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

Posted by Cam Hui -

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

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

 

Dovish at first glance

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

 

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

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

 

What the market missed

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

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

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

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

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

 

Policy error risk

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

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

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

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

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

Risk management at the Fed

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

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

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

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

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

 

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

 

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

When does the Fed pause?

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

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

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

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

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

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

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

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

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

10 or more technical reasons to be cautious on stocks

Posted by Cam Hui -

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

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

 

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

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

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

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

What I am cautious on stocks

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

 

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

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

Technical breaks everywhere

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

 

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

 

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

 

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

 

Clues from leadership rotation

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Warnings from trend following models

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

 

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

 

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

 

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

 

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

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

Faltering price momentum

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

 

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

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

 

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

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

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

The week ahead

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

 

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

 

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

 

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

Disclosure: Long SPXU
 

Why positive breadth won’t help the bull case

Posted by Cam Hui -

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

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

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

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

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

…and on a 1-2 week time horizon.

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

My inner trader remains short the market.

Disclosure: Long SPXU

How many pennies are left in front of the steamroller?

Posted by Cam Hui -

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

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

 

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

Risk appetite is deteriorating

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

 

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

 

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

 

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

Disclosure: Long SPXU
 

Could China take the baton if US growth falters?

Posted by Cam Hui -

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

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

 

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

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

The latest signals of each model are as follows:

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

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

What if I am wrong?

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

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

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

 

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

 

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

 

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

How resilient is China?

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

 

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

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

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

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

 

Modeling an American slowdown

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

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

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

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

“Professor, where did you get this data?”

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

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

“Professor, do you believe the data?”

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

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

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

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

He went on to give a personal example:

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

 

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

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

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

 

The unknown effects of hidden linkages

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

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

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

Yeung is no stranger to the game.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

What about the policy response?

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

Could China do it again?

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

Three reasons to ignore the Turkish Apocalypse hype

Posted by Cam Hui -

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

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

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

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

 

 

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

Central bankers have not begun to fight

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

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

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

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

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

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

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

Geopolitical pressure for a deal

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

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

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

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

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

 

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

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

How strong do we want this bridge to be?

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

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

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

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

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

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

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

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

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

Stock market outlook

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

 

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

 

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

Disclosure: Long SPXL
 

How far can stock prices fall in a bear market?

Posted by Cam Hui -

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

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

 

But that’s not the whole story.
 

A fundamental perspective

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

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

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

 

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

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

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

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

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

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

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

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

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

 

Scenario analysis

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

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

The results are summarized in the table below.
 

 

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

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

 

Two gifts from the market gods

Posted by Cam Hui -

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

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

 

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

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

 

The latest signals of each model are as follows:

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

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

More market warnings ahead

I received a lot of feedback from my post last week (see Major market top ahead: My inner investor turns cautious), mostly because it represented a major change in investment outlook. I would like to clarify a point that the post did not represent a sell signal for stocks, but the setup for a sell signal.

In the short run, the market gods have given investors two gifts. First, the evolution of the Turkish Tantrum provides investors a glimpse at what a real EM blow-up might look like in the future, especially if China were to undergo a debt crisis.

In addition, the path of least resistance for stock prices is still up for the next few weeks. Any rally therefore represents a second gift from the market gods. Investors can take the opportunity to lighten up their equity holdings in anticipation of long-term market weakness.

There have been plenty of warnings that US equities are topping out, starting with how monetary policy is affecting both Wall Street and Main Street. The latest Turkish inspired sell-off just provides another point of bearish pressure.

Even before Friday`s market blow-up, the fault lines were starkly revealed when the Deputy Prime Minister of Turkey tweeted a complaint about Fed policy.
 

 

In light of Friday’s above consensus core CPI print, the Fed is likely to stay on their preset course of a quarter point rate hike every three months. Already, the Turkish lira crisis has sparked an upside breakout of the USD Index. If the breakout holds, it will spell trouble in other quarters. In addition to the pressure on other vulnerable EM currencies, a rising USD depresses the Chinese Yuan (CNY) and raise the specter of a currency war.
 

 

The Turkish Tantrum as dress rehearsal

My base case scenario for the onset of a bear market is caused by Fed over-tightening, which slows the American economy into recession. But the last tax bill also created incentives for US companies to repatriate offshore funds, which drained liquidity from the offshore dollar market. These factors are combining to raise the stress levels for offshore USD borrowers, and EM borrowers in particular.

Take Turkey as an example. Turkey`s external debt position amounts to 56% of GDP, with most of the exposure from Turkish banks, rather than sovereign debt. CNBC reported that international exposure to Turkey is fairly broad, with some concentrated exposure by European banks in the form of loans, along with some ownership exposure to Turkish banks.

Data from the Bank for International Settlements (BIS) — often called the central bank of central banks — shows that Spanish banks are owed $83.3 billion by Turkish borrowers; French lenders $38.4 billion; and banks in Italy are owed $17 billion. Regulators in Europe are reportedly worried that the weaker currency will lead to defaults in foreign loans…

When asked about the impact of the ongoing troubles in Turkey, Timothy Ash, a senior emerging markets strategist at Bluebay Asset Management, told CNBC via email that “it’s likely mostly banking exposure at this stage.”

However, he added that exposure is “pretty international.” “European, U.S., Japan, China, Middle East — everyone,” he added.

The BIS cross-border figures also show that Japanese banks are owed $14 billion, U.K. lenders $19.2 billion and the United States about $18 billion.

 

 

Everyone should take a deep breath and refrain from panicking. Global central bankers have well recognized procedures to deal with minor crises like this one. As Josh Brown pointed out, Turkey is not very important in the grand scheme of things.
 

 

However, how the global authorities behave during the Turkish Tantrum will serve as a rehearsal for further EM blow-ups in the future, especially if China were to undergo a debt crisis.

That`s the first gift from the market gods.
 

An Emerging One Belt One Road debt crisis?

Even if China were to sidestep a debt crisis, debt pressures from its One Belt One Road (OBOR) initiative is likely to cause problems for other EM countries should the global financial system become stressed (see my 2015 post China`s cunning plan to revive growth). A Center for Global Development study found that 23 out of 68 countries identified as potential borrowers in the OBOR Initiative were at a “quite high” risk of debt distress. Already, Sri Lanka made headlines in late 2017 when it ceded control of Hambantota port to China Merchants Port Holdings, a Chinese SOE, because of OBOR debt payment difficulties.

In particular, eight of those 23 countries are at high risk of debt service problems because of OBOR projects. Those countries are Pakistan, Djibouti, the Maldives, Laos, Mongolia, Montenegro, Tajikistan and Kyrgyzstan. The most important country on this list is Pakistan. A recent FT Alphaville article entitled Belt and Road, or Debt Trap? pretty much sums up the story of the initiative. A debt crisis in Pakistan would not only be isolated to that country, but it has wider geopolitical implications for the rest of the world. Pakistan borders Afghanistan and it represents a major supply route for NATO troops engaged in that region. Financial and political turmoil in Pakistan would crate headlines that reverberate around the world.
 

European fragility

In addition to the exposure of Turkish loans to the European banks, September may see further turmoil in the European credit markets when over €400 LTRO loans come due. While the event may not necessarily affect US markets, it will be a stress point for the eurozone banking system, and serve to highlight the still fragile nature of the European banking system. (As a reminder to clear up any points of confusion, the following table from the ECB specifies dates in the dd/mm/yyyy format).
 

