Page 62 – Humble Student of the Markets

How I learned to stop worrying and love rising rates

Posted by Cam Hui - May 13, 2018

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

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

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

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

The latest signals of each model are as follows:

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

Yellow flags galore, but no red flags

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

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

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

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

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

Fed policy error risk

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

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

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

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

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

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

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

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

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

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

Rising rate risk

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

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

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

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

Too early to worry about a flattening yield curve

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

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

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

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

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

Can a trade war sink the economy?

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

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

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

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

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

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

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

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

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

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

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

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

Oil spike risk

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

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

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

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

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

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

Risks are rising, but too early to get overly bearish

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

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

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

The weeks ahead

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

The bulls are back in town

Posted by Cam Hui - May 9, 2018

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

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

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

Bullish indicators

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

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

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

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

Disclosure: Long SPXL

Why you shouldn’t get wedded to any market indicator

Posted by Cam Hui - May 7, 2018

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

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

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

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

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

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

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

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

Analyzing the indicators

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

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

Copper as China indicator

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

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

KOSPI: The global cyclical barometer

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

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

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

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

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

Why I am not ready to call a market top

Posted by Cam Hui - May 6, 2018

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

The latest signals of each model are as follows:

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

Market top is still ahead

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

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

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

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

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

Listen to the market

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

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

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

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

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

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

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

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

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

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

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

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

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

Fundamental conditions are still strong

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

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

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

Long-term technical trends are bullish

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

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

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

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

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

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

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

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

The week ahead

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

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

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

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

Disclosure: Long SPXL

Still choppy, still consolidating

Posted by Cam Hui - May 2, 2018

Mid-week market update: Stock prices are still consolidating sideways. The technical pattern could either be described as range-bound, or as a triangle. The market tested the bottom of the triangle this week, but support held.

The market indecision could be traced to the continued disagreement between fundamental and technical investors. Several weeks ago, I highlighted a Callum Thomas weekly (unscientific) poll of market sentiment showing a record level of technical bears combined with a high level of fundamental bulls (see Technicians nervous, fundamentalists shrug). The latest reading shows a continued bifurcation of opinion, though the difference in opinion is not as extreme.

The market may continue to trade sideways until fundamental and technical opinions begin to agree again.

A bullish bias

I continue to believe that the consolidation is likely to resolve itself in a bullish fashion. I have detailed the many fundamental and macro reasons why I am bullish, so I will not repeat them here (see How much does 3% matter to stocks?). However, there are many technical reasons why the intermediate term trend for stock prices is up.

For one, market breadth is supportive of the bull case. Both the NYSE and SPX-only Advance-Decline Lines are exhibiting positive divergences.

The price momentum factor remains in a long-term, albeit choppy, relative uptrend.

The uptrend in momentum has not been reflected in sentiment models. The latest update of the Commitment of Traders data from Hedgopia shows that large speculators, or hedge funds, are in a record crowded short position in the NASDAQ 100, which forms the bulk of the momentum stocks.

The latest II survey shows that % bulls have been declining and % bears rising. While these readings are contrarian bullish, sentiment may have to become more extreme for a durable bottom to occur.

The short-end of the term structure of the VIX is also telling a similar story. Short-term VIX (VXST) is trading above the VIX Index, indicating elevated fear levels and reflective of the anxiety evident in Callum Thomas’ technician survey. While readings are not at panic bottom levels, they do suggest limited downside equity risk.

My inner trader is bullishly positioned. In this choppy environment, he is inclined to buy the dips and take partial profits on the rips.

Disclosure: Long SPXL

How much does 3% matter to stocks?

Posted by Cam Hui - April 29, 2018

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

The latest signals of each model are as follows:

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

The 3% question

The US equity market took fright last week when the 10-year Treasury yield rose above 3%. Stock prices recovered when yields retreated. How much should equity investors worry about a 3% 10-year yield?

Rather than focus on any single level, investors would be advised to concentrate on the interaction between stocks and bonds. Consider the P/E ratio. The factors that drive equity prices are:

How fast is the E in the P/E ratio likely to grow?
What is the outlook for interest rates and how does it affect the E/P ratio?

It’s really that simple.

The history of rates and stock prices

When the stock market sold off last week, I pointed to the historical analysis from JPM Asset Management that “when yields are below 5%, rising rates have historically been associated with rising stock prices” (see Is good news now good news, or bad news?)

I also referred to the BAML Fund Manager Survey which indicated that fund managers were not overly worried about equities until yields approached 3.5%.

Those are all simplistic explanations that relate to valuation, but they don’t matter very much in the short run.

Good news is still good news

What really matters to stock prices is growth, and interest rates. The Q1 GDP report was an important test for investor psychology. Is good (economic) news still good (stock market) news, or bad news?

In other words, have investor focus from the bullish factors behind positive growth changing to a fear about the bearish effects of higher growth and inflation on interest rates?

As it turns out, the bulls squeaked out a narrow win on market psychology based on the results of the Q1 GDP report. Q1 GDP growth came in at 2.3%, ahead of market expectations of 2.0%. Bespoke observed that the Employment Cost Index was showing signs of acceleration. The acceleration was not just confined to higher management bonuses, but salaried staff as well.

Q1 GDP growth has historically been depressed by seasonal factors. When we unpack some of the unusual conditions, we can see that Q4 to Q1 was distorted by hurricane-driven Q4 spike in auto sales and home repairs. GDP growth ex-hurricane effects was 2.7%. YoY GDP growth, which sidesteps the seasonal issues, came in at 2.9%.

All in all, it was a strong GDP report. Moreover, inflationary factors were ahead of expectations. Core PCE prices rose 2.5% (vs. 2.4% expected), and the Employment Cost Index printed 0.8% (vs. 0.7% expected). These results should give the Fed hawks further ammunition to push for four rate hikes this year instead of three. Indeed, the latest market expectations from CME shows that the probability of four rate hikes this year has been rising, while the probability of three hikes fell. The market implied chances of three and four rate hikes are now roughly equal.

What did the market do after the GDP report? 2-year yields spiked initially but steadied to roughly flat at the close, and the yield curve flattened. Stock prices ended the day with a small gain.

Good news is still good news. It could have been a lot worse. Score one for the equity bulls in the category of market psychology.

Earnings, earnings, earnings!

What about earnings growth? The results from Q1 earnings season has been solid. The latest update from FactSet shows that both the EPS and sales beat rates are well above their historical averages. Consensus EPS estimates rose in response to the upside earnings surprise. From a longer term perspective, forward 12-month EPS changes are roughly coincident with stock prices. While upward earnings revisions are not bullish signals in isolation, they do serve as a confirmation of the direction of Street expectations.

The market was spooked last Tuesday when Caterpillar, which is a major global cyclical bellwether, report blow-out results. In the subsequent call, management deflated expectations by stating that Q1 earnings “will be the high-water mark for the year”. That remark sent the stock’s price down, and the announcement went on to pull down the market as well. Investors should relax. CAT’s problems are likely specific to the company due to higher raw material prices from steel tariffs.

The CAT episode prompted some traders to panic and state that the market was not reacting to earnings beats. Analysis from FactSet shows that perception to be incorrect. On average, stocks are rising on earnings beats, and falling on misses. That said, the magnitude of the market reaction during this earnings season has been muted when compared to the historical average.

Score one for rising growth expectations in the E of the P/E ratio.

Watch the real economy

What about the problem of rising yields? 2-year Treasury yields have been rising steadily since the Fed began its tightening cycle, and 10-year yields are near the 3% level. When do higher rates start to hurt stock prices?

While rising yields does create competitive pressures on holding stocks, the continued dominance of the “good news is good news” narrative suggests that investors should instead focus on the secondary effects of rising rates on the real economy.

There are two likely reasons for the E in the P/E ratio to fall. Either the the Trump White House plunges the global economy into a slowdown with a trade war, or the Fed over tightens the economy into a recession. The latest news indicates that trade tensions are easing. Trump reported sounded optimistic and stated that there was a “very good chance” that a trade war could be averted. Treasury Secretary Mnuchin is on his way to China for a round of negotiations.

That leaves the Fed. The Fed is undergoing a tightening cycle. Instead of asking when rising rates are likely to hurt the stock market, the better question is when rising rates is likely to slow economic growth. Historically, recessions have followed whenever the YoY changes in Fed Funds rates have exceeded the YoY change in employment. This indicator is getting close to a recession signal, and I will be watching the April Jobs Report closely Friday to see how it is evolving.

In addition, the combination of higher interest rates and quantitative tightening will have the effect of slowing money supply growth. In the past, a recession has followed whenever either M1 or M2 growth has fallen below the inflation rate. Money supply growth is decelerating rapidly, and real M2 is on pace to go negative later this year.

Watch the effects of rising rates on the real economy, not just the stock market.

Too early to get bearish

Still, it is too early to get too bearish on equities just yet. There are few signs of a bull market killing recession in sight. Initial jobless claims provide a timely high frequency pulse of the American economy. There was much excitement last week when initial claims fell to the lowest level since 1969. For a better perspective, initial claims adjusted for population has been steadily declining and making all-time lows in this expansion cycle.

Initial claims have been inversely coincident with equity prices during the past few expansion and provides real-time confirmation of stock market trends. The bull is still alive, according to this metric.

New Deal democrat monitors high frequency economic data, and he helpfully categorizes them into coincident, short leading, and long leading indicators. His analysis indicates that there are no immediate signs of recession, though the long leading indicators are deteriorating:

The nowcast remains positive, as confirmed again by the monthly data. The short term forecast has decelerated from strongly to normally positive. The long term forecast continues to tiptoe towards neutrality, but as of now remains weakly positive, with housing, as indicated by purchase mortgage applications being the chief reason for continued positivity, although the GDP report suggests housing may be weakening slightly as well.

The exuberant reception of WeWork junk bond issue (see the details of financial analysis from FT Alphaville and Bloomberg) shows that the animal spirits are alive. The company originally tried to raise $500 million in debt, but the issue was 5x oversubscribed and upsized by 40%. The bond was priced at 7 7/8%, thought it sank to below par soon after the offering.

The WeWork offering is an indicator of low stress levels in the financial system. In general, high yield (HY) bonds have been flashing a positive divergence against stock prices, though the risk appetite of investment grade bonds is roughly tracking equity movements.

Tiho Brkan recently highlighted SentimenTrader’s AIM composite sentiment model. Readings are at levels that have produced short-term bounces. At a minimum, downside equity risk is limited at these levels.

Despite the prospect of rising rates, the combination of a strong growth outlook, robust economic nowcast, lack of financial stress, and washed-out sentiment are signals that it is too early to get intermediate term bearish. While there is no doubt that the equity bull is mature, the day of reckoning is not at hand – yet.

