Wall Street: Where the Wild Things are

Posted by Cam Hui -

Mid-week market update: There is a children’s book called Where The Wild Things Are by Maurice Sendak that stands as a metaphor for the stock market’s action. Here is a summary from Wikipedia:

This story of only 338 words focuses on a young boy named Max who, after dressing in his wolf costume, wreaks such havoc through his household that he is sent to bed without his supper. Max’s bedroom undergoes a mysterious transformation into a jungle environment, and he winds up sailing to an island inhabited by malicious beasts known as the “Wild Things.” After successfully intimidating the creatures, Max is hailed as the king of the Wild Things and enjoys a playful romp with his subjects. However, he starts to feel lonely and decides to return home, to the Wild Things’ dismay. Upon returning to his bedroom, Max discovers a hot supper waiting for him.

A number of films have been made from the story, including a full length feature movie. Here is a animated short from Youtube (click link if the video is not available).
 

 

As the SPX corrected after testing a key resistance level at about 2800, Where the Wild Things Are is an apt metaphor for the market and its animal spirits. The question for the investors is what part of the story we are at. Are we at the stage where Max is romping with the Wild Things, or is Max about to leave the island, where the Wild Things threw their final tantrum by roaring their terrible roars, and showed their terrible teeth (FANGs)?
 

Bull case

Here is the bull case. From a technical perspective, the SPX is tracing out a bullish cup and handle formation. If the market were to stage an upside breakout from resistance, the measured target is about 3050. That target is consistent with my past analysis using point and figure charting that yielded upside targets of between 3000 and 3100 (see How far can this rally run?).
 

 

Market breadth is also supportive of new highs. Various flavors of advance-decline lines, such as the NYSE, SPX, and so on, have already achieved all-time highs, indicating broad based strength.
 

 

There is also fundamental and top-down macro support for higher prices. As we enter into Q2 earnings season, corporate guidance is highly upbeat, which should make for an excellent reporting season.
 

 

NFIB small business confidence remains very strong, which should be supportive of small cap performance. I would also add that the key vulnerability of the economy to a trade war is business confidence. So far, confidence is holding up well in the face of trade concerns.
 

 

The economic nowcast is on fire. The Atlanta Fed’s Q2 GDPnow stands at 3.8%, the New York Fed’s nowcast is 2.8%, and the St. Louis Fed’s nowcast is 3.4%. In addition, Jim O’Sullivan of High Frequency Economics observed that the elevated (and exaggerated) NFIB confidence level is consistent with 6% GDP growth.
 

 

Bear case

Despite the roaring nowcast and evidence of fundamental momentum, a case could be made that the market setting is the equivalent of Max preparing to leave the island of Wild Things. In particular, metrics of risk appetite look unhealthy and they appear to be rolling over.

Exhibit A is the performance of the price momentum factor, which has breached a relative uptrend. In addition, the relative returns of high beta (SPHB) compared to low volatility (SPLV) remains range bound. If the animal spirits are running wild, shouldn’t we be seeing evidence of this in the risk appetite indicators?
 

 

Similarly, risk appetite cracks are showing up in the credit markets. High yield (HY), or junk bonds, are exhibiting a negative divergence with stock prices. In addition, investment grade (IG) bonds have been underperforming for the last few months, which is another red flag.
 

 

Resolving the bull and bear cases

I resolve the bull and bear cases this way. I interpret the deterioration in risk appetite as an intermediate term cautionary flag. In the short run, a last gasp momentum can still carry stock prices to new highs. I agree with Kevin Muir of The Macro Tourist about his misgivings about the stock market, but current intermediate term sentiment and positioning is just a little too bearish for the market to crash here.

Although I am worried the moment I bare my soul about my lack in faith of any meaningful dip happening soon the Rosenberg-Gundlach decline will begin, I can’t help but lay it out on the table. I know all the reasons why the stock market should go down. The investor in me agrees 100% with the skeptics who worry we are late-cycle and that risks are rising. But the trader in me is even more concerned that everyone is already positioned for this outcome. Markets often go where they will hurt the most and make the majority look foolish. That path is higher – not lower.

Tactically, today’s muted response to the latest round of trade war angst in the US equity market, which fell -0.7% compared to losses of over 1% in Europe and Asia, is encouraging for the bull case. The hourly SPX chart shows an initial Fibonacci retracement support at about 2755, with further support at the 50% retracement level and former breakout-turned resistance at about 2740.
 

 

In all likelihood, these support levels will be tested. There is also a gap at 2762-2768 that is itching to get filled on weakness. As well, CNBC reported that Bespoke found that stock market returns tend to be subpar during the World Cup, which will not be complete until later this weekend.

Should the index test these support levels in the coming days, equally important will be the cues from non-US markets. Will their behavior be supportive of bullish or bearish momentum?

On the other hand, the bull case depends on the completion of the cup and handle formation with an upside breakout. If the market can decisively break out from resistance at 2800, then the bull case becomes much stronger, and we could see the index at 3000-3100 over the summer. I would then watch for the signs of a top once the Fear and Greed Index reaches overbought levels.
 

 

My inner trader is cautiously bullish and he is giving the bull case the benefit of the doubt. He took partial profits earlier this week as part of his risk control discipline when readings became short-term overbought. He is prepared to add to his long positions on a pullback.
 

Disclosure: Long SPXL
 

Trade War Apocalypse, or Sell the rumor, Buy the news?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

Bull or Bear?

The first real shots in the Sino-American Trade War were fired last week when the US imposed a series of tariffs on $34b of Chinese goods at 12:01 ET on July 6, 2018, and the Chinese retaliated with tariffs of their own. For investors, the current environment presents a dilemma.

On one hand, the prospect of a protectionist curtain descending around the world is bearish for growth, and for equity prices. On the other hand, the near-term outlook for economic growth and earnings are bright. In the absence of trade tensions, US stock prices should be breaking out to new highs.

The conundrum can be illustrated by the readings of the Fear and Greed Index, which is stuck in neutral and showing no signs of momentum nor direction. Is a Trade War Apocalypse just around the corner, which will collapse the index to new lows; or is this a case of sell the rumor, and buy the news? Arguably, the market’s rangebound behavior in 2018 is attributable to the earnings growth vs. trade jitters dilemma.
 

 

We examine the bull and bear cases.
 

Bull case: Global reflation

Last week, I asked if global markets could continue to rise if non-US markets and economies are weak (see A looming global recession, or buying opportunity?). I concluded that there were nascent signs of a turnaround abroad. This week, we are getting confirmation of a global reflationary rebound.

Start with the US, which has already been showing signs of economic strength. This chart of ISM (blue line) and SPX (orange line) may be all investors need to know about the stock market. ISM Manufacturing roared ahead and beat expectations, and we are seeing a continued positive divergence that is equity bullish.
 

 

Friday’s June Employment Report confirmed the upbeat assessment of the American economy. The report delivered a Goldilocks not-too-hot-not-too-cold reading for equity investors. Non-farm payroll beat expectations, and the figures for previous months were revised upwards. However, Average Hourly Earnings was tame, which was a signal that wage growth is not accelerating and does not pressure the Fed to turn more hawkish on monetary policy.

Other internals were also solid. Even though the unemployment rate rose, it was attributable to a rise in the participation rate. Moreover, the flow of “not in labor force” to “employed” rose. These conditions will give Fed policy makers some comfort that there is still slack in the jobs market and there is no urgency to accelerate the pace of monetary policy tightening.
 

 

There were also other signs of solid non-inflationary growth. Temporary jobs and quits from the JOLTS report have historically led civilian employment, and the latest jobs report show no signs that temp jobs are rolling over.
 

 

It was a solid jobs report that keeps Fed policy on track, and gave the hawks little ammunition to tighten faster. The report was so positive that it prompted David (the world is collapsing into recession) Rosenberg to reassess his bearish outlook for the economy.
 

 

On a bottom-up basis, there was also good news. The latest update from FactSet shows that forward 12-month EPS is still rising, indicating positive fundamental momentum.  Moreover, Q2 EPS guidance is coming at better than the historical average, which should make for a positive tone for the upcoming earnings season.
 

 

There was also good news over in Europe. Weakness in the eurozone Manufacturing PMI was offset by strength in the Services PMI, and the resulting Composite PMI showed signs of stabilization and rebound.
 

 

The turnaround can be best seen in the Citigroup Europe Economic Surprise Index.
 

 

Notwithstanding the rising trade tensions, there were signs of a rebound in China as well. Last week, I highlighted analysis from China Beige Book of unexpected growth acceleration. Gavyn Davies confirmed that view in the Financial Times:

In China, our nowcast is much more surprising, because it reports an update in growth to above 8 per cent, while most other economists are talking about a slowdown in retail sales and fixed asset formation, with estimates of the GDP growth rate dipping to about 6.5 per cent.