 

The Warren Buffett warning

Another implicit market warning comes from Warren Buffett. The Q2 2018 report from Berkshire Hathaway showed that the company’s cash horde had grown to $111 billion. As the chart below also shows, cash levels have bee rising faster than the stock market, which is an indication that Buffett can’t find any bargains.
 

 

Less noticed by investors is Berkshire’s sale of its 31% stake in USG, the drywall manufacturer, which Buffett bought at the height of the financial crisis. The transaction raises more questions than answers. Hasn’t Buffett said that his time horizon for his holdings is forever? What is the USG sale telling us about market valuation and the economic cycle?

Indeed, the relative market performance of homebuilders has been tanking. Is the USG sale be a cautionary sign for the housing market?
 

 

From a macro perspective, housing starts are beginning to plateau, and may be in the process of rolling over.
 

 

Marketwatch also reported that Redfin CEO stated that the housing market had hit a “significant slowdown” in recent weeks:

The housing market hit a sudden and “significant” slowdown in the past few weeks that could continue in coming months, Redfin Corp.’s chief executive said Thursday afternoon…

He said a decline in U.S. home sales in June was expected to reappear in August and September after a slight relief in July, specifically calling out difficulties in markets on the West Coast that have driven home sales higher in the past few years.

“For the first time in years, we are getting reports from managers of some markets that home buyer demand is waning, especially in some of Redfin’s largest markets,” Kelman said, specifically calling out Seattle, Portland and San Jose as areas where inventory was still tight but did not seem to be pushing prices higher still.

“June sales were down in these markets by double-digits and inventory was up also by double-digits,” he said of the West Coast cities. “The trend is continuing in July and reports are now coming in from Washington, D.C.; Boston; Virginia and parts of Chicago as well that homes there are getting harder to sell.”

The housing canary in the coalmine is struggling. What could be next, especially if the Fed were to continue its path of policy normalization?
 

A Charles Gave recession warning

Another warning came from Charles Gave of Evergreen Gavekal, who issued a global recession alert:

Over the last three months, I have become increasingly concerned that a recession will hit the world economy in 2019. In this paper, I shall explain why. My reasoning is simple and is based on the behavior of an indicator I have long followed, which I call the World Monetary Base, or WMB. Every time in the past that this monetary aggregate has shown a year-on-year decline in real terms, a recession has followed, often accompanied by a flock of “black swans.” And, since the end of March, the WMB has again been in negative territory in year-on-year terms. As a result, and as I shall explain, there is a significant risk of a recession next year.

Before I launch into a detailed examination of my reasoning, I should perhaps recap what the WMB is and why it is so important. It starts with the US Federal Reserve, which, because it controls the dominant reserve currency, acts as de facto central bank to the world. By purchasing government bonds from domestic banks, so flooding them with reserves, the Fed can engineer an increase in the US monetary base.

The Fed also provides “reserves” to other central banks. Typically, this happens when the US dollar is overvalued and/or when the US economy grows faster than the rest of the world. This combination leads to a deterioration in the US current account deficit, which means that the US starts to pump more money abroad. These excess dollars appear first in the hands of foreign private sector companies. But if they earn more than they need for working capital, they sell the excess to their local central banks in exchange for local currency.

As a result, local monetary bases rise, and the surplus US dollars get parked in central bank foreign reserves, where they show up as a line item of the Fed’s balance sheet called “assets held at the Federal Reserve Bank for the account of foreign central banks”. Increases in this item must have as their counterpart increases in the monetary bases of non-US economies (unless foreign central banks sterilize their purchases of US dollars).

So, if I take the US monetary base, and add to it the reserves deposited by foreign central banks at the Fed, I get my figure for the World Monetary Base. From this aggregate, I can get a rough idea of the pace of base money creation around the world, either through direct intervention by the Fed in the US banking system, or indirectly through US dollar accumulation by foreign central banks. When the WMB is growing, I can be relatively confident about the future nominal growth of the global economy. And when it’s contracting, it makes very good sense to worry about a recession.

 

A contracting world monetary base? USD shortage? Turkish Tantrum? A possible OBOR debt repayment crisis? Ouch!

Gave concluded that a recession may hit as soon as March 2019, which is well ahead of my own forecast of a late 2019 slowdown.

A world-wide recession is looking more and more probable. And if the time lag is similar to those in the past, it could hit by March 2019. Indeed, looking at the performance of markets over the last six months, it looks as if a bear market may have already started everywhere but in the US. As I have written repeatedly in recent months, bears are sneaky animals. Their victims seldom see them coming.

 

A looming trend following warning

Finally, from a technical perspective, Chris Ciovacco’s trend following model is poised to flash a bearish warning. This model calculates a 30, 40, and 50 week moving on the NYSE Composite. If the shorter moving averages start to roll over and cross over the longer term averages. The latest readings show that the short 30 wma rolling over and it is on the verge of crossing over the 40 wma, which would change market conditions from what Ciovacco describes as “volatility to ignore” to “volatility to respect”. (Note that the SPX is superimposed on the three moving averages, and have no effect on how each of the averages are calculated).
 

 

The storm clouds are gathering on the horizon.
 

Last Hurrah rally still in play

Despite the presence of all these risks, the Last Hurrah scenario remains in play. The latest update from FactSet shows that Q2 earnings season results have been nothing short of spectacular.
 

 

While Q2 earnings results may be dismissed as backward looking, Bespoke observed that earnings guidance is still positive, though decelerating. These conditions are supportive of further price gains, and the bears will have to wait for guidance to start rolling over before taking full control of the tape.
 

 

In addition, while the monthly price chart that I highlighted last week of the Wilshire 5000 showed a warning of a negative RSI divergence, the MACD histogram has not turned negative (marked by vertical lines). A negative reading on the MACD histogram, combined with negative RSI divergence, would be the definitive sell signal for the market.
 

 

In other words, don’t panic just yet. Take advantage this gift from the market gods to lighten up positions on market rallies.
 

The week ahead

Looking to the week ahead, I wrote in my previous post that the stock market appeared to be extended and it was in need of a rest (see Traders: Market stalling, but buy the dip). I did not expect that jitters over Turkey would be the catalyst for a disorderly sell-off.

In the short run, the market is oversold and poised for a relief rally. Breadth indicators from Index Indicators show an oversold condition over a 1-2 day time horizon.
 

 

With the caveat that a small sample size (N=4) may not be very meaningful, the VIX Index spiked on Friday from under 11 to over 13. Oddstats observed that, in past instances, such episodes have been bullish for stock prices.
 

 

The market successfully tested a minor trend line on Friday, and it remains in a well-defined rising channel after its upside breakout at 2800. Barring further negative surprises, expect the market to grind upwards and break out to fresh highs in the weeks ahead.
 

 

Wait for the Fear and Greed Index to rise above 80 into the target zone before selling.
 

 

My inner investor is preparing to lighten his long equity positions should the market rally to new highs. Subscribers received an email alert on Friday that my inner trader had re-entered his long positions in anticipation of higher prices next week.
 

Disclosure: Long SPXL
 

Traders: Market stalling, but buy the dip

Posted by Cam Hui -

Mid-week market update: My inner trader remains constructive in his bullish view for stocks, but the recent advance appears to have gotten ahead of itself. My trading models indicate a 2-4 day period of weakness, followed by continued strength into all-time highs.

