Europe, Kevin Muir suggested that the battle over the Italian budget opens the door to dragging the EU into a round of fiscal stimulus. The Italians had proposed a budget that amounts to 2.4% of GDP, which is a level that Americans would envy.

Antonio Fatás, professor of economics at INSEAD, recently indirectly supported the Italian view by stating that European fiscal policy is too procyclical and inflicting damage on the economy:

The question of how procyclical fiscal policy affected economic performance in the euro area has been controversial, with seemingly never-ending debates on the size of fiscal policy multipliers. The work of Blanchard and Leigh (2013) was an inflection point in this debate. They provided convincing evidence of large short-term multipliers in response to the fiscal consolidation during 2010 and 2011. Their work also suggested that policymakers had underestimated the size of the multipliers, making fiscal policy even more procyclical.

Building on this work, in a recent paper Larry Summers and I showed evidence that these damaging effects have persisted (Fatás and Summers 2018). Looking at forecasts to 2022, GDP is still affected by the consolidation of those early years. This is consistent with a view that hysteresis has turned procyclical policy into permanent scars on GDP.

Procyclical fiscal policy was leading to an “economic doom-loop”:

We are describing a situation in which policymakers start with unfounded pessimistic views about potential GDP. They take fiscal policy actions based on these views. Policymakers ignore both the actual size of the short-run fiscal policy multiplier, and the possibility that both the initial cyclical shock and the effects of their policies create hysteresis.

Because they underestimate multipliers, the short-term effects of their policies are a surprise. They downgrade, once again, estimates of potential GDP and engage in a second wave of fiscal consolidation. The tragedy is that as policymakers act on their pessimism about potential, the cyclical effects of their policies become permanent through hysteresis. As a result, their forecasts become true partly because of the effects of the policies they designed in response. This is self-fulfilling pessimism.

The final outcome is an economy whose potential output is significantly lower because of successive downward revisions (Figure 3). The effects of the earlier decisions are amplified through successive rounds of procyclical policy. This reduces GDP forecasts until 2022.

CNBC reported that the mob is gathering against Brussels. Budget discipline wasn’t just slipping in Italy, but France, among others:

France, the second-largest economy in Europe, received a letter from Brussels last week, warning that its planned debt reduction in 2019 does not respect the proposals that Paris had agreed previously with the EU. Spain, Belgium, Portugal and Slovenia were also effectively told off by the EU.

In the case of France, the 2019 budget plan sees its structural deficit (the difference between spending and revenues, excluding one-off items) falling 0.1 percent this year and 0.3 percent in 2019. Paris had agreed in April to an annual reduction of 0.6 percent of GDP (gross domestic product) for its structural deficit.

How much longer can the Growth and ~~Stupidity~~ Stability Pact survive?

Tax cuts in China

In China, the authorities are trying something different from their usual stimulus script of infrastructure-driven growth. The WSJ reported that Beijing is proposing 2019 personal tax cuts that could amount to 1% of GDP:

Beijing could enact tax cuts and other measures for 2019 equivalent to over 1% of GDP, according to Ma Jun, a former chief economist at China’s central bank. If true, that could surpass last year’s U.S. tax relief as a proportion of economic output.

Beijing’s old stimulus methods of monetary-policy easing and higher local-government spending are looking tricky to implement this time. Banks are weighed down by bad loans, while local-government-owned fundraising companies are groaning under debt of up to $6 trillion, according to Rhodium Group estimates.

There may be some cause for optimism. Callum Thomas of Topdown Charts reported that Chinese property prices, which is a sensitive barometer of the health of the Chinese economy, is on the mend. In particular, non-tier 1 cities real estate prices are beginning to recover again, which could take the tail-risk of a property collapse off the table.

In conclusion, will any of this fiscal stimulus work, either in China or the rest of the world? Deficits hawks will recoil at the rising level of spending, but investors will recognize that stimulus will have the effect of kicking the can down the road. Whether the can kicking exercise will improve the long-term growth outlook is intermediate-term irrelevant. It will have have the effect of avoiding a 2020 recession, and therefore limit equity downside risk in the next year.

Uncomfortable questions

In spite of the forgoing analysis, I believe the scenarios of a Fed-driven soft landing, or the re-emergence of a round of fiscal stimulus, are relatively low probability events. Even if we were to accept such possibilities, the bulls have to answer some uncomfortable questions about the headwinds facing stock prices.

In the US, the markets are expressing considerable skepticism about the growth outlook. I warned in August about a negative monthly RSI divergence in the Wilshire 5000, which is the broadest index of US equities. In the past, similar negative divergences have been accompanied by MACD crossover sell signals (vertical line). The recent weakness in the stock market has driven the MACD histogram negative. An October month-end close at this level would flash a sell signal, which has been an infallible forecaster of further equity market weakness.

In Europe, Nordea Markets pointed out that Sweden is a small open economy and therefore a leading indicator for eurozone growth. The latest reading of Swedish PMI shows further weakness. Could fiscal action, even if it were to be enacted, arrive in time to arrest the likely weakness?

In China, the tax cut proposal is not showing up in real-time signals from my China rebalancing theme, as measured by the long New (consumer) China ETF and short Old (finance and infrastructure) China ETF pairs for quite some time. The two pairs consist of long Invesco Golden Dragon China (PBJ) and short iShares China (FXI), and long Global X China Consumer ETF (CHIQ) and short Global X China Financial ETF (CHIQ). As the chart below shows, New (consumer) China continue to dramatically underperforming Old (finance and infrastructure) China.

Lastly, what about the global effects of the Brexit and the trade war? Marketwatch reported that UBS estimates the combination of a hard Brexit and the Sino-American trade war could raise tariffs to levels not seen in 15 years. What would that do to global growth?

In conclusion, the bullish path that I have laid out is part of any good scenario analysis performed by analysts to measure the risks to their forecasts. While these bullish resolutions are possible, and I am maintaining an open mind as to possibilities, I continue to believe a bearish resolution is the most likely resolution outcome.

No, the market isn’t going to crash

Subscribers received a series of email alerts last week that resolved with a Trifecta buy signal near the close on Wednesday. When the market turned around and rallied strongly on Thursday, I received a series of congratulatory messages and virtual high-fives. While I was appreciative of the compliments, I thought that the sentiment backdrop had turned bullish a little too quickly, and the bottom may not be in.

When stock prices cratered at the open on Friday, the messages had turned to “maybe your model should have sold on Thursday.” There were a number of questions asking for comparisons of current market conditions to past market crashes.

Let me assure everyone. The market is not crashing. This is not 1987. To be sure, the market top in 1987 was preceded by technical deterioration, just as it was evident prior to the current downturn. However, there was one key difference. In 1987, the Fed made several staccato-style rate rapid hikes in order to defend the US Dollar. Fed policy is far less aggressive today.

This is also not 2008. The Crash was 2008 was a financial crisis. There are few signs of financial stress in the US banking system today.

That said, stress levels are elevated in China. I recently identified a number of bearish tripwires (see The storm brewing in Asia). In particular, the share prices of property developers are particularly sensitive canaries in the Chinese coalmine.

For some perspective, I refer readers to an FT Alphaville profile of China Evergrande:

It boasts an enterprise value of $145bn. In the first half of the year it generated $44bn of revenues and $4.5bn of profits, paying out half in dividends. It has $98bn of debt, $44bn of it due within the next twelve months.

The answer is China Evergrande, a real estate kraken with tentacles stretching across China. It does all things property including development, investment, management and construction, along with a host of smaller ventures in technology, finance and healthcare.