 

The unexpected strength in Caixin China PMI is also supportive of the rebound thesis.
 

 

In light of this evidence of a synchronized upturn in economies of the three global major blocs, global stock prices should be staging a reflationary rally.
 

The bear case: Tariffs, tariffs, tariffs…

The bear case rests on the risks of a trade war. Even though widespread opposition from business groups is building against Trump’s tariffs, both the US and China appear to be digging in their heels in their negotiating positions.

The main damage from the trade war can be found in a deterioration in business confidence. The latest FOMC minutes reflect the heightened angst as expansion plans are put on hold [emphasis added]:

Participants reported that business fixed investment had continued to expand at a strong pace in recent months, supported in part by substantial investment growth in the energy sector. Higher oil prices were expected to continue to support investment in that sector, and District contacts in the industry were generally upbeat, though supply constraints for labor and infrastructure were reportedly limiting expansion plans. By contrast, District reports regarding the construction sector were mixed, although here, too, some contacts reported that supply constraints were acting as a drag on activity. Conditions in both the manufacturing and service sectors in several Districts were reportedly strong and were seen as contributing to solid investment gains. However, many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy. Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.

Reuters reported that the Chamber of Commerce has launched a campaign against Trump’s tariffs. Will he listen to this Republican leaning group ahead of the mid-term elections?

The U.S. Chamber of Commerce, the nation’s largest business group and customarily a close ally of President Donald Trump’s Republican Party, is launching a campaign on Monday to oppose Trump’s trade tariff policies…

“The administration is threatening to undermine the economic progress it worked so hard to achieve,” said Chamber President Tom Donohue in a statement to Reuters. “We should seek free and fair trade, but this is just not the way to do it.”

There are signs that these complaints are falling on deaf ears. Axios reported that, despite widespread polling that the Democrats will retake control of the House and challenge for the Senate in November, “President Trump and some West Wing officials believe Republicans will hold on”. In fact, “Trump is already holding frequent rallies in key areas for the midterms, and will travel even more after Labor Day. He relishes the fight, and loves the idea that he’ll save the House for Republicans.”

Why listen to these defeatist business groups when you think you will win?

At the same time, The Economist reported that Beijing thinks that they can outlast Trump in a trade war of attrition:

An authoritarian regime can limit and dictate the public discussion. After the stockmarket tumbled, authorities warned journalists against citing the trade conflict as an explanation, according to a directive published by the China Digital Times, a website that tracks government censorship. Reporters were also ordered to emphasise the economy’s bright spots. In America, meanwhile, the hurly-burly of its public discourse has been on display. On July 2nd the US Chamber of Commerce, the country’s biggest business group, launched a lobbying campaign to explain how tariffs would hurt the economy. Republican lawmakers in Congress are criticising the president’s trade policies more openly than heretofore—though on past form, if Mr Trump pushes ahead, they will probably fall into line.

Another source of confidence for China is the knowledge that it is not fighting America alone. From steel tariffs on Japan to threats of auto tariffs on Europe and negotiations that might wreck the North American Free-Trade Agreement, Mr Trump is taking on every one of America’s allies. China has tried to rally them to its side. It has asked the European Union to join it in condemning Mr Trump’s trade actions, according to Reuters (the EU declined because of its own trade grievances against China). Even as it raised tariffs on soyabeans from America, it removed them from soyabeans from India, South Korea and others in Asia. Xi Jinping, China’s president, has hinted that its markets will become more open to non-American firms.

There have been many macro models of the effects of a trade war (see my January publication Could a Trump trade war spark a bear market?). The latest estimate from the Bank of England assumes a 10% across the board tariff. It would take 2.5% off GDP, and the secondary effects would roughly double the costs. Moreover, the effects would be felt all around the world.

Bank of England simulations suggest that the impact of narrow, bilateral tariff increases through direct trade channels would tend to be small – reflecting the small share of overall exports affected – and would be largely confined to the countries directly involved. However, a larger, increase in tariffs of 10 percentage points between the US and all of its trading partners could take 2½ per cent off US output and 1 per cent off global output through trade channels alone, although the impact on the UK is smaller reflecting a greater exchange-rate driven boost to net exports.

 

 

It would be a very bumpy ride. If the US were to take a 5% hit to GDP growth, it could easily crater stock prices at a magnitude similar to the Great Financial Crisis, if not more.
 

Market implications

After reviewing the bull and bear cases, what should investors do? The answer is tricky, because navigating between the bull and bear cases is a study in policy direction and investor psychology.

In the realm of policy, will one side blink in this mano-a-mano war of nerves, as Trump did with in the case of ZTE?
 

 

The next data point to watch is NFIB small business optimism, which is due to be reported Tuesday morning. Should confidence show signs of collapse (and the headline gets widespread play on Fox News), it would put pressure on Trump to find a face-saving compromise.

One other issue that investors should consider is how the markets will start to discount the effects of the mid-term elections in November. As the summer progresses and should it become evident that the Democrats will control the House, how will the market react?
 

 

An Axios article recounted the advice of the Bush 43 White House OSG (Oh Sh** Group) that was formed in preparation for a Democratic victory. They had this advice for Trump aides:

  • Democrats now will have subpoena power: “Oversight committees are going to bombard you with calls for testimony and documents,” requiring massive West Wing legal bandwidth.
  • Democratic chairs can suddenly go after your spending, your email, your calendars, your notes.
  • “Things that might get a pass — or be one-day stories, or wiped under the rug — when you have the same party can suddenly became major stories. Every single thread, happening anywhere in the government, gets pulled.”
  • Democrats are likely to pick “weak members of the herd” — vulnerable Cabinet members — and go after them from all directions.
  • “Clear the decks now of anyone you think is going to cause more pain and embarrassment than you’re willing to spend.”
  • “The confrontational footing is a huge distraction. You have to structurally prepare for how you’re going to deal with ongoing battles where suddenly you’re not setting the agenda.”
  • “Figure out which issues you’re going to fight on, and which Democratic issues you can try to co-opt and make progress on.”

In other words, governing will become far more difficult that it is today. Not only will it be impossible to get any legislation passed, the Mueller probe, if it’s not concluded, will likely take on a new life of its own. In addition, the Fed will likely have inverted the yield curve by late 2018 or early 2019, which is a recession and equity bear market warning.

The market environment will become increasingly hostile. Don’t be surprised if the markets get spooked by such a scenario in the next few months.

On the other hand, the Credit Suisse Risk Appetite Indicator is already in the panic zone, indicating that much of the downside has already been discounted. In light of the upbeat near-term reflationary environment, risky assets like equities are poised to stage a rip-your-face-off rally on any hint of good news.
 

 

I observed last week that the USD is technically vulnerable, and USD weakness would be supportive of non-US asset prices. As well, a falling greenback would take some of the pressure off trade tensions. The USD Index has reacted as expected as it was rejected at a key resistance level while exhibiting a negative RSI divergence. The index is now testing its 50 day moving average (dma).
 

 

A last hurrah?

In conclusion, the strength of the bullish and bearish cross-currents makes it difficult to make a definitive market forecast, but my base case scenario calls for a last hurrah equity rally in the next few weeks. Sentiment remains bearish, indicating significant upside potential on any bullish catalyst. Last Friday’s imposition of tit-for-tat tariffs, along with the better than expected June Employment Report, may have triggered a buy the news rally.
 

 

Sentiment has become sufficiently washed out and that even Mexican stocks staged a relief rally.
 

 

The SPX impressively regained its 50 dma and broke out through the 2740 resistance level, and filled in a gap at 2740-2755. The bulls now have control of the tape, and the next resistance level can be found at about 2800.
 

 

The short-term outlook also confirms the longer term bullish picture. The SPX staged an upside breakout from an inverse head and shoulders formation on the hourly chart last Friday. The measured target is resistance at about 2800.
 

 

In the absence of any major bearish surprises, I would expect that the market to grind upwards and possibly test the January highs. The bearish tripwire that I would watch for is whether the VIX Index can fall below its lower Bollinger Band, which can be a signal of a rally exhaustion. As well, I would watch for either overbought readings or excessive bullishness as the index tests key resistance levels.
 

The week ahead

However, in the short-term (1-2 days), the market may have run ahead of itself and need a pullback or sideways action to consolidate its gains, based on the % of stocks above the 5 dma.
 

 

Longer term indicators, such as the % of stocks above the 10 dma, suggest that the market may initially get rejected at resistance at 2800.
 