In the short-term, the market is flashing cautionary signals for traders. The SPX is exhibiting negative RSI divergences as it broke out to new recovery highs. As well, the VIX Index breached its lower Bollinger Band for two consecutive days, indicating an overbought market. Historically, such conditions have led to market weakness lasting 2-4 trading days. If history is any guide, a short-term trading bottom is most likely to occur either Friday or Monday.
 

 

All-time highs ahead

Unless the magnitude of the dip is severe enough to breach the 2800 breakout level, there is no reason why the cup and handle upside breakout target of 2925-2960 should not be reached.
 

 

Market breadth, as measured by the Advance-Decline Line, is supportive of further price gains.
 

 

And so is credit market risk appetite, as measured by the relative performance of high yield (junk) bonds.
 

 

However, short term (1-2 day horizon) breadth indicators from Index Indicators have become overbought indicating a brief pause or pullback is in order.
 

 

Subscribers received an email alert yesterday that my inner trader had stepped aside and moved into 100% cash. He is waiting for a dip and short-term breadth indicators to pull back to either a neutral or oversold reading in the next few days before re-entering his long positions.
 

A bullish setup for gold

Posted by Cam Hui -

As the stock market enters the late stages of its bull run (see my last post Market top ahead? My inner investor turns cautious), inflation hedge vehicles typically rally as inflationary pressures rise. We are starting to see a similar effect in gold prices.

As the chart below shows, the recent weakness in gold prices can largely be attributed to USD strength (green line, inverted). One constructive element for the gold price outlook is the positive RSI divergence as the price tests support.
 

 

Washed-out sentiment

Sentiment also appears to be washed out. The latest update of CoT data from Hedgopia shows that the positions of large speculators, or hedge funds, in gold futures are at or near capitulation levels.
 

 

Inflation expectations rising

Moreover, gold prices have been lagging as inflation expectations have risen. Even as gold violated an uptrend line, inflation expectations in the credit markets have been steadily rising.
 

 

Positive seasonality

Another factor supportive of gold is seasonality. If history is any guide, August and September tends to see an above average probability of higher gold prices.
 

 

Key risk

The key risk to the bullish gold thesis is the US Dollar. The USD Index is testing a key resistance level while exhibiting a negative divergence, which should see the greenback retreat and commodity prices rise. However, there are no guarantees when it comes to market behavior. If the USD Index does stage a decisive upside breakout through resistance, all bets are all.
 

 

As an aside, the fate of gold prices, and the USD Index has broad implications for Sino-American trade tensions. With the caveat that correlation does not represent causation, Market Commentary observed that Chinese yuan (CNY) to gold stock (XAU) volatility has been falling, which suggests that the Chinese may be pegging their currency to gold.
 

 

The volatility of CNY to broad commodity prices tells a similar story.
 

 

Should the USD retreat, and gold prices fall, CNYUSD is likely to rise, which would alleviate market concerns about a trade war turning into a currency war. Such a development would act to reduce risk premiums, and be bullish for stock prices.
 

Major top ahead? My inner investor turns cautious

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Cautionary signs ahead

My formerly bullish inner investor is turning cautious. This major change of opinion is not without precedence. The chart below is a record of my investment calls, and it shows that I have been neither a permabull or permabear. I was correctly bullish when the stock market dipped in 2015, and I turned cautious in the first half of 2015, and in early 2018.
 

 

I am now seeing the early technical signs of a developing cyclical top for the bull market that began in 2009. While this is not a call to sell everything as a bear market can take some time to develop, my inner investor is taking steps to rein in his risk exposure in preparation for a market top in the next few months.
 

A developing long-term top

I came to this conclusion through the prisms of technical analysis and top-down macro-economic analysis. The most convincing technical sign of a developing stock market top is the negative divergence RSI exhibited by the monthly chart of the broad-based Wilshire 5000 (WLSH). WLSH made a marginal all-time high in July compared to January on a closing basis, but showed a negative RSI divergence. Past similar conditions have signaled either major market tops or, at a minimum, a corrective pullback.
 

 

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

The latest update of sector leadership shows that defensive sectors are either the emerging or actual market leaders, indicating developing market weakness. Defensive sectors such as Consumer Staples, REITs, Utilities, and Healthcare are all either in the improving or leading quadrants, while high beta and cyclical sectors such as Technology and Industrial stocks are either in the weakening or lagging quadrants.
 

 

The RRG analysis for equal-weighted sectors, which minimizes the effects of megacap heavyweights in each of the sectors, is also supportive of the thesis of emerging defensive sector leadership.
 

 

As well, the failure of the price momentum factor has been a drag on risk appetite and raises another cautionary flag for the bull case. At the same time, the relative performance of high beta to low volatility stocks is testing the bottom of its recent trading range. A violation of relative support would be a signal that the bears are taking control of the tape.
 

 

In short, a series of long-term technical signals are leading to a cautious outlook for US equities.
 

Macro dark clouds on the horizon

At the same time, dark macro-economic clouds are gathering on the horizon. I agree with the analysis of New Deal democrat, who has done an excellent job of categorizing high frequency economic statistics into coincident, short leading, and long leading indicators. NDD’s latest weekly update of US economic conditions shows that long leading indicators, designed to forecast economic conditions a year in advance, have deteriorated from positive to neutral, and they are on the verge of turning negative, which is a recession warning. However, coincident and short leading indicators are all pointing upwards.

As has been the case for many months, both the nowcast and the short-term forecast remain positive, led by manufacturing, the stock market, and jobless claims.

The longer-term forecast recently turned from positive to neutral. This week the readings were stable, but real M1, the yield curve, and purchase mortgage applications are all close to tipping this negative.

While I am not in the habit of anticipating model readings before they occur, the current trajectory of long leading indicators suggest that the American economy is likely to enter recession in H2 2019. As stock prices tend to look ahead by about a year, that suggests that a cyclical market top may be developing about now.

Although standard economic analysis is pointing to a possible economic slowdown in late 2019, there are two factors that may act to further spook the markets. The first is a possible trade war that could crater global trade. How trade tensions develop is an unknown, but the markets seem to be mostly shrugging off the worst-case scenario of a full-blown trade war for now.

One risk that market analysts have largely ignored is the repercussions from the November mid-term elections. In all likelihood, the Democrats are likely to retake control of the House, though they face an uphill battle in the Senate. Should such a scenario unfold, there two negative market developments that I have seen few analysts discuss.

The first is the fiscal policy effect of the Democrat’s takeover of the House, and possibly the Senate. Expect a tighter fiscal policy in 2019. There will be no further tax cuts, and a possible partial rollback of the tax cuts passed in 2017. The combination of tight fiscal and monetary policy will act to slow economic growth further, which is a development that the market has largely ignored.

In addition, a Democrat controlled House will see more political fireworks between the White House and Congress. Committee chairs will be controlled by Democrats, and expect committees to come into greater conflict with the Trump administration. Congressional committees will have the power to subpoena anything and everything, such as Trump’s tax returns. Cabinet secretaries can be called to testify before committees on all sorts of issues that have been ignored by the Republican controlled committees.

Expect the Mueller probe, if it continues into 2019, will take on a greater prominence. A worst-case analysis of the Mueller inquiry could morph into a Watergate-like drama. Recall that the market reacted badly to the Watergate hearings, but they occurred against a backdrop of recessionary conditions in the wake of the Arab Oil Embargo. A similar scenario of the combination of tight fiscal and monetary policy cools the economy into a slowdown, and Watergate style hearings that paralyzes Washington in 2019 is well within the realm of possibility.

