China: A 19th Party Congress postscript

Posted by Cam Hui -

A decent interval has passed since China’s 19th Party Congress (see Beware the expiry of the 19th Party Congress put option), and it’s time to check in again on China to see how things are progressing. For the China bears, the overhang in debt looms large.
 

 

The worries are especially acute in light of International Monetary Fund’s publication of the results of its financial stability assessment of China. In connection with that review, the IMF issued the following warning about three sources of vulnerability:

  • Excessive debt: In particular, concerns were raised over the rapid buildup of debt to keep non-viable zombie companies alive.
  • Growth of shadow banking: The growth of the shadow banking system makes it more difficult to monitor and control the risks in the financial system.
  • Moral hazard: The IMF also raised concerns over “moral hazard and excessive risk taking” because of the belief that the government will bail out troubled state-owned enterprises (SOEs) and local government financing vehicles (LGFV).

The concerns raised by the IMF echoes the writings of Winston Yung at McKinsey, who penned an article called “This is what keeps Chief Risk Officers in Chinese Banks awake at night“.

  • Economic downturn leads to the emergence of credit risk
  • Risk management cannot keep up with constantly changing business models: 
  • Asset liability mismatch
  • Significant risk from off balance sheet activities

It’s all about real estate!

Simply put, the problems of credit growth have fueled a real estate boom in China. The following chart tells the story of a Chinese cultural affinity towards property investment. The latest figures show that 43% of household wealth was in real estate.
 

 

That’s just the household sector. Reuters analyzed the debt burden of the corporate sector and found that it had been growing steadily, despite government attempts at deleveraging.
 

 

When broken down by sector, the biggest five-year debt growth rate came from (surprise!) real estate, though industrial companies have the largest proportion of debt outstanding. Despite these classifications, virtually all companies appear to be exposed to the real estate sector in some form, from either straight ownership, to property development, to financing.
 

 

For another perspective, this series of (lightly edited) tweets from No Sunk Costs document the immense scale of the Chinese property sector.
 

 

Lenders gone wild

A recent Reuters article documents the shenanigans that have gone on in plain sight in property lending. When a property is sold, three bills of sale are prepared, with the open acquiescence of lenders:

When Zhu Chenxia bought a flat early last year from Lei Yarong in the up-market Nanshan district of China’s southern metropolis of Shenzhen, the two women drew up three purchase agreements to cover the deal.

Only one was genuine.

In the legitimate contract, Zhu agreed to pay Lei 6.49 million yuan (about $980,000) for the 96-square-meter apartment near the city’s border with Hong Kong, according to records filed in a Shenzhen court. With the help of her property agent, Zhu cooked up a second contract with Lei that overstated the value of the flat at 7 million yuan. This one was for the bank…

Mortgage fraud like the pair’s flouting of rules designed to protect banks is rampant in China’s roaring property market, according to interviews with buyers, sellers and dozens of property market insiders including real estate agents, lawyers, bankers, valuers and loan middlemen from three of China’s major cities and four smaller cities. Many of these people declined to be identified because they were familiar with or involved in “re-packaged” loan applications, the industry euphemism for these frauds…

Under the third contract she drew up with Lei, the Shenzhen flat was valued at only 2.8 million yuan, less than half its true value, the court records show. That contract was for showing to the taxman. At that value, Zhu would have saved more than 50,000 yuan in taxes, according to Shenzhen regulations.

Imagine the non-performing loan problem. For now, lenders are more interested in loan growth and therefore turn a blind eye to mortgage fraud, which appears to be quite common, and they appear to have adopted a “don’t ask, don’t tell” mortgage origination policy:

Reuters interviewed 12 property agents selling new and existing homes who said they had helped clients dodge lending rules. Another veteran salesperson in Shanghai who works at real estate company E-House China said around 50 percent of his clients engage in some kind of mortgage fraud. The person declined to be identified, and the company didn’t respond to questions.

Property agents often recommend buyers use so-called loan agents to help them secure funds from lenders. These loan agents have created an industry satisfying the demand for funds from borrowers unable to meet lending standards.

Bankers anxious to hit lending targets also introduce borrowers to these agents, according to property insiders. The use of loan agents allows the bankers to keep fraud at arm’s length.

Besides household debt for property purchase, analysis from Reuters showed that SOEs are not immune from excessive debt burden. Debt burden at 75 of the CSI Central SOE 100 Index, which excludes financials, came in roughly 25% of revenue. That means operating margins have to be at least 25% for these companies to be profitable.
 

 

The government’s response

Just because a part of the economy is precariously positioned, in this case property and finance, doesn’t mean it will crash. In the wake of the 19th Party Congress, the authorities are taking steps to gently deflate the bubble, and pivot to a path of more sustainable growth. The good news is that Beijing has abandoned the “growth at any cost” model. The bad news is a shift toward an SOE driven growth strategy (via Tom Orlik at Bloomberg):

The early signs on economic policy from the 19th Party Congress are mixed. On one hand, Xi dropped the explicit mention of the commitment to double GDP from 2010 to 2020 — the basis of the annual 6.5 percent growth target. If that target is now sidelined, it will remove a significant distortion from China’s policy apparatus and a major cause of rising debt levels. On the other hand, China’s state planners appear to be in the ascendant. Industrial strategy loomed large in Xi’s speech. The call for a “stronger, better, bigger” state sector was echoed.

If that’s an indication of where policy makers’ priorities now lie, then it’s a troubling one. Deng’s clearest lesson for Xi is that market reforms — not state planners — are the path to China’s national renewal.

Last week, Caixin reported that the Politburo is taking additional steps to cool the property market:

The Politburo of the Communist Party of China, the country’s top decision-making body, said in a meeting on Friday that reforming the housing system and building a long-term policy for the real estate market are top priorities for 2018, according to the official Xinhua News Agency.

The bull and bear cases

Does this mean that Beijing tank the real estate market, which could then take down the Chinese economy? Let’s consider the bull and bear cases.

The bear case is relatively easy to make. China’s economy is sitting on a mountain of debt. The sugar high of the artificial stimulus leading up to the 19th Party Congress is starting to wear off. Fathom Consulting’s indicators of industrial activity are weakening.
 

 

Real-time indicators, such as industrial metal prices, are rolling over.
 

 

Combined with Beijing’s stated intention to slow down the real estate market, the risk of a financial accident rises very quickly.

The bull case

I would remind readers that this site is not Zero Hedge. If you are looking for permanent bearishness, you should look elsewhere.

There is a case to be made that China is unlikely to crash. The PBOC still has plenty of bullets left if disaster were to strike. At a minimum, the PBOC has plenty of room to lower the RRR in order to inject liquidity into the financial system and the economy.
 

 

As an example, just as bond yields spiked in November, Tom Orlik pointed out that the PBOC injected significant levels of liquidity into the banking system. There were several consecutive days where the PBOC injected over USD 3 billion. To put those figures into some context, the Fed’s quantitative tightening program placed an initial limit of USD 6 billion of Treasury securities to roll off the Fed’s balance sheet per month – and the PBOC injected roughly half that amount into the banking system in a single day. This shows that, when push comes to shove, the PBOC is ready to act to ensure financial stability.
 

 

Chen Zhao, chief strategist at Alpine Macro, recently made the case that China is not at risk of a Minsky Moment in an FT article for the following reasons:

  • Debt-to-GDP is an invalid metric for measuring risk: Debt is a stock concept. GDP is flow.
  • China has plenty of room to service debt: The domestic savings rate is 48%.
  • Credit risk is sovereign risk: Since the government and SOEs are so intimately involved in the economy, credit risk is sovereign risk. And most of the debt is denominated in RMB, which is a currency that the government controls.

The long Yuan trade

In addition, Kevin Muir at The Macro Tourist outlined an offbeat bull case for CNYUSD. His analysis began with an interview with hedge fund manager Felix Zulauf, who believed that Xi Jingping needs to slow the Chinese economy next year in order to have a strong rebound by 2021, when Xi is up for re-election:

China I believe is in an interesting position right now. You heard President Xi’s speech last week, and in 2021 there is the 100th anniversary of the Chinese Communist party and it’s very clear that they want to have a strong economy at that time. If you want to have a strong economy in 2021, you stimulate in 2020. And they are central planners. So that’s means they have to take their foot off the pedal in 2018, 2019. I think in ‘18 and ‘19, they will address the imbalances in the financial sector and that will slow down the Chinese economy in ‘18 and ‘19, which will also slow down the rest of the world.

So we are entering a period where sometime in ‘18, I would say the peak of the market will be in the first half, the peak in the economy is probably from mid-2018 on, and then we slow down into 2020.

And 2022 is the next Chinese Congress, and President Xi is probably the first leader who tries to run for a third time. So he wants to have a very good economy in 2021 and 2022. That means he has to first slow things down, restructure some of the imbalances in the system because if he tries to carry through, it could backfire on him. It could be the worst of all worlds. Namely a completely overheated situation, with high inflation rates, etc…

That’s why I think the leader of this cycle, China, is going to slow down next year.

Muir went on to explain that China is running an extremely loose fiscal policy through its “one belt-one road” initiative, but starting to run a tight monetary policy to cool the property market in 2018-19:

We have a Chinese President who wants to be re-elected shortly after his party’s 100th anniversary celebration in 2021. Therefore, it will be important that the Chinese economy is humming along at full speed at that time. To do that, he needs to stimulate in 2020, but the problem is, if he doesn’t tap the brakes now, he might risk overheating before then. President Xi will therefore take the hit, and get the pain over with in 2018 and 2019. Yet the story is further complicated by the fact that China’s long run infrastructure program is causing a hot fiscal policy. All of these factors add up to a much tighter PBOC for the next couple of years.

Call me an idiot, but I am tempted to take the long Yuan trade. I know that seems insane – all those really smart hedge fund managers are all forecasting a China collapse. But buying Yuan is probably better than betting on stocks going down because of the tight Chinese monetary policy. Not convinced it’s the best trade, and not even sure if I am going to do it in any real size, but I have often found the hardest trades, are often the best trades.

This scenario is based on the assumption that China can contain any fallout from a slowing real estate market.

Endogenous vs. exogenous shocks

I believe that resolving the bull and bear debate depends on whether the Chinese economy is subject to an endogenous shock driven by government policy, or an exogenous shock from abroad, which the central authorities cannot control. The bulls are largely correct in that most of the debt is denominated in RMB, and any so-called debt crisis will not be the typical EM crisis experienced in the past. Beijing can engineer soft landings, as long as they control both the regulatory and credit levers. If reform efforts threaten financial stability, the authorities can always back off. Indeed, we have seen the same start-stop pattern of deleveraging in the past few years.

However, what happens if China is hit by an external shock? Global central banks are entering a tightening cycle. What would happen to China if American demand slows as the Fed normalizes monetary policy? Already, we are seeing signs of a global rebound in inflationary surprise, which will embolden monetary authorities to raise rates and discontinue their emergency QE rescue measures.
 

 

As the PBOE tightens monetary policy, this will drive Chinese corporations to seek cheaper financing offshore. Bloomberg found that borrowers are flocking to the Hong Kong branches of Chinese banks to borrow, and exposure is nearly USD 1 trillion. This level of exposure of loans in a non-RMB currency creates an additional level of risk for the Chinese financial system.
 