 

The market flashed a buy signal when the stochastics rose above an oversold level in late June. However, the challenge for the bulls will be to sustain some upside breadth and momentum in order to flash a series of “good overbought” readings.
 

 

If the global reflation theme is truly in play, then much will depend on the participation of non-US markets. The Euro STOXX 50 has already flashed a buy signal. Watch for a possible upside breakout from its downward sloping channel, which would be positive for the bull case.
 

 

The Shanghai market (bottom panel) remains in freefall, but the Chinese stock market is dominated by individual traders and can only be characterized as a casino. Meanwhile, the closely China-related Hang Seng Index, however, is on the verge of delivering a stochastics buy signal. Watch for possible bullish development!
 

 

Similarly, the Singapore market is testing a key support level and may be on the verge of flashing a buy signal.
 

 

My inner investor remains constructive on equity prices. My inner trader added to his long positions early last week, and he is prepared to buy more should a pullback occur. However, volatility risk is rising because of trade and foreign policy uncertainty. Traders are advised to adjusted their positions in accordance with the heightened risk environment.
 

Disclosure: Long SPXL
 

An oversold bounce, but how far?

Posted by Cam Hui -

Mid-week market update: I would first like to convey to all of my American friends my best wishes for a Happy 4th of July. Enjoy you day off, as more fireworks may be on the way.

The stock market appears to be starting an oversold bounce. Callum Thomas has been conducting an weekly (unscientific) Twitter poll since July 2016. Sentiment seems to be sufficiently washed out for an oversold rally.
 

 

Similarly, breadth readings from Index Indicators also show that the market is ready for a bounce.
 

 

The big question is, “How far can stock prices rise?”
 

A bearish milestone?

The bulls face an intermediate term problem of weakening momentum. Marketwatch highlighted the fact that both the DJIA and SPX are approaching a bearish milestone. As of last Friday, these two stock indices had been in correction territory for 99 days, which is the longest stretch since the GFC.
 

 

Ed Clissold of Ned Davis Research also expressed concern about the lack of a breadth thrust:

It’s been 140 days since the $SPX Feb. 8 low, and no breadth thrust. In 10% corrections within bull markets, longest between market low and breadth thrust was 126 days. Means market lows are NOT in place or rally w/no breadth thrust market has made new highs w/o breadth thrusts 50% of the time. BUT, those rallies have been shorter (median 6 mths) and shallower (21%) than w/breadth thrust (22 mths and 56%).

My own observation of price momentum stocks’ inability to hold their relative uptrend is also worrisome.
 

 

Is the correction over?

There are two problematical outcomes that Ed Clissold identified. First, the correction may not be over. Even if it were, any recovery is likely to be weak.

Let’s first address Clissold’s thesis that this correction may not be over. If the market is truly in a corrective phase, then we should see signs of price momentum failure (check), and breaches of uptrends. For the latter, I rely on Chris Ciovacco’s trend following model, where he calculates a 30, 40, and 50 week moving average of the NYSE Composite to determine if the intermediate term trend is flagging. As the chart below shows, there are no indicates of moving average crossovers (yet). Under these conditions, I am inclined to give the bull case the benefit of the doubt. (Note that the SPX is superimposed on the three MAs below and shown for illustrative purposes only).
 

 

A weak rebound and sell signal setup?

Ed Clissold also made the point that corrective markets without breadth thrusts have exhibited weak rebounds. This sets up a scenario where the market rallies but either get rejected at resistance, or just make a marginal new high before failing. Should the latter occur, we would see a negative RSI divergence on the monthly chart, which could be a warning of a major market top.
 

 

On the other hand, Michael Batnick at The Irrelevant Investor believes that investors shouldn’t be overly worried about the market’s failure to make new highs [emphasis added]:

But in the five plus years since March 2013 the index (TR) has compounded at 13.2% per year. Remember, this is after gaining 26% per year over the previous four years (148% total). So it’s really okay if we go another 100 or 200 or even 300 days without a new high.

Stocks fall into the what have you done for me lately category, but if you define lately as in last few years instead of last few weeks or months, they’ve done plenty.

 

Bullish and bearish tripwires

My own interpretation is somewhere in between the bulls and bears. On one hand, evidence of flagging momentum and the lack of breadth thrusts is problematical for the bulls. On the other hand, the Ciovacco trend model indicates that the bears have not gained the upper hand on an intermediate term time basis.

Here are my bullish and bearish tripwires. The bears have to either force a prolonged consolidation, followed by price weakness so that trend models roll over.

The bulls need to stage a strong upside breakout, preferably aided by evidence of broad global breadth. I demonstrated in a recent post (see A looming global recession, or buying opportunity?) that non-US equity market strength depends on the USD weakness. So far, the market action has been constructive. The USD Index has been rejected at resistance while exhibiting a negative RSI divergence.
 

 

The recovery in the Chinese yuan is equally bullish. The CNYUSD stabilized and rallied this week when the PBOC jawboned the exchange rate upward. As there were market fears that China may weaken its currency and start a currency war in response to Trump’s trade war, the combination of CNY strength and broad USD weakness is a welcome development which will not raise trade tensions. (Note that the chart below shows USDCNY, and a rising rate indicates CNY weakness, not strength).
 

 

For now, the SPX is cycling upward on a stochastic buy signal in the context of an uptrend. Initial resistance can be found at about 2740, with secondary resistance at 2800.
 

 

My inner investor is giving the bull case the benefit of the doubt. My inner trader is long the market, and he hopes to enjoy the ride.
 

Disclosure: Long SPXL
 

What you may not know about the Smart Money Index

Posted by Cam Hui -

This is one in an occasional series of articles highlighting hidden investing factors. For the previous article in the series, please see What you may not know about small cap stocks.

There has been some buzz in social media about the following chart that correlates the Fed’s balance sheet with the Smart Money Index (SMI). Readers can draw their own conclusions, but the initial take has bearish implications.

 

What’s behind the SMI, and is it bearish for stock prices?

Unpacking the Smart Money Index

I am indebted to Jesse Felder, who analyzed the SMI and explained how it is calculated:

Much has been made of the plunge in the Smart Money Index this year and for good reason. In the past, major downturns in the index like we are witnessing today have proved to be prelude to major downturns in stock prices. Many have wondered about the underlying dynamics for the decline in the index of late and I think it may be fairly easy to explain. The index simply represents the difference between the first 30 minutes of trading and the last hour. The idea here is that novice traders trade the open and more experienced traders trade the close. The difference reflects the net trading of these ‘smarter’ traders.

Felder went on to discuss two reasons why the SMI might not be capturing the same effect as it did a number of years ago. The first is the proliferation of ETFs and algo trading:

However, the truth is that with the dramatic rise in the popularity of ETFs the markets have changed a great deal in the past decade. The vast majority of trading volume is not performed by individual traders but by algorithms. In addition, the vast majority of trade volume also now occurs during the last half hour of trading as passive and other systematic vehicles perform their daily balancing acts needed to match their benchmarks.

I would agree with that assessment. When I managed institutional money, I understood that the time horizon of my models were sufficiently long that I had little or no edge in short-term price movements. My typical practice was to put my orders into an algo whose objective was to meet the volume weighted average price (VWAP) of the day, while limiting my order size to a maximum of 20-30% of average daily volume. We generally missed actual VWAP by a few basis points, because the algo was not perfect in predicting the volume during the day. Nevertheless, we recognized that the trading pattern tended have a “volume smile”, as depicted in this chart of SPY.

 

Final hour trading patterns can be chaotic, as market makers in different instruments scrambled to square their books by the end of the day. As Jesse Felder explained, these market participants cannot be characterized as “smart money”.

Buybacks driving SMI readings

Felder also cited another problem with SMI, namely stock buyback managers are precluded fro trading in the last half hour of the trading day:

Another major change in the markets in recent years is that, more than ever before stock buybacks dominate overall demand for equities. So far this year, they have surged to a record pace. Considering the fact that buybacks are prohibited during the final half hour of trading it could be that the smart money index simply reflects the difference between corporate demand for equities (early in the day) and the natural investor demand for equities (largely reflected at the close).

Ed Yardeni also highlighted stock buybacks as a source of equity demand:

Obviously, buyback activity was boosted by repatriated earnings following the passage of the Tax Cuts and Jobs Act at the end of last year. It lowered the corporate tax rate on such earnings from the 35.0% statutory rate to a one-time mandatory tax of 15.5% for liquid assets and 8.0% for illiquid assets payable over eight years. Odds are that corporations will continue to buy back their shares at a solid pace through the end of this year, though not at the record set during Q1.