In short, 2019 will be legislative hell for the Trump administration. The markets may not like this development.
 

Don’t panic

Despite these cautionary signs, this is not an investment call to sell everything, but a warning of a possible market top. Topping processes can take some time to fully develop.

Firstly, please be reminded that the Wilshire 5000 chart is based on monthly prices, and negative RSI divergences can continue for several months before playing out. In addition, the relative performance of defensive sectors shows that they are bottoming against the market. With the exception of healthcare stocks, the other sectors are not in clear relative uptrends, indicating that the bears do not have the upper hand just yet.
 

 

My last hurrah scenario of a rally to new all-time highs remain in play for the next few weeks. The SPX has successfully tested the breakout turned support level of 2800 and the cup and handle breakout structure remains valid. :Last Thursday’s market reaction to the Trump administration’s announcement that it was considering additional tariffs on Chinese imports was a positive for the bulls. In addition, the NASDAQ 100 held support at the key 50 day moving average was also short-term positive for stock prices.
 

 

At a minimum, I would wait for signs of euphoria from sentiment indicators such as the Fear and Greed Index before calling a top.
 

 

The latest update from FactSet shows that the results from Q2 earnings season has been outstanding, and forward 12-month EPS has been surging. As forward EPS is coincident with stock prices, it is difficult to see how a bear phase could start with such near-term strength in fundamental momentum.
 

 

Lastly, a turnaround in the relative performance of value/growth ratio would be an indication of a change in market direction. Despite the recent hiccup, the bulls still have control of the tape.
 

 

Differing time horizons

How investors and trader should react to my change of opinion depends on their investment objectives and time horizon.

My inner investor is not interested in day-to-day blips in stock prices, and current conditions suggest that the risk/reward ratio for equities is turning unfavorable. He is therefore inclined to start de-risking his portfolio, with the target equity weight specified in his Investment Policy Statement (IPS) as his ceiling. In addition, he is considering changing his equity exposure from long-only to buy-write positions as a way of cushioning his downside risk. Another way of engineering risk control might be to use either the 50 or 200 dma as partial or full stop losses as a way of letting winners run and limiting losses.
 

 

My inner trader, on the other hand, is more focused on the possible upside potential. He is staying in his long positions until either a break of 2800 support, or sentiment becomes euphoric, which is likely to occur when the index breaks up above 2900.
 

Disclosure: Long SPXL
 

From FOMO to Tech Panic to…

Posted by Cam Hui -

Mid-week market update: I am writing the mid-week update a day early for two reasons. First, tomorrow is FOMC day and anything can happen. As well, I am getting on an airplane and I will be in the air when the market closes.

It is astonishing how nervous the market has become after Facebook’s disappointing earnings report. Callum Thomas performs an unscientific Twitter poll on weekends, and the bears have come out of the woodwork. Even if you are bearish, you have to ask yourself how much downside risk could there be at current levels? These conditions are indicative of the jittery nature of this market. A brief and minor pullback was enough to move sentiment to a crowded short reading.
 

 

In the short run, the ability of the SPX to hold above its breakout level, and the NDX to hold above its 50 day moving average points to an oversold rally here.
 

 

Poised for an oversold rebound

In my last post (see The universe is unfolding as it should), I outlined a number of bearish tripwires, which have not been triggered. SPY/TLT, which measures the stock/bond ratio, recently staged an upside breakout to an all-time high and retreated to test its breakout. Watch for signs of a decisive pullback before turning more bearish. Keep in mind that pullbacks after upside breakouts are normal.
 

 

There has also a lot of angst about weakness in FAANG stocks. The following chart shows the relative performance of the Russell 1000 Growth Index against the Russell 1000 Value Index. How worried should you be about that minor blip and pullback?
 

 

In short, until these trends are violated in a major fashion, I am inclined to give the intermediate term bull case the benefit of the doubt.

Tomorrow is FOMC day and while anything can happen, the following study from Rob Hanna of Quantifiable Edges shows that FOMC days tend to have a bullish bias. In light of the Powell Fed’s tendency to avoid market surprises, Wednesday’s market action is likely to conform to historical norms.
 

 

The real test for the bulls and bears is the market’s behavior on the market bounce. Will it be able to sustain upward momentum, or will it fail and price weaken again? Even if you are bearish, I suggest that you wait for the rally before putting on a short position.
 

Disclosure: Long SPXL
 

The universe is unfolding as it should

Posted by Cam Hui -

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

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The inevitability of rising trade tensions under a GOP president

Posted by Cam Hui -

There has been a lot of hand wringing about the rising level of protectionism in the US and around the world. Let’s take an alternative view to perform our analysis. Imagine an alternative universe, where Donald Trump did not secure the GOP nomination in 2016, but another Republican went on to win the election. I am going to make the bold assertion that trade tensions would have risen in any case.
 

 

There are two reasons for my conclusion. First, globalization has stalled, and the low hanging fruit from globalization and globalized supply chains has mostly been harvested. In addition, a Republican President would have enacted a tax cut, and the resulting fiscal stimulus would have created a positive growth differential with the rest of the world and pushed up the USD. The combination of shrinking benefits from globalization and a rising exchange rate would inevitably heighten trade tensions.
 

Stalling globalization

Credit Suisse recently presented analysis indicating that the growth in global trade has flattened out. Global trade had been rising steadily since 1960, but growth has stalled since the Great Financial Crisis.
 

 

The UN Conference on Trade and Development also presented a study concluding that stagnation in the development of global value chains, as measured by foreign value added share in exports (FVA) that began in 2012, has continued. At the same time domestic value added (DVA) has been climbing during the same period.
 

 

In short, the low hanging fruit from globalization and global supply chains has been harvested.
 

Keynesian fiscal stimulus = Positive growth differential

Trump has governed very much like a run-of-the-mill Republican in his first year in office. A recent study published at VOX used a “synthetic control method” to replicate how the American economy would have performed without Trump. This technique was used to measure the effects of one-time events such as German reunification, and the costs of Brexit. The study found that there has been no Trump effect on the economy.

Now let’s take that exercise a little further and imagine that another Republican had won the White House, and he had the cooperation of a friendly Congress. Historically, the priority of every GOP led administration has been tax cuts. Trump`s tax cut plan is therefore no surprise.

What is unusual about the current round of tax cuts is that it was enacted during a period of boom. In the past, budget deficits have risen in lockstep with unemployment. This time, Trump chose to enact a round of fiscal stimulus while the economy was firing on all cylinders.
 

 

Steve Collender, otherwise known as @thebudgetguy, recently wrote that Trump’s trillion dollar budget deficits are here to stay:

According to CBO, the deficit this year will be $804 billion and will rise to $981 billion next year and $1 trillion in 2020. CBO then projects that it will keep rising through the end of the 10-year projection window until it hits $1.5 trillion in fiscal 2028.

These projections are based on current law, which says that many of the tax cuts enacted in 2017 expire as the Tax Cuts and Jobs Act requires. If, as many expect, the law is changed so that none or only some of the provisions are allowed to expire, the revenue loss will be even greater and the deficits even larger.