That reach makes some of the numbers mind boggling, particularly when it comes to the company’s debt. For instance, it paid $4.2bn of interest over the first six months of 2018 — more than the revenues of 259 of the S&P 500’s constituents in the same period, according to S&P Capital IQ.
fell.

Here is the latest chart of China Evergrande (3333.HK), which we find constructive for two reasons. First, the stock has not broken major support, which is a positive sign. In addition, the stock rose on Friday (October 26, 2018) even as the Hang Seng Index.

In addition, the shares of other Chinese developers with problematical chart patterns, such as Greentown China (3900.HK), are also holding key support levels.

Do you feel better now?

The week ahead: Navigating volatility

Looking to the week ahead, volatility is obviously elevated and navigating the volatility will be a challenge for both investors and traders. I will begin my analysis that begin with a longer term perspective, followed by shorter and shorter time frames.

The market is seeing a rare oversold condition that has historically been resolved with oversold bounces. I highlight the following conditions from the chart below. First, the S&P 500 is testing a key uptrend line that began in the market bottom of 2009. Initial trend line tests rarely fail, which is supportive of the bounce scenario. In addition, the market is exhibiting oversold conditions on both the 5-week RSI (top panel), and the NYSE McClellan Summation Index (NYSI, bottom panel).

Bottom line: This kind of market action is evident either at the end of corrections, or at the beginning of bear markets. Even if this is the start of a bear market, stock prices have rallied first before falling again. Even the initial downlegs of the 2007-08 bear market saw oversold rallies after the market reached such oversold conditions.

In addition, the latest update from Open Insider show that insiders have been engaged in sustained buying of the shares of their own companies. While the action of these “smart investors” are not tactically useful as a short-term timing signal, this is nevertheless constructive for equity prices.

The NAAIM Exposure Index, which measures the sentiment of RIAs, is showing signs of panic. As the chart below shows, past breaches of the lower weekly Bollinger Band by NAAIM sentiment have been low risk long entry points.

In the short-term, the market is poised for a relief rally. The S&P 500 is exhibiting a series of positive RSI divergences while testing long-term trend lines. The longer term question is price behavior once the rebound occurs. The first test of resistance is the 200 dma, which stands at roughly 2767. That will be the first test for the bulls.

Friday’s trading saw the unusual combination of a large drop in the S&P 500 of -1.7% while the VIX Index also fell. I went back to 1990 and found that this was quite rare (N=14). As the chart below of cumulative returns shows, such events have typically seen a 1-2 day rebound, pullbacks in days 3-4, followed by rallies out to a four week time horizon.

The % positive metric comes to a similar conclusion, though the success rate on day 2 is less certain.

My inner investor had been de-risking since August and he is trying to suppress a “I told you so” smirk. My inner trader bought into the market last Wednesday in anticipation of a relief rally.

Disclosure: Long SPXL

How short-sellers can get hurt in a bear market

Posted by Cam Hui - October 25, 2018

This is a cautionary tale about the importance of return objectives and risk control. Regular readers know that while my trading model has not be perfect, it has been quite good for swing trading purposes.

So far in the month of October, my main trading account is up 7.1%, while the SPY is -7.1%. I don’t write this to brag, but to illustrate a point. A secondary account that trades the exact same signals, but uses a more aggressive leverage ratio, underperformed at 5.2%.

This brings up my point about defining return objectives and risk control.

Short is not the opposite of long

Let’s start with the basics. A short position is not the opposite of a long position. David Merkel at Alphe Blog correctly pointed out the key differences:

I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited. It is really a hard area to get right.

Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long. If you just hold stocks, bonds, and cash, no one can ever force you out of your trade. The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment. Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.

Short sellers also have an extra portfolio construction problem when it comes to the dynamics of position sizing. If you are right in your short decision, you have to short more stock as the stock goes down in order to maintain that position`s percentage weight in the portfolio. This issue is especially acute when managing long-short, or equity market-neutral, portfolios. Otherwise, the sizes of the long and short positions will be off balance.

Bear markets are more volatile

Short-sellers who take a directional, rather than hedged bet, face a different problem. If you make a directional bet that a stock or an index will fall, you will benefit if the market is undergoing a bear phase.

The follow observation may sound obvious, but bear markets are more volatile than bull markets. The chart below shows volatility, as measured by the VIX Index, has tended to spike when returns fall (bottom panel).

It was the higher volatility effect during bear phases that accounted for the lower return of the account that used a higher leverage. Even though the buy and sell decisions were mostly correct, the combination of slightly bad timing of a day or two early at inflection points, and the dynamic leverage varying trading system of the more aggressive account resulted in subpar returns.

This episode illustrates an important lesson for investors. Portfolio managers have two main decisions to make. What do you buy and sell, and how much do you buy and sell?

Both accounts had the same buy and sell decisions, but varied on positions sizing and timing. The main account took smaller positions, changed position sizes based decisions to either average down, or to selectively take partial profits. The more aggressive account took bigger initial positions, and found that when it came time to add to them, it was already at its maximum position size.

Sometimes less is more.

Lessons learned

My recent experience has led to several key takeaways:

Know your returns objectives: Investors need to know that outside of war and rebellion that cause the permanent loss of capital, equities perform well and a long equity position will yield superior returns in the long run. Under such conditions, investors can improve portfolio performance merely by sidestepping bear markets. In other words, some people don`t have to short the market. Holding cash, or an uncorrelated asset class like bonds, may be enough. You don’t have to be a hero and unnecessarily stick your neck out. It depends on your return objectives.

Bear markets are more volatile: If you want to short the market, understand that even if you are right, the environment will be more volatile. Reduce your position sizes accordingly.
Counter-trend position are riskier than trend positions: Traders can realize good profits on calling the primary trend. Counter-trend moves, by contract, tend to be more brief and therefore riskier. Adjust counter-trend positions in accordance risk levels.

Live and learn. I have re-aligned the risk management practices of the second underperforming account to conform with those of the first account.

Defensive and Value leadership = Bear market?

Posted by Cam Hui - October 23, 2018

Mid-week market update: I am publishing my mid-week market update early in light of the recent market volatility.

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

RRG analysis through a style, or factor, lens. Growth styles have been weak and they are located in the bottom half of the chart. By contrast, value styles such as dividend growth, high quality, large cap value are ascendant.

The RRG chart through a sector rotation lens tells a similar story. High beta sectors, such as technology, communication services, and consumer discretionary stocks are in the bottom half, indicating weakness. By contrast, defensive sectors such as healthcare, utilities and consumer staples are strong.

This kind of market action can be interpreted in two ways. On one hand, it is not unusual to see defensive sectors become the sector leaders during a market pullback. Once the bulls regain their footing, the high beta sectors can regain their footing and lead the market upwards again. On the other hand, the emergence of defensive and value leadership can be a signal of a regime shift where the bears are slowly taking control of the tape.

A value revival?

We can see signs of a reversal in the relative performance of growth and value stocks. The Russell 1000 Value to Russell 1000 Growth ratio bottomed recently while exhibiting a positive RSI divergence. Does this mean value is beginning to turn up?

Rising defensive leadership

The emergence of defensive sectors is actually global in nature. Callum Thomas of Topdown Charts documented how the cyclical to defensive performance ratio has been rolling over all around the world. The US is just a little late to that party.

Bespoke also analyzed cyclical to defensive performance in two ways. The consumer discretionary to consumer staples ratio recently peaked at what may be a cycle high. The last peak occurred in March 2000, which coincided with the top of the NASDAQ bubble.

The technology to utility stock ratio looks even more ominous and speaks for itself.