Yardeni attributed rising buyback activity a favorable cost of capital comparison of equities to bonds:

[C]orporate finance managers have a big incentive to buy back their companies’ shares when the forward earnings of their corporations exceeds the after-tax cost of borrowing funds in the bond market. Using the pretax corporate bond yield composite overstates the after-tax cost of money borrowed in the bond market. The spread between the forward earnings yield and the pretax cost of funds did widen after 2004 and remained wide well into the next decade. Obviously, it did the same on an after-tax basis. … The bottom line is that as corporate managers have increased their buyback activities, their version of the Fed’s Model has probably had more weight in the valuation of stocks. In theory, this means that valuation should be determined by the corporate version of the model.

 

BAML projected buyback activity in their latest fund flows report, and it is expected to increase in the next quarter.

 

At this point, it is tempting to come to a bearish conclusion about how stock buybacks are the only activity holding up the market. However, I would point out that the stock buyback ETF (PKW) has underperformed the market in the last three years. Something else is buoying stock prices, and it’s just buybacks.

 

Now let’s overlay the original Fed balance sheet and SMI chart with the the PKW/SPY ratio. It’s not a perfect fit, but do you notice a pattern?

 

In conclusion, here is what we know about the Smart Money Index and stock buybacks:

  • Buyback managers cannot trade in the last half hour of the day, which is a source of distortion of SMI readings.
  • Buyback activity have been rising in 2018.
  • Buyback stocks have underperformed the market, and therefore not the primary driver of market returns.
  • SMI has fallen dramatically, and at the same time, buyback stocks (whose buyback levels are rising) have similarly lagged the market in the same time frame.

With the caveat that correlation isn’t causation, but what conclusion should we draw from this analysis?

A looming global recession, or buying opportunity?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Non-US weakness = ?

The markets have taken a risk-off tone recently, which raises the perception of a global slowdown. The protectionist measures announced by the Trump administration have not helped matters, and it appears the global economy is becoming increasingly fragile.

Three weeks ago, I asked if global markets could rise if it depended on purely US leadership (see Can America still lead the world?). Since then, US stocks have staged an upside relative breakout against the MSCI All-Country World Index (ACWI). The performance of non-US equities in both the developed countries (EAFE) and emerging market countries (EM) appear challenging.
 

 

The following chart from Topdown Charts shows that global breadth is deteriorating. The number of countries whose stock indices are above their 200 day moving averages (dma) has plunged precipitously.
 

 

These readings either represent a terrific buying opportunity, or an ominous signal of an impending global recession. The bear case is supported by the deterioration in global economic surprise indices (ESI), which measure whether economic releases are beating or missing expectations. As the following chart shows, global ESIs have been falling. Moreover, the bottom panel shows that the percentage of countries with ESI greater than 0, indicating a balance between positive and negative surprises, are at recessionary lows.
 

 

The probability of a global recession is rising rapidly, according to Ned Davis Research.
 

 

Is this the beginning of the end? Is the world about to crash into a global slowdown? To answer those questions, I consider the outlook for the three major trading blocs, the US, China, and Europe. During the course of my analysis, I discovered a bullish catalyst hiding in plain sight.
 

Upbeat America

Starting in in the United States, this region is the bright spot of global growth. The Atlanta Fed’s nowcast of Q2 GDP growth stands at a blistering 4.5%, though the estimate has pulled back from its previous highs.
 

 

An examination of global growth expectations shows that American economy stands along as surprising to the upside.
 

 

The latest update of the evolution of Q2 2018 EPS estimates from FactSet shows that earnings estimates are still rising even after the tax cut ramp. In the past, EPS estimates has shown a pattern of excess optimism and getting revised downwards as reporting date approaches.
 

 

Enough said. There is nothing wrong with the US economy. As I pointed out previously, the US is not at the immediate risk of a recession (see How close are we to a recession?)
 

Decelerating and overleveraged China

China is a different story. We all know about the trouble brewing in China. Fathom Consulting’s indicators show that growth is rolling over, and its estimate of actual GDP growth is 6.2%, which is well below the GDP growth rate.
 

 

Financial leverage remains a problem. In the wake the PBOC’s RRR cut which cut yuan borrowing costs, non-RMB debt costs are still stubbornly high. USD borrowing costs for highly indebted Chinese companies are breaching 10%.
 

 

In addition, the PBOC’s move to cut the RRR has seriously weakened the CNYUSD exchange rate. While the RRR cut could be viewed as a technical adjustment to raise onshore liquidity so that Chinese banks could bring shadow banking assets back onto their balance sheets, it has also been interpreted as an effort to weaken the currency in the face of a brewing trade war with America. This brings up the spectre of a repeat of the episode of 2015, when a falling yuan cratered the Shanghai Index by 50%, and sparked a correction in global equity markets.
 

 

Here is the bull case. First, the current CNY weakness episode is different from 2015. As the above chart shows, the CNY devaluation occurred independent of the USD. Today, CNY exchange rate movement is largely attributable to changes in the USD Index.

As well, Leland Miller of China Beige Book stated in a CNBC interview that Chinese growth is better than expected, and Beijing appears to be starting a stimulative cycle after a period of contractionary fiscal and monetary policy. China Beige Book found that sales and profits are rising, and so are capital expenditures.
 

 

In addition, the risks of a 2015-style crash in the Chinese stock market are overblown. In 2015, the decline in Chinese stocks was fueled by skyrocketing margin loans. This time, margin loans are nowhere near the levels seen in 2015.
 

 

My own real-time market based indicators of Chinese rebalancing are on track. I track two pairs of New (consumer) China ETFs against Old (financial and infrastructure) China ETFs. Both pairs are pointing to the ascendancy of the New China.
 

 

Here is one other real-time puzzle for the China bears. If the Chinese economy is tanking, why is Australia performing so well. The top panel of the accompanying chart shows the performance of MSCI Australia against ACWI, and the bottom panel shows the AUDCAD exchange rate. The economies of both Australia and Canada have similar resource-like characteristics, except that Australia is more sensitive to China, while Canada is more sensitive to US growth.
 

 

Dismal Europe

The apparent view in Europe also appears to be dismal. Angela Merkel is fighting for her political life. European ESI is rock bottom near -100, which is as low as it can get.
 

 

The shares of Deutsche Bank are hitting new lows virtually on a daily basis, and its performance is an illustration of how Europe never solved its banking problems since the Great Financial Crisis.
 

 

On the other hand, there are a number of silver linings in the European dark cloud. First, Italian consumer confidence unexpectedly rose last week. Wait, what? Yes, that Italy. The political unrest Italy. The Italy governed by the alliance between anti-immigrant Lega Nord and popular Five-Star Movement.
 

 

In addition, European stocks appear attractive. FT Alphaville reported that Citi strategist Jonathan Stubbs pointed out that the Free Cash Flow (FCF) of European companies have more than enough to cover their dividends. Stubbs went on to forecast a dividend bull market for European equities.
 

 

 

BNP Paribas strategists outlined a different bull case, namely that European ESI is as bad as it gets, and therefore they are contrarian bullish:

Economic surprise rebound could be a boost? Our analysis suggests that a recovery in surprise indices from an extreme low, as is currently being seen, could be followed by nearly 15% European equity market returns over the next six months . We believe that the latest dovish ECB meeting could be a catalyst for this change.

We just need a positive growth surprise and European equities will soar.
 

The bullish catalyst hiding in plain sight

This brings me to my final point of a bullish catalyst for non-US equity, the US Dollar. The level of the USD is important because its performance has historically been inversely correlated to the relative returns of non-US markets. The accompanying chart shows the relative performance of emerging market stocks against ACWI, along with the USD Index. Historically, the rolling 52-week correlation between the two series has been negative. In other words, USD strength leads to EM underperformance.
 

 

Here is a chart of the relative returns of South Korea. I chose the Korean market for two reasons. First, it is highly sensitive to Chinese growth because of the physical proximity and trading relationship between the two countries. As well, the South Korean economy is a global indicator of cyclical growth. The long-term correlation between the relative performance of Korean stocks and the USD Index is also negative.
 

 

Over in Europe, the chart below shows the relative performance of the Euro STOXX 50 against ACWI (all in USD). While the recent relationship has turned negative, the long-term correlation pattern between the EURUSD exchange rate, which is largely the inverse of the USD Index, has historically been positive.
 

 

The bullish catalyst hiding in plain sight for non-US stocks is USD weakness. From a technical perspective, the outlook is hopeful. The USD recently failed at resistance while exhibiting a negative RSI divergence, which is bearish for the currency.
 