CBO’s projections are also based on solid economic growth. Although CBO’s forecast is less rosy than what the Trump administration used in its budget, it still assumes that what is already the longest economic expansion in U.S. history will last another 10 years. Slower economic growth or a downturn will obviously increase the deficit even further.

As a result, CBO’s already-unprecedented projected trillion dollar-plus deficits should be considered as the best-case scenario. It’s actually more likely that the deficit will reach $1 trillion at least a year earlier in 2019, that is, next year.

While the deficit hawks may bemoan the projections of runaway debt, would the outcome have been significantly different under any other Republican administration? Tax cuts are part of the GOP’s DNA. Any other Republican would have passed a tax cut in some other shape or form. As Vice President Dick Cheney famously said in 2004, “Ronald Reagan proved that deficits don’t matter.”
 

A stronger greenback = Uncompetitive exports

Here is why fiscal policy matters. Currency strategist Marc Chandler recently invoked the policies of Ronald Reagan in his budget and foreign exchange analysis:

In 2008 and 2009, those advocating more aggressive fiscal policy, including in the US, including the Federal Reserve, were defeated on political and ideological grounds. “A debt crisis cannot be resolved by issuing more debt,” went a popular refrain. Fast forward a decade and the fiscal stimulus that is being provided in the form of tax cuts and spending cuts are larger than in 2008-2009.

The last time the US pursued such a policy mix on anywhere near this magnitude was in the early 1980s. The US ended up sucking in so much of the world’s saving that it led to cries of relief. The dollar’s recovery from the 1970s slump began generating large trade deficits, chronic current account deficits, and a protectionist backlash. In September 1985, the G5 met at the Plaza Hotel in New York and agreed on sustained coordinated intervention to drive the dollar lower.

The Reagan stimulus drove up the budget deficit, but at the same time it raised the growth differential between the US (red line) and the rest of the world (blue line). The positive growth differential put upward pressure on the USD (black line), which made US exports less competitive, and raised trade tensions.
 

 

If the Republicans of our alternative universe enacted a tax cut and fiscal stimulus plan in 2017; economic growth would have surged from the Keynesian stimulus; the USD would have inevitably risen and raised trade tensions. The difference in trade tension between Trump and any other GOP White House is only a matter of degree.
 

How Trump is different

Here is where Trump is philosophically different from other GOP presidents. While most Republicans are free traders, Trump is the opposite in his thinking on trade. The current occupant of the White House has sought to reverse much of the effects of globalization of the last few decades.

We know who won and who lost from the era of globalization from Branko Milanovic’s well-known elephant chart. This chart depicts the income growth across global income percentiles for the period 1988 to 2008. The winners were the middle class in the emerging economies, as they benefited from rising incomes as companies offshored production, and the very rich, who engineered globalization. The losers were the inhabitants of the subsistence economies, because their economies were too undeveloped to benefit from the globalization wave, and the middle class in the developed economies, who saw stagnant real income growth as jobs got offshored.
 

 

If Trump were to be successful in his trade initiatives, what would the effects be on markets and the global economy?

Let’s return to the elephant chart. Trump’s objective in raising tariffs is to force manufacturing back to US shores. By reversing the globalization effect, the winners would be the middle class of the developed economies, such as the US, and the losers would be the emerging markets.
 

 

For investors, this brings up a key question. While emerging market asset prices are understandably likely to deflate under a Trump program, what happens to Wall Street? US stock prices were big winners under globalization. If regulatory changes forced manufacturing back inside the US, labor costs would rise, and margins would fall. Moreover, global trade would decline, and so would sales growth. While some of those negatives would be offset by higher American household income and spending power, the likely net effect would be lower earnings growth, and falling P/E multiples.

Bottom line, Trump’s trade policies would be bearish for stock prices. As to whether the outcome is politically desirable, I leave that conclusion up to the reader. That answer is well beyond my pay grade. In these pages, I only analyze markets.
 

Charted: How worried should you be about a trade war?

Posted by Cam Hui -

Understandably, there has been a lot of market angst over a looming trade war. Indeed, the University of Michigan Business Confidence Index shows a rising level of anxiety.
 

 

How worried should you be?
 

Measuring the Trump effect

I approach the question in a number of ways. First, let’s measure the Trump effect on the economy. An article over at VOX used a technique called “synthetic control method” that is frequently used to estimate the effects one-time shocks, such as German re-unification or Brexit. They found that Trump had little or no net effect on economic growth or employment:

Our approach is to let the data speak for itself. We let an algorithm determine which combination of other economies matches the evolution of real GDP in the US beforethe 2016 election with the highest possible accuracy. For this purpose we rely on a large data set of 30 other OECD economies and observations from 1995Q1 up to 2016Q3. Assuming we find a good match, we can then compare the evolution of the US economy since the election of Trump to its doppelganger that did not get the ‘treatment’ of electing Trump.

This so-called synthetic control method goes back to Abadie and Gardeazabal (2003) and has been successfully applied to study the effects of similar one-off events such as German reunification, or the introduction of tobacco laws in the US (Abadie et al. 2010, 2015). We also use it in a recent study that identifies the economic costs of the Brexit vote (Born et al. 2018b).

It is important to stress that the economies picked by the algorithm and the weight they are assigned is entirely data-driven and open to replication by other researchers. The better the algorithm constructs a close economic doppelganger for the US economy as a weighted combination of other OECD economies, the more accurate our results will be. For the US, the matching algorithm attributes high weights to Canada and the UK, but also to Denmark and Norway (for details, see Born et al. 2018a).

 

Trade war anxiety

One of Trump’s signature policies has been to hold trade partners’ feet to the fire in order to obtain what he perceives as a better trading relationship. As the market has a disposition to free trade, these trade initiatives have been viewed as equity bearish.

The chart below shows the incidence of the word “tariff” or “tariffs” in the Fed’s Beige Books in 2018. While the level of anxiety has risen since the April Beige Book, a simple frequency count indicates that concerns have stabilized and began to taper off.
 

 

Goldman Sachs also found the frequency of Trump’s tweets on trade bear little relationship to the VIX Index.
 

 

These last two charts constitute a Rorschbach test on the market’s reaction to trade policy. Is the market telling us that Trump’s bark is worse than his bite when it comes to trade policy, or is it under-reacting?

If you are in the former camp that the message from Mr. Market is correct, then you should be shrugging off the trade jitters and jump on the fundamental momentum bandwagon. As earnings season progresses, stock prices are likely to undergo a FOMO (Fear of Missing Out) rally.
 

 

On the other hand, if you take Kevin Muir’s position and Trump will increasingly press his trade policy views as we approach the mid-term elections, then you should either sell everything or possibly short the market.
 

 

It’s your call.
 

How the equity bulls and bears may both be right

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

The Zen of Bull and Bear

The latest BAML Fund Manager Survey shows that institutional managers have turned decidedly cautious on the outlook for the global economy. Profit expectations are tanking, positioning has turned more defensive, as global equity weights are being trimmed, and bond weights are rising, though managers remain underweight the asset class.
 

 

At the same time, the SPX has staged an upside breakout from a cup and handle formation, with an upside target of 2925-2960. The bullish surge is supported by a recovery in both European and China-related markets.
 

 

Who is right, the bulls or the bears? How about both? The difference may be just a question of different time horizons.
 

A case of institutional cautiousness

I am certainly sympathetic to the latest round of institutional cautiousness. Accounts that take weeks or months to trade in and out of positions should be de-risking their portfolios. While I am not suggesting the clients should “sell everything”, they should be adjusting their risk profile to a neutral position, especially if their equity betas are above their targets.