 

Imagine a scenario in which the PBOC tightens monetary policy, and CNYUSD appreciates as outlined in Kevin Muir’s thesis, then the US economy slows into a mild recession as the Fed tightens policy. Demand slows, Chinese corporate defaults rise, and starts to cascade. Under normal circumstances, Beijing could ease policy, but it may not be enough to offset falling demand through the trade channel. Even though China has a closed capital account, capital starts to flee and CNYUSD plummets.

Watch the Hong Kong market as the canary in the coalmine. Watch the CNY exchange rate. Watch Australian and Canadian real estate. Watch commodity prices.

Here comes the blow-off

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

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 will also receive email notices of any changes in my trading portfolio.

Party on!

Friday’s November Jobs Report highlighted a number of important bullish data points for the stock market in the weeks ahead. The headline non-farm payroll release came in ahead of expectations, while average hourly earnings missed. At the margin, tame wage pressure which will restrain the Fed from becoming overly aggressive in raising rates.

As well, Thursday’s release of initial jobless claims also underlined the remarkable inverse correlation between initial claims (inverted scale) and stock prices. So far, the continuing improvement in initial claims is supportive of higher equity prices.
 

 

In his latest update of high frequency economic data, New Deal democrat painted a bright picture for the near term, and an improving long term outlook:

The nowcast and the near term forecast remain very positive, with only relatively strong oil prices juxtaposed with relatively weak commodity prices as flies in the ointment. The longer term forecast, which I briefly downgraded to neutral, is weakly positive again.

Throw in the anticipated corporate tax cuts, it is difficult to contain our short-term enthusiasm. This week, I review my Recession Watch indicators and find that the current snapshot of recession risk is receding, though there are still some key risks on the horizon (also see Things you don’t see at market bottoms: Rational exuberance edition).

A leading indicator review

As a reminder, my Recession Watch indicators is a set of seven leading indicators designed to spot a recession a year in advance. They are split into three broad categories, the consumer and household sector, the corporate sector, and financial and monetary conditions.

Starting with the household sector, the outlook looks bright. Real retails sales are rising with no signs of a top in sight.
 

 

The housing sector is a highly cyclical measure of consumer durables. Peaks in housing start have historically been recessionary warnings. The latest figures show that housing starts are recovering after a weak patch, though some of the surge may be related to hurricane rebuilding. That said, this sector is likely to face artificial headwinds next year as higher Canadian lumber prices and the partial loss of mortgage interest destructibility raise housing prices and dampen demand.
 

 

On the other hand, real private residential investments have not recovered as strongly. However, this is a quarterly data series, compared to the more timely monthly frequency of housing starts.
 

 

On the surface, the consumer and household sector is in good shape. However, the lack of wage growth suggests that households are spending in anticipation of better times ahead. To cope, they are either digging into their savings, or borrowing to keep up with consumption.
 

 

This is not anything to panic over, but these conditions represent a cautionary flag longer term.

Corporate sector: Mildly positive

Conditions in the corporate sector can be best described as mildly positive. Historically, corporate bond yields have bottomed out well before the onset of a recession. Current readings show that corporate bond yields are falling, but the last low occurred in August 2016. This indicator tends to be very early, so it is nothing to worry about yet.
 

 

NIPA corporate profits are recovering after oil prices cratered in 2015. Corporate profits to unit labor costs (blue line) have made a new high for the cycle, though real corporate profits (red line) just missed the new high.
 

 

Corporate profits tend to be released with a lag, and proprietors’ income is a more timely data series. Real proprietors’ income has not made a new high for the cycle yet. Call the corporate profits/proprietors’ income indicators a mixed positive. Throw in the prospect of corporate tax cuts, they get even better.
 

 

Financial and monetary conditions: Watch out for the Fed

The third leg of my leading indicators is financial and monetary conditions. It is no secret that the Federal Reserve is embarking on a monetary policy normalization cycle of unknown length and magnitude. As the Fed tightens, money supply growth has tended to slow. In the past, either real M1 or M2 growth has fallen negative ahead of recessions. The latest readings show that real M2 growth stands at 2.3% and it is decelerating quickly. At this rate, it could easily go negative in Q1.
 

 

As well, the market has shown great concerns about the shape of the yield curve, which is flattening but nowhere near an inversion yet. However, should the Fed continue on its course to raise rates at its December meeting and proceed with three quarter-point hikes in 2018, the yield curve could easily be inverted by Q2 or Q3.
 

 

Despite the signs of tame inflation, there are plenty of indicators that show nascent inflationary pressures. The New York Fed’s Underlying Inflation Gauge estimates underlying trend CPI to be 2.25% to 3.00%, which is well above the Fed’s 2% target.
 

 

Moreover, measures of global inflation show that inflation surprise is turning up around the world.
 

 

Bottom line: Don’t expect the Fed to slow down in its course of rate hikes.

Investment implications

Putting it all together, the near term implications for US equities is bullish. The latest update from FactSet shows that earnings estimates continue to rise, indicating positive fundamental momentum.
 

 

From a technical perspective, risk appetite indicators are behaving well. There are few signs of stress from the credit markets after the hiccup in November.
 

 

NASDAQ and momentum stocks have also begun to recover after suffering a recent scare. The technical uptrend for both the NASDAQ 100 and the relative uptrend for price momentum remain intact.
 

 

Next week is option expiry week. Rob Hanna at Quantifiable Edges found that December OpEx has been one of the better OpEx weeks in the year.
 

 

In conclusion, the near term outlook looks unabashedly bullish. Barring an unexpected event, such as a trade war, or a shooting war on the Korean peninsula, positive momentum should carry equity prices to further highs – until the Fed steps in and hits the monetary brakes.

My inner investor remains constructive on equities. My inner trader covered his shorts on Thursday and went long the NASDAQ 100 on Friday.

Disclosure: Long TQQQ

Duel of the market studies

Posted by Cam Hui -

Mid-week market update: Swing and day traders are often fond of studies that show an edge under certain market conditions. But what happens when two different studies disagree?

On one hand, Rob Hanna at Quantifiable Edges published a study yesterday that signaled a likely bullish outcome for stock prices. Yesterday (Tuesday) would have day 1 of that study.
 

 

On the other hand, I had identified a hanging man candle on Friday. While hanging man formations are thought of as bearish reversals, further studies showed that they don’t necessarily resolve themselves in a bearish fashion unless there is a bearish follow-through the next day.
 

 

When the market opened up strongly on Monday, I had given up on Friday’s hanging man, but the market astonishingly closed in the red to flash a bearish confirmation. My own historical study indicates that these episodes tend to be short-term bearish, and bottom out between day 3 and 4, which translates to either this Thursday or Friday.
 

 

How can we resolve this apparent contradiction in market studies?

Market getting oversold

As a quant, I am always cautious about studies that torture the data until it talks. One way of resolving conflicting conclusions is to analyze the market conditions outside the scope of the study.

The short term (1-2 day time horizon) charts from Index Indicators show that, as of the close Tuesday, the market was getting oversold.
 

 

The long term (1-2 week time horizon) chart also showed that long term trading breadth indicators had fallen dramatically below neutral and closing in on a near oversold reading.
 

 

As of the time of publication, Index Indicators has not updated their charts yet. Even though the SPX closed flat on the day, the negative market breadth today suggests that these readings are likely to get worse, which indicates that the bearish impulse may be close to getting played out.

How far will the Tech weakness go?

One of the features of the recent market weakness is the selloff in Tech stocks, and semiconductor stocks in particular. One of the other features of the current episode is the rotation of funds into other sectors, such as Financials. Business Insider recently highlighted analysis from Credit Suisse which indicated that sector correlation is at a historical low. These circumstances, where losses in one sector are offset in gains in another, serve to mitigate the losses in the major market indices.
 

 

That said, how bad is the Tech and semiconductor selloff and what are the likely outcome when it ends? An analysis of the relative performance of semiconductor stocks shows that they are oversold, and the selling pressure is likely to end soon.
 

 

An analysis of the Tech sector shows a similar result.
 

 

In connection with the current rotation, Bloomberg highlighted analysis from Andrew Lapthorne of Societe Generale, who believed that the violent reaction in Tech was not just simple sector rotation, but quant factor rotation from momentum into value. As the chart below shows, the relative performance of the price momentum ETF (MTUM) remains intact.
 

 

If Lapthorne is correct, and institutional and hedge fund quants are rotating factor exposures, then there is no telling how much further the Tech weakness has to go. I will be monitoring the relative performance of MTUM in the near future. Even though these stocks may see a near term bounce in the days ahead, an analysis of the weekly relative performance of the semiconductor stocks shows that they are not anywhere near an extreme oversold reading on the weekly chart. In the past, whenever the relative RSI has become overbought and mean reverted, the relative underperformance of this group does not end until RSI becomes oversold.

Should Tech start to turn around here, especially with the market mildly oversold, we could see a short-term market bottom in the next few days. This suggests that both studies are correct. The hanging man candle will see a market bottom this week, and the bullish resolution from Rob Hanna’s study will see a temporary market top next week. This is also consistent with the consolidative seasonal pattern identified by Callum Thomas in the early part of December.

My inner trader is short the market, but he is getting ready to pull the trigger and cover his position in the next few days. Stay tuned.

Disclosure: Long SPXU

Should you be worried about an elevated Shiller P/E?

Posted by Cam Hui -

In my discussions with investors, the Cyclically Adjusted P/E (CAPE), or Shiller P/E, has come up numerous times as a risk for the U.S. stock market. The current reading of 32x is only exceeded by the peak during the NASDAQ Bubble, and it is higher than the levels seen before the Crash of 1929. Does this mean that the risk of a substantial stock market drawdown in the near future is rising?
 

 

I studied the question in the context of some of the criticisms of the Shiller P/E and made a number of adjustments to the calculation. I found that the answer is the same. The U.S. equity market is expensive, but Shiller P/E does not work well as a short-term market timing technique. However, I have found that the combination of valuation and price momentum can provide clear warning signs that the market is about to enter a bear market.

Adjusting Shiller P/E for the Great Financial Crisis

The Shiller P/E uses the average 10-year real earnings as one of its inputs. One of the points made in our investor discussions is the effects of the Great Financial Crisis of 2008–2009 (GFC) will be fading soon from the calculations. Once those depressed earnings drop off the 10-year trailing window, the ratio should decline, which makes valuation much cheaper.

The adjustment for the GFC depends on the timing of recessions during Robert Shiller’s study period, and current conditions today. The chart below shows that the current equity bull market, which began in March 2009, is well above average. Past profit and economic cycles were shorter, and therefore Shiller P/E calculations would have tended to include at least one recession during its 10-year lookback period.
 

 

For another perspective, following chart shows history of NIPA corporate profits, which historically have been correlated with equity market profits (see BEA study), and the Wiltshire 5000 as a frame of reference for equity returns. As the chart shows, the frequency of recessions was early in the post-WW II period and past Shiller P/E calculations would have tended to include recessionary periods where earnings contracted in its 10-year lookback periods.