 

Moreover, the summary of the Commitment of Traders report from Hedgopia indicates that large speculators have pivoted from a net short to a net long position in USD futures. Dollar bulls today no longer have COT positioning as a sentiment tailwind.
 

 

We just have to wait for a fundamental catalyst for USD weakness. This could occur in the form of a non-US growth surprise, either in Europe or China. Expectations are extremely low in Europe, and analysis from China Beige Book indicates that it has already detected a Chinese growth surprise that is not reflected in the data.

Another possible trigger for USD weakness might be Trump toning back his belligerent trade rhetoric. As he embarks on the campaign trail for Republican candidates during the mid-term elections, he is likely to receive pushback from businesses as his tariffs begin to bite. These comments from the Dallas Fed’s manufacturing survey is just one example.

Fabricated Metal Product Manufacturing

  • Steel tariffs to NAFTA partners is a mistake. Higher steel prices could slow down strong projects and the manufacturing recovery which started in fourth quarter 2017
  • I can’t believe the effect the tariff response has had on the metals trade. Somebody needs their head examined if they think this is good for the American economy
  • We are about to raise prices for the first time in six years due to the rising cost of steel and aluminum. This is going to cause some uncertainty, with our customers looking elsewhere to purchase products we manufacture

Machinery Manufacturing

  • There is lots of uncertainty among manufacturers regarding the impact of the steel tariffs. Even steel sourced from the U.S. is rapidly in price due to capacity constraints

Consider these selected comments from the Kansas City Fed’s manufacturing survey:

“The steel tariffs are not helpful. Material prices are rising and these costs have to be passed along to the consumer.” 

“Bracing for the worst concerning China tariffs. We will move the last of manufacturing off shore. Loss of business due to tariffs will have a larger impact than interest rates.”

CNN Money reported that about 21,000 companies have filed for tariff exclusions, indicating that trade actions are starting to bite. Unless these business concerns are adequately addressed, this kind of grassroots opposition from businesses is likely to create electoral headwinds for the Republicans.

In summary, I began this publication with the rhetorical question. Does the current round of non-US equity weakness represent a buying opportunity, or a signal of the beginning of a global recession? Current readings indicate that no signs of a uncontrolled deceleration in any of the three major regions.  The ECB recently released a round-up of eurozone growth. They attributed the slowdown to a combination of cyclical and temporary factors, but the expansion remains solid.

Overall, the economic expansion should remain solid, supported by the underlying strength of the euro area economy. Although survey results have again moderated somewhat, they remain consistent with further solid growth. Going forward, the solid growth is expected to continue, albeit possibly at lower rates, as the ECB’s monetary policy measures continue to underpin domestic demand. Private consumption should continue to be supported by employment gains and rising household wealth. Investment is expected to strengthen further on the back of very favourable financing conditions, rising corporate profitability and solid demand. In addition, the broad-based global expansion is providing impetus to euro area exports.

A “solid expansion” is also a reasonable characterization of the global economy. In the absence of recession risk, I can only conclude that the current corrective period is a buying opportunity.

The most likely bullish catalyst is USD weakness. The USD Index is technically primed to pull back. We just have to wait for the fundamental trigger.
 

The week ahead: Bull or bear?

Looking to the week ahead, the market will be faced with a number of cross-currents. Asset prices are likely to respond to the headline of the day, but it is unclear which news they will focus on. On one hand, Caixin reported that China opened the economy to more foreign investments. Such a development could be interpreted as conciliatory and serve to lower trade tensions, which is bullish.

The National Development and Reform Commission (NDRC), China’s top economic planner, and the Ministry of Commerce jointly published the 2018 version of the so-called “negative list” on Thursday, which removed foreign ownership restrictions on some industries in China.

The number of restricted items on the latest list dropped to 48 from 63 the previous year. The new list will take effect on July 28.

In a statement on its website, the NDRC said that the culling of the negative list illustrated China’s commitment to further opening up its market to foreign investment.

The new list mapped out opening-up measures in 22 industries, including banking, mining, automotive, shipping, airplane design and manufacturing, railway construction, and agriculture.

On the other hand, the expected victory of left leaning Obrador in Mexico’s election Sunday is likely to cast a chill on US-Mexican relations, and heighten the risk of a collapse of the NAFTA negotiations. As well, the news that North Korea is covertly increasing their nuclear warhead production could raise geopolitical in North Asia.

A similar set of bullish and bearish cross-currents can be found from a sentiment analysis perspective. I had written last week that one of the obstacles to a sustainable rally was the lack of fear, and the market may need a final wash-out before stock prices can rise in a sustainable fashion (see A trader`s guide to spotting market bottoms).

Since I wrote those words, BAML`s funds flow report found that last week was the second largest weekly outflow from equities in its recorded history, and it was the thrd larges ever outflow from US equities.
 

 

In addition, the CBOE put/call ratio spiked indicating rising anxiety. Even more encouraging were the days the put/call ratio rose when the market rallied, indicating price strength skepticism.
 

 

Jeff Hirsch at Trader’s Almanac also observed that July 1 is seasonally the second best day of the year for stock prices.

On the other hand, I pointed out that Saturday, June 30, is a major QT day for the Fed, when over $30b in Treasury securities are rolling off the balance sheet (see 4 reasons why the bull is still alive).
 

 

Kevin Muir at the Macro Tourist observed that QT days have been bearish for equities. Monday, July 1, will be a major test of the QT market weakness thesis.
 

 

My inner investor remains constructive on equity prices. The intermediate term outlook remains positive, as measured by breadth and credit market risk appetite.
 

 

My inner trader covered his short positions early last week and dipped his toe in on the long side. He expects to add to his long position on Monday should the market hit an air pocket, or if the SPX stages an upside breakout above resistance at 2740 and fills the gap at 2740-2750.
 

 

Disclosure: Long SPXL
 

A trader’s guide to spotting market bottoms

Posted by Cam Hui -

Now that the SPX flirted with the combination of the 2700 level and its lower Bollinger Band (BB), it’s time to see if the market is ready to bottom on a short-term and intermediate basis.
 

 

Let`s analyze outlook from the perspective of breadth, momentum, and sentiment.
 

Breadth and momentum

The readings from breadth and momentum indicators are mixed. The breadth reading from Index Indicators certainly indicates that the market is oversold, and it would be no surprise for stock prices to bottom and rally from these levels. But is it sufficiently oversold for a durable bottom?
 

 

I wrote in my last post (see 4 reasons why the bull is still alive) that I was waiting for a re-test of the lows that was accompanied by a positive RSI divergence. We got the re-test yesterday (Wednesday) as the SPX undercut its previous low, but neither RSI-5 nor RSI-14 exhibited a positive divergence. Arguably, these readings could be interpreted as bearish because RSI-14 put in a lower low, indicating negative momentum, and RSI-5 remained oversold, indicating a “bad oversold” condition that implies further downside.
 

 

On the other hand, both RSI-5 and RSI-14 did show positive divergences on the hourly chart. That’s a thin thread for the bulls, but at best we can call it a wash.
 

 

Sentiment

There is both good news and bad news for the equity bulls on the sentiment front. Let’s start with the good news. AAII sentiment plunged this week when bullish sentiment pulled back and bearish sentiment spiked. While sentiment can get more bearish, the experience in the last 5 years has shown that downside risk is limited at these sentiment levels. I would note, however, that AAII sentiment is at best an intermediate term indicator and these charts are weekly charts. They tell us little about what might happen tomorrow or the day after.
 

 

One worrisome feature of sentiment models is the market is not just showing enough panic for a durable bottom. None of the components in my Trifecta Bottom Spotting Model is flashing a buy signal. At a minimum, I would look for the VIX term structure to invert, indicating widespread fear, and TRIN to spike above 2, indicating a margin clerk/risk manager induced price insensitive capitulation. None of this has happened yet.
 

 

Putting it all together, I can conclude that the short-term bottom is near and downside risk is relatively limited, but the market is in need of a final flush before stocks can stage a sustainable rally. My inner trader covered his shorts earlier this week and dipped his toe in on the long side. He is waiting for signs of a capitulation low before fully committing himself as an unabashed bull.
 

Disclosure: Long SPXL
 

The 4 reasons why the bull is still alive

Posted by Cam Hui -

Mid-week market update: In light of the recent market turmoil, I thought I would publish my mid-week market update early. The Shanghai Index moved into bear market territory by declining 20% on a peak-to-trough basis overnight. The SPX is testing its 50 day moving average (dma). Europe is struggling as both the FTSE 100 and Euro STOXX 50 have violated near-term support levels.

Is this a warning that the bull is dying?

I have some good news and bad news. The good news is the bull market is still alive. The SPX is undergoing a correction, but it remains in an uptrend within a range-bound consolidation that began in February.
 