There are numerous signs that the American economy is in the late stages and an expansion, and a recession could begin as soon as H2 2019. A number of my long leading indicators, which are designed to spot a recession a year in advance, are flashing warning signals. My long leading indicators are classified into three categories: household, corporate, and monetary indicators.

Among the household indicators, the disappointment in housing starts is a warning sign. I would add the caveat that this is a noisy series, but a downturn in this highly cyclical industry has occurred ahead of past recessions.
 

 

That said, real retail sales remain healthy, indicating that the household sector is still in good shape. This is not a time to panic about an imminent recession.

Among the corporate indicators, corporate bond yields have tended to bottom well ahead of past recessions. This indicator tends to be very early, therefore a bottom in yields should not be interpreted as a reason to panic, just a sign of a late cycle expansion.
 

 

Other elements of the corporate sector are not signaling caution. So far, corporate profits, another long leading indicator, are not rolling over. In addition, there are no signs of a credit squeeze, which is a pre-condition for a recession.

The monetary long leading indicators are the most problematical. The yield curve, whether measured as the 2-10 spread or the 10-30 spread, is flattening. In the past, an inverted yield curve has been an uncanny predictor of recessions. As usual, the Fed has trotted out a series of excuses why the yield curve is displaying a false signal (see (Don’t fear) the yield curve). Moreover, there has been growing disagreement between the regional Fed Presidents, who have voice concerns about the flattening yield curve, and the Fed governors, who have found reasons to ignore its signal. Historically, it is the latter group that has held the greatest power in determining monetary policy. At the current rate of raising the Fed Funds target by 0.25% every three months, the yield curve is likely to invert late this year, indicating a recession in late 2019.
 

 

Even if we were to discount the predictive power of the yield curve because of the Fed`s QE program that affected the long end of the curve, real money supply growth, measured as either M1 or M2, has turned negative ahead of past recessions. The Fed`s policy of normalizing monetary policy has seen money supply growth decelerate. While the data is very noisy, both real M1 and real M2 growth are decelerating rapidly and are on the verge of turning negative.
 

 

While I am not in the habit of anticipating model readings, there are signs that economic momentum is slowing, and the current path of monetary policy is setting the economy up for a recession to begin in H2 2019. The CME`s latest market derived expectations show one quarter point rate hike in September, followed by a second in December. Such a policy path is likely to invert the yield curve and drive real money supply growth negative some time this year.
 

 

Notwithstanding the market’s expectations, the path of policy normalization appears to be set on a pre-determined path, especially when viewed in the context that the current real Fed Fund rate remains negative indicating a highly accommodative policy. Moreover, the Fed has made it clear that it is uncertain about how to adjust policy in the event of a trade war, and it will take a wait and see approach before reacting. A recent BOE study that modeled the effects of a full-blown global trade war found that inflation would spike, which would put policy makers in the uncomfortable position of deciding whether to ease in the face of rising inflation, however transitory it may seem.
 

 

Similarly, Bloomberg recently highlighted a study indicating problematical inflationary pressure facing the Fed in the event of a trade war:

A multi-colored graphic that’s made the rounds at the Federal Reserve hints at what Chairman Jerome Powell could face if President Donald Trump succeeds in throwing globalization into reverse: Higher prices for many goods and potentially faster inflation.

Plugged as possibly the chart of the century by economist and originator Mark Perry, it shows that prices of goods subject to foreign competition — think toys and television sets — have tumbled over the past two decades as trade barriers have come down around the world. Prices of so-called non-tradeables — hospital stays and college tuition, to name two — have surged.

“We would have fewer choices, potentially less quality, less productivity and higher prices if we reverse globalization,” said Timothy Adams, president of the Washington-based Institute of International Finance, who’s discussed the chart and its implications with Fed policy makers.

Just as globalization has been a headwind holding back inflation, its unraveling could end up being a tailwind in the years ahead, pushing costs higher as countries and companies retreat from the international marketplace. That would be on top of the one-time effect that Trump’s tariffs will have on prices of selected imports, putting pressure on the Fed to raise interest rates at a faster pace than the gradual path it has currently mapped out.

 

Under these circumstances, it would be eminently sensible for investors with long time horizons to begin de-risking their portfolios now.
 

One last hurrah

On the other hand, I have been in the tactical “last hurrah rally” camp for several weeks. While the long-term forecast calls for caution, the near-term outlook looks bright.

As we enter Q2 earnings season, the outlook from FactSet is upbeat. Q2 guidance is the second most bullish since FactSet began monitoring earnings guidance. Both the sales and EPS beat rates are well above their historical averages, indicating positive fundamental momentum.
 

 

In addition, stock prices are behaving as expected. The market is rewarding earnings beats and  punishing misses. There had been some concern among analysts that the market reaction may be skewed if companies raised concerns about rising tariffs and trade friction, regardless of past results. So far, that does not appear to be the case.
 

 

From a technical perspective, the upside breakout of the SPX from its cup and handle formation confirms that the bulls have taken control of the tape. As well, the upside breakout in US equities is supported by strength in Europe, as evidenced by the upside violation of the downtrend by the Euro STOXX 50.
 

 

Over in Asia, China and Chinese related equities are bottoming after exhibiting positive RSI divergences. They appear to be poised for relief rallies.
 

 

The technical price recoveries in these regions are also supported by recoveries in the regional Economic Surprise Indices (ESI), which measure whether high frequency economic releases are beating or missing expectations. Here is ESI Europe.
 

 

ESI China is also making a nascent recovery.
 

 

In conclusion, this market is something for everyone if the scenario that I outlined becomes reality. Traders can take advantage of a momentum driven rally which is likely to take the major indices around the world to fresh highs. At the same time, long-term investors can take advantage of any market strength as an opportunity to de-risk.
 

The week ahead

Looking to the week ahead, the key risk to the bullish narrative is an upside breakout in the USD Index. The USD Index is once again testing a key resistance level while exhibiting a negative divergence. However bearish the technical indicators, this does not preclude further USD strength, which is likely to induce a risk-off episode, particularly in emerging market stocks and bonds.
 

 

In addition, the market has shown a high degree of concern about weakness in the Chinese yuan (CNY), and it has viewa falling CNYUSD exchange rate as the trade war turning into a currency war. I agree with Ed Yardeni`s assessment that such an interpretation is erroneous. If the currency of country B fall against the currency of country A, but the currencies of countries C, D, and E also rise against the currency of country A, then country B is probably not manipulating its exchange rate. The problem lies with the policies of country A.

While the Fed continues to gradually normalize monetary policy, the People’s Bank of China cut reserve requirements sharply in recent weeks. That undoubtedly contributed to the 6.2% plunge in the yuan from its mid-April peak.

If Trump does raise the ante by slapping a 10% tariff on $200 billion of imports from China, a stronger dollar relative to the yuan might very well offset most of the inflationary consequences for the US. To add insult to injury, Trump could revive his attacks on China as a “currency manipulator.” However, in my opinion, it is US trade policies, not Chinese intervention, that is weakening the yuan.

Trump knows that a weak yuan could cause the Chinese some real pain, by increasing the yuan cost of buying dollar-priced commodities, especially oil. China’s PPI inflation rate, which was 4.7% on a y/y basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month.

Nevertheless, I have learned that when the animal spirits start a stampede, it is wise not to stand in front of the herd.
 