The week ahead

Looking to the week ahead, New Deal democrat‘s comment that the “short term forecast has decelerated from strongly to normally positive” may be setting the tone for the stock market’s outlook for the next few weeks. While the short term forecast remains positive, its deceleration has provided the impetus for the current correction. Stock price are likely to consolidate and remain range bound until some of the uncertainties that overhang the market are resolved.

That said, the S&P 500 may be in the process of staging an upside breakout from a bull flag, which would higher prices ahead. However, the market is approaching overbought readings from a short-term (1-2 day) time frame.

On a longer (3-5 day) time frame, breadth readings are neutral but exhibit positive momentum tendencies, which is bullish.

While the bias is bullish, expect lots of event driven volatility next week. From a macro perspective, the FOMC announcement on Wednesday, and the Jobs Report on Friday will undoubted create some choppiness. As well, Q1 earnings season is in full swing, and remember how AMZN, CAT, and FB created both upside and downside market swings last week?

My inner investor continues to be bullish on equities. My inner trader had taken a small long position, and he is prepared to add to his longs should the opportunity present itself.

Disclosure: Long SPXL

Is good news now good news, or bad news?

Posted by Cam Hui - April 25, 2018

Mid-week market update: What should we make of the stock market now that the 10-year Treasury yield has breached the 3% level? Should we pay attention to the JPM Asset Management historical analysis which stated, “When yields are below 5%, rising rates have historically been associated with rising stock prices”?

Should we pay attention to the latest BAML Fund Manager Survey, which concluded that the median manager is not overly worried until the 10-year yield crosses 3.5%?

Up until now, good (economic) news has translated to good (stock market) news, and bad news has been bad news. At some point, market perception will shift to putting greater weight on the bearish factors behind higher growth because of the expectation of a more hawkish Fed response, over the bullish factors behind better earnings growth.

Is the market at that turning point when good news is bad news, and bad news is good news?

The Q1 GDP report this Friday provides an important litmus test of whether that inflection point has been reached. Supposing that GDP growth comes in at better than expectations. Will stocks rally because of higher growth expectations, or drop because higher growth will pressure the Fed to raise rates at a faster pace? Similarly, what if growth came in at below expectations?

What about the yield curve? Will it steepen or flatten in response to the GDP report?

Dissecting GDP growth expectations

Consider the market expectations of preliminary Q1 GDP, which is schedule to be released Friday morning. The market consensus is a growth rate of 2.0%, which is equal to the Atlanta Fed’s nowcast and below the New York Fed’s nowcast of 2.9%.

Market expectations have been racheted downwards because of seasonal problems. Jim O’Sullivan, who has been one of the most accurate economic forecasters in the last 10 years, recently highlighted the below seasonal trend of Q1 growth rates.

On the other hand, expectations may have fallen too much. Brian Gilmartin at Fundamentalis recounted a discussion he had with David Ranson:

On another topic, further to our recent conversation, there was a bit of a bombshell Thursday morning from the Bureau of Economic Analysis. Real intermediate output grew at a rate of 7½ percent in the fourth quarter. This is a strong leading indicator of GDP, but the neat thing is that hardly anyone is watching it! The news implies an extremely strong start to GDP growth this year – probably overriding the drag from capital-market turbulence. 2018 has begun on an unexpectedly strong note that investors haven’t yet had a chance to recognize, forecasters remaining pessimistic. I see chances for 3+ percent growth in 2018 – or even 3½ percent – greatly strengthened. More specifics available shortly.

Years ago, I worked for Batterymarch chief executive Tania Zouikin, who had been Ranson’s partner at Wainwright Economics, and I am familiar with his forecasting approach. Ranson uses real-time market data to forecast economic releases, because market data tends to be forward looking while other economic statistics have backward looking biases. That is a philosophy that I have adopted in my own work in incorporating technical analysis into my own top-down investment views.

If Ranson is right and Q1 GDP sees an upside blowout surprise, will stocks rally or deflate? That will be the litmus test of market psychology. The Fed has signaled that its base case is three rate hikes this year, with four hikes a definite possibility. The probability of four hikes is rising quickly.

Is the market underpricing or overpricing the Fed’s interest rate policy even as earnings have beaten expectations?

Underlying conditions improving

During the jittery sentiment, macro and technical conditions may be putting a floor on stock prices. Trade war fears are receding. Reuters reported that Trump said that there was a “very good chance” of a US-China trade deal, and Treasury Secretary Steve Mnuchin is expected to travel to China to negotiate the deal. In a separate Reuters report, Trump also said that NAFTA talks are going “nicely”, and Canada expressed optimism over changes in the auto rules content of the treaty.

Risk appetite indicators based on the credit market (high yield bonds) and stock market (price momentum) remain healthy. As another measure of risk appetite, I am also watching carefully the market reception of WeWork’s unsecured junk bond offering (analysis via FT Alphaville). which is a financing from a “sharing economy” company with negative cash flows.

There may be further good news from the option markets. Bloomberg reported that the realized volatility of weak balance sheet companies are lower than strong balance sheet companies, which may be a confirmation of the heightened risk appetite message from the credit markets for lower credit paper. That said, some caution may be needed in embracing this such a bullish interpretation, as the higher volatility of strong credits has been distorted by the turmoil in technology stocks, which tend to have clean balance sheets.

Twitter breadth, as measured by Trade Followers, has been trending positive for the last few weeks. In particular, bullish breadth has been rising even as the market consolidated sideways, which is bullish.

The market is flashing a mild oversold reading based on Tuesday’s close, and readings are likely to have improved based on today’s market action.

For now, the market remains range bound between its February low and March high. Until it breaks out of that range, market behavior is to be interpreted as choppy and consolidative. The bulls could even describe the recent price action as a bear flag, which is a consolidation pattern that breaks upwards.

My inner trader is inclined to give the bull case the benefit of the doubt for now. The market reaction to the Friday GDP report will be an important test of market psychology as a guide to future direction.

Disclosure: Long SPXL

Don’t miss the eurozone revival!

Posted by Cam Hui - April 23, 2018

Remember my post, Opportunity from Brexit turmoil? I suggested on February 22, 2018 that we were seeing a setup for a long trade in UK equities. Brexit political chaos was reaching a crescendo, and there was a chance that we may see another referendum where the Remainers could prevail.

Since then, while there is no news of a second referendum, Business Insider reported that Theresa May may resign if she loses a vote on leaving the customs union after Brexit. The FTSE 100 (top panel) has steadied, and rallied through resistance and a downside gap from early February. In addition, UK equities have turned up relative to global equities (bottom panel) and begun to outperform.

We may be seeing a similar buying opportunity in the eurozone.

Signs of a turnaround?

For several months, it appeared that the European economic revival was faltering, as evidenced by the falling Economic Surprise Index (ESI), indicating that macro releases were consistently missing market expectations.

The ESI isn’t the stock market, and Citigroup found that buying the market when the ESI is extremely depressed level has been rewarding, with positive returns 14 out of 15 episodes.

The market is setting for a contrarian buy signal. The latest BAML Fund Manager Survey shows global managers have been reducing their eurozone equity weight for several months, indicating flagging enthusiasm for the region.

We now may have the bullish catalyst in sight. The ESI indicator is designed to be mean reverting, and today’s series of eurozone PMIs shows that the deterioration may be finding a bottom. Eurozone composite PMI was steady and beat market expectations.

The technical conditions of the Euro STOXX 50 is also supportive of further gains. The index broke up through a key resistance level, and it is now testing overhead resistance at its 50 day moving average. In addition, the relative performance of the index against global equities (bottom panel) indicates that it staged an upside breakout through a relative downtrend, indicating high outperformance potential.

In short, we have all of the elements of a buy signal in eurozone equities. Low expectations from macro deterioration, elements of a turnaround, and a positive technical backdrop. Is it time to buy?

Trade war jitters fade, but for how long?

Posted by Cam Hui - April 22, 2018

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

The latest signals of each model are as follows:

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

Falling trade tensions = Equity bullish

I have written in these pages before that, in the absence of trade war tensions, the path of least resistance for stock prices is up (see Watch the Fed, not the trade war noise).

From a technical perspective, stock market is well supported by positive divergence from breadth indicators. Both the SPX Advance-Decline Line and the NYSE common stock only A-D Line made all-time highs last week.

From a fundamental viewpoint, equity valuations are not especially demanding when compared to bonds. The market started to get concerned last week when the 10-year yield approached 3%, but some perspective is in order. As the following chart shows, FactSet reported that forward P/E ratio is in the middle of its 5-year range. By contrast, the 10-year yield is near the top of its 5-year range, indicating slightly equities are cheap relative to Treasuries. On a 10-year perspective, however, the forward P/E is above its historical range and so is the 10-year yield. Depending on your time horizon, valuations are either slightly cheap or slightly expensive, but levels are nothing to panic over.

In addition, earnings are continuing to rise. Results from Q1 earnings season have been solid, with above average EPS and sales beat rates. In addition, forward 12-month EPS are rising, indicating positive fundamental momentum.

The bullishness is not just attributable earnings results. Brian Gilmartin at Fundamentalis pointed out that revenue growth and beat statistics are highly encouraging.

What could possibly go wrong?

How a trade war hurts America

How about a trade war that craters corporate earnings? For some perspective on how a full-blown trade war would hurt the American economy, we can examine the business reaction from the latest Beige Book. The latest April report contained 36 references to the words “tariff” or “tariffs”, compared to none in the previous two editions. Most of the concerns comes from rising input costs, and that`s just from the newly enacted aluminum and steel tariffs, which are minuscule compared to the next round of proposed Section 301 tariffs on $50 billion of Chinese imports.

Boston Fed [emphasis added]

Two contacts brought up the proposed China tariffs and said they represent a major risk. One was a toy manufacturer who sources 75 percent of their production from China. The second said that punitive tariffs on Chinese aluminum had already had a big effect: “Thin gauge foil” is produced only in China and tariffs raised the price three-fold; the contact argued that “these tariffs are now killing high-paying American manufacturing jobs and businesses.”

Don’t hold back, tell us how you really feel.

Philadelphia Fed

Of the 22 manufacturing firms that offered general comments, seven mentioned impacts from recent tariffs or proposed tariffs–most noted rising prices or anticipated rising prices; just one firm anticipated greater demand.

Cleveland Fed

According to contacts, recently imposed tariffs have accelerated price appreciation of steel products, in some cases at double-digit rates.

Rising freight volumes across product segments were attributed primarily to solid economic growth. There is concern about the sustainability of increasing volume because of newly enacted tariffs and potential outcomes from NAFTA negotiations.