The bifurcation of the high beta vs. defensive stocks is evident within sectors as well. The chart below shows the relative performance of healthcare stocks and the relative performance of biotechs, which are part of the healthcare sector. The two have been tracking each other closely until early September, when the main healthcare sector began to outperform the market while the high beta biotech stocks lagged.

What the bulls have to do

The sector weighting chart shows the challenges facing the bulls. While healthcare is the second large weight in the index, other heavyweight sectors such as technology, financials, consumer discretionary, and communication services have been weak. How can the index rise in the face of such weakness?

Callum Thomas also highlighted this rather ominous analysis showing the long-term earnings growth expectations from IBES. Are these growth estimates sustainable in the face of the poor relative performance of cyclical vs. defensive sectors?

These growth projections are occurring during a backdrop when the fiscal stimulus boost from the tax cuts are starting to fade.

From a bottom-up viewpoint, the benefits of the tax cut to earnings growth is expected to shrink dramatically in 2019. As well, investors shouldn’t expect similar boosts from factors such as revenue growth and margin expansion.

Is the bull dying?

None of this means that investors should panic and sell everything right away. While there are some technical warnings, we don’t have a definitive sell signal just yet. CNBC reported that strategist Jim Paulsen of Leuthold Group indicate that the market may need a 15% gut check in order for the bull to continue:

“My guess is that we’re going to have a bigger correction than we’ve had yet,” said Paulsen on CNBC’s “Trading Nation” on Friday.

“I think a good gut check to sentiment, like a 15 percent correction, might be just the ticket to extend this bull market,” he added.

Paulsen told CNBC a correction is necessary to reflect a changing market environment where rates are on the rise, earnings are peaking, and economic growth might slow.

“What we need is a lower valuation, I think, to sustain a different environment if this recovery is going to continue,” he said.

“I don’t think we can handle that environment at 20-some-times trailing earnings, probably more like 15 to 16 times trailing earnings and we’re a ways from that,” the investor added.

In other words, the market needs a correction in order to have a valuation reset. Paulsen went to recommend that investors rotate into more defensive sectors, and I concur:

“It’s probably time to get more defensive and not have as much octane on from here as you have earlier in this bull market,” said Paulsen, highlighting safety sectors such as utilities, staples, and real estate investment trusts (REITs) as good bets in this environment.

From a technical perspective, here is the test for the bulls and bears. The McClellan Summation Index is at levels consistent with bounces if this is a pullback within a bull market, but it could fall further if a bear market has begun.

In short, the market is short-term oversold and poised for a bounce, if the primary trend is still bullish. If the trend is indeed changing, then the market is insufficiently oversold to bounce. Watch to see if the oversold rally materializes. If it does, watch the evolution of sector and style leadership. Can the high beta and high octane sector regain the upper hand?

Those will be the key tests for the bulls and bears in the days to come.

Disclosure: Long SPXU

The brewing storm in Asia

Posted by Cam Hui - October 21, 2018

The latest signals of each model are as follows:

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

Looking for the risk in the wrong places?

Waiting for China to report its Q3 GDP growth used to be not very suspenseful. Is it going to be 6.7%, which was the last report, or will they allow it to fall to 6.6%, which is the market expectation? As it turned out, Q3 GDP came in at 6.5%, which was below market expectations, and a possible signal of acute weakness in the Chinese economy.

Notwithstanding the highly manipulated economic statistics coming from China, I have been monitoring the real-time signal of the China rebalancing theme using my long New (consumer) China ETF and short Old (finance and infrastructure) China ETF pairs for quite some time. The two pairs consist of long Invesco Golden Dragon China (PBJ) and short iShares China (FXI), and long Global X China Consumer ETF (CHIQ) and short Global X China Financial ETF (CHIQ). As the chart below shows, New (consumer) China has been dramatically underperforming Old (finance and infrastructure) China.

To add insult to injury, Old China is also performing badly on an absolute basis. Last week, I outlined a number of disparate real-time bearish tripwires (see A correction, or the start of a bear market?). Most of the indicators focused on either US or global macro factors. One was the share of major Chinese property developers because property prices are sensitive barometers of financial stress, and rising financial stress would be especially important in light of the high degree of leverage in the Chinese financial system.

The share prices of Chinese property developers are weakening, and in some cases breaking down technically. When I focused on US indicators, I may have been looking for risk in all the wrong places.

Cracks appear in the China real estate

A recent FT article illustrates the high level of dependency that the Chinese economy has to real estate:

The property sector is estimated to account for 15 per cent of China’s gross domestic product, with the total rising closer to 30 percent if related industries are included. A downturn would add to financial strains on China’s heavily indebted property developers which paid record sums for land during auctions last year but are now struggling to recoup their investment.

Other evidence of a downturn is starting to emerge. Sales by floor area dropped 27 per cent year on year during the “golden week” national holiday earlier this month a peak period for house buying in China, according to research house CRIC, which tracks 31 cities.

Although average new home prices in China’s top 70 cities grew 1.4 per cent in August, the last month for which official figures are available, analysts say falling sales mean a period of price cuts has begun.

Since financial statement quality can be *ahem* dubious in China, lending is mainly based on asset value, and land constitute roughly 40% of collateral in total lending. If property developers were to cut prices, it would have an immediate effect on the health of the financial system. It was therefore no surprise that protests against price cuts have arisen across China:

A wave of protest by Chinese homeowners against falling property prices in several cities has raised fears of a downturns in the country’s real estate market, adding to pressure on Beijing to stimulate the economy.

Homeowners in Shanghai and other large cities took to the streets this month to demand refunds on their homes after property developers cut prices on new properties to stimulate sales.

In Shanghai, dozens of angry homeowners descended on the sales office of a complex that offered 25 per cent discounts to demand refunds, causing clashes that damaged the sales office, according to online reports that were quickly removed by censors. Similar protests have been reported in the large cities of Xiamen and Guiyang as well as several smaller cities.

As official statistics from China tend to be unreliable, I rely on indirect real-time market-based indicators for clues to the healthy of the economy. Here are the shares of China Evergrande Group (3333.HK), which is one of the largest property developers in China. The stock is resting at a key support level.

Here is China Vanke (2202.HK), which is in a downtrend and broke a support level.

The chart of Greentown China (3900.HK) looks downright ugly.

Country Garden (2007.HK) also broke support and it is in freefall.

You get the idea. The share prices of Chinese property developers have all broken support, with the exception of Evergrande, which is testing a key support level. All are in major or minor downtrends. They only recovered on Friday after the authorities verbally intervened, as reported by the Asian Nikkei Review:

Chinese financial regulators on Friday provided verbal support to ease unrest in the markets. People’s Bank of China Yi Gang said the central bank is studying some targeted measures to ease financing difficulties of companies. Guo Shuqing, chairman of the China Banking & Insurance Regulatory Commission, said separately that systemic financial risks were “totally controllable” and that the recent market turmoil is “seriously out of line” with economic fundamentals.

I am watching if the strong stocks like Evergrande (3333.HK) break support, or the weak stocks like Greentown (3900.HK) breaks its long-term support and test its 2011 or GFC lows. That will be a sign that the authorities have lost control and China’s economy is undergoing a disorderly unwind.

A weakening economy

The softness in property prices is occurring against the backdrop of a weakening economy. Seven out of 10 of Fathom Consulting’s CMI 2.0 Indicators, which is an array of indicators that monitor the economy, are falling. Only one out of the 10 is rising, real exports, but the increase could be attributable to a surge from a “beat the tariffs” effect that is likely to be given back in the next few months.