 

Equity bulls were helped when the PBOC intervened to stop the CNY slide Friday, and a presidential tweet served to soften the greenback. While the technical conditions point to further USD weakness, the behavior of the dollar remains a wildcard for the markets. Could labeling China a currency manipulator be next?
 

 

In the meantime, the SPX pulled back from its upside breakout at 2800, but the breakout is holding. Also helpful to the bull case is the all-time high seen in the NASDAQ Composite last week.
 

 

As well, I would also point out that mid and small cap stocks have broken out past their January highs, which addresses the complaints I have read that the market advance was accomplished with narrow participation.
 

 

The upcoming week will be a test of character for the bulls. If the market were to follow the script from late 2017 and melt-up, then breadth conditions are tactically sufficiently oversold for stock prices to rise.
 

 

Otherwise, expect further consolidation and sideways action next week.
 

Programming Note

Publications will be lighter than usual as I will be in South Africa on safari and visiting friends in the Cape Town area. I will be publishing my usual weekend updates, though mid-week commentaries may not be forthcoming as internet access may be spotty. That said, even though I will be on safari, the accommodations can hardly be described as “roughing it”.
 

 

My inner investor remains constructive on equities. My inner trader would normally be piling in on the long side, but in view of his trip and possible uncertain internet connection, he is keeping his long commitment relatively light.
 

Disclosure: Long SPXL
 

Upside breakout, FOMO rally next?

Posted by Cam Hui -

Mid-week market update: It’s finally happened. The SPX staged a convincing upside breakout from its cup and handle formation. Depending on how you draw the lower line, the upside target is in the 2925-2960 range. The first test will be resistance of the January highs.
 

 

Upside breakouts are bullish. What more do you need to know?
 

Bullish confirmation

The upside breakout has been confirmed by the bullish market action in other US and non-US indices. The NASDAQ Composite has already made an all-time high.
 

 

The broadly based Wilshire 5000 has made a similar upside breakout of a cup and handle formation.
 

 

I wrote earlier in the week that China related plays were wash-out and poised for relief rallies (see Tariffs to the left, tariffs to the right…Contrarians buy China!).
 

 

European markets have also turned up. The Euro STOXX 50 has rallied and violated a downtrend, which is bullish.
 

 

In short, the upside breakout in the SPX is supported by both US and non-US indices. The next challenge for the bulls is to maintain momentum with a series of “good overbought” conditions. Should that happen, it could form the backdrop for a FOMO (Fear of Missing Out) bullish stampede in the manner of the late 2017 market melt-up.
 

 

Disclosure: Long SPXL
 

Tariffs to the left, tariffs to the right…Contrarians buy China!

Posted by Cam Hui -

The news about the Sino-American trade war seems to get worse every day. Callum Thomas pointed out that corporate managements are increasingly raising concerns about rising tariffs.
 

 

Chinese stocks have cratered, along with the stock indices of China’s largest Asian trading partners. However, a couple of contrarian buy signals are appearing. First, trade tensions are now showing up in the one place that you might expect, FX volatility.
 

 

As well, Chinese and other Asian markets are washed-out and poised for relief rallies, which would also be supportive of higher global equity prices.
 

Poised for an oversold rally

From a technical perspective, Chinese and Asian markets are showing signs of a turnaround. The Shanghai Index recently flashed a buy signal when the stochastic recovered from an oversold condition, which was supported by a positive RSI divergence. Chinese share prices fell Monday because of softer than expected economic data, but such conditions may present as an ideal entry point.
 

 

The Hang Seng Index in Hong Kong also exhibit a similar pattern of positive RSI divergence and stochastic buy signal.
 

 

The South Korean KOSPI also flashed a stochastic buy signal.
 

 

The same goes for the Taiwan market, which is important as it is a bellwether for the semiconductor industry.
 

 

I could go on, but you get the idea. In short, the stars are lining up for an oversold rally in China-related plays. After all, how can you not buy when pictures like this one goes viral?
 

 

The surprising conclusion from sector leadership analysis

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

What sector will lead?

The bulls appear to have taken control of the tape. The SPX is exhibiting a bullish cup and saucer formation. If it achieves a decisive breakout at 2800, the upside target is about 2950*. In all likelihood, the upside breakout will occur, as there is strong breadth support as small cap, midcap, and NASDAQ indices all achieved all-time highs last week.
 

 

As US stock prices are poised for fresh highs, one of the key questions is the nature of the leadership that investors should expect. A standard approach of using Relative Rotation Graph charting yielded some answers, but a further factor-based analysis indicated a surprising level of risk exposure.

* I had previously published an upside target of 3050 in a past versions of the cup and handle analysis. The 3050 figure was a arithmetic error. My apologies for the mistake.
 

Bullish intermediate market outlook

The fundamental and macro backdrop of the stock market has been unchanged for the last several months. The nowcast and short (3-6 month) leading indicators are very positive, which is supportive of stock prices.

If you are looking for a quick and dirty indicator of stock market direction, look no further than initial jobless claims, which has shown a remarkable inverse correlation with equities.
 

 

As well, the latest update from FactSet shows that forward 12-month EPS continue to rise, indicating positive fundamental momentum that is supportive of higher prices. In addition, John Butters of FactSet observed that the coming quarter is the second best quarter for corporate guidance since 2006, which should set the backdrop for a solid Q2 earnings season.
 

 

The market action of the past few months has been consistent. It has reacted positively to rising growth fundamentals, but news driven events mainly related to trade jitters have caused temporary setbacks. The likely upside breakout at 2800 indicates that market psychology is discounting the negative effects of a trade war.
 

Sector leadership analysis

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

An RRG chart of the US market reveals that the leading sectors of the market are Technology, Consumer Discretionary, and REITs. Healthcare stocks may represent the emerging leadership, and the most obvious laggards are Industrials and Financials.
 

 

Is that the full story? One of problems with float weighted indices is the index may be dominated by just a few stocks. As an example, Amazon and Netflix comprise about 30% of the Consumer Discretionary sector. The RRG chart of equal weighted sectors against the equal weighted index provided a way of verifying our preliminary conclusions of sector leadership. The conclusions are roughly the same, as the sectors are all roughly in the same sector leadership spots.
 

 

Another way of verifying the sector leadership trends is to analyze sector behavior in Europe. While US stocks have been leading European stocks, the market internals of both markets have tended to be relatively synchronized. The RRG chart of European stocks also tell a similar story. Technology and Consumer Cyclical stocks are the leaders, followed by Healthcare. Financial stocks are the laggards.
 

 

A detailed sector review

RRG analysis represents a first cut at leadership analysis. Here is a more detailed look at selected individual sectors that I would overweight.

The continued strength in Technology stocks has been a surprise, especially in light of evidence of faltering price momentum. However, the relative strength of the sector, whether on a float or equal weighted basis, is testament to powerful market leadership at work.
 

 

Consumer Discretionary stocks stand out well in the RRG analysis, but a comparison of the float and equal weighted relative returns reveals that much of the sector’s strength is a float weighted attributable to Amazon and Netflix. Nevertheless, the equal weight analysis shows that the sector is making a broad saucer shaped relative base, and it has potential for outperformance.
 

 

Healthcare is another sector making a constructive saucer shaped relative base.
 

 

Finally, I would suggest taking overweight positions in the interest sensitive sectors as a hedge against market weakness. These are defensive sectors, but they are also exhibiting similar saucer shaped bottom relative return patterns.
 