Richmond Fed

Steel and aluminum prices rose sharply and were expected to rise further as a result of recently-imposed tariffs.

Atlanta Fed

Overall, businesses continued to report relatively benign input-cost pressures. However, some contacts noted rising prices for transportation, as well as steel as tariff rhetoric increased.

Chicago Fed

Manufacturers facing higher steel and aluminum costs because of the new tariffs expected to pass on about half of the increased costs to their customers on average.

Minneapolis Fed

Multiple contacts reported dramatic increases in the prices for steel products, partly attributable to recently announced tariffs; a manufacturer of tractor trailers said they “can’t raise prices as fast as material costs.”

Dallas Fed

Price pressures remained elevated over the past six weeks. Input cost pressures increased among energy, manufacturing, and construction firms, partly due to the announced tariffs on steel and aluminum. Upstream energy firms said the steel tariffs represent a worry, although some contacts said there shouldn’t be much of an impact on costs until 2019 when contracts roll over. Downstream energy contacts were still figuring out how much of their steel is subject to the new tariff and how that will affect their costs and investment decisions. Several manufacturers said that talk of steel tariffs immediately resulted in higher steel prices. An architecture firm noted that the increase in steel costs will impact the ability of their clients to move forward with some construction projects. Average gasoline and diesel prices were fairly stable, although transportation services contacts noted that fuel costs were up notably from a year ago.

Expectations regarding future business conditions remained optimistic, although several contacts noted that the newly enacted tariffs were creating a lot of uncertainty in their outlooks for activity and prices. Refiners and petrochemical producers specifically mentioned their views about the potential negative impact of these tariffs on construction projects.

San Francisco Fed

Contacts reported a jump in inflationary pressures for metals prices, partly due to the anticipation of tariffs and unrelated increases in raw material costs.

Most of the concerns over tariffs raised by businesses in the Beige Book pertain to higher input costs, which hurts American competitiveness. Chad Bown at the Peterson Institute broke down the list of items in proposed Section 301 tariffs and found that they are mostly capital equipment or intermediate goods that can’t be easily replace by US manufacturing because supply chains have become global:

One out of every five tariffs that he selected involved a product with the word “parts” in its description. Most were so technical that even trade experts had no idea what they were, except to know that businesses and workers rely on those “parts” from China to remain competitive in the global marketplace.

Most of those types of products go into something bigger and better being made by Americans. And especially for those on the list, the imports from China are nowhere near zero. I classified all 1,333 products and found that intermediate inputs and capital equipment comprise almost 85 percent of the $50 billion of imports subject to Trump’s tariffs.

Is it any wonder why NFIB small business confidence edged down in March, albeit from a highly elevated level?

The businesses reaction so far has only been in response to the aluminum and steel tariffs. Those effects are relatively small and amount to a trade skirmish. What happens if the Sino-American trade relationship descend into a full-blown trade war? Researchers at the New York Fed recently published a study which asked, “Will new steel tariffs protect US jobs?” Here is the somewhat awkward conclusion for the Trump White House:

Although it is difficult to say exactly how many jobs will be affected, given the history of protecting industries with import tariffs, we can conclude that the 25 percent steel tariff is likely to cost more jobs than it saves.

The fastest way to reduce the trade deficit is to plunge the economy into a recession. Donald Trump appears to be unknowingly walking down that path.

How a trade war hurts China

Across the Pacific, the effects of a trade war will be very ugly for China. Even worse, a China slowdown is likely crater the global economy.

Exports account for roughly 20% of Chinese GDP. Daniel Lacalle pointed out that falling exports to the US would probably plunge China into a hard landing.

The hit to Chinese growth won’t just come from rising tariffs. Non-tariff barriers will also play a role to tank trade flows. The global nature of supply chains also makes US companies vulnerable to trade tensions. As an example, Beijing could disrupt American manufacturing by shutting down key Chinese suppliers of US companies like Apple using the pretense of failed health inspections. Tom Orlik at Bloomberg highlighted China’s vulnerability using the latest American ban on exports to Chinese phone maker ZTE as an example.

A Chinese slowdown would plunge most of Asia into recession. The sudden halt in global growth is unlikely to be firewalled in Asia. A Business Insider article pointed out that Germany would be especially vulnerable to a Chinese growth deceleration. If Germany, which has been the growth locomotive of the eurozone, were to slow, what happens to Europe?

“The German model depends on trade being as free as possible,” Dennis Snower, head of the Kiel Institute for the World Economy, an influential think tank in Germany told the Financial Times.

“If you hurt trade flows, then Germany will be hurt.”

Many German firms, particularly automakers and producers of other forms of heavy machinery have supply chains and manufacturing processes that heavily involve both China and the USA.

As an example, both BMW and Mercedes have major operations in the USA, with BMW’s plant in Spartanburg, South Carolina producing almost 2,000 cars per day. Mercedes has a major operation near Tuscaloosa, Alabama, employing upwards of 4,000 people.

In the event that China levies an import tariff on cars manufactured in the USA, it would have a major negative impact on the overall business of Daimler, the parent company of BMW and Mercedes.

According to the Financial Times, Daimler is “the largest vehicle exporter from the US by value and China is their number one market.”

In short, a Sino-American trade war will have far reaching global consequences.

Trade war fears are fading

Fortunately, the belligerent trade rhetoric is starting to fade. Xi Jinping’s speech at the Boao conference on April 10 appeared to have broken the rhetorical logjam. Even though the promises that Xi made were not very new, his conciliatory tone calmed the markets. Undoubtedly there are lots of back channel discussions about how to defuse the possible trade war.

Even though there is no “trade tension” ETF, I built a trade tension factor to measure the market’s perception of trade war risk. The blue line in the chart below shows the relative return of pure US revenue companies in the Russell 1000 (AMCA) compared to the Russell 1000. I would interpret a rising line (domestic companies outperforming) as rising trade tensions, net of currency effects. The green line is the USD Index. When the USD is rising (green line falling), multi-nationals enjoy an earnings tailwind. Even though AMCA has only had a fairly brief trading history, we can see that the blue line representing the trade tension factor has roughly tracked the green line, which represents the inverse of the USD, in 2017. Even though the USD (green line) has been range bound for much of 2018, the trade tension factor has been highly volatile, and illustrates the ups and downs of trade anxiety in the past few months.

Readers who want to follow along at home can use this link for real-time updates.

Even though trade tensions have been falling recently, the market is not out of the woods. Trump’s recent broadside aimed at Rusal spiked metal prices and sent commodity markets into turmoil. Despite the market’s apparent on nonchalance on trade tension risk, the Rusal episode shows Trump’s America First policy remains in effect. Who knows what will come next?

While I am cautiously bullish on equities because of a solid technical backdrop and improving growth fundamentals, investors should keep a close eye on my trade tension factor as a way of monitoring trade tension risk.

The week ahead

Looking to the week ahead, I wrote last Tuesday that, even though I remained bullish, the market was due for a brief pause (see Time for a pause in the bulls’ charge). Stock prices subsequently topped out on Wednesday and weakened for the next two days. The market is now testing its 50 dma and a key uptrend line that began in early April. If that trend line holds, the next upside resistance is the gap at about 2750 formed on March 19. Further resistance can be found at the 2790-2800 level.

Short-term breadth indicators from Index Indicators are flashing near oversold readings that are enough for a bottom at Friday’s levels.

Another possible bullish development was the news out of North Korea. After Friday`s market close, North Korea announced that it is suspending all nuclear and ICBM tests ahead of the summit with South Korean President Moon next week. The market may interpret this event in a bullish way and it could spark a risk-on rally at the open on Monday.

My inner investor remains bullish on stocks. My inner trader went to cash last Tuesday, and he plans to re-enter the market on the long side on Monday, as long as we don`t get a rip-the-bears-face-off bullish stampede. Earnings season will be in full swing next week. Even if my inner trader doesn’t catch the initial rally on Monday, there will likely other opportunities as stocks will be volatile and reacting to the headline of the day.

The canary in the credit crunch coalmine

Posted by Cam Hui - April 18, 2018

Historically, every recession has been accompanied by an equity bear market.

One characteristic of every recession has been a credit crunch. As the economy slows, banks react by tightening their lending criteria, which dries up the availability of credit, and eventually causes a credit crunch. There are a number of ways that investor can monitor the evolution of lending standards.

The most obvious way is to watch the Fed’s lending officer survey. The latest data shows that readings remain benign for both corporate and individual borrowers. One disadvantage of the survey is the results only come out quarterly, which is not very timely and amounts to looking in the rear view mirror.

A more timely data series are the Chicago Fed`s Financial Conditions Index, and the St. Louis Fed`s Financial Stress Index. Current conditions show that Stress levels are starting to rise, though the absolute stress levels remain low. Both of these data series are released monthly, which is more timely than the lending officer surveys.

There may be a better real-time way of watching for a credit crunch.

Tesla: The canary in the credit crunch coalmine

One of the functions of recessions is to unwind the excesses of the previous cycle. The finances of Tesla (TSLA) is the poster boy of the this expansion. Recently, Tesla CEO Elon Musk shot back a reply to an article in The Economist which indicated that the company needs to raise $2.5b to $3b this year as it continues to burn cash.

Much of the controversy surrounding TSLA hinges on whether the company can produce its mass market Model 3 cars in size. The latest lawsuit, which features a number of accounts from former employees, sheds light on that Herculean task. Here are just a few highlights from the lawsuit, starting with the key claims:

16. In May 2017, when Defendants stated that the Company was “on track” to meet its mass production goal, as production on a fully automated production line was supposed to be ready to begin, and in August 2017, when production on a fully automated production line was supposed to have already been in place and Model 3s were supposed to be coming off the line, according to a number of former employees, the Company had not yet finished building its automated production lines in either Fremont or Nevada. Tesla was neither ramping up mass production, nor “on track” to mass produce Model 3s at any time on or around the end of 2017.

17. Defendants Musk and Ahuja, who visited the Fremont facility on a regular basis, knew that the Model 3 production line was way behind the publicly announced schedule and that it would never mass produce the Model 3 in 2017.

18. As Defendants claimed to be on track for mass production in 217, the Fremont facility was assembling Model 3s, by hand , in the “beta” or “pilot” shop,” a facility to assemble prototypes. The actual mass production line at Freemont was yet to be completed. Workers in the pilot shop were not even able to build enough Model 3s to carry out the necessary testing on the vehicles, and most Model 3 workers were being reassigned, or spending their days cleaning. It was evident to anyone who visited the Fremont facility – and Musk himself visited the unbuilt production line area every Wednesday, known internally as “Elon Day” – that the production line was not yet built, that parts for the necessary robots were not present, and that construction workers were spending most of their shifts sitting around with nothing to do. Multiple former employees corroborate the fact that there was no fully functioning automated production line when Tesla was telling the world that there was, and that the construction site where the line was being built was clearly and visibly far from completion.