 

The bad news is traders need to expect more short-term pain.
 

Market internals still bullish

In addition to the above chart showing the SPX in an uptrend, a number of market internals indicate that the bears have not gained control of the tape. Consider, for example, the relative performance of defensive sectors. Consumer Staples stocks are still in a multi-year downtrend relative to the market, and Utilities appear to be trying to be bottom, but they have not shown any inclination to stage a relative breakout beyond their consolidation band.
 

 

One other clue about market direction comes from the performances of Financial stocks. The sector has been lagging the market lately, but why are the high-beta broker-dealers beating the sector? Broker-dealer stocks have historically tracked the returns of the sector in general, and in a bear phase, you would expect them to show greater weakness. Instead, they are outperforming.
 

 

In short, these charts indicate that the intermediate term outlook for US equities remain bullish.
 

Bottoming, but not THE BOTTOM

Here is the bad news. Monday’s selloff created too much technical damage for the market to make a V-shaped bottom. In particular, market leadership such as large cap NASDAQ stocks are rolling over. The NASDAQ 100 has breached an uptrend on both an absolute basis and relative to the market.
 

 

Equally serious is the breach of the relative uptrend by the price momentum factor. Assuming that the bull run were to continue, we will have to see a transition from Tech and momentum to another market leader.
 

 

One candidate for continued leadership are small caps. The performance of small cap stocks, which have also been market leaders, is more constructive. The Russell 2000 violated an uptrend line on an absolute basis, but its relative uptrend remains intact. However, small caps comprise a tiny weight off the overall market, and they cannot carry the rally by themselves.
 

 

While the intermediate term structure is still bullish, these trend violations have created sufficient technical damage that cannot be fixed with a simple V-shaped bottom. The most likely scenario is the market undergoes several days of choppiness that end with a second test of the previous bottom before it can stage a sustainable rally.

I tweeted the signs of a setup for a buy signal on Monday when the VIX Index rose above its upper Bollinger Band (BB). Past reversions of the VIX below its BB have been good trading buy signals. I would also point out that in two of the three past instances when these signals have occurred in the last six months, the market weakened after the buy signal to retest the previous lows before rallying. The retests were accompanied by positive divergence on RSI-5.
 

 

The combination of bullish intermediate backdrop, high levels of technical damage, and short-term oversold readings all point to a similar pattern of rally and retest of the lows.

Subscribers received an email alert that my inner trader had covered all of his shorts and taken an initial (small) long position. He will be waiting for the retest in the next few days to add to his long positions.

One possibility for the timing of a retest of the lows could occur this coming Monday. In the past, the stock market has weakened on days when the Fed has conducted its Quantitative Tightening programs when securities were allowed to mature and roll off its balance sheet (see Offbeat Thursday and Friday forecasts). According to the New York Fed, the next big QT day is June 30, 2018, when over $30b of Treasury securities will be maturing. As June 30 is a Saturday, the market effect would not be seen until the next trading day, which is Monday.
 

 

My inner trader has taken profits on his shorts and taken a long position, but the commitment is not large.
 

Disclosure: Long SPXL
 

How Trump’s midterm strategy heightens market risk

Posted by Cam Hui -

A recent Axios story featured an interesting political perspective on Trump’s possible strategy for the midterm elections:

An odd paradox in defining this moment in politics: The more President Trump does, says and tweets outrageous things, the more his critics go bananas and the better he does in the polls.

Indeed, Gallup’s tracking poll of presidential approval has been steadily rising for much of this year. CNBC also reported that a majority of Americans approve of Trump’s handling of the economy for the first time.
 

 

Axios went on to state that this strategy is risky because it is entirely dependent on energizing his support base:

The rise in Trump’s numbers, and the shrinking Democratic advantage in House races, are reinforcing Trump’s worship of his own instincts on policy.

  • Except many of these choices may make his reelection even more dependent on his worshipful base, and less appealing to swing voters.
  • It’s a circular political strategy that relies on ignoring independent voters, and assuming they won’t turn out.
  • It creates a narrow, treacherous path to reelection.

Call it a short-term gain for medium term pain electoral approach that creates significant market risk.
 

When does the piper get paid?

One example of Trump’s electoral approach is his latest tweet that raises trade tensions with allies that spooking the markets today.
 

 

While the theme of unfair trade may play well with his base, the real pain in the developing trade war hasn’t been fully felt in America’s heartland. Nevertheless, Reuters reported that anxiety levels are rising.

Farmers overwhelmingly supported Trump in the 2016 election, welcoming how he championed rural economies and vowed to repeal estate taxes that often hit family farms hard.

Now those same farmers are seeing crop prices fall and export markets shrink after Trump’s tariffs triggered a wave of retaliation from buyers of U.S. apples, cheese, potatoes, bourbon and soybeans.

“A lot of people in the ag community were willing to give President Trump the benefit of the doubt,” said Brian Kuehl, executive director of Farmers for Free Trade. “The reason you are seeing people increase the pressure now is because the pressure is increasing on them. Now the impact is really starting to hit. It is not something you can just take lightly.”

His group, along with the U.S. Apple Association, will start running television ads on Tuesday attacking Trump’s tariffs in Pennsylvania and Michigan, apple-growing states that could play a role in which party controls Congress after the November elections…

Even before trading partners imposed tariffs, U.S. farmers were facing a tough year. Net farm income was expected to fall 6.7 percent to $59.5 billion in 2018, according to the U.S. Agriculture Department.

Now an even more bearish tone hangs over agricultural markets due to trade spats with NAFTA partners Canada and Mexico, plus mounting tensions with China and Europe.

CNN featured a similar report about the growing unease in farm country:

But in southern Minnesota, where generations of soybean farmers and pork producers are already used to economic uncertainty, Trump’s tough talk on trade has been demoralizing.

The same tariffs that Trump touted on Wednesday have left these growers as collateral damage in an escalating fight with China. Tariffs beget tariffs in the fight, and the Chinese have targeted both American staples, pushing down commodity prices and sinking farm values.

As Republicans and Trump eye Minnesota as a key state for 2018 and beyond, they run the risk that the same tough talk on trade that made Trump so popular in the state might backfire on some of his most loyal supporters.

Time is of the essence, too. While summer is the growing season for soybeans, farmers will begin harvesting in September and October, weeks before midterm elections that will surely be seen as a political referendum on the President.

Moreover, Trump’s industrial tariffs are not hitting their mark. In an era of globalized supply chains, tariffs on intermediate goods have a devastating effect on manufacturing, according to analysis from the Peterson Institute.
 

 

An example of the collateral damage is this story about a Missouri nail manufacturer that is at risk of closing its doors because it is owned by a Mexican company that imports Mexican steel as the raw material for its products.

A spokesperson for a Missouri manufacturer of nails says President Donald Trump’s tariff on steel has cut orders by over 50 percent and may result in the business being shut down, putting close to 500 employees out of work.

According to MissouriNet, Mid Continent Nail Corporation in Poplar Bluff, which is the last major nail producer in the U.S. — has already laid off 60 temp workers and is making plans to lay off 200 permanent employees by the end on July in order to stay afloat. Should the business stay in a death spiral company officials warn they could close by Labor Day.

The report notes that Mid Continent is one of the largest employers in Butler County and eliminating the remaining 440 jobs, which pay an average of $12.50 an hour, would devastate one of the poorest counties in the state.

Already, Bloomberg has reported that Harley-Davidson is considering moving production to the EU as a result of Europe’s retaliatory tariffs.

Trump’s electoral strategy is risky because it trades off the immediacy of rising approval against the costs of tariff protection. It’s a race against time. Can the Republicans get the Trump base to turn out and support them before the trade wars collapses the economic roof? How many Trump supporters are willing to lose their jobs, or bankrupt themselves to Make America Great Again?
 

Why this matters to the markets

I wrote in my last post that one of the greatest threat of a trade conflict is business confidence (see How close are we to a recession?). In particular, I highlighted a speech by Atlanta Fed president Raphael Bostic about his observations of the evolution of confidence:

I began the year with a decided upside tilt to my risk profile for growth, reflecting business optimism following the passage of tax reform. However, that optimism has almost completely faded among my contacts, replaced by concerns about trade policy and tariffs. Perceived uncertainty has risen markedly. Projects already under way are continuing, but I get the sense that the bar for new investment is currently quite high. “Risk off” behavior appears to be the dominant sentiment among my contacts. In response, I’ve shifted the risks to my growth outlook to balanced.

Business confidence is a funny and fragile thing. Right now, small business optimism stands at its second highest level in its 45-year history. What happens if the trade war effects start to bite, and begin to hurt sales and employment?
 