The Epoch Times reported that China Beige Book, which monitors the Chinese economy through a myriad of bottom-up sources, had some good news and bad news about China. The good news is Q3 was not as bad as it looks:

China Beige Book’s broader gauges of capital expenditure show that in the third quarter investment spending expanded faster in most sectors, not surprisingly led by key industries in the new economy.

Consumption trends are another area of misconception. Market watchers have been behind the curve on the state of Chinese retailing since at least May this year, when official retail sales growth fell to a 15-year low. More timely China Beige Book data show this weakness in official retail sales was primarily a lagged reflection of past softness, which we had reported during late 2017 and early 2018.

China Beige Book’s latest results show retail outperforming yet again, with sales, profits and hiring all improving. Recent official data have only very recently been playing catch up.

Lastly, the credit environment is also far more active than Beijing would have you believe. In spite of the government having yet to officially reverse its deleveraging policy, our data show corporate borrowing spiked in Q3, rocketing to the highest level since 2013.

The bad news is the systemic nature of the slump. Manufacturing is weak, and it is likely to become weaker. Moreover, the economy is not responding to the traditional stimulus tools:

What is most worrisome, then, is not the conventional story of Q3 weakness, but rather the opposite: that the economy is already seeing boosted levels of borrowing and investment and yet growth is weakening, nevertheless.

Like 2015, manufacturing is under fire, with earnings and profits weakening and orders getting crushed, especially on the export side. Notably this is occurring even before the more recent, larger round of Trump tariffs were imposed.

Moreover, cost pressures are increasing. Inventories are ramping up. And cash flow is suffering across the board, with the Q3 spike in late payments the worst we’ve picked up since late 2015.

In all of this we see alarming parallels with mid-2015, a period of heightened activity which presaged the China crisis of early 2016.

No PBOC rescue

Reuters reported that Beijing’s efforts to stimulate the private business sector with easier credit is not working. In central banker parlance, the transmission mechanism is broken:

Beijing is keen to show results after four rounds of policy easing, so China’s big banks are playing along, highlighting their efforts to boost lending to cash-starved small firms, offering collateral waivers and setting loan targets.

But in reality, banks’ loan eligibility requirements for small and medium-sized enterprises (SMEs) remain stringent, making it too difficult or too expensive for them to borrow, according to bankers and company executives.

That has forced some small firms, including exporters, to simply give up on borrowing and put investment plans on hold.

The health of millions of small firms, most privately owned, is crucial to China’s efforts to ward off a sharp slowdown and mass job losses while fighting a bitter trade war with the United States.

In the meantime, S&P recently warned that local government (LGFV) hidden debt could be “as high as Chinese renminbi (RMB) 30 trillion-RMB40 trillion (US$4.5 trillion-US$6.0 trillion)”. The ratings agency expects that the central government will weaken support for LGFV debt over time, and more defaults are likely.

This time, the PBOC may be out of bullets. It is difficult to see how the central bank could ride to the rescue one more time by turning on the credit spigots when the economy is already over-leveraged, LGFV debt is out of control, and the SME transmission mechanism is broken. The PBOC has embarked on a program to slow the economy, and M2 money supply growth has been slowing. As the chart shows, M2 growth leads GDP growth by about a year, and the market has to be prepared for further growth deceleration.

Real M2 growth leads GDP growth by 1 year

A China hard landing?

The WSJ recently posted the factors leading to the past recessions in G7 economies since 1960. Of the 111 factor occurrences, China is at high risk in 59, or 53%, of those instances, if you add in the potential of a currency war, as well as a trade war.

We have heard these kinds of China scare stories before, but this amounts to a “this will not end well” story if there is no bearish trigger. The poor performance of over-leveraged Chinese property developers, which represent the canaries in the coalmine of an over-leveraged sector, could very well that trigger. Such a development has grave implications for China, and possibly for the prospects of the global economic and financial systems.

From a technical perspective, the monthly MACD sell signal flashed by global stocks is another bearish warning for investors.

A storm is brewing in Asia, and investors should be de-risking their portfolios. If the share prices of the property developers were to break down to multi-year lows, it would be a signal to really batten down the hatches. These stocks represent real-time canaries in the coalmine of an over-leveraged sector. The global economy relies on major EM countries like China and India as sources of growth. A hard landing in China would have grave implications for the prospects of the global economic and financial systems.

The week ahead

In the past week, the bottom-up fundamentals were strong, but the market did not respond to the good news. Q3 earnings season is under way, and the latest update from FactSet shows that both the EPS and sales beat rates were well above the historical averages. Moreover, Street analysts continued to revise earnings upwards, indicating positive fundamental momentum.

Here is the bad news. While the market punished earnings misses, it did not reward beats. The market’s failure to respond to positive news is a bearish sign that investor psychology may become excessively bullish, and some adjustments to expectations need to be made.

Bespoke also observed that the market was “selling the news”, as stocks that reported, regardless if the results were positive or negative, opened higher but closed lower on the day.

The hourly chart shows that the S&P 500 broke down out of a rising trend line (dotted line) Thursday, and rallied up to test the falling trend line Friday. These are the hallmarks of a relief rally failure indicating that a likely test of the old lows is likely underway. Subscribers received email alerts when my inner trader was stopped out of his long positions Thursday, and his entry into an initial short position Friday when the market strengthened to test the falling trend line.

The Fear and Greed Index stands at 14, which is in the sub-20 level where past bottoms have been made. However, low readings represent a bottoming condition and they are not immediate actionable buy signals.

That said, the market is likely too far off. The normalized equity-only put/call ratio flashed a buy signal by reaching a panic extreme level and began to mean revert.

As I pointed out in my last mid-week post (see Is there any more pop after the drop?) sentiment has not panicked yet, as evidenced by the lack of a spike in bearish sentiment in the II survey, and the backdrop of greed that allows Wall Street banks to price an Uber IPO at $120 billion valuation, which is a 66% boost from its last financing. These conditions suggest that we need another flush before a durable bottom can be made.

Short-term breadth indicator readings from Index Indicators are consistent with past oversold-bounce-retest patterns seen in past bottoms.

My inner investor has been increasingly cautious on equities since August. My inner trader tactically shorted the market in anticipation of a final panic selloff that marks the bottom of this pullback. He entered into a small initial short position Friday, but he is prepared to add to his shorts should the market strengthen early next week.

Disclosure: Long SPXU

Is there any more pop after the drop?

Posted by Cam Hui - October 17, 2018

Mid-week market update: Is there any more “pop” after last week’s drop? The market certainly had a big rally yesterday, and it is not unusual to see a pause the day after a big move.

Here are the bull and bear cases.

Bull case

Option based sentiment is supportive of further advances. The history of the normalized equity-only put call ratio is high enough to see stock prices advance when sentiment has been this bearish in the past. That said, oversold markets can become more oversold and we haven’t seen this indicator reverse downwards, which would indicate a shift in momentum. Such an event would be a better trigger for a buy signal.

The put/call ratio remains elevated today and stands at 1.16, which is also short-term contrarian bullish.

Even Chinese stocks seem to be trying to bottom here. The Shanghai Composite hit a 4-year intra-day low Wednesday, but reversed to close higher on the day. This may be an indication of the start of a global relief rally.

I was recently asked about emerging markets. There is a nascent positive divergence occurring between EM equities and EM bonds. The chart below shows the relative performance of EM stocks against the MSCI All-Country World Index (ACWI, blue line), and EM bond price performance against their duration-equivalent Treasuries (green line). The bottom panel shows that the historical correlation of these two indicates has tended to be positive. EM bonds are turning up, but EM stocks continue to lag.