Skipping ahead to the accounts of the former employees:

125. Some time in late April or early May of 2016, FE1 participated in a meeting with Musk, CFO Jason Wheeler, and the Vice President of Engineering. FE1 stated that during that meeting, he told Musk directly that there was zero chance that the plant would be able to produce 5,000 Model 3s per week by the end of 2017.,,

190. According to FE9, the Gigafactory was plagued by problems related to producing usable models, and the first battery model was completed long past the deadline when the Model 3 was supposed to have been launched. The process required apply adhesive at a specific ratio, which if not done properly caused the batteries to “fall off.” Parts and spaces between parts were small, making correct module completion challenging. FE9 stated that prior to automated production, human error resulted in poorly produced modules “all the time,” with workers rushing products through the line, assuming problems “would fix [themselves],” which they did not…

195. During FE9’s tenure, which lasted almost to the end of the Class Period, the Gigafactory produced no more than two battery packs at most per day, sufficient for two cars. Realistically, it took a full day – comprised of two shifts – to produce a single battery pack, and, even then, it was not a “customer saleable pack,”, i.e., a pack that passed inspection and was ready to be installed in the Model 3.

196. The only “customer saleable pack” was completed in October 2017, shortly before FE9 left Tesla. A company-wide email was sent congratulating the engineers and production workers for their hard work.

Really? And the battery Gigafactory is TSLA’s competitive moat?

For some perspective of TSLA’s production problems, FT Alphaville reported that Max Warburton of Bernstein Research diagnosed the company’s problems as trying to automate before perfecting the production process:

What is the inspiration behind Tesla’s automation? Tesla has bought German robots and a German automation company (Grohmann). But the German OEMs – traditionally the most enthusiastic proponents of automation – have actually been rowing back on it in recent years. The best producers – still the Japanese – try to limit automation. It is expensive and is statistically inversely correlated to quality. One tenet of lean production is “stabilise the process, and only then automate”. If you automate first, you get automated errors. We believe Tesla may be learning this to its cost.

In other words, TSLA is never going to fix its production problems, and it will continue to burn cash. The latest report from Reuters that the company is pausing production for several days to fix its production problems is not helpful to its bull case. The only thing keeping the company’s finances in shape is Elon Musk’s flair at selling his vision to investors.

So what happens when the animal spirits turn and banks tighten their lending standards? That bring me up to my point. While I am not an advocate for either selling or shorting TSLA, I believe that the stock is the canary in the credit crunch coalmine for this market cycle.

The chart of the stock price shows two ranges, with the stock in the lower part of a higher range. However, the lower panel of the chart shows that the stock remains range bound relative to the market, though the stock is tracing out a minor falling channel.

Should it break the relative range to the downside, that would be a signal to batten the hatches.

Disclosure: No positions

Time for a pause in the bulls’ charge

Posted by Cam Hui - April 17, 2018

Mid-week market update: Don’t get me wrong, I am still bullish, but the stock market rally appear a little extended in the short run and due for a brief period of consolidation. The SPX broke out from its inverse head and shoulders (IHS) pattern this week, cleared its 50 day moving average (dma), and filled in the gap from March 22. The next upside objective is the IHS objective of 2790-2800, whic coincides with resistance defined by the highs set in late February and March.

In the short run, however, the market looks overbought and may be due for a pause.

Short term cautionary signals

I am seeing a number of short term (2-5 day) cautionary signals. Breadth indicators from Index Indicators are flashing highly overbought signals.

The stock market rally was strong enough to depress the VIX below its lower Bollinger Band (BB).

This is a setup for a sell signal for the stock market. The table below depicts a study I did last October. When the VIX falls below its lower BB and mean reverts, which hasn’t happened yet, equity returns have been subpar. However, the results are not compelling enough to go short.

This week is option expiry week. Rob Hanna of Quantifiable Edges documented in the past that April OpEx is one of the strongest OpEx weeks of the year, but further investigation revealed that the market tends to peak out on the Wednesday of April OpEx and treads water for the rest of the week.

Still bullish

Despite these short term headwinds, my inner trader is still bullish and expects to buy after an expected brief pause. Breadth indicators are bullish. The SPX only Advance-Decline Line is supportive of this advance. In addition, the small cap A-D Line made a new high.

Risk appetite measures also remain healthy.

My inner trader went to cash today as he believes that short-term risk/reward is unfavorable over the next few days, especially during a volatile period such as Earnings Season. However, he expects to be buying back in after a brief period of consolidation.

Buy gold for the late cycle inflation surge?

Posted by Cam Hui - April 15, 2018

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

The latest signals of each model are as follows:

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

Late cycle expansion = Inflationary revival

The missiles have flown, and the bombs dropped. Inflationary pressures are rising. Is this the time for gold to shine?

Notwithstanding the short-term effects of geopolitical tension, consider the longer term inflationary pressures, which are building not just in the US but globally. Ned Davis Research recently pointed out that roughly two-thirds of countries are growing above their long-term potential. Unless these countries can increase their potential through faster labor force or productivity growth, inflationary pressures begin to build, followed by central bank tightening. We could reach recessionary conditions in the next year or so.

This suggests that the economy is undergoing a late cycle expansion characterized by capacity constraints, which would lead to an inflationary revival. Gold prices are currently testing a key resistance level. Should it stage an upside breakout, who know how far they could go.

The macro bull case for gold is easy to make. Gold is an inflation hedge, and inflation momentum is rising.

J C Parets of All Star Charts highlighted a washout in the silver/gold ratio as an indicator of precious metal risk appetite. A rising silver/gold ratio would indicate that animal spirits have taken over the precious metal complex, which would be highly bullish.

Tiho Brkan pointed out that hedge funds are in a crowded short in silver futures, which is bullish for silver, and for gold by implication.

In short, sentiment models indicate that silver prices are poised for a powerful rally. The combination of rising geopolitical tensions, and possible strength in silver prices would be highly bullish for gold and other inflation hedges.

Does that mean that investors and traders should pile into precious metals in anticipation of a late cycle inflation surge? Not so fast! There are two sides to every story, and the bull case for gold may be too facile to be true.

The bull case for gold

The underlying fundamental case for gold rests on rising inflation. The New York Fed`s Underlying Inflation Gauge (UIG) shows a distinct upward acceleration with the March reading at 3.1%, which is well above the Fed`s 2% inflation target.

Not only is inflation rising in the US, the Citigroup Inflation Surprise Index indicates that positive inflation surprises are global in scope.

The junior/senior gold stock ratio (GDXJ/GDX) is equally encouraging for the bulls. As the following chart shows, the GDXJ/GDX ratio has tracked the silver/gold ratio very closely. Both are measures of precious metal risk appetite. Even as the silver/gold ratio languish at multi-decade support levels, the GDXJ/GDX is exhibiting a positive divergence, which could foreshadow strength in gold prices.

Should gold prices stage an upside breakout through resistance, point and figure charting calls for upside targets in the 1609 to 1678 range, depending on charting differences based on daily, weekly, and monthly prices, as well as box size and reversal parameters.

Stock market implications

What about the stock market? During the typical late cycle expansion phase, inflation hedge sectors become the market leaders, and stock market momentum starts to fade, but prices continue grind upwards.

As we head into Q1 earnings season, the quarter-end update from JPM Asset Management shows that the market is trading at a forward P/E of 16.4, which is decidedly average and not demanding by historical standards.

As the forward P/E ratio is average, so are expected returns.

In addition, forward 12-month EPS continues to be revised upwards, which is an indication of fundamental momentum. FactSet reported that Q1 earnings guidance is the most bullish on record since they started tracking this metric in Q2 2006.

A scenario of a slow upward price grind is consistent with former Value Line research director Sam Eisenstadt’s latest forecast. I had most recently written about Eisenstadt’s track record (see Is this what a regime change looks like?) and pointed out that the r-squared on his six-month forecasts is 0.26, which is a remarkable statistic. The chart below shows the track record of his forecasts, as documented by Mark Hulbert. Hulbert reported that Eisenstadt’s latest SPX target for September 30 is 2775, which represents a price gain of 4.5% from current levels.

So up, up and away, for gold prices and, in the absence of trade tensions, stock prices?

The bear case

If life could be that simple!

There is a glaring anomaly in the bull case. The chart below of the silver/gold ratio shows an unusual divergence with the US Dollar Index. Gold prices, as well as the silver/gold ratio, had shown difficulty making headway in spite of the weakness in the USD, which is inversely correlated to gold (note that the USD Index is inverted on the chart). The last time this happened was in the 2007-08 period, which resolved itself with a rally in the USD (and weakness in gold prices). The bull market scenario based on a bottom in the silver/gold ratio is not that simple. Either the silver/gold ratio takes off, and which is gold bullish, or the USD rallies, which is gold bearish.

Put it another way, the price of gold is reflective of inflation expectations. But gold also depends on the degree of monetary policy accommodation. Is the Fed ahead or behind the inflation fighting curve?

The latest FOMC minutes showed that the Fed is taking a more hawkish tilt in monetary policy, which is gold bearish. A Bloomberg story made the point that there are no doves left at the Fed. The consensus has shifted from a balanced and symmetric risk assessment to a debate over the degree of upside risks to growth and inflation.

After the release of the FOMC minutes, the yield curves flattened, which is the bond market’s signal that it expects slower growth because of Fed policy. Both the 2-10 yield curve, which is now under 50bp, and the 10-30 yield curve, at 20bp, at sitting at new cycle lows.

There are a number of other factors supportive of a USD rally. The Commitment of Traders chart from Hedgopia shows that large speculators are in a crowded short in the USD Index.

The euro is the biggest weight in the USD Index, and large speculators are in a crowded long in EUR futures.

In addition, the Citigroup Europe Economic Surprise Index (ESI) indicates that European and Japanese macro data have disappointed badly, indicating a loss of growth momentum. By contrast, US ESI is positive, elevated, and stable.

Notwithstanding the possibility of a more hawkish Fed, which is USD bullish, the widening spread between American and European growth expectations also puts upward pressure on the USDEUR exchange rate. USD strength is likely to be bearish for gold prices.

Trade the breakout

Having outlined both the bull and bear cases for gold, who is right, the bulls or the bears?