Should the current economic cycle continue into 2019 without a recession, then arguably the effect of dropping off the recessionary earnings of the GFC actually artificially elevates Shiller P/E, rather than act to make the market less expensive.
 

 

Another way of addressing the 10-year GFC recession problem is to extend the lookback period. DQYDJ has such a facility. Extending the lookback period to 20 years shows that valuations are similarly elevated.
 

 

Adjusting Shiller P/E for macroeconomic conditions

A researcher at the San Francisco Fed recently proposed a novel way of adjusting the Shiller P/E for the effects of changes in r* and other macroeconomic inputs (see link to paper). To explain, r-star (r*) is what economists use to describe the long-term expectation for the real rate. Even though it is not observable, a useful proxy is long-term forecasts for Fed funds, adjusted for the Fed’s inflation target, found in the Fed’s dot-plot.

In the latest dot-plot, the median Fed forecast now stands at 2.75%. Assuming it reaches its inflation target (2%) that would put the real rate at 0.75%.

Kevin Lansing of the San Francisco Fed found that changes in CAPE was highly correlated to changes in r-star:

Figure 3 shows that shorter-run movements in r-star generally go in the same direction as the CAPE ratio. The correlation between the two series is strongly positive. This pattern is consistent with the idea that upward movements in r-star tend to be observed during booms or recoveries, which are periods of lower macroeconomic uncertainty (Lansing 2017). Lower uncertainty stimulates investors’ demand for risky assets like stocks, contributing to a rise in the CAPE ratio. Likewise, downward movements in r-star tend to be observed during recessions or crises, which are periods of higher uncertainty. Higher uncertainty stimulates investors’ demand for safe assets like U.S. Treasury securities while stock prices tend to fall, contributing to a decline in the CAPE ratio. Using the projected path for r-star from Figure 1, the projected path for the 20-quarter change in r-star shows a continued increase for a time, followed by a reversal as r-star levels off at 1%.

 

These results may initially appear to be counterintuitive. Why should the Shiller P/E rise as r* rises? This effect can be explained by changes in expectations. During the late phase of an expansion, stock prices can rise even as the Fed raises interest rates. That’s because positive effects of expected higher earnings growth overwhelms the negative effects of higher interest rates, which results in P/E expansion. The same effect is observable when Shiller P/E and r* rise together.

Lansing went on to fit a projected CAPE ratio into the future using a series of macroeconomic variables, namely the Laubach-Williams (LW) two-sided estimate of r-star, the CBO four-quarter growth rate of potential GDP, the 20-quarter change in the LW r-star estimate and the four-quarter core PCE inflation rate.
 

 

He concluded:

Over the long history of the stock market, extreme run-ups in the CAPE ratio have signaled that stocks may be overvalued. A simple regression model that employs a parsimonious set of macroeconomic explanatory variables can account for most of the run-up in the CAPE ratio since 2009, offering some justification for its current elevated level. The same model predicts a 13% decline in the CAPE ratio over the next 10 years. This prediction, if realized, would imply lower returns on stocks relative to those enjoyed in recent years when the CAPE ratio was rising.

In effect, investors can expect no help on expected equity returns after macroeconomic adjustments.

High Shiller P/E = Low LT returns

Having established that the Shiller P/E is elevated, what does that mean for investors? The experience of the last 10–20 years has shown that a high Shiller P/E is not necessarily a danger signal for equity prices. Stocks have continued to rise even in the face of above-average CAPE. Simply put, CAPE is ineffective as an intermediate-term market timing model, though it can be a useful tool to forecast long-term returns.

Michael Lebowitz at 720Global projected 10-year U.S. equity returns under a variety of scenarios using the combination of earnings growth, starting and ending Shiller P/E and 10-year Treasury yields. His base-case scenario called for Shiller P/E to fall from the current elevated levels to one standard deviation above its long-term average in 10 years. Expected U.S. equity returns came in at 2.7%, which is barely above the yield of the 10-year Treasury note.
 

 

In other words, U.S. equities will be nothing to write home about.

A better way to market time with Shiller P/E

CAPE is not known for being a market timing tool, as high Shiller P/E ratios have not historically been followed by bearish markets. There may be a better way, which I wrote about before.

The blogger Econompic found that adding price momentum to CAPE valuation can be an effective way to time the market. He found that equity prices are at the greatest risk of a major decline when CAPE is above 30 (32x today), and CAPE is falling.
 

 

This study makes market timing with Shiller P/E simple. As long as CAPE is rising, as evidenced by rising prices that raise the ratio, bear market risk is low, but get out of the way when the market starts to decline.

Investors should bear this rule in mind in the current environment where Shiller P/E stands at an elevated reading of 32x.

Brace for a more volatile 2018

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

The latest signals of each model are as follows:

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Volatility ahead

Equity market volatility, as measured by the VIX Index, has been extraordinarily low by historical standards.
 

 

Last week’s events is setting the stage for greater market volatility in 2018, which stems from the following three sources:

  • Political uncertainty
  • Fiscal policy
  • Monetary policy

Let’s examine each, one at a time.

The tale of l’affaire Russe

Last Friday, the stock market was hit by the report that former Trump administration National Security Adviser Mike Flynn had pleaded guilty to a minor charge, and he was fully cooperating with the Mueller investigation by testifying against the Trump campaign in return for leniency. It was further reported that Flynn claimed that Trump had directed him to contact the Russians during the election (later corrected to the transition period). The SPX nosedived over 1% on the news, though it recovered later in the day to close -0.2%. The difference between the timing of any Russian contact is legally important. If candidate Trump had contacted the Russians during the campaign, it could be interpreted as a violation of the Logan Act which prohibits ordinary citizens from negotiating with unfriendly governments. Contacting foreign governments during the transition period to conduct foreign policy could be viewed as it constitutes the normal business of a new team.

Nevertheless, it is hard to see how Flynn got off so lightly if the only revelation was the Trump transition team had contacted the Russian government. There was no mention of the planned Gulen rendition to Turkey in return for a $15 million fee in the indictment, and Mueller declined to indict his son. The Lawfare blog’s quick and dirty analysis concluded that we should expected further bombshells in the near future:

The narrowness [of the charge against Michael Flynn] gives a superficial plausibility to the White House’s reaction to the plea. Ty Cobb, the president’s ever-confident attorney, said in a statement: “The false statements involved mirror the false statements [by Flynn] to White House officials which resulted in his resignation in February of this year. Nothing about the guilty plea or the charge implicates anyone other than Mr. Flynn.” Cobb reads Friday’s events as an indication that Mueller is “moving with all deliberate speed and clears the way for a prompt and reasonable conclusion” of the investigation.

This is very likely not an accurate assessment of the situation. If Mueller were prepared to settle the Flynn matter on the basis of single-count plea to a violation of 18 U.S.C. § 1001, he was almost certainly prepared to charge a great deal more. Moreover, we can infer from the fact that Flynn accepted the plea deal that he and his counsel were concerned about the degree of jeopardy, both for Flynn and for his son, related to other charges. The deal, in other words, reflects the strength of Mueller’s hand against Flynn.

It reflects something else too: that Flynn is prepared to give Mueller substantial assistance in his investigation and that Mueller wants the assistance Flynn can provide. We are not going to speculate about what that assistance might be. But prosecutors do not give generous deals in major public integrity cases to big-fish defendants without good reason—and in normal circumstances, the national security adviser to the president is a very big fish for a prosecutor. The good reason in this case necessarily involves the testimony Flynn has proffered to the special counsel’s staff. The information in that proffer is not in any of the documents released Friday, and it may not even be related to the information in those documents. Prosecutors tend to trade up. That is, for Mueller to give Flynn a deal of this sort, the prosecutor must believe he is building a case against a bigger fish still.

Notwithstanding any dispute over whether anyone violated the Logan Act, the Trump team`s troubles with the Mueller probe are not over. Trump’s weekend tweet was problematical, as he admitted that he knew Flynn had lied to the FBI, and then asked Comey to back off on the Flynn investigation. Many legal analysts have interpreted these actions as obstruction of justice, which was the charge that forced Nixon`s resignation.
 

 

The latest Gallup presidential job approval, which was taken before the Flynn news, shows that Trump’s approval at 34%. Historically, the stock market has not performed well when the approval rate falls to 35% or lower.
 

 

That’s bearish, right? Well…should sufficient evidence surface to force either the resignation or impeachment of Donald Trump, the knee-jerk market reaction would be bearish. However, Wall Street would undoubtedly sleep better at night if President Pence were to be in the White House, which would be a bullish outcome.

Hence the potential volatility. How this plays out, or how the market is likely to react to any single piece of news, I have no idea. But watch for rising political uncertainty in the year ahead.

Upside volatility from a cyclical surge

Notwithstanding any possible noise from l’affaire Russe, the market will continue to focus on the combination of the earnings and interest rate outlook. Even without any tax cut effects, the earnings outlook looks bright, which will likely be a source of upside equity price volatility.

As experienced investors are aware, Street analysts tend to publish earnings estimates that are too high and then gradually revise them downward. The latest update from FactSet indicates that Q4 EPS estimates are seeing the least amount of downward revisions since Q2 2011.
 

 

In addition, the latest FactSet summary of EPS estimates show that normalized forward 12-month EPS continues to rise steadily. This is another sign of bullish fundamental momentum that is supportive of higher stock prices.
 

 

In addition, Callum Thomas pointed out that the market is enjoying a period of macro tailwinds, as economic surprises and investor sentiment, otherwise known as FOMO, tend to surge into January.
 

 

Tax cuts: Upside or downside volatility?

What about the effects of the corporate tax cuts? The aggregate benefits of a corporate tax cut may be marginal. The next step for the tax bill is the reconciliation between the Senate and House versions of the bill before it can become law. One of the key differences is the Senate version of the bill cuts the corporate tax rate to 20% in 2019, while the House version immediately lowers the corporate tax rate to 20% in 2018.

Assuming the optimistic case that the corporate rate is 20% in 2018, a Reuters report indicated that the consensus 2018 EPS estimate would be about $150. Based on the current FactSet FY2018 estimate of $146.05, that amounts to a 2.7% increase in EPS. To be sure, other strategists put the increase higher, in the 5-8% range,
 

 

A mid single digit percentage increase in earnings, which translates to a similar level of stock market price appreciation, assuming no further multiple expansion? Is that all?

Ed Yardeni came to a similar conclusion using top down data. Yardeni, who declared that he was “all for tax cuts”, but he was “having a problem with the data”. He analyzed the effective corporate tax rate using two separate and distinct sources, the GDP data, and IRS data. The effective corporate tax rate was somewhere between 13.0% and 20.7%. If the effective rate is already that low, what’s the benefit of cutting the statutory rate to 20%?
 

 

Yardeni concluded:

Congress may be about to cut a tax that doesn’t need cutting. Or else, the congressional plan is actually reform aiming to stop US companies from using overseas tax dodges by giving them a lower statutory rate at home.