Is this a hopeful sign of a turnaround in risk appetite for the bulls?

The bear case

The bear case rests mostly on sentiment. The latest II survey shows that the number of bulls have plunged, but bearish sentiment has not risen. Where is the fear?

These results are consistent with Callum Thomas’ (unscientific) equity sentiment poll taken last weekend. Net sentiment turned more bullish after a -4.1% plunge in stock prices. There may be too much greed for the market to make a durable bottom here.

Speaking of too much greed, the WSJ reported that Wall Street banks told Uber it could price an IPO at a $120 billion valuation next year, which would represent a 66% increase from the valuation from its last financing, which was $72 billion. Too much greed, not enough fear.

Don’t overstay the bounce

I resolve the bullish and bearish cases as the market is undergoing a short-term bounce, but it needs a second downdraft to flush out the stubborn bullishness among investors. So far, the market action this week is following the historical October OpEx pattern observed by Rob Hanna at Quantifiable Edges. Historically, Monday has been weak (yes), Tuesday strong (yes), and Wednesday has been weak (sort of), but expect a rebound tomorrow.

My own study of post-October OpEx week shows that Mondays has a bullish bias, but the rest of the week looks relatively normal.

I am also watching the short-term breadth indicators from Index Indicators using different time frames. The % above 5 dma became wildly overbought Tuesday, and therefore is no surprise that the market pulled back today.

Using a slightly longer time frame, the % above 10 dma recovered Tuesday but it was still in negative territory. I would expect this indicator to recover to at least a mild overbought reading before this relief rally is over.

My inner investor is increasingly cautious. My inner trader got long the market last Friday and he is playing for a continuation of the short-term bounce before shorting against either late this week or early next week.

Disclosure: Long SPXL

Tops are processes: Here is why

Posted by Cam Hui - October 15, 2018

I received a ton of comments after yesterday’s post (see A correction, or the start of a bear market?), probably because of the tumultuous nature of last week’s market action. Readers pointed out a number of buy and sell signals that I had missed in yesterday’s post and asked me to comment on them. (Rather than email me directly, I encourage everyone to put their comments in the comments section rather so that the rest of the community can see them.)

The bullish and bearish signals are not necessarily contradictory, as they operate in different time frames. I believe that they reinforce my conviction that the market is undergoing a long-term top. Tops are processes. Stock prices don`t go straight down when the market tops out. The most recent break was just a warning.

Even if you are bearish, I reiterate my view that the markets are too oversold to meltdown from current levels. Rob Hanna of Quantifiable Edges found that market bounces that begin on a Friday tend to be the most reliably bullish.

Here is the other feedback that I received which makes me believe that the US equity market is in the process of making a top.

Cautious technicians

The most notable comments came from multiple readers, who alerted me that a number of well-known technicians had turned cautious. Josh Brown highlighted the analysis from Ari Wald, who observed that internal cracks, which appeared first in non-US markets, are broadening.

In addition, JC Parets of All Star Charts turned cautious after staying bullish for a very long time:

Some of you guys have been reading my work for over a decade. But I understand there are many newer readers, so I think it’s important to address what’s going on here. I’ve been called a Permabull many times for over 2 years now, meaning that they believed I just always had a bullish bias towards stocks. The truth is that while so many were eager to pick a top during this entire rally, I was consistently bullish because the weight of the evidence pointed that way. This is no longer the case and our approach has had to adapt over the past week to a new environment.

The markets had gone through his stops:

We’re fortunate to have been accurate with our risk levels. As soon as Small-caps broke 169, things got bad. There was no reason to be in them for us if we were below that in $IWM. Large-caps broke our levels early this week and things got progressively worse after our prices were breached. That is why we set them. That’s the good news. The bad news is that I’m confident this is just the beginning.

The severe technical damage suffered has turned Parets more cautious, though he is not outright bearish just yet:

I believe we are entering a period of what is, at the very least, a period of consolidation. I think we’re lucky if it’s another 2015. That wasn’t so bad and markets recovered quickly to begin one of the greatest runs in history. I hope you enjoyed it.

The bigger issue here is that we’ve broken a lot of important levels. This makes any strength vulnerable to overhead supply. In other words, instead of the infamous BTFD – Buy The Freakin Dip, the old STFR – Sell The Freakin Rip is most likely to rule moving forward. I’m sure my friends at Stocktwits will have a lot of fun with this one. That’s just the environment we’re in now. Either we resolve through much lower prices and get it out of the way quickly, like 1987, or it’s a drawn out process that could take 6-12 more months.

These changes of hearts illustrate the adage that market tops are processes. Different indications turn bearish in different time frames. I turned cautious back in August due to a negative monthly RSI divergence (see 10 or more technical reasons to be cautious on stocks). Since then, the market rose to an all-time high and then fell.

Here we are today, as other technical analysts have followed suit and turned cautious, sparked by trend line violations and trend following models, which tend to be late by design.

Two US Dollars

One of the bearish tripwires that I had outlined in yesterday’s post (see A correction, or the start of a bear market?) was the US Dollar. I wrote that the stock market had a history of running into trouble whenever the year/year change in the USD Index rose above 5%.

One reader astutely pointed out there are really two US Dollars that are relevant for the financial markets. There is the onshore USD, which affect terms of trade, and the operating margins of large cap companies with foreign exposure. In addition, there is the unregulated offshore USD market, otherwise known as eurodollars, whose year/year change had already breached the 5% level. Indeed, the eurodollar futures curve start to flatten and slightly invert starting in June 2020.

In order to analyze the effects of offshore USD stress, I used the inverse of the EM currency ETF (CEW) as a proxy for the offshore USD, as EM markets are far more vulnerable to hiccups in offshore USD shortages. As the chart below shows, a breach of the 5% year/year level has seen mixed results in the last 10 years. The stock market took a tumble only half the time.

In conclusion, this analysis shows that EM markets are especially fragile to further shocks, but fragility does not necessarily translate into bear markets. However, it does illustrate an additional risk that investors should monitor.

More signs of Chinese weakness

Another reader pointed that that Chinese car sales are tanking as a sign of weakness in the Chinese economy (via the BBC):

Car sales in China fell 11.6% in September to 2.4 million – the third month in a row of year-on-year decline.

The deceleration comes amid a slowdown in China’s economy and has pinched performance at vehicle manufacturers around the world.

At Ford, September sales in the country tumbled 43% compared with 2017, the US carmaker said on Friday.

The report followed steep declines reported earlier by Volkswagen, Jaguar Land Rover and General Motors.

Anne Stevenson-Yang of J Capital observed that car sales are correlated with property markets:

Indeed, my China pairs trades of New (consumer) China vs. Old (finance and infrastructure) China ETFs show that New China is lagging on a relative basis.

That said, I agree with Chris Balding when he stated that the greatest threat to Chinese stability is its property market, which is suffering from an off-the-charts level of financial leverage.

I am also cognizant of Anne Stevenson-Yang’s comment that cracks in the car market may be a warning of further property market weakness. I will therefore remain with my property developer stock prices as the key canary warning of trouble in the Chinese coalmine.

Insiders are buying

Lastly, some alert readers pointed out a Mark Hulbert column indicating that the “smart money” corporate insiders are buying this dip. The charts from OpenInsider confirms this assessment. Insider selling (red line) has dried up recently and fallen below the level of insider buying (blue line), which is a buy signal for this indicator.

Does that mean that stock prices will recover and rally to fresh highs?