I have no idea. What I do know is the bull case is not as easy as it sounds. Much depends on the direction of Fed policy, and the perception of Fed policy. I would therefore keep an open mind, and allow the market to give us clues by watching for the following signs:

Upside breakout in gold prices;
Recovery in the silver/gold ratio, which is confirmed by the GDXJ/GDX ratio; or
The USD Index breaks out of its recent trading range, either on the upside or downside.

Until then, I remain “data dependent”.

The week ahead

Look to the week ahead, the SPX failed to stage an upside breakout last week from its inverse head and shoulders setup, but conditions are still supportive of the bull case. The small cap Russell 2000 did break out, and it pulled back to test the breakout turned support level.

The relative performance of high yield, or junk bonds, to duration equivalent Treasuries, and the relative performance of the price momentum factor both indicate healthy risk appetite.

The latest AAII sentiment survey has declined to a minor bearish extreme. While sentiment indicators are highly inexact for market timing, these readings point to limited downside near-term potential for stock prices.

Tom Lee observed that bearish AAII sentiment at the start of Earnings Season tends to lead to higher stock prices a month later, though the data is noisy.

Seasonality is also on the side of the equity bulls. Jeff Hirsch of Almanac Trader found that the bulk of April’s stock gains tend to occur at the second half of the month. The chart below shows the seasonal stock market pattern in April. Friday was day 10, which represents the typical bottom for the month.

Next week is also option expiry week. Rob Hanna of Quantifiable Edges observed that April OpEx is one of the most positive OpEx weeks of the year.

The market was spared the usual geopolitical related volatility from the attack on Syria because it occurred on Friday after the market closed. Subsequent events suggest that that the Russian response will be limited, if any, and the bombing will have little effect on global tensions. I expect that the markets will therefore respond with either be a relief rally, or ignore the event and allow the fundamental and technical conditions to assert themselves.

Both my inner investor and inner trader remain bullishly positioned.

Disclosure: Long SPXL

A bottoming process

Posted by Cam Hui - April 11, 2018

Mid-week market update: As the market bounces around in reaction to the headline of the day, it is important to maintain some perspective and see the underlying trend. Numerous sentiment and technical indicators are pointing towards a bottoming process and a bullish intermediate term outlook. Day-to-day price movements, on the other hand, are hard to predict.

Consider, for example, the positioning of large speculators (read: hedge funds) in the high beta NASDAQ 100 futures and options. Hedgopia reported that large speculators are in a crowded short in NDX.

By contrast, large speculators are in a crowded long in the VIX Index, which tends to move inversely with the stock market.

While Commitment of Traders data analysis tend to work well as a contrarian indicator on an intermediate term time frame, sentiment models can be inexact market timing indicators.

Bullish technical confirmation

In the short-term, risk appetite and breadth indicators are also supportive of higher prices. This hourly chart of the SPX suggests that the index is in the process of forming an inverse head and shoulders formation. Before jumping the gun and getting all excited, good technicians know that head and shoulders formations are not complete until the neckline is broken. Nevertheless, both the NYSE new highs-lows breadth indicator and the relative performance of high yield bonds against duration-equivalent USTs indicate positive divergences. Should the market stage an upside breakout at the 2675 neckline, the measured target would be about 2800, with initial resistance at about the 2700-2710 level.

The small cap Russell 2000 is already showing signs of an upside breakout from its inverse head and shoulders pattern. The index pulled back but remains above the breakout resistance turned support level.

Equally encouraging is the behavior of Schaeffer`s open interest put/call ratio on SPY, QQQ, and IWM, which surged to levels last seen in 2011.

If history is any guide, such readings have been bullish on an intermediate term basis. Shorter term, however, results are mixed and uncertain because of the low sample size (N=8). Even though one-week average and median returns are promising, the one-week % positive statistic of 63% is virtually indistinguishable from the benchmark anytime statistic of 59%.

Greater clarity from Earnings Season

As we enter Q1 earnings season in the weeks ahead, the market may get greater clarity from the fundamental outlook. The latest update from FactSet indicates that forward 12-month EPS continue to rise, indicating fundamental momentum. As well FactSet also reported that the positive to negative guidance ratio is at an off the charts bullish reading.

Earnings reports begin in earnest on Friday, starting with a selected financial stocks. While the market is likely to react on a daily basis to the earnings and macro news of the day, I expect that the bullish fundamental, technical, and sentiment factors outlined will assert themselves in the weeks to come.

Let the reporting season begin!

Disclosure: Long SPXL

China’s cunning plan to defuse trade tensions and reduce financial tail-risk

Posted by Cam Hui - April 10, 2018

About three years ago, I outlined China’s plan to extend its infrastructure growth without creating more white elephant projects in China (see China’s cunning plan to revive growth). Enter the One Belt, One Road (OBOR) initiative to create infrastructure projects in the region. OBOR projects were to financed by the Asia Infrastructure Investment Bank (AIIB), which many countries had been falling all over themselves to finance. The infrastructure projects were to be led by (surprise) Chinese companies, which would extend their flagging growth.

Fast forward to 2018, The Nikkei Asian Review and The Banker issued a report card of OBOR projects. Here are their main findings:

Project delays After initial fanfare, projects sometimes experience serious delays. In Indonesia, construction on a $6 billion rail line is behind schedule and costs are escalating. Similar problems have plagued projects in Kazakhstan and Bangladesh.

Ballooning deficits Besides Pakistan, concerns about owing unmanageable debts to Beijing have been raised in Sri Lanka, the Maldives and Laos.

Sovereignty concerns In Sri Lanka, China’s takeover of a troubled port has raised questions about a loss of sovereignty. And neighboring India
openly rejects the BRI, saying China’s projects with neighboring Pakistan infringe on its sovereignty.

None of these problems are big surprises. I had outlined in my 2015 post that Chinese led infrastructure projects tended to see inflated costs, and the geopolitical objective of OBOR was to extend China’s influence in the region.

Today, China faces two separate problems. The most immediate issue are rising trade tensions with the United States. The second and more pervasive issue is the growing mountain of debt, which are backed by less productive assets, which elevates financial tail-risk. The China bears’ favorite chart exemplifies that problem.

The latest developments indicate that Beijing has developed a cunning plan to defuse both trend tensions and reduce financial tail-risk.

Growing trade tensions

China’s current account surplus with the United States is a sore point with Donald Trump, but trade imbalances are in the eyes of the beholder. This analysis from Nomura indicates that China’s current account surplus would be greatly reduced if Hong Kong fund flows were to be included. Other analysts have pointed out that the advent of global supply chains overstate China’s trade surplus. For example, if Apple were to import an iPhone manufactured in China with a stated value of $1,000, many of the iPhone components are manufactured elsewhere, and so is the intellectual property value of the $1,000 phone. If you were to only include China`s value-added to the $1,000 iPhone, it would fall substantially.

China`s cunning plan

Still, there are a number of legitimate complaints about China`s mercantilist trade policies voiced not only by Americans, but by a growing chorus of other countries. In response, Xi Jinping made a speech on Tuesday at Boao Forum in an effort to cool trade tensions. While his concessions that he offered are not very new, his conciliatory tone cheered the markets. Here are the main points of his speech:

China will lower tariffs for imported vehicles and ease foreign restrictions on the ownership of auto manufacturing
China pledges to open a variety of industries to greater foreign investment: aviation, shipping, and financial services
China will strengthen property rights protection, including intellectual property rights

These proposals are nothing new, and general big picture statements are short on specifics. It remains to be seen whether these proposals will act to reduce trade tensions.

But wait! Did Xi say he would open financial services to foreign investment? One of the biggest problems faced by the China is the resolution of the growing debt bubble. Even though most of the debt is denominated in RMB, and popping the bubble will not result in a typical emerging market debt crisis where most of the debt is denominated in USD while a country’s currency tanks, resolving a future debt crisis will not be without costs. In all likelihood, Bejing will opt to socialize the debt, and the price of debt socialization will likely be a prolonged period of slow growth.

Enter “foreign investment in financial services”. If the foreign devils could be convinced to enter the Chinese market and lend in RMB, China will have managed to externalize financial tail-risk. The PBoC won’t have to socialize the cost, it will be the foreigners. Oh, please! Don’t throw me in the briar patch!

Some steps are already being taken. SCMP reported that foreigners are buying China’s onshore bonds in anticipation of Chinese inclusion in bond indices:

Chinese onshore bonds are becoming a larger part of global investors’ portfolios, suggesting their gradual acceptance as mainstream fixed income investment ahead of their anticipated official inclusion into one of the most followed international benchmark bond indexes.

Foreign investors’ participation in yuan-denominated Chinese onshore bonds rose to 1.09 trillion yuan (US$172.9 billion) in March, up from 1.07 trillion yuan in February and from 761.6 billion yuan in March 2017, according to data from China Central Depository & Clearing. The increase in foreigners’ holdings however is from a low base – foreign ownership remains only about 2 per cent of China’s US$12 trillion bond market.

The initiative to open Chinese domestic capital markets even got Ray Dalio all excited (see Bloomberg interview). Both Dalio and the Chinese leadership are known to have long time horizons and play the long game.

Who is right? Who has the cunning plan?

Evaluating Jim Paulsen’s market warning

Posted by Cam Hui - April 9, 2018

I have been a fan of Jim Paulsen for quite some time. The chart below depicts the track record of my major market calls. His work formed the basis for my timely post in May 2015 (see Why I am bearish (and what would change my mind)), which was received with great skepticism at the time.

The track record of my major market calls

This time, though, I believe that Jim Paulsen’s warning for the equity market outlined in this Bloomberg article is off the mark. Paulsen’s cautionary signal for the stock market is based on his Market Message Indicator, which has rolled over. The indicator is described in the following way:

The gauge takes five different data points into account: how the stock market is performing relative to the bond market, cyclical stocks relative to defensive stocks, corporate bond spreads, the copper-to-gold price ratio, and a U.S. dollar index. The goal is to devise a gauge that acts as a proxy for broad market stress.

I have annotated (in red) in the chart below the subsequent peak in the stock market after this indicator gave a sell signal. This indicator is far from infallible, but the market has weakened the last few times this indicator peaked and rolled over. During the study period that begins in 1980, some sell signals simply did not work, or there were long delays between the sell signal and the actual peak.

Here is what I think Paulsen is missing.

A cyclical and stress indicator

The Market Message Indicator uses five components to time stock prices, namely the stock/bond ratio, cyclical/defensive stock ratio, corporate bond spreads, copper/gold ratio, and the USD. These components mainly measure cyclical strength and stress.

While these components capture economic and global cyclicality well, they don’t tell the entire story of the risks facing stock prices.