It is unclear how much of the stock price rally in the last few months is attributable to the cyclical effects of better earnings growth, and how much is discounting the effects of a tax bill. Given the relatively meager tax cut estimated boost to 2018 EPS growth. The tax bill may already been discounted by the market. In that case, we may be setting up for the downside volatility effect of “buy the rumor, sell the news” scenario when the bill is actually passed.

And we haven’t even discussed the possibility of a government shutdown in early December…

How will the Fed react?

Assuming that the GOP tax cut package does pass, another downside wildcard is the Fed’s reaction. Will the Fed be more inclined to tighten monetary policy faster in the face of fiscal stimulus?

Consider where we are today. The market is fully discounting a December quarter-point rate hike, and about two quarter-point rate hikes in 2018. By contrast, the Fed’s dot plot calls for a December hike, followed by three more raises next year.
 

 

While there has been some discussion from Fed officials about the uncertainty surrounding possible rate hikes in light of the absence of inflation, the inflation internal indicators are edging up. In all likelihood, we will start to see rising inflationary pressures in the very near future. As an example, the New York Fed’s Underlying Inflation Gauge (UIG) has been gradually rising. The latest readings in October shows the full data set measure at 3.0%, while the price-only measure at 2.3%. Both of these metrics are above the targeted inflation rate of 2.0%.
 

 

In the past, real YoY money supply growth has gone negative ahead of recessions. Real M2 growth is falling and could go negative by Q1 or Q2 at the current pace of deceleration.
 

 

In addition, the nomination of Marvin Goodfriend as Federal Reserve Governor will tilt the FOMC in a more hawkish direction. I wrote about Goodfriend last June (see A Fed preview: What happens in 2018?). At that time, I had highlighted the Gavyn Davies endorsement of Goodfriend for the Fed by characterizing him as an orthodox rules-based monetarist:

  • Goodfriend’s conservative pedigree goes all the back to Reagan’s Council of Economic Advisors. He is a typical member of his generation…in having a very profound distaste for inflationary monetary policies.
  • Goodfriend believes in a formal inflation target, which he thinks should be approved by Congress, rather than being set entirely within the Fed…On the Taylor Rule, Prof Goodfriend has recently argued that the FOMC should explicitly compare its policy actions with the recommendations from such a rule, because this would reduce the tendency to wait too long before tightening policy.
  • Goodfriend believes that interest rates are a much more effective instrument for stabilising the economy than quantitative easing.
  • Goodfriend has frequently argued forcibly against allowing an “independent” central bank to buy private sector securities such as mortgage-backed bonds, which he deems to be “credit policy”.
  • Goodfriend has always been worried that “independent” central banks will develop a chronic tendency to tighten monetary policy too late in the expansion phase of the cycle.

Goodfriend has also shown himself to be a highly dogmatic advocate of demonstrating central bank credibility in its price stability mandate. As an example, he wanted to raise rates in 2011, even as the eurozone underwent its crisis and Washington underwent a debt ceiling crisis. As a way of demonstrating its credibility, Goodfriend believed that the Fed should abandon a gradualist monetary policy and adopt a rapid-fire decisive approach to interest rate changes (via FT Alphaville):

Goodfriend was also sceptical of the Fed’s decision to begin raising interest rates in 2015, when inflation was weak — even excluding commodities — and nothing indicated it would quickly return to 2 per cent. According to this former student, Goodfriend believed the Fed should make its moves over relatively short periods of time. Thus the 1994-5 tightening was close to ideal because it quickly recalibrated the level of short-term interest rates from 3 per cent to 5.25 per cent. (With an overshoot to 6 per cent in the middle, but still…)

The former student recalls Goodfriend saying that if the Fed were to raise interest rates in 2015 it would probably have to wait a long time before any additional rate increases, which would damage the Fed’s credibility and potentially worsen the downtrend in inflation expectations. That’s more or less exactly what happened. According to this student’s account, Goodfriend would have preferred the Fed waited until it could commit to a relatively short and uninterrupted campaign of “normalisation”.

You want policy volatility? You’ll get it with Marvin Goodfriend. Despite his monetarist beliefs, Marvin Goodfriend may be more tolerant of rising inflationary pressures, at least initially, and then respond with a series of staccato rate hikes to cool off the economy.

Left unsaid during the news of the Goodfriend nomination is the identity of the Fed vice chair. The latest speculation of the two top contenders are John Taylor, who is just as dogmatic as Goodfriend and equally hawkish, and the more moderate Mohamed El-Erian.

Even though El-Erian may be viewed as the moderate and pragmatic choice by Wall Street, he may turn out to have far more hawkish views should he assume the position as vice chair. In early 2016, El-Erian had penned a Project Syndicate essay, entitled “The End of the New Normal?”. In that essay, he worried that the Fed would run out of bullets in the next downturn, and it was time for fiscal policy to engage in some of the heavy lifting currently performed by monetary policy. More recently, he wrote a Bloomberg article that was supportive of the tax bill and infrastructure plan, which is likely to endear him to Trump:

That brings us back to the importance of policy implementation in sustaining and buttressing the historic rally in stocks.

To maintain the uptick in growth, Europe and the U.S. need to implement measures that reverse persistent downward pressures on potential — that is, the ability of advanced economies to grow not just today but also in the future, and to do so in a more inclusive manner.

In the U.S., this requires progress on Capitol Hill on the tax plan, as well as congressional support for the administration’s infrastructure initiative and steps to enhance labor productivity and improve the benefit-to-cost ratio of technological innovation.

That said, the passage of a tax cut would take some of the pressure off the Fed to be overly accommodative and embark on a faster pace of  monetary policy normalization. While Mohamed El-Erian as vice chair would largely be supportive of the Republican tax bill, he would also push for faster pace of rate hikes.

The market is only expecting about two quarter-point rate hikes next year. Would four or five hikes increase market volatility?

The week ahead

Looking to the week ahead, the market may be ready for a brief pause in its advance. I sent out an alert to subscribers on Thursday that my trading account was taking a short position in the market. A number of signs of bullish exhaustion were starting to appear.

First, risk appetite was starting to roll over. Momentum stocks, which had been performing well, had begun to weaken relative to the market. As well, small cap stocks, which tend to be more domestically exposed and more sensitive to tax cuts, underperformed even as the tax bill made its way through the Senate.
 

 

Sentiment is getting a little frothy. The 10 day moving average of the CBOE put/call ratio (CPC) has reached a crowded long reading. In the past, the market has tended to stall out at these levels of complacency.
 

 

In addition, Tommy Thornton identified a monthly $SPX DeMark upside exhaustion signal on Friday.
 

 

The track record of these signals have been remarkable, though the sample size is small (N=7).
 

 

My inner trader is short the market, and he is waiting for either signs of oversold conditions on short-term indicators to cover, or a renewed upside surge to fresh highs as a way of defining his downside risk. The market ended Friday with a hanging man candle, which is a potential sign of a bearish reversal.
 

 

History has shown that if we get any downside follow-through on Monday, the short-term outlook is bearish for stock prices over a 3-4 day time horizon.
 

 

My inner investor remains constructive on stocks, and his asset allocation is at roughly the level specified by his investment policy statement. If history is any guide, the market is likely to pause briefly before resuming its seasonal rally into year-end (via Topdown Charts).
 

 

Disclosure: Long SPXU

What’s next for the tax cut bull?

Posted by Cam Hui -

Mid-week market update: It was clear from yesterday’s market action that the equity bull depends entirely on the success of the Republican tax cut bill. The market rallied on the news that the tax cut bill had made it out of Senate Budget Committee. It manage to shrug off the news of a possible government shutdown, and a North Korean ICBM test, which was later determined to have a range to reach the entire Continental United States.

The combination of the market enthusiasm yesterday and the strength in the Goldman Sachs high tax basket indicates that the market is discounting the passage of the bill.
 

 

Roadblock ahead

The Senate’s version of the bill now goes to the floor of the Senate. Here is where it is likely to run into trouble. Under the Byrd Rule, which states that Senate legislation on budget and spending can be passed with a simple majority without filibuster and then undergo the reconciliation process with House legislation, it needs to pass two tests. First, it cannot increase the deficit by more by $1.5 trillion over 10 years. As well, it cannot raise the deficit any more after the 10 year period. The determination of whether a bill passes those tests is done by the non-partisan Joint Committee on Taxation (JCT). Any budget legislation that is not Byrd Rule compliant is subject to filibuster and needs a 60 vote majority to pass the Senate.

The Republican Senate leadership is trying to bring the bill to a vote on the Senate floor this week, before the JCT has scored the bill. Notwithstanding all the bargaining that is going on right now to get the bill passed, the Washington Post reported that the JCT is rushing to produce a score, whose “optimistic estimate for completion of this analysis is late Wednesday”.

While we don’t have the JCT report yet, we have the results of other models. The analysis of the Penn-Wharton model, which is run by a former Bush administration official, found that “the Senate Tax Cuts and Jobs Act reduces federal tax revenue in both the short- and long-run relative to current policy”, or increase deficits after 10 years, even with dynamic scoring. That doesn’t sound Byrd Rule compliant to me. It’s hard to see how the JCT analysis would come to a significantly different conclusion.

What about the effects of Bob Corker’s proposed “trigger tax”, where tax rates rise if growth does not hit projected targets and the deficit rises? Would that solve the Byrd Rule problem?

Here is what former Reagan budget director David Stockman had to say about writing and implementing a “trigger tax” provision:

The problem is, what is the baseline for measuring any revenue shortfall, and what happens if the short-fall is due to a recession or some other un-programmed economic development? Or even a multi-quarter growth hiatus that may or may not be the on-set of an officially designated “recession” by the authorities at the NBER.

You editor speaks with some authority on this point—having helped devise such a “trigger tax” back in 1983 when Ronald Reagan was looking for a way to raise taxes to stem the exploding deficit caused by the 1981 cut without admitting he was back-tracking. The long and short of it was Reagan’s “trigger tax” never got off the ground because even the threat of a trigger release causes it own set of adverse but impossible to quantify economic feedbacks.

In addition, CNBC reported that other Republican senators opposed the “trigger tax” provision.

Bottom line, the Senate version of the tax bill is hanging on by a very thin thread. If the JCT does manage to publish an analysis, the bill will not be Byrd Rule compliant and will need 60 votes to pass the Senate. Good luck with that.

Equity bulls need to be prepared for a rude awakening should the JCT manages to publish its analysis before the Senate vote.

Technical market condition

Notwithstanding the hurdles surrounding the passage of the Senate tax bill, Urban Carmel highlighted some short-term risks to the market after the strong market action on Tuesday:

US indices closed at new all time highs on Tuesday. The gain was so strong that SPX closed 25% above its Bollinger Band width. This is rare. There have been only 5 similar instances since 2009. None marked an exact short-term top in the market, but all preceded a fairly significant drawdown in the week(s) ahead. Risk-reward over this period was very poor.

While the sample size is low (N=5), he found that the market tended to rise for a few days, and suffer a substantial correction in the weeks ahead:

What is noteworthy is that none marked an exact short-term top in the market – price was usually higher the next day or two – but all preceded a fairly significant drawdown in the week(s) ahead. Risk-reward over this period was very poor.