For a longer term perspective, I analyzed the history of insider buy signals from 2007 to 2011. Excessively insider buying compared to sales have historically been good tactical buy signals and they have indicated either low immediate downside market risk or market rallies in the weeks and months after the signal. However, insiders were not perfect market timers, as they were buying all the way down after the 2007 market peak.

Bottom line: Investors shouldn’t count on insider trading as a buy signal. However, traders can use insider buying as a tactical trading signal.

Where are the bears???

For the last word, I highlight Callum Thomas’ (somewhat) long running (unscientific) equity sentiment poll done on the weekend. As the SPX cratered by -4.1% last week, you would have thought that sentiment would have deteriorated and the bears would come out in force. Instead, sentiment improved, indicating that traders were itching to pile in and buy the dip.

I interpret these conditions as the market poised for a relief rally, but the intermediate term path of least resistance for stock prices is still down. Sentiment hasn’t fully washed-out yet.

In short, market tops are processes. Both investors and traders need patience to navigate this environment.

A correction, or the start of a bear market?

Posted by Cam Hui - October 14, 2018

The latest signals of each model are as follows:

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

Where’s the bottom?

When the market selloff began last Wednesday, Callum Thomas conducted an (unscientific) Twitter poll asking if this is a correction, the start of a bear market, or just market noise. The overwhelming response favored a correction, which is contrarian bearish from a sentiment viewpoint.

Regular readers know that I have become increasingly cautious on the outlook for US equities since August (see 10 or more technical reasons to be cautious on stocks and Red sky in the morning). Now that the major US averages have begun to show signs of technical breakdowns, it is time to ask, “Is this just a correction, or the start of a bear market?”

Correction: No recession in sight

There are numerous reasons to support the case that the latest round of weakness is only a correction. First, there are no signs of a recession yet. As I pointed out last week (see A recession in 2020?), my recession indicators are not flashing red, only flickering. We do not have a definitive recession signal yet. As investors know, recessions are bull market killers.

Corporate earnings decline in recessions. If there is no recession, equity valuations are not stretched by historical standards. The latest update from FactSet shows that the forward P/E ratio is 15.7, which is below its five-year average but above its 10-year average. Further stock market weakness would represent a valuation reset that would make US stocks quite attractive by historical standards,

Correction: Bondmegeddon nearly over

Another support for the bull case is analysis from Bryce Coward of Knowledge Leaders Capital that the bond market selloff, which sparked the rout in equity prices, may be mostly over because the bond market has mostly discounted the Fed’s expectations as outlined by the “dot plot”. Coward found that the spike in bond yields was mainly attributable to rising term premium, with little movement in inflation or real growth expectations.

When trying to understand the recent move in bonds, it’s helpful to measure the movement of each component of the bond: real growth expectations, break even inflation, and the term premium. The 18 basis point move was driven by the term premium rising by +18bps, a +1bps point rise in inflation expectations and a -1 basis point decrease in real growth expectations. That is, there was practically no alteration of either inflation expectations or growth expectations, and nearly the entire sell off was driven by the term premium.

Coward attributed most of the rise in term premium to jitters over a more hawkish Fed:

But just how much more does the 10-year need to rise to reflect Fed policy expectations? Very short-term rates could rise a little further, but longer-term rates are about reflecting the terminal Fed funds rate for this cycle. That is, the market could fully discount the Fed’s dot plot via curve flattening. As previously stated, the 10 year treasury bond yield is just the sum of the expected future short-term rates. At the end of the rate hiking cycle, those expectations should configure themselves such that the 10 year bond equals the terminal Fed funds rate. The median Fed member’s terminal Fed funds rate is currently 3.375%, just 17bps higher than the current 10 year treasury yield. The weighted average Fed member’s terminal Fed funds rate is 3.28%, just a few basis points higher than the current rate. This tells is that the rise in yields may be closer to its end than its start, but there is still a little to go to completely discount Fed policy, especially on the short end of the curve.

In conclusion:

The 10 year rate is very near to the Fed funds terminal rate for this cycle. This implies that long rates may not need to move much more to fully discount Fed policy, but that shorter-term rates may need to move a bit higher still, flattening the curve a bit.

Correction: Cautious institutions

Finally, one reason that is suggestive of a shallower, rather than deeper pullback, is a bifurcation in sentiment. I have outlined how long-term individual investor sentiment is over-stretched by historical standards, such as how household equity assets have exceeded real estate holdings (see The things you don’t see at market bottoms: Booming confidence edition).

By contrast, various institutional surveys have shown that institutions are generally cautious on equities, which would put a cushion on stock prices if they decline. Callum Thomas highlighted data from State Street’s custodian data, which shows that US investors are already defensively positioned.

Global institutional investors are also cautious on equities.

The latest BAML Fund Manager Survey also shows that managers are overweight cash…

…and they have been reducing their equity weights since late 2017.

While individual investors may be all-in on equities, institutions are cautious, which would provide a cushion should stock prices decline significantly.

Bear case: A hawkish Fed

While the case for a correction rests mostly on conditional outcomes, such as the lack of a recession signal right now, there is no assurance that the economy will not fall into recession in late 2019 or early 2020.

The Powell Fed has made it clear that the default path for monetary policy is to keep raising rates until they see definitive signs of a slowdown, otherwise known as “when something breaks”. While Powell has stated before that he is putting less weight in economic models, such as the Phillips Curve, and greater weight in market-based signals as measures of financial stability in monetary decisions, don’t expect a Powell Put in the manner of past Greenspan, Bernanke, or Yellen Puts.

Bloomberg reported that New York Fed president actually welcomed the stock market selloff as a way of cooling off risk appetite.

“The primary driver of us raising interest rates is just the fact that the U.S. economy is doing so well in terms of our goals,” Williams said Wednesday in a reply to questions after a speech in Bali, where the annual meetings of the International Monetary Fund and World Bank are taking place. “But I would also add that the normalization of monetary policy in terms of interest rates does have an added benefit in terms of financial risks.”

“A very-low interest-rate environment for a long time does, at least in some dimension, probably add to financial risks, or risk-taking, reach for yield, things like that,” he said. “Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.”

In short, despite the tamer than expected CPI print last week, don’t expect the Fed to pause in its policy path any time soon. The Fed is well on its way to keep raising rates until it sees signs of a cooling economy, by which time it may be too late to reverse course and avoid a recession.

As well, the counterpoint to the above analysis from Knowledge Capital Leaders indicating that the 10-year Treasury yield has mostly discounted the rate path implied by the dot plot is further rate hikes will act to invert the yield curve. Bloomberg also reported that Street strategists also expects the yield curve to continue flattening into 2019. Past inversions have been sure fire recession signals.

Bear case: A new Cold War

Even if the economy were to sidestep a recession, Trump’s trade policies have introduced further downside risk in the form of slower global growth. Notwithstanding the looming trade war between the US and China which could slow the two economies, as well as the economies of their major trading partners, the trade war is turning into a new Cold War. This is a new development that represents a tectonic shift in global trade patterns that puts a long-term speed limit on global growth potential.

The recent bombshell report from Bloomberg that Apple and Amazon’s network servers may have been compromised by Chinese spy microchips embedded in the motherboard of servers is a case in point. Despite the vehement and specific denials by Apple and Amazon, which were made by technical personnel rather than lawyers; the Reuters report that the UK cyber security agency supports Apple’s position, and whose denial was confirmed by the US Department of Homeland Security, these revelations will have a chilling effect on the ability of the Chinese to sell electronics to foreigners. The SCMP reported that this incident will force US vendors to re-think their supply chain security.