Consider, for example, the copper/gold ratio as a way of measuring global cyclicality. The copper/gold ratio is a useful metric of the global cycle. Copper has both inflation hedge and hard asset qualities and cyclical qualities, while gold is mainly an inflation hedge. A rising copper/gold ratio can be an indication of global growth acceleration, while the reverse is a signal of growth deceleration.

The following chart shows that the copper/gold ratio is more useful as an asset allocation indicator than a stock market timing indicator. Gold/copper is more correlated to the stock/bond ratio (grey bars, top panel) than the stock market (bottom panel). In fact, there have been three separate episodes where both the copper/gold ratio and stock/bond ratio fell, indicating that bonds outperformed stocks, but stock prices did not fall.

The same remarks are applicable to the other components of the Market Message Indicator.

What Paulsen is capturing

I believe that much of the cyclical slowdown captured by the Market Message Indicator can be attributable to a deceleration of Chinese growth. Only 2 out of 10 of the Fathom CMI indicators of Chinese growth are in expansion mode, the rest are either falling or rolling over.

The Citigroup China Economic Surprise Index, which measures whether high frequency economic indicators are beating or missing expectations, is rolling over from a very high level.

A series of macro data disappointments in Europe may have also contributed to anxieties about a global slowdown.

By contrast, US ESI is holding up well at elevated levels.

Incipient fears about non-US cyclical weakness may be sufficient to cause a correction in US equities, but are they enough to spark a bear market?

What Paulsen is missing

The answer is no. Sustained bear markets are usually caused by recessions. Even though my Recession Watch long leading indicators are showing some signs of weakness, the immediate risk of a recession is still quite low.

The one missing ingredient for a recession is an overly aggressive monetary policy that tightens a fragile and weakening economy into a slowdown. That is why I emphasized the focus on monetary policy in my post yesterday (see Watch the Fed, not the trade war noise).

Further, I also observed in yesterday’s post that the stock market appeared to be starting to ignore bad news. Sentiment models are flashing crowded short readings, which is an indication that downside risk may be limited. I highlighted this normalized equity-only put/call ratio, which reached an overly pessimistic level and started to roll over, which is usually interpreted as a buy signal.

In short, Paulsen’s model has identified nascent cyclical weakness. As stock prices have pulled back from their January highs, the downside risk highlighted by his model may have already happened, and sentiment models are already overly bearish, indicating low downside risk.

The correction has already happened. It may be too late to sell.

Watch the Fed, not the trade war noise

Posted by Cam Hui - April 8, 2018

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

The latest signals of each model are as follows:

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

Fade the trade war jitters

“Fool me once, shame on you. Fool me twice, shame on me.” We’ve seen this movie before on trade. The White House begins the process with tough and inflammatory rhetoric, only to see the threats walked back or watered down later.

Consider the case of the steel and aluminum tariffs, which were levied for national security reasons. The initial announcement shocked the market, but the Trump administration eventually walked back most of their effects by providing exemptions for Canada, Mexico, the EU, Australia, Argentina, Brazil, and South Korea. Um, those exemptions account for over half of American steel imports. What “national security” considerations are we referring to?

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

The NAFTA negotiations followed a similar pattern of using bluffs as a tactic, and reacting afterwards. Trump began the process by declaring the free trade agreement “unfair” and “terrible”. He then threatened to tear up the treaty. The latest news from Bloomberg indicates that American negotiators are pushing very hard to have an agreement in principle in place by the Peru Summit of the Americas that begin April 13 next week. How much leverage will the American side have if the other negotiators know that Trump wants a deal by next week? Much work needs to be done before an agreement in principle can be made, but watch for more climbdowns and a declaration of “victory” by the White House.

So why worry about a possible trade war with China? Investors worried about equity downside risk should instead focus on the likely direction of monetary policy. New Deal democrat recently outlined a simple recession model which states that whenever the YoY change in the Fed Funds rate rose above the annual change to employment, a recession has followed within a year.

As the Fed normalizes monetary policy, it is on the verge of making a policy error where it tightens into a weakening expansion and crashes the economy. Recessions have invariably translated into equity bear markets in the past. That’s why investors should look past the trade war noise and focus on monetary policy.

Trade war: Strong offense but weak defense

In the wake of last week’s news of China’s retaliatory tariffs, and Trump’s response to consider an additional $100 billion in tariffs on Chinese goods, there has been no shortage of analysis of the relative positions of both sides. The best summary comes from the Washington Post, which correctly characterized the US as having the upper hand on trade (offense), but China having the upper hand on political resilience (defense):

China has more to lose economically in an all-out trade war. The Chinese economy is dependent on exports, and nearly 20 percent of its exports go to the United States. It sold $506 billion in stuff and services to the United States last year. In contrast, the United States sold $130 billion to the Chinese.

“In a serious economic battle, the U.S. wins. There is no question about it,” said Derek Scissors, a resident scholar at the American Enterprise Institute who has helped advise the administration on China.

But this isn’t just an economic fight, it’s also political, and there’s a strong case that President Trump would be less able to sustain a protracted conflict than the Chinese — especially with the 2018 midterm elections coming.

The following chart depicts US soybean production, which is a major target of Chinese retaliation. Of the 10 biggest soybean producing states, Trump won eight in the last election. A full-blown trade war will impose serious electoral pain upon the Republican Party in the upcoming midterms.

By contrast, Beijing has the financial and political capacity to to keep their economy afloat until November.

Moreover, the past leadership of the Chinese Communist Party showed it was capable of starving millions of its own citizens in order to achieve their political objectives. Xi Jinping’s “president for life” status is a signal that he has the political capital and sufficient control of the political apparatus that the Chinese economy could sustain a high level of suffering. Now imagine how a similar level of pain would play out in battleground states such as Iowa, Ohio, and Wisconsin.

The WSJ reported that Trump’s new economic advisor Larry Kudlow walked back some of the Apocalyptic tone of the trade rhetoric:

There’s no trade war here. What you’ve got is the early stages of a process that will include tariffs, comments on the tariffs, then ultimate decisions and negotiations. There’s already backchannel talks going on.

Undoubtedly there are lots of backchannel discussions to find a face saving solution for both sides. Relax, and buy the trade war panic.

A focus on monetary policy

Instead, the real risk that equity investors face is monetary policy. The economy is at capacity and starting to run “hot”. The questions for equity investors is how quickly the Fed tightens, and what effect will that have on profits, growth, and P/E multiples.

In the wake of the surprisingly weak March Jobs Report, Fed chair Jay Powell gave a speech last Friday with a dovish tone to signal three rate hikes in 2018. By contrast, Reuters reported that former Fed chair Janet Yellen gave a far more cautious message to investors in a speech to Jefferies clients indicating that the growth and inflation risks are tilted to the upside:

Monday’s larger forum for Jefferies clients, she expressed the view that three or four rate rises were likely this year, and that recent U.S. tax cuts and a boost in government spending posed at least some risk of running the economy hot, according to the first source, who requested anonymity.

Jamie Dimon also sounded a similar cautionary tone on the future path of interest rates in his annual message to JPM shareholders:

Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal. We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate — reacting to the markets, not guiding the markets. A simple scenario under which this could happen is if inflation and wages grow more than people expect. I believe that many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think. While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect.

He continued:

It would be a reasonable expectation that with normal growth and inflation approaching 2%, the 10-year bond could or should be trading at around 4%. And the short end should be trading at around 2½% (these would be fairly normal historical experiences). And this is still a little lower than the Fed is forecasting under these conditions. It is also a reasonable explanation (and one that many economists believe) that today’s rates of the 10-year bond trading below 3% are due to the large purchases of U.S. debt by the Federal Reserve (and others).

A more hawkish Fed? A 4% 10-year Treasury yield? Yikes!

The impact of tight monetary policy

Here is what is at stake. As the Fed normalizes monetary policy, money supply growth tends to slow. Historically, whenever real money supply growth, whether M1 or M2, goes negative, a recession has followed. At the current pace of deceleration, real M2 growth is likely to flash a recession signal by Q4 2018.

One consequence of monetary tightening can be seen in the evolution of the yield curves. Both the 2-10 and 10-30 yield curves are flattening. A further two quarter-point rate hikes are likely to result in inversions. While there was a long lag between the yield curve inversion and equity market top in the 2007, the previous two cycles saw the market top out between 2-6 months after the event.

We can also see the effects of tighter monetary policy in the financial condition indices. Financial stress is starting to rise, but there are no signs of a credit crunch yet.

Goldilocks is still in the house

For now, not-too-hot and not-too-cold Goldilocks conditions are still prevalent. Scott Grannis pointed out that buoyant ISM Manufacturing readings are indicative of better GDP growth.

The latest update of EPS estimates from FactSet shows that forward EPS continuing to rise, which is indicative of fundamental momentum ahead of Q1 earnings season. Moreover, FactSet reported that a record number of companies are issuing positive Q1 earnings guidance, which is also bullish.

The upbeat assessment is not just confined to US equities. Ed Yardeni observed that forward revenues are rising globally.

To be sure, core PCE is showing strong upward momentum. It is only a matter of time before the Fed turns more hawkish.

More worrisome for equity investors was Fed governor Lael Brainard’s speech on financial stability last week, which signaled the fading of a Powell Put. Brainard stated that monetary policy should not be the tool to achieve financial stability:

The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy). The objective of financial stability policy is to lessen the likelihood and severity of a financial crisis. Guided by that objective, our financial stability work rests on four interdependent pillars: systematic analysis of financial vulnerabilities; standard prudential policies that safeguard the safety and soundness of individual banking organizations; additional policies, which I will refer to as “macroprudential,” that build resilience in the large, interconnected institutions at the core of the system; and countercyclical policies that increase resilience as risks build up cyclically.

In other words, don’t count on monetary policy to ride to the rescue should the markets fall apart.

Echoes of 2011

Looking ahead to the remainder of April, the market backdrop is reminiscent of the summer of 2011. The political environment was highly uncertain, and dominated by frequent eurozone summits, where participants were planning to have a plan to solve the Greek Crisis. At the same time, stock prices were volatile but stopped reacting to bad news, Equities were range-bound while flashing frequent oversold readings, as measured by my Trifecta Bottom Spotting Model, and Zweig Breadth Thrust oversold conditions. The market eventually broke up out of the range when the European Central Bank stepped in with their LTRO cheap loan scheme to re-liquify the banking system.

We are seeing a similar level of washed out sentiment today. The normalized equity-only put/call ratio is showing a constructive mean reversion from a crowded short reading. If history is any guide, such episodes have indicated favorable risk/reward ratio, with low downside risk.