Subsequent analysis going back to 1986 found that the risk-reward to be unfavorable as well:

The pattern described in this post was more common prior to 2003. Below are additional 18 instances since 1986. Roughly 75% fit the bearish pattern described above; in 5 instances (mostly in 1995-96), SPX continued to rise largely unabated.

For another perspective, the breadth metrics from Index Indicators found that the market was overbought on short (1-2 day), medium (3-5 days), and long (1-2 week) time horizons.
 

 

These readings do not necessarily mean that the market has to correct significantly. However, some consolidation or minor weakness may be in order in the near future.

Things you don’t see at market bottoms: Rational Exuberance edition

Posted by Cam Hui -

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.

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:

As a result, I am publishing another edition of “things you don’t see at market bottoms”.

Rational exuberance

This is roughly the time for investment strategists to write their outlook for next year. I called for a possible blow-off high in stocks early in the year, followed by a rocky second half (see 2018 Outlook: The Bulls’ Last Charge). By contrast, Street strategists had turned unabashed bullish for 2018. Two separate strategy teams separately and independently rationalized their bullishness as “rational exuberance”.
 

 

In addition, Bloomberg reported that “the average estimate of all the major brokerage firms predicts that stocks are expected to rise 10 percent next year”. Birinyi Associates found that the S&P 500 performs poorly when the average year ahead forecast calls for gains of over 10%:

Stock market research firm Birinyi Associates has tracked the predictions of Wall Street strategists back to 2001. The general conclusion, according to Birinyi’s director of research Jeff Rubin, is not to put too much faith in them. The stock market has plunged in years when analysts predicted it would go up a lot, and jumped in years when Wall Street strategists said it would go up only a little. (Strategists as a group rarely predict down years and haven’t since 2001.) But there is one pattern to look out for: Years in which Wall Street is looking for a double-digit return for the first time in a while.

 

These results are consistent with the research conclusions of the BAML Buy Side Indicator, which is “based on the average recommended equity allocation of Wall Street strategists as of the last business day of each month”. When Street strategists become overly bullish, defined as the Sell Side Indicator rising to at least one standard deviation above its 4-year moving average, equity performance has tended to struggle. (Annotations are mine because the data has been updated since the original chart was produced.)
 

 

Please note that current Sell Side Indicator readings are roughly two-standard deviations above the average, which suggests even weaker equity returns ahead.

BBB Borrower Issues 3-Year Bond at Negative Yield

Would you pay a BBB borrower to take your money? Evidently, that has happened. What’s more, Business Wire reported that the deal was over four times oversubscribed.

Veolia (Paris:VIE) has issued a 500 million 3-year EUR bond (maturity November 2020) with a negative yield of -0.026 %, which is a first for a BBB issuer.

The transaction was very positively welcomed by the investors, which led to an oversubscription ratio over 4. Thanks to this strong demand, Veolia managed to issue the bond with a spread against swap rate of 5 basis points, which is the tightest spread ever achieved for a 3-year fixed-rate EUR Corporate bond.

Thank you, European Central Bank for your QE programs.

Short Selling Managers Are Disappearing

Sometimes I find the most fascinating tidbits. David Swensen, the Chief Investment Officer of Yale University, stated in an interview that he found that short sales represent an important area of opportunity from a contrarian viewpoint. One sign occurred when Yale had to change its short-selling performance benchmark because the number of short selling managers was disappearing:

One of the obvious areas of opportunity in an environment of extended valuations is short something. Recently we had to change an index that we use to measure the returns of short sellers, because the index stopped being published because there weren’t enough managers to populate the—populate the index. So it’s incredibly out of favors. Short sellers have suffered enormously. And I think that’s an area of opportunity.

Monster Art Sale

The art world was recently rocked by the auction sale of Leonardo da Vinci’s portrait of Christ, known as Salvator Mundi, for a record US$450 million. The chart below from SentimenTrader shows that, while these astounding prices don’t always pinpoint the exact market tops, the timing and the amount involved certainly raise eyebrows.
 

 

Crypto and Other Madness

Market lore tells the story of how Joe Kennedy got out of the stock market before the Crash of 1929 when a shoeshine boy started talking to him about stocks. Minneapolis Fed President Neel Kashkari’s tweet may be the modern equivalent for crypto-currencies.
 

 

This astonishing anecdote was followed by the Bloomberg story that survivalists, who had a propensity to hoard food, water and weapons to prepare for the Apocalypse, were turning from holding gold to Bitcoin as a store of wealth:

Across the North American countryside, preppers like McElroy are storing more and more of their wealth in invisible wallets in cyberspace instead of stockpiling gold bars and coins in their bunkers and basement safes.

They won’t be able to access their virtual cash the moment a catastrophe knocks out the power grid or the web, but that hasn’t dissuaded them. Even staunch survivalists are convinced bitcoin will endure economic collapse, global pandemic, climate change catastrophes and nuclear war.

“I consider bitcoin to be a currency on the same level as gold,” McElroy, who lives on the farm with her husband, said by email. “It allows individuals to become self-bankers. When I fully understood the concepts and their significance, bitcoin became a fascination.”

I could ask what these people are smoking, but I found this on Twitter.
 

 

Ummm, never mind…

Embrace the Blow-off (but with a stop-loss discipline)

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

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 will also receive email notices of any changes in my trading portfolio.

Yield Curve freakout

I received a considerable amounts of feedback to my post last week (see 2018 outlook: Last charge of the bulls) over my comments about the risks posed by a flattening yield curve. Interest in the term “flattening yield curve” has spiked, but consistent with levels last seen when the yield curve flattened to this level.
 

 

My readers highlighted some recently published articles indicating that a flattening yield curve doesn’t matter.

  • Scott Grannis wrote a thoughtful piece about the contrary indicators that point to a slowdown.
  • Cullen Roche at Pragmatic Capitalism concluded that a flattening yield curve isn’t a concern until it inverts, and that analysis from the Cleveland Fed indicated that the current yield curve implies a 12% chance of a recession.
  • Tim Duy observed that a flattening yield curve is a typical market reaction in a tightening cycle, though it suggests that “the economy remain mired in a low rate environment for the foreseeable future” and the Fed probably didn’t expect it to flatten this much.
  • Philadelphia Fed President Patrick Harder voiced concerns about inverting the yield curve in a Bloomberg interview.
  • The San Francisco Fed released a paper entitled, “A new conundrum in the bond market?”, that was reminiscent of Greenspan’s hand wringing over the flattening yield curve even as the Fed raised rates in 2005.

I agree 100%. The more the authorities pay attention to a metric, the less the metric matters. In some instances, the metric can be gamed, just like China’s regional GDP growth statistics.
 

 

Even though an inverted yield curve has been an uncanny leading indicator of recession, it may not work this time because of the effects of the Fed’s quantitative easing (and now quantitative tightening) program on the bond market. Indeed, the Fed’s own estimates showed that its QE programs had pushed the 10-year yield down by 100 bp, which had the effect of manipulating the shape of the yield curve.
 

 

There are sufficient contrary indicators that the economy is booming, and the near-term odds of a recession is low. Those conditions are consistent with my belief that the stock market is undergoing a terminal blow-off phase, but Scott Grannis’ work also hint at how investors might look for signs of a market top.

Investors can embrace the blow-off, but I can also offer you some risk control techniques that can act as a kind of stop-loss discipline.

The yield curve is not a red flag

Scott Grannis recently outlined a well reasoned thesis of why investors should not be overly concerned about the flattening yield curve. Cutting to the chase, here is his conclusion:

Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.

In his post, Grannis pointed out that financial conditions are loose.
 

 

Even though the yield curve is flattening, past recessionary episodes have been preceded by a positive and rapidly rising real Fed Funds rate.
 

 

In summary, Grannis is arguing that monetary conditions are far from tight. In the past, it has been tight monetary policy that has cooled growth and plunged the economy into recession. Today, the economy is booming, liquidity is plentiful, inflation is tame, and inflationary expectations are muted. We live in a not-too-hot and not-too-cold Goldilocks period. Therefore equity investors should not get overly bearish.

I agree, to a certain extent. Here is where we differ. My scenario calls for rising inflationary pressures to appear soon, which would cause the Fed to become far more hawkish than market expectations (see 2018 outlook: Last charge of the bulls). Nevertheless, Grannis’ analysis reveals some clues of what to look for in as a top develops.

How to watch for the Top

Here is what I am watching. These signals can be divided into two categories. The first would indicate that tighter monetary conditions are starting to have a significant negative effect on either the economy or the markets.

Are financial conditions tightening? Financial condition indices are currently signaling loose conditions. Equities are unlikely to get overly stress until financial and liquidity conditions tighten as the Fed raises rates.
 

 

As financial conditions are historically correlated with the VIX Index, one real-time indicator of tightening liquidity might be the VIX.
 

 

The lack of volatility is not just restricted to the VIX Index, which measures equity volatility. Callum Thomas at Topdown Charts pointed out that low bond volatility is also a characteristic of a late cycle expansion. A rise in the MOVE Index could also be a signal that the market could be topping (annotations in red are mine).
 

 

As the Fed normalizes monetary policy, money supply growth has tended to decline in response to tighter conditions. Watch for real money growth to go negative. The latest readings show that YoY real M2 growth at 2.7% and decelerating.
 

 

Grannis pointed out that past yield curve inversions have been accompanied by a positive and rising real Fed Funds rate. We are not there yet.
 

 

Momentum and risk-on stampede

From a technical perspective, I am watching for signs of faltering momentum as a warning of a market top. The current macro environment is showing strong fundamental and price momentum. The latest update from John Butters of FactSet indicates that forward 12-month EPS continues to rise strongly, which is an indication of fundamental momentum.
 

 

The market has been dominated by a risk-on bias. The Relative Rotation Graph (RRG) chart by style shows that leadership has been shown by high beta stocks, such as small caps, growth, and momentum stocks.
 

 

The relative performance of different flavors of price momentum factors is also strong, as measured by MTUM and PDP.
 

 

From a sector perspective, leadership is dominated by technology, as inflation hedge groups such as mining and golds starting to falter.
 

 

The technology driven momentum has the fundamental potential to continue for a few more months. Brian Gilmartin, writing at Seeking Alpha, observed that much of the sector is driven by the iPhone cycle, which has the potential to be positive in Q1.

The tech sector could see a “binary” year, with strong growth in the first half of 2018 and slower growth in the 2nd, with the variable being how “super” the iPhone SuperCycle turns out to be.

Another way of showing this for readers is to show Apple’s fiscal ’18 and ’19 EPS estimates and expected growth:

 

Note that estimated YoY growth in Q4 is still strong. Q4 earnings are reported during Q1, which has the potential to create a tailwind for technology stocks during that period.

BAML quantitative strategist Savita Subramanian found that this kind of growth and momentum driven leadership is typical of the behavior in a late stage bull market.
 

 

However, some caution may be warranted in making too large a bet on price momentum. Topdown Charts recently pointed out that price momentum is highly extended on a global basis.
 

 

On the other hand, just because a market is overbought does not mean that it can`t become even more overbought. BAML`s Subramanian observed that the terminal stage of a market bull usually shows the best performance.
 

 

Her analysis suggests that this bull may have some upside left before it gets exhausted.
 