Although experts remain divided over whether China has the technical know-how to pull off the spy chip hack described by a Bloomberg BusinessWeek report last week, technology research firm IDC believes one thing is certain – the incident will push US hardware vendors to reconsider the integrity and location of supply chains to safeguard security.

“Advanced semiconductor design is the next battleground between China and the rest of the world to ensure security is hard-wired in silicon to employ the most stringent standards and processes across the supply chain,” according to an IDC report co-authored by five analysts including Mario Morales, programme vice-president of enabling tech and semiconductors.

“Vendors will also continue to move forward with implementing their own hardware design and extend the capability to critical components needed for their equipment and workloads. This will be the new arms race in the IT world,” the report said.

This incident is expected to hobble China’s next step in economic development in accordance the China 2025 plan to move into higher value-added design:

IDC said that the ramifications of the story are just beginning to be felt, and cautioned that China’s manufacturing and supply chain is deeply integrated within the business models of many US companies. As such, the supply chain dependency of many American-based vendors will need to be reassessed to stave off any future security hacks.

At the same time, CNBC reported that the Trump administration is, in effect, starting a new Cold War with China (my words, not theirs):

The administration’s clearest and most comprehensive broadside on China yet followed what one official called “thousands of hours” of study and planning. It will involve agencies across the U.S. government, from the Pentagon to the U.S. Trade Representative. The consequences will be both immediate and potentially generational for global economic and security matters.

These initiatives include:

A landmark speech by Vice President Mike Pence at the Hudson Institute, calling out China as America’s foremost threat, ahead of Russia, due to both the scope and seriousness of its activities abroad and within the United States.

An underreported aspect of the new U.S.-Mexico-Canada trade agreement that requires all three parties to inform the others if they begin trade talks with “non-market economies” (read China). Trump administration officials view it as a template for trade deals to follow.

A leaked report that the U.S. Navy’s Pacific Fleet has proposed a series of military operations during a single week in November to send a warning to China and to provide a deterrent to its Beijing’s regional military ambitions.

On Friday, the Pentagon released the results of a yearlong look at vulnerabilities in America’s manufacturing and military industrial base. “China represents a significant and growing risk to the supply of materials deemed strategic and critical to U.S. national security,” including a “widely used and specialized metals, alloys and other materials, including rare earths and permanent magnets,” the report says.

Pence went far beyond Trump’s UN speech statement that China was acting to influence American elections against him. Pence said for the first time, echoing a view held by Trump since before his presidential campaign, that “what the Russians are doing pales in comparison to what China is doing across this country.”

These steps represent a new containment policy of attempting to slow or halt China’s development path and drive to becoming a superpower, and goes well beyond the initial stated goal of returning offshored jobs back to America. Reuters reported that the Five Eyes global signals intelligence alliance is broadening its cooperation with other countries such as Germany and Japan to counter Chinese influence operations and investments:

The five nations in the world’s leading intelligence-sharing network have been exchanging classified information on China’s foreign activities with other like-minded countries since the start of the year, seven officials in four capitals said.

The increased cooperation by the Five Eyes alliance – grouping Australia, Britain, Canada, New Zealand and the United States – with countries such as Germany and Japan is a sign of a broadening international front against Chinese influence operations and investments.

Some of the officials, who spoke on condition of anonymity because of the sensitivity of the talks, said the enhanced cooperation amounted to an informal expansion of the Five Eyes group on the specific issue of foreign interference.

While China has been the main focus, discussions have also touched on Russia, several said.

“Consultations with our allies, with like-minded partners, on how to respond to China’s assertive international strategy have been frequent and are gathering momentum,” a U.S. official told Reuters. “What might have started as ad hoc discussions are now leading to more detailed consultations on best practices and further opportunities for cooperation.”

As China has been a major engine of global growth over the last few decades, these steps are likely to have the secular effect of slowing overall global growth potential.

Already, China is seeing the cyclical effects of slowing growth. Chinese business confidence is getting crushed in the wake of the trade war. The Thomson Reuters/INSEAD Asian Business Sentiment Index for China has plunged from 63 to 25.

Bear case: Ambitious earnings expectations

The last major risk to the bull case comes from overly optimistic earnings expectations. Analysis from Morgan Stanley shows that the Street expects margin expansion in every non-financial sector in 2019.

These projections appear to be highly ambitious in light of the following two factors:

Possible margin pressure from rising labor costs, especially in light of Amazon’s minimum wage boost to $15; and
Either margin pressures from rising tariffs, or inflationary pressures if higher tariffs are passed through to consumers. In the latter case, the Fed will be forced to raise rates at an even a faster pace.

I will be closely monitoring Q3 earnings season for clues on these two key issues. How much pressure are they seeing from higher compensation costs? What about the trade war? The initial effects are just starting to be felt, and we may see either cost pressures, or guidance as to the ability of companies to pass on tariff related price increases.

As time passes, these dual pressures are likely to increase and so does the risk for earnings disappointment.

Bearish tripwires

To recap. Is this the corrective pause that refreshes, or the start of a bear market? Frankly, I don’t know. However, I am relying on the following disparate real-time macro and technical tripwires for a bear market.

First, the relative performance of bank stocks has been a good real-time warning of rising stress in the financial system. These stocks have been weak on a relative basis and they are on the verge of testing a key support level. Watch for a technical breakdown, which hasn’t happened yet.

The stock market has stumbled four out of five times in the last 10 years whenever the USD Index has risen 5% or more year/year. That’s because the USD has both been viewed as a safe haven currency, a rising USD also acts as a form of monetary tightening, and a stronger greenback creates an earnings headwind for large cap multi-nationals with foreign operations. The USD Index would need to reach about 98 to trigger this bearish tripwire.

Rising oil prices have historically been a sign of rising inflationary pressures, which would force the Fed to take a proactive stance to cool growth excesses. In the past, stock prices have take a tumble whenever the year/year change in oil prices exceed 100%. Oil prices would have to reach about $100 to trip this bearish indicator.

As well, it is becoming clear that China and Asia are undergoing a major slowdown. The key question is the resiliency of the Chinese economy and financial system. The canaries in the coalmine are the Chinese property developers, such as China Evergrande (3333.HK). So far the stock has retreated and it is testing a major support level. A decisive break could be a real-time signal of an uncontrolled unwind of leverage whose effects could spread worldwide. Watch closely!

Finally, I warned in the past about the technical risks posed by the negative monthly RSI divergences showing up in the Wilshire 5000 chart. That said, past bearish breaks have been accompanied by a MACD sell signal, which hasn’t occurred yet. The reading is barely positive, and we would need to see a negative monthly close before flashing a sell signal.

That said, MACD did flash a sell signal for global stocks in July, and global stock prices have historically been higher correlated with US stock prices.

The good news that is none of these bearish tripwires have been triggered. However, it doesn’t mean that the bulls can sound the all-clear signal. A number of these indicators are on the verge of turning bearish.

I am watching these indicators closely. Each of these indicators represent an independent dimension of market risk, and any of the them, it’s going to mean trouble. Nevertheless, I am maintaining an open mind as to how these risks resolve themselves.

The week ahead: Playing the bounce

Looking to the week ahead, the market has suffered much technical damage in a very short amount of time. It is highly unusual for stock prices to suddenly fall from an all-time, slice through the 50 day moving average (dma) support, and then cratered to the 200 dma, all in less than two weeks. It is difficult to believe how the bulls could regain control and proceed as if nothing happened with a V-shaped recovery. The last time this happened was the February correction after the January blow-off. The market rallied, but returned to test its lows about two months later.