Technical analyst Pat Hennessy also observed a similar case of bearish exhaustion. The VIX Index is underperforming even when stock prices fall, indicating that implied volatility is also not responding to bad news.

The SPX appears to have found its footing at its 200 dma. The bears have been unable to push prices below the 200 dma support level despite the bad news on the trade front. The SPX staged an upside breakout through a downtrend last week, and Friday’s weakness saw the index retreat back to test the downtrend line. Initial upside resistance can be found at the 50 dma level, which also coincides with the gap located at about the 2700 level.

Insider activity also added another intermediate term bullish signal to stock prices. Open Insider data flashed a buy signal in late March as insider selling (red line) dried up and briefly fell below the level of insider buying (blue line).

The signals from this group of “smart investors” are not infallible, but if history is any guide, downside risk is limited at current levels.

My inner investor remains constructive on the equity outlook for the next few months. My inner trader is also bullishly positioned, and he believes that the risk/reward ratio favors the bulls over the bears.

Disclosure: Long SPXL

The post-FANG market beaters hiding in plain sight

Posted by Cam Hui - April 4, 2018

Mid-week market update: It is encouraging that the stock market held up well in the face of bad news on global trade. Global markets adopted a risk-off tone on the news of Chinese trade retaliation, but the SPX managed to hold a key support level and rally through a downtrend line.

Looking over the past few weeks, equity market weakness really started rolling when technology stocks rolled over in March. The carnage was not just confined to Facebook, or Amazon, but to the entire technology sector and globally. The relative performance of European technology stocks (green line) paralleled the relative performance of US technology.

One encouraging sign for the broader market can be found in my risk appetite metrics. High yield bonds (top panel) are not confirming the weakness in stock prices, though momentum (middle panel), and high beta (bottom) panel are struggling.

Notwithstanding the weakness in the technology sector, where can investors find opportunity (or places to hide) in light of the constructive view on the broader equity market?

Quality and Value the emerging leadership

We can get some clues with the use of RRG charts. The Relative Rotation Graph (RRG) is 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. Instead of applying RRG analysis to sectors, I decided to think laterally and apply rotation analysis to factors, or styles.

A number of observations stand out from this RRG analysis:

Momentum and growth, which are in the top right leading quadrant, are in the process of rolling over;
Emerging leadership does not just consistent of defensive styles, such as low volatility, but…
Quality, and Value.

We can see how leadership is changing. I have already shown how price momentum, and high beta vs. low volatility are struggling. One interesting standout from the RRG chart is the emerging leadership of high quality stocks.

One attractive feature of the superior performance of the high quality factor is that it was largely achieved without making big sector bets. The accompanying chart from Morningstar shows the variance in sector weights between QUAL and the Russell 1000 benchmark. The biggest sector differences were only 2-3%, seen in an overweight position in Financials and underweight in Technology.

Other factors of note are large and small cap value. The superior relative performance of small cap value over large cap value is not a surprise in light of the recent revival of small cap stocks, which may also be worthwhile to consider (bottom panel).

One factor that I would think twice about despite its position in the top right improving relative strength quadrant is low volatility. The recent outperformance of low volatility stocks appear to be a low beta effect. Low vol began beating the market when stock prices turned down.

The sector exposure of SPLV can be seen in dramatic fashion from this Morningstar chart. The ETF has significant overweight positions compared to its Russell 1000 benchmark in Industrial and Utility stocks, and underweight positions in Energy, Healthcare, Communication Services, and Financials.

Think about what you are betting on. If you want to maintain some equity market exposure, but in a defensive fashion, low volatility is certainly a good candidate. However, don’t expect this factor to outperform should stock prices take off.

A plain vanilla market rotation

In conclusion, the market seems to be undergoing a plain vanilla rotation. The underlying internals appear to be constructive. Watch for high quality and value stocks to take the leadership baton from the faltering growth names.

Disclosure: Long SPXL

What’s the real test? The 200 dma or you?

Posted by Cam Hui - April 2, 2018

As the SPX sold off today and tested the 200 day moving average (dma) while exhibiting positive RSI divergences, a Zen-like thought occurred to me. Is the market testing the 200 dma, or is it testing you?

Oversold, but…

The stock market is obviously very oversold. My Trifecta Bottom Spotting Model flashed another exacta buy signal today. While this model has not worked well in the recent past, the appearance of either an exacta or trifecta signal is an indication of an oversold market, with the caveat that oversold markets can get more oversold.

The TRIN indicator, which can indicate panic selling when it rises above 2, is more revealing on the 30-minute chart. During “normal” periods of panic liquidation, TRIN spikes at the end of the day in conjunction with price declines because of margin clerk and risk manager induced selling. Today, we saw TRIN hold up and rise, even as the market staged a minor late day rebound.

Now that’s real panic selling!

Unbridled panic

I recently pointed out that the Fear and Greed Index is now in single digits. Even if you are bearish, be warned that major market down legs don’t begin with sentiment at these levels.

As for the test of the 200 dma, I refer readers to Helene Meisler’s recent Real Money column, where she stated that the time to worry about a breach of this key support level is when the 200 dma begins to fall:

The general rule is the longer the S&P (or any index or stock) spends in a trading range and then breaks down from there, the more negative it is because that has given the long-term moving average line a chance to roll over — and rolling-over moving average lines are resistance on any rally.

The 2011 template

I suggested last week (see Technicians nervous, fundamentalists shrug) that a template for today’s market might be 2011, when the market chopped around for about two months before resolving itself in a bullish fashion. During this period, which is marked by the shaded area, the market generated a series of exacta and trifecta buy signals, as well as Zweig Breadth Thrust oversold readings.

Even if you are bearish, wait for the rally (and there will be one) to see if the market makes a lower high before going short.

Disclosure: Long SPXL

Is this what a regime change looks like?

Posted by Cam Hui - April 1, 2018

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

The latest signals of each model are as follows:

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

Tech rollover = Regime change?

Is the stock market undergoing a regime change? The Average Direction Index (ADX) is a trend indicator developed by J. Wells Wilder to measure the strength of a price trend. The higher the ADX level, the strong the trend. The chart below shows the relative performance of technology stocks compared to the market. Even though this sector remains in a relative uptrend, the ADX of the relative performance ratio began to roll over in late 2017. The weakness in trend culminated in the recent carnage of FANG and semiconductor stocks.

The enthusiasm for technology stocks may be overdone, as the sector has exceeded its weight in the SPX index, which last peaked during the NASDAQ Bubble.

There is a fundamental reason for the weakness in this sector. I had written about this possibility last October (see Peak FANG), where I suggested that the regulators would come for the Big Data companies in the next recession. Facebook and Google were the prime targets because they were in the surveillance business, largely because of the creepiness effect of their practices. Of the other FANG names, Amazon is also vulnerable because of their strategy to entice users into their walled garden by learning everything about them in order to sell them goods and services. The latest Facebook episode mane mean that the competitive moats of these companies may be already breached. A prolonged period of market performance may be in store, much in the manner of Microsoft after its anti-trust battle with the Justice Department.

In connection with the failure of FANG and technology leaders, the stock market is also showing signs of weakening. The SPX recently breached an uptrend line, and its ADX has also rolled over.

These developments raise two key questions for investors. If technology leadership is indeed failing, can any other sectors step up to take its place? As well, does the weakness in these high octane and high beta groups the sign of a top for the overall stock market?

The bull case

Let’s the bull and bear cases, starting with the bull case. A review of leadership by market cap shows that even though NASDAQ leadership wanes, mid and small cap stocks are poised to take over the leadership mantle. The smaller size effect is evident even within the NASDAQ 100 index, as the equal weighted NASDAQ 100, which gives bigger weights to the smaller cap stocks within the index, is outperforming its cap weighted counterpart (bottom panel).

Looking ahead to Q1 earnings season, the short-term outlook appears to be bullish. FactSet reports that forward 12-month EPS estimates are rising, which is indicative of positive fundamental momentum. Moreover, Q1 corporate guidance is on pace to be the best on record since quarter on record since FactSet started keeping records in 2006.

The positive momentum is not just confined to earnings, which is arguably affect by the newly passed tax cuts. Ed Yardeni found that are also being revised upwards as well, which is indicative of fundamental momentum at the operating level.

At a sector level, I have a couple of candidates that could become the new market leaders. Morgan Stanley recently reported that their capex tracker is surging. Rising capital expenditures would be supportive of earnings gains in the capital goods Industrial sector.

I analyzed the relative market performance of equal weighted industrial stocks, as heavyweight GE, which has been a significant laggard, is dragging down the cap weighted sector (bottom panel). The equal weighted relative performance of the industrial and capital goods sector (top panel) shows that the sector has been trading in relative range in 2018. Further positive earnings surprise could see this sector stage a relative upside breakout in the near future.

The other candidate for market leadership are financial stocks. Both the equal and cap weighted sector are in relative uptrends, though the equal weighted stocks are slightly better behaved (top panel) when compared to the cap weighted sector (bottom panel).

In short, the stock market bull remains intact. Earnings growth expectations are supportive of higher prices, with an anticipated shift in leadership from technology (25% weight) to industrial (10% weight) and financial stocks (15% weight).

The bear case

One of the key legs of the bear case rests on the amazing work of former Value Line research director Sam Eisenstadt. Six months ago, Mark Hulbert wrote that Eisenstadt had forecasted an SPX target of between 2620 and 2640 at the end of March. The index closed at 2641. Hulbert had been highlighting Eisenstadt’s forecasting track record for years, and stated that the r-squared of Eisenstadt’s six month forecast is 0.31, which is statistically significant at the 95% confidence level. The chart below shows Eisenstadt’s out of sample six month SPX forecasts since 2013, as documented by Hulbert.

Here is what concerns me. In the last forecast as of September 2017, Hulbert wrote that “two of the more important inputs are low interest-rates and market momentum…[which] are mildly positive right now”. Both interest rates and momentum have deteriorated since then.

I have already pointed out how the ADX indicator is signaling a trend change and a possible loss of price momentum. Monetary conditions are also tightening and interest rates are rising. Both the 2-10 and 10-30 yield curves are flattening to a cycle low. Even though neither yield curve is inverted, two more quarter point rate hikes would do it. This would create the pre-conditions for a recession in late 2018, and an equity bear market to begin soon afterwards.

The loss of momentum is setting up for an RSI negative divergence sell signal. If history is any guide, the past three bear markets have been preceded by negative divergences in the 14-month RSI. While I am not in the habit of jumping the gun on model signals, should the latest correction end at these levels and rally to either test or make marginal new highs in the next couple of months, a negative RSI divergence is likely to appear at that point.