 

Embrace the Dark Side, buy growth and momentum.

The week ahead

Looking to the week ahead, the outlook appears to be mixed. Subscribers received an email alert that my trading account had taken profits on all of its long positions and moved to 100% cash because of the event risk posed by the upcoming vote next Thursday on the GOP tax bill. The market was not overbought, but the lack of bullish follow through was disturbing for the bulls, and these readings could be indicative of a short-term top.
 

 

Schaeffer’s Research also found that the week after Thanksgiving has historically shown a minor bearish bias, at least until Friday.
 

 

However, should the market rise next week, the odds are much better for stock prices in the next three months.
 

 

My inner investor remains constructive on stocks. He is neutrally positioned with his asset allocation at his investment policy target weight. My inner trader took profits on Friday, but he is still intermediate term bullish. He is hoping for a pullback next week so that he can buy in at lower prices. His positioning is consistent with the observation from Callum Thomas of the market seasonal pattern of a brief period of consolidation in late November and early December, followed by a rally into the year end.
 

Round number-itis at SPX 2600?

Posted by Cam Hui -

Mid-week market update: The mid-week market update is being published a day early because of the shortened trading week due to American Thanksgiving on Thursday.

You can tell a lot about market psychology by the way it reacts to news. Early Monday morning (Europe time) and before the market open, a grim Angela Merkel announced that coalition talks had collapsed, and she was unable to form a government. DAX futures instantly took a tumble, and so did US equity futures. Over the course of the European trading day, equity prices recovered and the DAX actually closed in the green. US stocks followed suit and closed with a slight gain. This was a signal that the market has a bullish short-term bias.

I issued a tactical “buy the dip” trading call for subscribers last Friday. Now that the SPX has risen to test resistance at 2600, which represents an all-time high, is it time to sell the rip?
 

 

Negative divergences galore

There are plenty of reasons to be cautions. Credit markets, as measured by the relative price performance of high yield (HY), investment grade corporate bonds (IG) and emerging market (EM) bond prices against their duration-equivalent Treasury benchmarks, have recovered smartly from the risk-off episode last week, but they are still showing a negative divergence as equities test all-time highs.
 

 

Similarly, the market is also showing a negative divergence on RSI-5 and RSI-14.
 

 

Looming government shutdown

As Americans recover from their Thanksgiving long weekend next week, one market risk that could appear is the looming December 9 deadline for a Continuing Resolution (CR) to fund the federal government. That’s because the Republican leadership has been spending so much effort on their tax bill that little attention has been given to the CR that funds the government. Writing in Forbes, here is how Steve Collendder (@thebudgetguy) sees the situation:

Congressional staff, lobbyists and reporters all cheered when the current continuing resolution — the law that’s keeping the government’s lights on while Congress figures out what to do about the fiscal 2018 spending bills — was drafted so it would expire on December 9. They all figured the early-in-December deadline meant they could make relatively secure plans to be out-of-town for the holidays.

I sure hope they didn’t get nonrefundable tickets.

The GOP’s efforts to enact a tax bill by President Trump’s arbitrary and nonsensical Christmas 2017 deadline has made it almost certain that Congress will be in session until close to the end of December. That, in turn, virtually guarantees that the (hopefully) final funding decisions for the year also won’t be made until the end of the month.

That will wreak havoc with holiday schedules. It could also mean there could be a federal government shutdown by January 1.

In addition, Politico reported that Congress speeds towards a shutdown over Dreamers, with the CR as the leverage that the Democrats holds over the Republicans.

Will the market get spooked over the a government shutdown and possible Treasury default in January?

Positive seasonality, strong momentum

On the other hand, stock prices are enjoying a period of positive seasonality and strong momentum.  The Wednesday before and Friday after Thanksgiving have historically leaned bullish, while Cyber Monday leaned bearish.
 

 

Jeff Hirsch at Almanac Trader observed that high beta small cap stocks are entering a period of positive seasonality.
 

 

My former Merrill Lynch colleague Walter Murphy highlighted the strong breadth performance today (Tuesday).
 

 

Current conditions show that high beta, tech stock driven high beta, high octane, and momentum stocks have dominated the market, and there is no end in sight. These reading suggest that, notwithstanding any short-term weakness, stock prices are likely to continue to rally into year-end.
 

 

How should traders interpret this environment of strong momentum with negative divergences? I believe that a buy the dip/sell the rip is still the best short-term approach. However, short-term indicators, such as the % above the 10 dma from Index Indicators, are nowhere near overbought yet.
 

 

My inner trader is long the market, but waiting for short-term overbought readings to appear to take profits. With any luck, that opportunity may appear on Black Friday.

Disclosure: Long SPXL

Relax! NAFTA isn’t going to collapse

Posted by Cam Hui -

As American, Canadian and Mexican negotiators meet for a fifth round of NAFTA discussions in Mexico City, CNBC reported that a number of analysts are projecting significantly high odds that the trade pact would fall apart:

Jens Nordvig, Exante Data CEO, sent out a warning note Monday that his firm now sees a 30 to 40 percent chance of NAFTA “blowing up” by March.

While Ian Bremmer, president of Eurasia Group said in a note Monday that he has long thought there was 50/50 chance NAFTA would fall apart, but he is also becoming increasingly concerned.

“The big risk is that trade tension in NAFTA spreads to a more global stage, for example if the EU sides with Mexico in WTO disputes. This is where the global risk grows very large,” Nordvig said in an email.

Canada’s McLean’s magazine proclaimed in an article that, “If NAFTA dies, ‘all hell will break loose’“. As a consequence of these trade jitters, both Canadian and Mexican equities have underperformed American ones.
 

 

Relax, even if the Trump administration didn’t get its way in its negotiations, the path to walking away from NAFTA will be long and difficult.

Obstacles to leaving NAFTA

Bloomberg recently published an excellent primer on how Trump could kill NAFTA (it’s not as easy as you think).

Technically, any country could leave on six month’s notice, but the process of leaving the trade pact will be as complicated as the Brexit process. The NAFTA treaty was implemented as an Act of Congress, H.R. 3450, the North American Free Trade Agreement Implementation Act, and it will be up to Congress to repeal all of the laws that set up the NAFTA relationship in order to unwind the treaty.

That’s where the political obstacles come in. Here is a chart of each state’s biggest export trading partner. Umm…see the problem?
 

 

The Petersen Institute analyzed the effects of a cold turkey NAFTA withdrawal and concluded that it would have a direct cost of 187,000 export jobs, mostly in the American heartland (click link to see the interactive impact by state).
 

 

Notice a pattern here? The worst hit states tend to be deep red Republican leaning areas that voted for Trump. Assuming that the GOP fails to pass a tax bill by year-end, and Trump wanted to deliver a political victory by withdrawing from NAFTA, he will find a fight in Congress with Republicans.

Relax. Despite the tough rhetoric, it’s difficult to see how the Trump administration could realistically tear up the NAFTA treaty.

2018 outlook: The last charge of the bulls

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • Trading model: Bullish (upgrade)

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

The outlook for 2018

It`s that time of year, when investment strategists look ahead to the following year. I favor the analytical framework of New Deal democrat, who views the economy through the prism of coincident, short leading, and long leading indicators. I agree with NDD`s latest assessment that the short term outlook is very strong. While NDD scores the long term outlook as neutral, long leading indicators have been gradually deteriorating. A continuation of the Fed tightening cycle could see downward pressure to equities from either valuation or recessionary warnings by mid-year.

Enjoy the party for now. The global economy is undergoing a reflationary surge, and the outlook for Q1, and possibly Q2, is bright. Consequently, equity bulls are responding with one last charge.
 

 

Be warned, however, that the early part of 2018 could be as good as it gets for this cycle. Chris Puplava observed that consumer confidence is nearing the 90th percentile level going back to 1967.
 

 

Such readings have seen stock prices perform poorly over a 1-2 year time horizon. The latter half of 2018 could therefore be very bumpy.
 

 

Short leading indicators all green

Looking over the next few months, it`s hard to argument with the combination of positive fundamental and price momentum. The US Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, is surging (orange line). While high than expected growth is likely to put upward pressure on interest rates and bond yields, that`s a worry for later.
 

 

Now that Q3 earnings season is mostly done, it was a quarter of strong results. Urban Carmel, writing at The Fat Pitch, pointed out that stock market gains were mainly driven by earnings growth. About two-thirds of the rise in the market was the result of profit increase, and about one-third from multiple expansion, based on the expectations of further growth ahead.
 

 

EPS gains were not illusory, either. Virtually all (89%) of the growth in EPS was organic profit growth, and only 11% attributable to buybacks.
 

 

The latest update from John Butters of FactSet tells the story of Wall Street optimism. Forward 12-month EPS estimates are rising, indicating positive fundamental momentum.
 

 

Forget about the sensational warnings about the combination of a Hindenburg Omen and Titanic Syndrome, the stock market is unlikely to crash during Q1 2018. New Deal democrat`s weekly assessment of high frequency economic indicators found that “all short leading indicators…remain positive”. Equity investors can’t ask for much more than that.

Watching for inflation in 2018

Looking further into 2018, however, some dark clouds are gathering on the horizon. The biggest macro risk for the US economic outlook in 2018 is the re-emergence of inflation.

Rising inflationary pressure is especially insidious as some Fed officials have been reluctant to normalize rates due to the absence of inflation. Should inflation begin to rise again, those objections are likely to be stilled, and market expectations of a December rate hike, followed by two more quarter-point hikes in 2018 may prove to be overly dovish.

Last week’s October CPI report may be the indication of an inflationary revival. Core CPI came in slightly ahead of expectations (blue line), while Median CPI, which has been significantly more elevated than Core, is also rising.
 

 

Inflation internals are also signaling an acceleration. The blue line below shows the difference between PPI and CPI, while the red line is Core CPI. When the PPI-CPI spread rises sharply during a late cycle expansion, which is what the economy is experiencing now, it is often a signal of an inflationary blow-off to which the Fed would undoubtedly respond.
 

 

Since the Fed’s operates mainly from a Phillips Curve framework, measures of labor market slack are important metrics to the determination of monetary policy. Labor market slack, as measured by slack as a fraction of the labor force (blue line), or the spread between the U6 and U3 unemployment rates (red line), are at levels seen at the lows in the previous economic cycle. While acceleration in wage growth has not made an appearance yet, these statistics are likely to make Fed policy makers sit up and take notice.
 

 

Fed watcher Tim Duy believes these low unemployment rates leave the Fed no choice but to hike rates. The experience of the late 1960’s, when unemployment fell below 4% and inflation accelerated from 1.5% to 4.8%, showed that the slope of the Phillips Curve steepened dramatically. Rate hike delays would run the risk of the Fed finding itself significantly behind the inflation fighting curve.
 

 

The market effects of higher rates

The conditions that I just described are likely to be equity negative and push the economy into recession. Past tightening cycles has seen real money supply growth go negative, which has been a signal of recession. In the past, it has been M1 growth (blue line) that has fallen below inflation (black line). The current cycle is seeing an unusual condition where M2 growth (red line) decelerating to about 3%, which is a cautionary signal. Continued normalization of monetary policy should see real money supply growth decelerate further and becoming negative in the near future.
 