 

I had also asked in my last post what might happen if the Democrats regain control of Congress. Could the tax cuts get reversed, which would spook the markets?
 

 

A reader pointed out a Bob Shiller commentary in the New York Times that corporate tax cuts are difficult to reverse unless there is a war. I stand corrected. However, I can easily envisage the Bernie Sanders and Elizabeth Warren wing of the Democrats becoming ascendant after the next election and starting a new war. At a minimum, expect the deregulation drive to end. Another obvious target might be Big Tech such as Facebook, Google, and Amazon, which are becoming pariahs because of the sheer creepiness of their surveillance business models (see Peak FANG?).

As fund flows have followed performance, BAML highlighted the staggering level of fund flows into the technology sector this year. If they come after the FAANG stocks, what will happen to market leadership, and market confidence?
 

 

Bottom line: Trump’s electoral strategy creates a high level of market risk. First, the immediate costs of protectionism are becoming clear, and business confidence could tank as a result. In addition, the electoral consequences of a Democrat victory in November also raises the stakes on the prospects of re-regulation, with a particular focus on the FAANG stocks, which are today’s market leaders.

If Trump chooses to stay with this electoral strategy of energizing his base, then expect further market choppiness in the days and weeks ahead.
 

How close are we to a recession?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Dueling recession forecasts

A minor scuffle erupted in the blogosphere last week. Fed watcher Tim Duy took issue with David Rosenberg’s recession call with an article entitled “No, A Recession Is Not Likely In The Next Twelve Months. Why Do You Ask?“. While Duy acknowledged that Fed policy is likely to be the trigger for the next recession, he disputed Rosenberg’s contention that a recession is about to begin.

I buy the story that the Fed is likely to have a large role in causing the next recession. Either via overtightening or failing to loosen quickly enough in response to a negative shock…

But the timeline here is wrong. And timing is everything when it comes to the recession call. Recessions don’t happen out of thin air. Data starts shifting ahead of a recession. Manufacturing activity sags. Housing starts tumble. Jobless claims start rising. You know the drill, and we are seeing any of it yet.

For a recession to start in the next twelve months, the data has to make a hard turn now. Maybe yesterday. And you would have to believe that turn would be happening in the midst of a substantial fiscal stimulus adding a tailwind to the economy through 2019. I just don’t see it happening.

Duy does not believe that Fed policy is tight enough to cause a recession in the near future:

As far as the Fed is concerned, I don’t think we are seeing evidence that policy is too tight. The flattening yield curve indicates policy is getting tighter, to be sure. But as far as recession calls are concerned, it’s inversion or nothing. And even inversion alone will not definitively do the trick. I think that if the Fed continues to hike rates or sends strong signals of future rate hikes after the yield curve inverts, then you go on recession watch.

With inflation still tame, however, the Fed may very well flatten the yield curve with two more hikes and then take a step back. To be sure, it will be hard to stand down or even reverse course on the yield curve alone. After all, the yield curve is a long leading indicator. It will be the outlying data. But there is a reasonable chance the Fed will not tempt fate in the absence of a very real inflationary threat.

Who is right? Tim Duy or David Rosenberg? In the past, every recession has been accompanied by a bear market.
 

 

Is a recession just around the corner?
 

Reading the Fed tea leaves

If Fed policy is one of the main drivers of the next recession, then some key questions come to mind:

  • How hawkish or dovish is Fed policy?
  • How close is the economy to recession?

Fed chair Jerome Powell gave an important speech last week outlining his approach to monetary policy. Powell deviated from Fed orthodoxy by casting doubt on the effectiveness of the Phillips Curve in an environment of well-anchored inflationary expectations:

What would be the consequences for inflation if unemployment were to run well below the natural rate for an extended period? The flat Phillips curve suggests that the implications for inflation might not be large, although a very tight labor market could lead to larger, nonlinear effects. Research on this question is ambiguous, again reflecting the limited historical experience. We should also remember that where inflation expectations are well anchored, it is likely because central banks have kept inflation under control. If central banks were instead to try to exploit the nonresponsiveness of inflation to low unemployment and push resource utilization significantly and persistently past sustainable levels, the public might begin to question our commitment to low inflation, and expectations could come under upward pressure. So far, we see no signs of this. If anything, some measures of longer-term inflation expectations in the United States have edged lower in recent years.

If not inflation, then what should the Fed focus on? Powell went on and focused on financial imbalances as the cause of recessions [emphasis added]:

Can persistently strong economic conditions pose financial stability risks? Of course, strong economic conditions are a good thing! Such conditions can make the financial system better able to absorb shocks through strong balance sheets and investor confidence. But we have often seen confidence become overconfidence and lead to excessive borrowing and risk-taking, leaving the financial system more vulnerable. Indeed, the fact that the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions. Today I see U.S. financial stability vulnerabilities as moderate and broadly in line with their long-run averages. While some asset prices are high by historical standards, I do not see broad signs of excessive borrowing or leverage. In addition, banks have far greater levels of capital and liquidity than before the crisis.

Powell speech can be seen from both dovish and hawkish viewpoints. The lack of inflationary pressures indicates that Powell is reluctant to be overly hawkish in raising rates. On the other hand, he is likely to keep on hiking and normalizing policy as long as financial stability risks are low.

How low is financial stability risks, and what are long leading indicators telling us about the risks of a recession? Starting with the indicators from the Chicago and St. Louis Fed, current indicators of financial stress are tame, which are signals that credit conditions are still relatively easy.
 

 

My other monetary condition recession indicators are all in neutral territory but deteriorating. In the past, either real M1 or M2 growth has turned negative ahead of recessions. Money supply growth is still positive, but decelerating. At the current rate of deceleration, real M2 growth will turn negative in Q3 or Q4.
 

 

In the past, annual changes in employment and annual changes in the Fed Funds rate has converged ahead of recessions. At the current pace, the two lines are expected to cross late this year if the current pace of convergence continues.
 

 

Yield curve inversions have also been an uncanny forecaster of past recessions. The yield curve is flattening, and should the Fed raise rates at the current pace, we should see an inverted yield curve either in late 2018 or early 2019.
 

 

While I do not believe in anticipating model readings, the current trajectory of these long leading indicators suggest that we will get a recession warning in late 2018, and a possibly recession in late 2019. Since the markets look ahead 6-12 months, that would put the window for a stock market top some time between this winter and next summer. I would caution that this is a highly speculative forecast, as we do not have the recession signal yet. In practice, I prefer to stay “data dependent” in determining my investment view.
 

Other recession wildcards

Assuming the speculative scenario that a recession were to begin in late 2019. That implies a probable market top about late this year. However, there are a couple of factors that could either spook the markets early or accelerate the recession schedule. The biggest threat is a trade war.

Much depends on how a trade war affects business confidence. Reuters reported that Jerome Powell expressed concern about rising business uncertainty because of trade policy.

“Concerns seem to be rising,” said Powell, speaking to a European Central Bank conference in Portugal. While Powell said he would not comment on specific proposals from the Trump administration, “for the first time we are hearing about decisions to postpone investment, postpone hiring, postpone making decisions. That is a new thing. If you ask is it in the forecast yet, is it in the outlook, the answer is no. And you don’t see it in the performance of the economy.”

Atlanta Fed President Raphael Bostic echoed the Fed Chair’s remarks in a recent speech:

I began the year with a decided upside tilt to my risk profile for growth, reflecting business optimism following the passage of tax reform. However, that optimism has almost completely faded among my contacts, replaced by concerns about trade policy and tariffs. Perceived uncertainty has risen markedly. Projects already under way are continuing, but I get the sense that the bar for new investment is currently quite high. “Risk off” behavior appears to be the dominant sentiment among my contacts. In response, I’ve shifted the risks to my growth outlook to balanced.

One important real-time indicator of trade jitters is soybeans, which is a target of China’s retaliatory tariffs. The bad news is prices have cratered. The good news is they are showing signs of stabilization, indicating that the initial round of panic may be playing out.
 

 

If Trump’s trade dispute with China extends into September, which is harvest season for soybeans, then a political dynamic begins to come into play. The negative effects of low agricultural product prices will begin to seriously affect the Republicans’ electoral prospects in the farm states, which formed the bulk of Trump’s support in 2016.

Should the Democrats make significant headway in the midterm elections and win back control of Congress, the market will begin to discount the reversal of the recently passed tax cuts. The boost to corporate earnings from fiscal policy in 2018 will turn into a headwind in 2019. The combination of contractionary fiscal policy and monetary policy could prove to be a potent combination that crashes economic growth. Watch the polls in the fall, as the markets will anticipate outcomes before the November elections.