A different kind of regime change

Speaking of regime changes, another regime change risk is rapidly rising because of Donald Trump’s appointment of John Bolton as National Security Adviser. In a recent op-ed, conservative commentator George Will described Bolton as the “second most dangerous American”:

Because John Bolton is five things President Trump is not — intelligent, educated, principled, articulate and experienced — and because of Bolton’s West Wing proximity to a president responsive to the most recent thought he has heard emanating from cable television or an employee, Bolton will soon be the second-most dangerous American. On April 9, he will be the first national security adviser who, upon taking up residence down the hall from the Oval Office, will be suggesting that the United States should seriously consider embarking on war crimes.

As a reminder, Bolton was a strong advocate of the war on Iraq. He is also a strong advocate of attacking Iran and North Korea.

For the first time since the Second World War, when the mobilization of U.S. industrial might propelled this nation to the top rank among world powers, the American president is no longer the world’s most powerful person. The president of China is, partly because of the U.S. president’s abandonment of the Trans-Pacific Partnership without an alternative trade policy. Power is the ability to achieve intended effects. Randomly smashing crockery does not count. The current president resembles Winston Churchill’s description of Secretary of State John Foster Dulles — “the only bull I know who carries his china closet with him.”

Like the Obama administration, whose Iran policy he robustly ridicules, Bolton seems to believe that America has the power to determine who can and cannot acquire nuclear weapons. Pakistan, which had a per capita income of $470 when it acquired nuclear weapons 20 years ago (China’s per capita income was $85.50 when it acquired them in 1964), demonstrated that almost any nation determined to become a nuclear power can do so.

Bolton’s belief in the U.S. power to make the world behave and eat its broccoli reflects what has been called “narcissistic policy disorder” — the belief that whatever happens in the world happens because of something the United States did or did not do. This is a recipe for diplomatic delusions and military overreaching.

As recently as February 2018, Bolton penned a WSJ editorial entitled “The legal case for striking North Korea first”. Moreover, he has shown a history of strong arming the intelligence community to his views. In one case, when the intelligence officer refused to change his assessment, Bolton tried to get him fired (via Lobe Log).

The most egregious recent instances of arm twisting arose in George W. Bush’s administration but did not involve Iraq. The twister was Undersecretary of State for Arms Control and International Security John Bolton, who pressured intelligence officers to endorse his views of other rogue states, especially Syria and Cuba. Bolton wrote his own public statements on the issues and then tried to get intelligence officers to endorse them. According to what later came to light when Bolton was nominated to become ambassador to the United Nations, the biggest altercation involved Bolton’s statements about Cuba’s allegedly pursuing a biological weapons program. When the relevant analyst in the State Department’s Bureau of Intelligence and Research (INR) refused to agree with Bolton’s language, the undersecretary summoned the analyst and scolded him in a red-faced, finger-waving rage. The director of INR at the time, Carl Ford, told the congressional committee considering Bolton’s nomination that he had never before seen such abuse of a subordinate—and this comment came from someone who described himself as a conservative Republican who supported the Bush administration’s policies—an orientation I can verify, having testified alongside him in later appearances on Capitol Hill.

When Bolton’s angry tirade failed to get the INR analyst to cave, the undersecretary demanded that the analyst be removed. Ford refused. Bolton attempted similar pressure on the national intelligence officer for Latin America, who also inconveniently did not endorse Bolton’s views on Cuba. Bolton came across the river one day to our National Intelligence Council offices and demanded to the council’s acting chairman that my Latin America colleague be removed. Again, the demand was refused—a further example of how such ham-fisted attempts at pressure seldom succeed. There was even more to the intimidation than has yet been made public, but I leave it to those directly targeted to tell the fuller story when they are free to do so.

The NY Times reported that Secretary of Defense Mattis has told colleagues he is unsure if he can work with John Bolton.

I had suggested in early January that 2018 would be the year of “full Trump”, after he had achieved the primary objective of the tax cuts (see Could a Trump trade war spark a bear market?). The Bolton appointment is just part of an emerging pattern of the “full Trump”, where he has acted on his instincts.

Bolton will undoubtedly steer foreign policy toward tearing up the deal with Iran, which is likely to destabilize the region. Bloomberg reported that Energy Secretary Rick Perry is discussing the sale of nuclear power stations to Saudi Arabia in support of American supplier Westinghouse, which is in Chapter 11 reorganization. The sale would give the rights to the Saudis to enrich uranium, which is the first step to the acquisition of nuclear weapons.

The geopolitical threat is not restricted to just North Korea and Iran. The more dangerous red line is China, where Trump is playing the Taiwan card. A recent editorial in the state controlled China Daily warned against the passage of the Taiwan Travel Act, which permits high level discussions between Washington and Taipei officials:

Unlike trade, though, Taiwan is a matter of sovereignty. For Beijing, it is a clearly defined core interest that is not negotiable.

This latest move is reflective of what George Will characterized as using “U.S. power to make the world behave and eat its broccoli” that is risky and could lead to war, whether with North Korea, Iran, or China. As Bolton settles into his position, geopolitical risks is likely to rise, starting in 2H 2018. A rising geopolitical risk premium will unsettle global markets. In that case, the defense and aerospace sector is likely to outperform, and could become a safe harbor for equity investors should investors get rattled. The industry group is already in a relative market uptrend. The history of the group shows that it performed well and acted as a counter cyclical manner during the post 9/11 bear market.

Resolving the bull and bear cases

In summary, the bull case for equities is based on continued underlying fundamental and economic momentum. The near-term earnings outlook appears bright, and even if technology leadership were to falter, industrial and financial stocks are poised to take up the baton.

The bear case consists of rising monetary and price momentum headwinds. Price momentum is weakening, bond yields are rising, and the yield curve is flattening, which is a sign that the bond market is discounting slowing economic growth. In addition, the Trump’s appointment of John Bolton as National Security Adviser is likely to raise the geopolitical risk premium later this year.

Who is right? How about both? The near-term direction for equities is bullish, and stock prices are likely to test the old highs or make further marginal highs. However, this is part of a topping pattern where stock prices make a cyclical high this summer, and bearish factors begin to dominate later in the year.

The week ahead

The week ahead may see further market volatility as last week. I believe that intermediate term downside risk is limited. The Fear and Greed Index is in single digits and oversold. Major bear legs simply do not start with readings this low.

Market breadth indicators are supportive of a market bottom. Both the NYSE A-D Line and the NYSE Net highs-lows have exhibited positive divergences.

SentimenTrader also pointed out that the put/call ratio is favors market gains over the next two months.

That said, the rally Friday left the market overbought on a short-term (1-2 day time horizon) basis. Expect some pullback or consolidation early next week.

On a longer term (3-5 day) time horizon, readings are only neutral, and exhibit positive momentum. Expect further gains later in the week.

The big event next week will be Friday’s Jobs Report, followed by a speech by Fed chair Jay Powell on the economic outlook later in the day.

My inner investor remains constructive on equities. My inner trader is long the market. He believes that the risk/reward ratio favors the bulls over the bears.

Disclosure: Long SPXL

Technicians nervous, fundamentalists shrug

Posted by Cam Hui - March 28, 2018

Mid-week market update: Both my social media feed and the my questions this week have a jittery tone. Will the 200 day moving average (dma) hold as the SPX tests this important support level? What sectors or groups could step up to become the next market leaders if technology stocks falter?

Callum Thomas of Topdown Charts highlighted an important bifurcation in sentiment between the technicians and the fundamental analysts. He has been conducting an (unscientific) Twitter poll on a weekly basis since July 2016, and the latest results show a record level of bearishness among technicians, while fundamental analysts have largely shrugged off the recent round of market weakness.

Who is right?

Fundamentally bullish

Let’s start with the fundamental outlook. As we approach quarter end, all eyes start to turn towards Q1 earnings season for some signs on stock market direction. One of the early clues to earnings season is corporate guidance. John Butters of FactSet reported last weekend that guidance is at an off the charts bullish reading:

At this point in time, 104 companies in the index have issued EPS guidance for Q1 2018. Of these 104 companies, 52 have issued negative EPS guidance and 52 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 50% (52 out of 104), which is well below the 5-year average of 74%.

If 52 is the final number of companies issuing positive EPS guidance for the first quarter, it will mark the highest number of S&P 500 companies issuing positive EPS guidance for a quarter since FactSet began tracking EPS guidance in Q2 2006.

I have documented in the past that bottom-up EPS estimates surged because of the tax cut effect. As the chart below shows, the rise in estimates from lower tax rates have petered out, and we are now seeing the organic growth element of EPS growth in Q1 estimates.

Looking ahead into April, the earnings outlook is positive. Trade war fears are fading. What do you have to worry about?

A crowded short

There is also evidence of capitulation. Inverse ETF volume is spiking indicating a crowded short. The last time this happened, the market was unwinding its crowded short volatility trade.

Notwithstanding the longer term problems that confront Facebook, the latest magazine covers could be interpreted as a contrarian buy indicator for the stock.

Technical buy signals everywhere, but…

From a short-term technical and sentiment perspective, I am seeing buy signals everywhere, though the market does not be responding as expected to these models, which is causing some concern.

Rob Hanna of Quantifiable Edges maintains a Capitulative Breadth Indicator (CBI). While his normal buy signal occurs when CBI reaches 10, a study of its reading of 9 still shows a bullish edge.

Recession Alert’s Selling Pressure indicator shows that current conditions as extremely stretched on the downside, though a buy signal has not been generated yet until mean reversion occurs.

Similarly, I had highlighted a VIX buy signal when it rose above its upper Bollinger Band and mean reverted, though the market hasn’t responded as expected with a rally.

A past historical study has also shown a bullish edge.

Why the choppiness?

More volatility ahead?

Ed Clissold of Ned Davis Research resolved the edginess felt by many technicians this way with some good news and bad news. The good news is selling pressure is abating, implying that any 200 dma test will not be resolved in a bearish fashion.

The bad news is that the bearish breadth thrusts that the market has experienced tend to be followed by further choppiness.

The best analogy of current market conditions may be the summer of 2011, when the market chopped around for about two months in a range for about two months before rallying. That period was marked by several false starts, as marked by exacta and trifecta buy signals from my Trifecta Bottom Spotting Model, and oversold readings from the Zweig Breadth Thrust indicator. If 2011 is the template, then expect the near-term SPX range to swing between 2600-2800, with an initial upside target of filling the gap at around 2700.

My inner trader remains bullishly positioned, as he believes that downside risk is limited at current levels. The Fear and Greed Index stands at 6. While I cannot predict what the market might do in the short-term, major bear legs simply do not start with readings at such low levels.

Disclosure: Long SPXL