 

An overweight position in interest sensitive sectors may be appropriate, as the latest CFTC Commitment of Traders report indicates large speculators, which are mostly hedge funds, have taken a crowded short position in the 10-year Treasury Note. Such an extreme position is potentially contrarian bullish.
 

 

Factor exposure considerations

No analysis of sector leadership would be complete without an analysis of the sector factor beta. An RRG analysis of factors, or styles, shows that market leadership is dominated by small cap and selected growth styles. Value factors such as quality, and dividend growth are laggards.
 

 

The strength exhibited by small cap leadership highlights a factor exposure that many investors may have missed. Small cap outperformance has been highly correlated with USD strength.
 

 

The USD Index is technically vulnerable to a pullback. It has tested a key resistance level and failed while exhibiting a negative RSI divergence. In addition, the index rallied to test the underside of an uptrend, and it also failed at resistance. These conditions suggest that the path of least resistance for the USD Index is down.
 

 

The recent strength of the USD in the past few months makes the leadership of Technology stocks that much more remarkable. Analysis from FactSet shows that the sector has the most foreign exposure of the index. A rising dollar would create headwinds for the earnings in this sector, and still these stocks outperformed. Should the USD weaken as expected, then it should create even a greater tailwind for this sector. The obvious key risk is a trade war that hurts both the supply chain and margins of this highly globalized sector.
 

 

In light of the USD sensitivity, one approach that investors could adopt is a barbell strategy to overweight Technology and the interest sensitive stocks of Utilities and REITs.

Another factor sensitivity that I would like to address is the yield curve. Historically, the relative performance of Financial stocks has been correlated to the shape of the yield curve. A steepening yield curve has been bullish for outperformance of this sector, and a flattening yield curve bearish. The only exception has been the market reaction in the wake of Trump’s electoral win, where Financial stocks rallied in anticipation of better earnings through deregulation and tax cuts.
 

 

The yield curve has been flattening form most of this year in response to Fed policy. It is hard to see what might reverse that trend, and therefore I would suggest a continued underweight in Financial stocks.

In summary, a review of sector leadership shows a number of sectors that investors could overweight:

  • Technology still the champ
  • Consumer Discretionary and Healthcare are emerging leadership candidates
  • Interest sensitive sectors such as REITs and Utilities have the useful defensive qualities and are also showing up as possible market leaders

Lastly, the relative performance of Financials has historically been correlated to the yield curve. As long as the yield curve continues its flattening trend, it will be difficult for Financials to outperform.
 

The week ahead

Looking to the week ahead, even though the SPX has staged a marginal upside breakout at 2800, near term caution is warranted on a tactical basis for a number of reasons. First, the upside breakout was achieved while exhibiting a negative divergence on RSI-5.
 

 

The negative divergence is clearer and more visible on the hourly chart. If the index were to pull back, there are a couple of downside gaps that could be filled, with initial Fibonacci support just below the second gap at about 2760. If that breaks, secondary support can be found at 2740.
 

 

The near-term action argues for a brief period of pullback and consolidation. Breadth indicators have become overbought and they are pulling back. Even if intermediate term price momentum is strong, look for a minimum pullback to levels just below neutral, as was the case during the strong period at the end of 2017.
 

 

The upcoming week is OpEx week. Analysis from Rob Hanna of Quantifiable Edges show that the directional bias for July OpEx is little more than a coin toss.
 

 

My inner investor is still long the market. My inner trader has a minor long commitment, and he is prepared to add to his position on market weakness, or a decisive upside breakout.
 

Disclosure: Long SPXL
 

Don’t mistake this site for a chat room

Posted by Cam Hui -

I had a number of questions and comments from my last post (see Wall Street: Where the Wild Things are) when I wrote that my trading account, while still bullish, had taken “partial profits earlier this week as part of his risk control discipline when readings became short-term overbought”. The comments ranged from “where can I find a record of where your decisions to take partial profits” (answer: you can’t) to “why did you not tell us when you made that trade?”/
 

>Humble Student of the Markets state:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

What does this mean, beyond the usual legalese? Why is the content “not investment advice”?

What many investors don’t realize that the process of constructing a portfolio involves three major decisions:

  1. What do you buy and sell?
  2. How much do you buy and sell?
  3. How do you diversify your investments?

Much of the content on this site revolves around question 1. I know nothing about you. I don’t know what your return objectives are. I don’t know your tax situation, or even your tax jurisdiction. I don’t even know how much risk you can tolerate. With respect to the first question, I therefore don’t know if any investment or instrument discussed is appropriate for you. Since I know nothing about you, I would not even try to answer the last two questions.

That’s why nothing on this site is investment advice.

If I was your fund manager, we would have discussed your investment situation, and I would know enough about you to create an Investment Policy Statement (IPS). We don’t have that kind of relationship.

That’s why nothing on this site is investment advice.

If I were the manager of a fund that you bought into, there would be disclosure documents about the sorts of investment instruments that the fund can buy, and the risk levels that the fund is expected to undertake. We don’t have that kind of relationship either.

That’s why nothing on this site is investment advice.
 

Disclosure of conflict

At the same time, I write about my investment views on the site, and I will express bullish or bearish opinions on the market, sectors, or specific instruments. I believed that it was appropriate to disclose any possible conflicts that I may have because of my own investment positions.

That’s where the “trading alerts” come in.

Whenever I initiate a new trading position, subscribers get an email alert of those changes for conflict disclosure purposes. However, subscribers will not receive notification of changes in position sizing because any conflict has already been disclosed.

Here is the part that created the misunderstanding. I know nothing about you. I don’t know if my trading positions are appropriate for you. My tax situation is not your tax situation. My pain threshold is different from your pain threshold. In the absence of any such discussions, changes in my own position sizing is not necessarily relevant to your situation, and therefore it would be misleading for me to disclose those trades.
 

Not a chat room

There are a number of other websites that offer real-time chat room services. This is not one of them. There are a number of key differences between Humble Student of the Markets and a chat room.

First, the holding time horizon of “my inner trader”, which represents my trading account, is longer than most chat room day trading or swing trading services. I publish and update the idealized track record returns of my inner trader on a weekly basis based on trades using signals from the subscriber trader alerts. The average holding period is 18.0 trading days.

I disclose the track record of “my inner trader”, which is contrary to the practice of many other trading services.
 

 

As the average holding period of these trades is relative long, there is little urgency to making the trades on the day of the signal. In fact, my analysis shows that the returns from waiting 1, 3, and 5 days after the signal are better than the base case where the trades are executed on the day of the signal.
 

 

For another perspective, here are the relative returns of a hypothetical account that traded five days after the signal day. My conclusion from this analysis indicates that my trade timing isn’t perfect, and it is arguably early.
 

 

One last point about chat rooms. The going rate for a chat room subscription, where you get access to real-time signals, is about USD 200 per month, or over USD 2000 per year. That pricing structure is an order of magnitude higher from Humble Student of the Markets (see our pricing page).

In conclusion, readers who are looking for high frequency trading advice should look elsewhere (one useful site to take a look at is LaDuc Trading, where Samantha LaDuc takes the bold step of actually disclosing her trading record). At Humble Student of the Markets, my primary objective is to write about investments. A secondary objective is trading, but even then, the time horizon of my trades is longer than many day and swing trading services.