The following chart from FactSet tells the story of how forward EPS, which are coincident with stock prices, have evolved this year. Earnings estimates rose in two phases, beginning with a tax cut surge, and then followed by a continuing cyclical rebound on business optimism. What if the Democrats retake Congress and the market begins to anticipate the reversal of the tax cuts?
 

 

The week ahead

While I remain intermediate term bullish on equities, I recently turned cautious (see Is the trade war correction over?). While the window for a correction that conform to the rally and pullback pattern that began in March is nearly closed, short-term readings suggest that a final flush may be in order before stock prices can stage a sustainable rally.

The most disturbing technical pattern is faltering leadership from the NASDAQ leadership. The NASDAQ 100 breached an uptrend line while exhibiting a series of negative RSI divergences.
 

 

Mid cap stocks also display a similar pattern of uptrend violation, and the weakness was confirmed by declining RSI momentum.
 

 

While small caps remain in an uptrend, I highlighted the vulnerability that these stocks face because of their high correlation with the USD Index (see What you may not know about small cap stocks). Equally disturbing is the uptrend violation shown by the SPX.
 

 

These technical conditions suggest that the market may either need to consolidate sideways, or it needs a final capitulative selloff to flush the weak hands out of their long positions.

I will be monitoring the performance of the price momentum factor, which remains in a relative uptrend. Watch for a test of the trend line should the market panic, and see if the uptrend stays intact.
 

 

My inner investor remains constructive on stocks. My inner trader is still tactically short, but his commitment is relatively light.
 

Disclosure: Long SPXU
 

What you may not know about small cap stocks

Posted by Cam Hui -

This is one in an occasional series of articles highlighting the hidden investing factor exposures, starting with small cap stocks. Small caps have been on an absolute tear lately, both on an absolute basis and relative to large caps.
 

 

Does that mean you should jump on the small cap momentum train?

Momentum is evident even from a fundamental viewpoint. Analysis from Yardeni Research reveals that small cap earnings estimates have been rising faster than large caps, even after the tax cut earnings surge. If you squint, you will see that the slope of small cap EPS revisions is steeper than large cap revisions.
 

 

Hidden USD factor exposure

However, small cap outperformance can be partly explained by their USD exposure. The correlation between the size factor and the USD is evident in the chart below.
 

 

While correlation isn’t causation, there are valid fundamental reasons for this relationship. Large cap companies tend to be more global in nature, and therefore more sensitive to fluctuations in exchange rates. A rising USD hurts large cap earnings, but domestically oriented small caps earnings improve on a relative basis.

From a technical perspective, some caution is warranted on the USD. The USD Index is currently testing a key resistance level, while exhibiting a negative RSI divergence.
 

 

Under such bearish USD circumstances, investors are cautioned to give some second thought to the continued outperformance of small cap stocks.
 

Is the trade war correction over?

Posted by Cam Hui -

Mid-week market update: The fate of this market is becoming highly news dependent. Ed Yardeni recently stated in on CNBC that he has never seen a “president this bullish and bearish at the same time”. The market wants to go up on earnings, but it has been held back by Trump`s protectionism.

Will stock prices rise or fall? Is the trade war correction over?

Unfortunately, my time machine is in the shop getting fixed. However, we can rely on technical and sentiment analysis to give us some clues. First and most encouraging was the market price action overnight. The Shanghai market stabilized and showed a minor gain after the horrendous drop Tuesday. The stock markets of China’s major Asian trading partners also showed signs of recovery, and the markets in Hong Kong, South Korea, and Singapore successfully tested key support levels.
 

 

In addition, I had highlighted a technical pattern on June 10, 2018 (see Can America still lead the world?) indicating that the market had broken down out of a series of bearish wedges. Each breakdown was accompanied by either the VIX breaching or touching its lower Bollinger Band. Subsequent corrections have lasted roughly two weeks, and each pullback have been increasingly shallow, which is intermediate term bullish.
 

 

If history is any guide, and notwithstanding more trade war jitters, the market’s weakness should end this week. Tactically, it is less clear whether we have seen the actual bottom of this correction just yet.
 

Not enough fear

However, my sentiment models suggest that fear hasn’t spike sufficiently for a durable bottom. Mark Hulbert wrote this week’s market weakness may not just attributable to the Sino-American trade spat, but excessively bullish sentiment among NASDAQ market timers. His Hulbert Nasdaq Newsletter Sentiment Index (HNNSI) reached an extreme bullish reading. In other words, sentiment had reached a crowded long, and the news of the trade friction was just the spark for the sell-off.
 

 

Other sentiment indicators are also showing signs of complacency. The latest CBOE put/call ratio stands at 0.88, which can hardly be interpreted as a high level of fear.
 

 

The option market is also relatively sanguine about this week’s pullback. Neither the VIX Index is anywhere near its upper Bollinger Band, nor is the term structure of the VIX inverted. While neither of these signals need to be triggered for me to generate a trading buy signal, indications of spiking fear would supportive signs of a trading bottom.
 

 

Stock prices are also facing a seasonal headwind this week. Rob Hanna at Quantifiable Edges found that the week after June OpEx has been weak. On average, stock prices have historically fallen steadily during the week, except for a reflex rally on Wednesday.
 

 

In conclusion, the markets appear to be trying to bottom here, but the shape of the bottom is more likely to be a W rather than a V. Nevertheless, the intermediate term outlook remains bullish. The market leaders, the NASDAQ and small cap stocks, made fresh all-time highs today. It is difficult to interpret such developments as anything but bullish.
 

 

Subscribers received an email alert yesterday (Tuesday) that I was ready to cover my short position and go long if the SPX tested its support at 2735-2740. It never reached that level, and therefore my inner trader remains short in anticipation of a retest of Tuesday`s lows in the next few days.
 

Disclosure: Long SPXU
 

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

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

War is hell

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

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

 

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

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

Vulnerable trade partners

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

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

 

The second is as a percentage of US GDP.
 

 

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

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

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

 

Fragile China

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

 

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

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

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

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

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

Fragile Europe

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

 

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

 

An asymmetric trade war?

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

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

 

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

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

So much winning.

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

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

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

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

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

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

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

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

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

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

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

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

It all started when he hit me back!

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

The week ahead

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXU

 

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

Posted by Cam Hui -

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

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

Past editions of this series include:

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

Junk bond euphoria

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

 

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

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

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

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

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

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

Its Single Bs fetched 325bp to yield 6.1%.

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

 

Which bond market do you believe?
 

M&A gone wild

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

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

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

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

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

USA Today piles into FANGs

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

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

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

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

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

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

 

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

How far can this rally run?

Posted by Cam Hui -

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

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

 

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

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

 

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

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

Market still overbought

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

 

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

 

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

 

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

Disclosure: Long SPXU
 

Can America still lead the world?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A question of leadership

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

 

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

 

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

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

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

 

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

 

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

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

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

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

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

 

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

 

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

 

U-S-A! U-S-A!
 

Europe: The bears’ playground

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

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

China: A growth pause?

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

 

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

 

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

 

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

 

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

 

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

Regional opportunities and risks

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

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

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

The week ahead

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

 

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

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU
 

What June swoon?

Posted by Cam Hui -

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

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

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

 

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

A bulls’ party

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

 

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

 

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

 

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

 

The challenge for the bulls

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

 

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

 

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

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

Disclosure: Long SPXL, TNA
 

2 contrarian trades that will make you uncomfortable

Posted by Cam Hui -

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

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Revealed: The market timers’ dirty little secret

Posted by Cam Hui -

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.
 

What market timers won’t tell you

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

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

 

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

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

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

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

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

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

 

Eurozone crises are the best crises

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

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

 

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

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

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

“This will not end well”

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

What could possibly go wrong?
 

What’s the bearish trigger?

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

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

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

 

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

 

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

 

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

 

Are you sure you want to be bearish?
 

Recessions = Equity bear markets

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

 

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

 

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

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

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

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

 

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

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

 

The month ahead: A test for the bulls

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

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL, TNA
 

The hidden MACD message from the markets

Posted by Cam Hui -

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

 

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

 

That`s not the whole story.

Fun with MACD

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

 

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

 

Longer term, the monthly chart shows a falling MACD.

 

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

 

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

 

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

What you do depends on your own time frame.

Disclosure: Long SPXL, TNA

Offbeat Thursday and Friday forecasts

Posted by Cam Hui -

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

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

 

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

A QT warning?

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

 

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

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

 

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

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

A blowout Jobs Report?

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

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

 

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

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

 

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

 

Stay tuned for possible fireworks Friday.