 

Another factor that is likely to spook the markets is the gap between the market and the Fed’s expectations of monetary policy. While a December rate hike is a near certainty, the market believes that the Fed will only raise rates only twice next year, while the dot plot calls for three hikes. Should signs of inflation start to appear, the probability of three hikes will begin to rise and even four hikes would become a real possibility.
 

 

Another concern is the effects of rising rates on financial stability. New York Fed President Bill Dudley has been in favor of further rate normalization because financial conditions have been loosening even as the Fed raised rates.
 

 

While that interpretation is correct, the Chicago Fed’s Financial Condition Index has shown a near 1 for 1 correlation with the VIX Index. As the Fed tightens, it will eventually tighten financial conditions, and market volatility is sure to follow.
 

 

Equity investors caught between Scylla and Charybdis

Should the Fed embark on an aggressive rate hike cycle, it would put equity investors in a difficult place as they try to navigate between the metaphorical Scylla and Charybdis of monetary policy.

On one hand, should we see a parallel upside shift in the yield curve in response to monetary tightening, it could cause dislocation in equity valuation. The 10-year Treasury yield is forming a potential inverse head and shoulder pattern. Should the pattern complete with an upside break in the neckline, the measured upside target is in the 2.8-2.9% region, which would enough to cause a significant degree of P/E compression.
 

 

On the other hand, the 10-2 year spread has already flattened to 62bp, which is a cycle low. Should the yield curve flatten in response to rising rates, it would only take two or three rate hikes to invert the yield curve, which is a warning of a bull market killing recession.
 

 

Party’s not over yet

That said, all of these negative factors are unlikely to be important until Q2 2018 at the earliest. Relax, and enjoy the momentum party. Momentum remains a dominant factor in today’s market. As this smart beta analysis from Lazard Asset Management shows, returns to momentum are tied to risk appetite and the market just saw the start of a momentum cycle that probably has further to go (grey line).
 

 

Momentum stocks (MTUM) are in a solid relative uptrend against the market.
 

 

Callum Thomas pointed out that upside potential is considerable, especially if the market is undergoing a blow-off.
 

 

The week ahead

The near-term market outlook is a bit more uncertain. Subscribers got a trading alert on Friday when the trading model flipped from bearish to bullish. The market had gotten oversold when the VIX Index rose above its upper Bollinger Band and mean reverted below.
 

 

A historical study of such signals has seen mainly bullish outcomes. However, 35% of past signals have resolved themselves with W-shaped recoveries, where the market rallied, stalled and fell to test the previous low. The lack of fear and capitulation selling in the last pullback, which was extremely shallow, raises the probability above 35% in the current case.
 

 

I also wrote last week that I was waiting for the Fear and Greed Index to fall to a minimum of 40 before I can declare it to be oversold. The index did fall below 40 on Wednesday, but recovered on Thursday to 55 and closed Friday at 44. Past episodes where this index bottomed at 40 saw the stock market chop around for several weeks afterwards. This is also consistent with my belief that the market is likely to experience greater volatility for the next few weeks.
 

 

Next week is the week of American Thanksgiving. Jeff Hirsch at Trader’s Alamanac found while performance on Monday tended to be mixed, there was a bullish bias for the other days of the week. My inner trader is leaning bullish after the VIX buy signal, and breadth indicator showed signs of technical healing.
 

 

Nevertheless, there are a number of potential sources of downside volatility next week from the GOP tax bill and NAFTA negotiations. While I don’t expect much breaking news from the NAFTA talks, the Republican Senate bill faces a few major hurdles:

  • The bill funds the tax cuts by repealing the ACA individual mandate, which is politically risky in light of the last healthcare bill fiasco.
  • One hidden “feature” of the bill that has not been widely publicized is the CBO assessment that it would trigger about $100B in entitlement cuts, including $25B from Medicare, because of the PAYGO law. Such cuts are politically toxic, especially in a midterm election year.
  • The Republicans look increasingly likely to lose the Alabama special election, where the latest polls show that Democratic challenger Doug Jones trending ahead of the scandal ridden Republican Roy Moore.

 

 

  • The latest Joint Committee on Taxation assessment of the GOP tax plan on who gets a tax cut and tax increase could be problematical for the Republicans as the midterm elections approach.

 

 

  • The Republican margin in the Senator is extremely narrow. Ron Johnson of Wisconsin has already announced his opposition to the bill, which means that Majority Leader Mitch McConnell can only lose one more vote. Should Roy Moore lose the Alabama special election on December 12, or other potential GOP mavericks like Collins, McCain, Corker, Flake, or Paul move into the “no” column, tax reform will go down in flames.

On the other hand, stock prices could catch a bid if we get confirmation that the White House nominates Mohamed El-Arian to the post of Federal Reserve vice chairman (via CNBC). El-Arian would be welcome by the markets as a triumph of the pragmatists within the Trump administration over the rules-based ideologues in the Republican Party.

My inner investor remains neutrally positioned at the weights specified by his investment policy asset mix. My inner trader went long on Friday, but he believes that this is a market where traders should opportunistically buy the dips on weakness, and sell the rips on strength.

Disclosure: Long SPXL

An orderly retreat, but getting oversold

Posted by Cam Hui -

Mid-week market update: After several weeks of waiting, evidence of near-term weakness and consolidation is finally appearing. The SPX violated an uptrend this week and it is undergoing a retreat or a period of sideways consolidation.
 

 

Until today, this orderly retreat in stock prices was enough to depress stock prices, but not enough to flash oversold readings. Today`s decline, however, is beginning to spark oversold readings, indicating that a tradeable bottom may occur in the next few days.

Breadth deterioration continues

The weakness has been evident for weeks. The deteriorating in breadth and risk appetite that I recently identified are showing few signs of reversal. Credit markets are still performing badly. The negative performance of high yield (HY) against their duration equivalent Treasuries (blue line), EM bonds vs. UST (green line), and investment grade bonds vs. USTs (red line) are still headed downwards.
 

 

Small and mid cap stocks continue to underperform, indicating poor breadth participation. Leadership is restricted to just a few megacaps and large cap NASDAQ stocks.
 

 

The rise in risk aversion is spreading to Europe. Both the Euro STOXX 50 and FTSE 100 recently fell below their 50 dma, indicating a loss of momentum.
 

 

The poor performance of eurozone equities is particularly surprising in light of their recent positive macro surprises.
 

 

Tiho Brkan confirmed my observation about non-US market breadth by pointing out that global breadth is deteriorating.
 

 

Commodity prices are also falling, based on signs that Chinese economic growth may be coming off the boil. In particular, the cyclically sensitive industrial metals has fallen below both its uptrend line and its 50 dma.
 

 

Getting oversold

Some of the short-term lines that I outlined on the weekend where I would cover my short position have been crossed. RSI-14 has fallen to 50 or less. The VIX Index has risen above its upper Bollinger Band, indicating an oversold condition.
 

 

At the time of this writing, the Fear and Greed Index has not been updated since Monday night, and it is unclear whether it has fallen to the minimum target reading of 40. (In response to a reader comment, these are all minimum readings indicating that the market has fallen sufficiently to cover a short, and they are not necessarily buy signals, as oversold markets can get more oversold).

Interestingly, the Zweig Breadth Thrust Indicator is nearing an oversold setup, which could be indication of a brewing buy signal. Readers who want to follow this indicator in real-time can use this link.
 

 

As a way of estimating near-term downside risk, I went back in time for eight years and looked for past occurrences of negative HY negative performance to see how far down equities fell after such episodes. The early instances of poor HY relative returns saw the SPX experience drawdowns of 5-15%. The 2014-16 period can be discounted because HY was affected by the specific underperformance of energy related companies. Since then, HY underperformance has been relatively shallow, and SPX drawdowns were in the order of 2%. If the market were to see a 2% peak-to-trough decline, then that would put the SPX downside risk at around 2540.
 

 

Don`t get too bearish

Despite my short-term bearish bias, my intermediate term outlook remains bullish. I have already outlined the many signs of bullish intermediate term momentum last weekend (see The tax reform jitters correction?) so I would repeat them.

I would point out, however, that the release of the latest BAML Fund Manager Survey contained a number of surprises. Upon first glance, fund manager positioning indicating a stampede into risky assets may prompt a reflex interpretation of these readings as a contrarian sell signal. Upon closer examination, however, the historical evidence suggests that these bullish excesses are the first indications of a FOMO (Fear of Missing Out) melt-up. (I have annotated less extreme buy signals in grey, which are also consistent with market advances, not tops).
 

 

As well, the historical record shows that excessive valuation and risk appetite can take some time to resolve itself in a bearish manner. Similar levels of perceived excessive valuation and falling cash levels began to appear in 1998, which was well before the NASDAQ peak in early 2000.
 

 

What about the back up in yield spreads touted by Gundlach and others? Here is some context of the “blow out” in spreads. Bottom line: it’s a trading call warning and not a sign of the Apocalypse.
 

 

Don’t stay bearish too long. The melt-up may be just around the corner.

Disclosure: Long SPXU

Nervous about FANGS? Here is a washed-out high beta opportunity

Posted by Cam Hui -

Are you getting nervous about the FANG stocks? The debut of the FANG+ futures contract may mark a top for this group, as it presents an easy vehicle for hedgers to short these high beta stocks. But don’t despair, consider this chart of the relative performance of a high beta group that is washed-out, and may present an opportunity for investors and traders who missed out on the FANG move.
 

 

Would you buy this?

Thought about Biotechs lately?

The mystery chart is the relative performance of Biotech stocks (IBB) against the market. As the chart shows, the group is testing a key relative support zone when compared to the market. Unless the outlook deteriorates significantly, relative downside risk appears to be limited.

There are a couple of reasons to consider the Biotech stocks. First, the group is experiencing a bullish breadth divergence. IBB is a cap weighted ETF, which means that the largest capitalization stocks dominate the performance of that security. By contrast, the equal weight XBI Biotech ETF is performing much better.
 

 

There is also fundamental support for this group. The Morningstar fair value estimate shows that Biotech stocks are about 9% undervalued.
 

 

In conclusion, here is a high-beta group that is undervalued and washed-out. What more could anyone ask for?

The tax reform jitters correction?

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

The latest signals of each model are as follows:

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Tax reform jitters

This was the week that jitters over the Republican tax bill finally caught up with stock prices. Now that both the House Republicans and Senate Republicans have different versions of a tax bill, the market is waking up to the challenges ahead.

  • Both Houses of Congress have to reconcile their bills, which may not be easy. Further bargaining lies ahead, which has the potential to dilute the bullish effects of any corporate tax cuts.
  • Any bill will have to overcome the twin Byrd Rule hurdle of $1.5 trillion in incremental deficit in the next 10 years, and no further deficits after 10 years. Any violation of the Byrd Rule would require 60 votes in the Senate, which would be challenging as the GOP only has a 52-48 seat majority.
  • The Roy Moore scandal is creating additional uncertainty, as a Moore loss in the December special election in could cut the Republican majority to a single vote in the Senate.