The SPX ended the week at 2767, which is about the level of its 200 dma. However, it is difficult to know what the downside potential is should the 200 dma fail to hold as a support level. The next support level may be the lower weekly BB, which stands at roughly 2700.

Callum Thomas’ Twitter poll shown at the top of this post where 52% of respondents believed (as of Thursday morning) that this bout of market weakness is just a correction is worrisome. It suggests a strong entrenchment of the “pause that refreshes” or “this is a opportunity to buy the dip” mentality. Even if this is just a correction, the market may need a further shakeout to shake that complacency before a durable bottom can be seen.

Mark Hulbert pointed out last Thursday that his Hulbert Nasdaq Newsletter Sentiment Index (HNNSI), which measures the sentiment of Nasdaq market timers, had not fallen to washout levels yet. These readings also suggest that the market may need another downleg or re-test of the previous lows before a durable bottom is made.

However, it is also becoming apparent that the stock market is poised for an oversold bounce. Subscribers received an email alert after Thursday`s close indicating that the short-term trading model had turned bullish. Breadth indicators were oversold across multiple time frames. That said, past instances of these oversold extremes resolved themselves with an initial rally, followed by a retest of the lows some days and weeks later.

Indeed, the short-term breadth indicator (1-2 day horizon) has already begun to normalize, but the market remains oversold. The only question is how far this reflex rally can run.

Rob Hanna at Quantiable Edges offered some clues through his historical studies. He searched for back-to-back 50-day lows accompanied by extremely oversold RSI readings. This signal was triggered as of last Thursday`s close, and he found that the market tends to top out again between 3-5 days after the event, which makes the top either this coming Tuesday or Thursday.

Next week is also option expiry (OpEx) week, and Hanna found in a separate study that October OpEx has a historical tendency to be extremely bullish. He found that the market has historically topped out on the Thursday during October OpEx week.

If history is any guide, expect the trading peak to occur this coming Thursday. Even if you are bearish, wait for the bounce to short. Markets simply do not melt down further from such extreme oversold levels.

For now, my working hypothesis is a bounce of unknown magnitude and unknown duration, followed by a re-test of the lows (via OddStats). Severely oversold markets just don’t recovery and go straight up.

However, the bulls have one ray of hope. The NAAIM Exposure Index, which measures the exposure of RIAs, fell dramatically last week to levels below its Bollinger Band (BB). Historically, a breach of NAAIM Exposure below its lower BB has been an excellent short-term buy signal (vertical lines).

My inner investor become progressively more defensive since my warnings in August. He is monitoring the tone of reports from Q3 earnings season, which begins in earnest next week.

The early results are mixed . We are entering Q3 earnings season with heightened expectations and subpar corporate guidance. So far, companies with earnings beats are barely outperforming, but earnings misses are not being severely punished. As only 6% of the index has reported, these results are highly preliminary. We need to wait for more reports to gain a better perspective.

There were, however, some macro insights from the limited number (N=24) of earnings calls so far. While companies cited the strong USD as the greatest headwind to earnings results, there are signs that rising wages are beginning to pressure margins. As well, the trade war is starting to bite as “tariffs” and “China” are increasingly being cited as the negative operating factors.

Atlanta Fed president Raphael Bostic recently raised highlighted concerns about margin pressures from wages and tariff-related costs as a result of the Fed’s discussion with local businesses: These are factors that I will be monitoring as Q3 earnings season progresses.

Consistent with aggregate measures of wage growth, reports from my district suggest some firming in labor costs. A growing number of firms across the District reported an uptick in merit increases, averaging in the 3 to 3.5 percent range.

Further, there was a marked uptick in the reported ability of firms to pass on cost increases. This was especially true for firms subject to tariff- and freight-related cost increases. Those firms reported little to no pushback when passing along rising costs to their customers. But I get the sense that the phenomenon is becoming more widespread. It’s a development that I will continue to watch closely.

My inner trader took profits in his short positions and reversed to the long side last Friday in anticipation of a relief rally. Volatility has returned to the markets, and I would advise trader to scale their positions accordingly based their risk tolerance levels.

Disclosure: Long SPXL

The things you don’t see at market bottoms: Booming confidence edition

Posted by Cam Hui - October 11, 2018

The last time I published a post in a series of “things you don’t see at market bottoms” based on US based investor enthusiasm was in June. Sufficient signs have emerged again for another edition.

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

Past editions of this series include:

I reiterate my belief that excessively bullish sentiment may not signal the top of the equity market, but investors should be aware of the risks of an environment in which sentiment has become increasingly frothy.

Booming consumer confidence: Artisanal brooms edition

Chalk this story up to booming consumer confidence. Vox featured a story about artisanal brooms that cost up to $350 apiece.

I bought my plastic broom in the frenzied cleaning portion of my last apartment move. The amount of time and energy I expended trying to decide which broom to buy lasted the duration of my walk to the local Duane Reade, plus the short trip to the cash register. It cost maybe $10.

This is one corner of the American broom market: the unromantic, inexpensive corner many of us are familiar with. For the same price, you could also go to Home Depot and get a humble, conventional version made from broom corn, the straw-like plant also known as sorghum that yellows as it ages. But work your way up the pricing scale — and onto the websites of artists and individuals who make brooms by hand — and you’ll find gangly brooms made from found wood, pleasingly curved hand brooms made from ash and horsehair, thick palm brooms imported from Japan, and classic Shaker brooms with gleaming, octagonal walnut handles. If you want, you can spend $70 or $95 or even $350 on a broom.

The people who make and sell these kinds of brooms say they want to see them in use, and hope that the brooms’ craftsmanship and elevated design will inspire owners to leave them out as decoration when they’re not being used to sweep the floor. But because of its functional (and often gendered) nature, the broom is an everyday object that kicks up a lot of sticky questions when it collides with the artisanal movement.

As I pointed out before, consumer confidence internals point to a late cycle extreme. The spread between future and current conditions are consistent with conditions found in a late cycle expansion.

Spread between future and current conditions is a cautionary signal

Market frothiness

Meanwhile, over at the stock markets, we are seeing numerous signs of frothiness. Callum Thomas pointed out that the Assets Under Management (AUM) of leveraged long ETFs have spiked to all-time highs, while leverage short ETF AUM are falling.

Mark Hulbert also observed that the equity allocation in the IRAs of investors over 70 are back to levels seen at the last market top.

At the same time, BAML`s private client data shows cash at record lows and equity allocations near record highs.

Moreover, the percentage of household net worth held in equities now exceed real estate. These conditions were only found at the NASDAQ bubble top, and at the market peak of the late 1960`s.

I would point out the somewhat inconvenient study from Nick Magguilli at Of Dollars And Data that there is an inverse relationship between average equity allocation and 10-year future returns.

On the other hand, those are 10-year returns, and we are only worried about tomorrow or the next month. So risk-on!

Deal silliness

At the top of the market, investors often see silly deal getting done as greed becomes the dominant emotion and fear goes out the window. We can see that effect in the leveraged loan market, as the quantity of covenant-lite loans surge.

As well, the WSJ reported that the percentage of unprofitable IPOs now rival the figure last seen at the Tech Bubble top.

When I began the series, “things you don’t see at market bottoms”, cryptocurrencies and initial coin offerings (ICOs) were hot. Now that crypto prices have tanked, the mania has moved into cannabis. This tweet just about says it all.

Then there’s Turkey. Remember Turkey? This deal by the African Development Bank captures the market zeitgeist of today.

Excuse me, I have to run and swap my holdings of 100-year Argentina bonds (see The things you don`t see at market bottoms, 23-Jun-2017 edition) into zero-coupon TRY bonds…