Even before stock prices got spooked, the market showed signs it was ready to go down. There were cautionary signals from risk appetite indicators, which signaled rising skepticism over the passage of any tax bill. The top panel depicts the relative performance of high beta vs. low volatility stocks as a metric of risk appetite. Risk appetite perked up in September as the odds of a tax cut became more likely, then flattened out into a range. This pair broke down through a relative support on Friday. The other pairs show the relative performance of “champagne” stocks Sotheby’s (BID) and Tiffany’s (TIF) against the market. The “champagne” stocks have been underperforming the market for the last few months, which is another sign of market skepticism that much was going to be accomplished on the tax bill.
 

 

As well, the latest update from John Butters of FactSet shows that the market reaction to earnings reports may be showing signs of bullish exhaustion. EPS beats were barely being rewarded, while misses were severely punished (annotations are mine).
 

 

Tax cut headwinds

Bloomberg published a good summary of the challenges that the GOP faces in reconciling the House and Senate versions of the tax bill. Both chambers have boxed themselves by generating $1.5 trillion in deficits over 10 years, but different tax breaks and revenues sources in both bills. The reconciliation process will have to make the difficult choice of deciding which provision to keep (and add) in order to add up to a final $1.5 trillion deficit.

Jonathan Traub, who oversees tax policy for Deloitte Tax LLP, said the biggest sticking points will emerge as the Senate Finance panel begins rehabbing its bill to comply with Senate rules.

“That’s a hole that Hatch and the other Senate Republicans are going to have to fill,” Traub said. “And how they fill it may not be very attractive to House Republicans. It’s an unenviable challenge they face.”

On the House side, last-minute changes to the bill before it cleared the Ways and Means Committee on Thursday pulled its price tag under the $1.5 trillion allowed in the first decade under the budget resolution.

“Today, the first and oldest Committee in Congress passed transformational tax reform legislation that charts a new course for the country,” Ways and Means Chairman Kevin Brady said after his panel approved his tax bill.

To get there, the panel appears to have employed a touch of fiscal finesse: The single biggest source of new revenue in Brady’s changes stems from a revision that wouldn’t take effect until 2023 — raising questions about whether Republicans in Congress would ever really let it happen.

Then they have to appease the deficit hawks in the Senate as they navigate their fragile two seat majority:

Three senators have already raised concerns about tax cuts that increase the deficit, including Senator Bob Corker of Tennessee, Senator James Lankford of Oklahoma and Senator Jeff Flake of Arizona. “I remain concerned over how the current tax reform proposals will grow the already staggering national debt,” Flake said Thursday, calling for a “fiscally responsible” bill.

The Republicans may also be driven by an increasing sense of panic. Cristina Marcos of The Hill reported that one House Republican admitted that donations are likely to dry up should the tax reform bill fail. Falling political contributions would reduce their chances of retaining control in the midterm elections next year.
 

 

Moreover, the special Senate election in Alabama on December 12 to choose Jeff Session’s successor may represent a key deadline. Republican candidate Roy Moore has been accused of sexual improprieties with minors, and the news has split the Party. While there has been an outpouring of support for Moore, Politico reported that the National Republican Senatorial Committee has withdrawn its financial support for Moore’s campaign. Three GOP senators, Bill Cassidy of Louisiana, Steve Daines of Montana, and Mike Lee of Utah, have rescinded their endorsement of Moore. More importantly, Donald Trump put out a press statement distancing himself from Moore:

Like most Americans, the President believes that we cannot allow a mere allegation — in this case, one from many years ago — to destroy a person’s life. However, the President also believes that if these allegations are true, Judge Moore will do the right thing and step aside.

As the news of the scandal broke, the latest poll showed that his Democrat opponent Doug Jones had pulled even with Moore in support, which is highly unusual in a state that has leaned deeply red like Alabama. Should Moore lose the special election, it would erode the Republican majority in the Senate to a single vote, even as the leadership tries to manage the opposition of maverick senators such as Corker, Flake, Lankford, McCain, and Collins.

Warnings from technical deterioration

Even before last week’s market weakness, the stock market’s technical internals were looking rather unhealthy, as market breadth has shown signs of deterioration even as the index rose.
 

 

It could be said that market breadth is an imperfect timing tool. Negative divergence can exist for months before the major averages drop. The credit markets is another matter. Jeff Gundlach issued a series of warnings based on the action of the junk bond market.
 

 

While Gundlach highlighted the negative price action of junk bond, or high yield (HY), ETFs, I prefer to focus on the relative price action of HY bonds to equivalent duration Treasury paper, which neutralizes the interest rate effect to analyzes the credit spread effect (see The market`s report card on the GOP tax bill).. As the chart below shows, credit spreads were not only rising in the HY market, but investment grade corporates and EM bonds too. Even though HY and EM bonds recovered a bit on Friday, IG relative performance continued to deteriorate, indicating that further stress is likely ahead.
 

 

Indeed, the approach of using HY to measure risk appetite can be useful as a confirmation signal. The chart below shows the history of equities and the relative performance of HY to UST. With the exception of a brief episode in late 2014 when energy related HY dragged down the performance of the sector, the two series have been highly correlated in the last 10 years.
 

 

Don’t panic, it’s only a correction

Even if the tax bill were to fall apart and stock prices sell off, I would be inclined to buy the dip, as the intermediate term outlook is still bright. Fundamental momentum remains positive, which is bullish. FactSet reports that, with Earnings Season nearly over, EPS and sales beat rates are well above historical averages, and forward EPS is rising robustly, indicating Street optimism about the earnings outlook for 2018, even without tax cuts.
 

 

From a top-down perspective, the nowcast of the economy is upbeat. Initial jobless claims has shown a remarkable inverse relationship with stock prices in this expansion, and claims continue to fall.
 

 

The Citigroup Economic Surprise Index is rising, indicating that high frequency economic releases are handily beating expectations.
 

 

The upturn is global, and not just isolated to the US.
 

 

My inner investor would therefore regard any significant weakness in stock prices as a buying opportunity.

Correction not over

If we were to assume this is the start of a long awaited correction, then most indications suggest that it is not over. Short term indicators have not reached oversold and fear levels consistent with bottoms. After the SPX breached its uptrend line late last week, I am now watching both the RSI-14 to see if it can reach a minimum target of 50, and the VIX Index to see if it can breach the upper Bollinger Band (BB), which would flash an oversold condition.
 

 

Short term breadth indicators from Index Indicators are nowhere near an oversold reading.
 

 

Intermediate term indicators like the NYSE Common Stock McClellan Summation Index is also not oversold.
 

 

The Fear and Greed Index stands at 54, and the market has historically not bottomed until it has fallen to 40 or less.
 

 

My inner investor remains neutrally positioned, with his stock and bond weights at roughly their investment policy weights. My inner trader is short the market, and waiting for oversold conditions to materialize before he covers his position.

Disclosure: Long SPXU

The market’s report card on the GOP tax bill

Posted by Cam Hui -

Mid-week market update: The price action of stocks in the last few weeks makes it evident that US equities are awaiting the resolution of the Republican tax bill. This week will be critical for the progress of the bill through the House, as it is scheduled to be marked up in the Ways and Means committee. So far, the market verdict is not hopeful.

As the top panel of the chart below shows that high beta stocks rallied against low volatility stocks in September, followed by a range-bound market, indicating a lack of conviction. The bottom panel shows that this market has been mainly driven by momentum stocks.
 

 

Other market internals are also flashing warning messages for the bulls. From a political perspective, the tax bill is also running into trouble. These are all signs of likely corrective action ahead.

Poor technical internals

From a technical perspective, the market does not look healthy. The recent advance is characterized by extremely narrow leadership of megacap and large cap NASDAQ stocks. Both mid and small cap stocks are underperforming, and the equal-weighted NASDAQ 100 (NDX) is tanking against the cap weighted NDX.
 

 

It could be argued that negative breadth divergence could last a long time with few ill effects on the major averages. A more immediate concern is the negative divergence in risk appetite shown by the credit market, where high yield and emerging market bonds are underperforming equivalent duration Treasuries, but stock prices continue to rise.
 

 

In addition, there are signs of complacency showing up in the option market. While the low level of the VIX Index is a concern, the term structure of the VIX has steepened to historical extremes, indicating excessive bullishness.
 

 

Tax bill resistance

If the market is focused on the prospect of tax cuts, then the Republican tax bill is increasingly running into trouble on Capitol Hill. While the Democrats and other opponents may denounce the bill as a giveaway to the rich, CNBC reported that Fitch, which is a more credible third-party source, concluded that the proposed cuts “may lead to a short-lived boost to output”, but they “will not pay for themselves or lead to a permanently higher growth rate”. Moreover, “Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact”.

The longer the bill gets discussed, the more likely it will fail, as the delay allows third parties to study the bill and raise objections. The opposition by the National Association of Realtors and National Home Builders Associations over the mortgage interest deduction is well known. Other bombshells have emerged, which could create widespread opposition, such as:

  • The discovery that individuals would lose the state and local tax writeoff, but pass-through entities would not (via David Kamin)
  • A 20% excise tax on companies shifting profits to foreign subsidiaries in low tax jurisdictions. This would be a variation of the Border Adjustment Tax that was originally proposed by later abandoned by lawmakers (via Bloomberg, Business Insider)

I pointed out before (see Peak small cap tax cut euphoria) that the effective corporate tax rate is substantially below the stated statutory rate. Depending on how the tax loopholes are closed, and the eventual statutory rate, companies may in some instances end up with a tax increase, rather than a tax cut.
 

 

The latest WSJ report from Tuesday night showed that GOP lawmakers had retreated and the House tax bill is at least $74 billion over the $1.5 trillion limit specified by the Byrd Rule. Even if the excess gets resolved, the tax proposals face another fight in the Senate, where the Republicans hold a slim two vote majority.

1st and 10 on own 35

In short, the GOP tax bill faces many hurdles. Despite all of the progress so far, a football analogy would put them at first and 10 on their own 35 yard line. At this rate, even the prospect of a field goal is in doubt.

My base case scenario calls for a short-term correction, based on the combination of technical deterioration, and the likely perception of a tax bill failure. The intermediate term outlook is still bullish, as the growth outlook remains upbeat.

Disclosure: Long SPXU

Bull or bear? It depends on your time horizon

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

The latest signals of each model are as follows:

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Tops are processes

It is said that while market bottoms are events, which are sparked by emotional panic selling, tops are processes, which are the result of a series of connected episodes that depress prices. In the past few months, I have adopted the belief that the market is undergoing a topping process. Consequently, I become increasingly cautious about the stock market, though I do not believe that the ultimate top has been seen yet.

Here is what we know about the market on an intermediate term time frame:

  • Positive momentum: The market has been supported by strong price, fundamental, and macro-economic momentum. Most macro models show that the risk of recession is low or nonexistent.
  • Valuation: Valuation is stretched.
  • Sentiment: Sentiment has been frothy, which is contrarian bearish.
  • Technical: The pre-conditions for an intermediate or long-term top are not yet in place.
  • Short-term outlook: Much depends on the fate of the GOP tax bill and the market’s evaluation of other sources of risk, such as the Middle East.

Under these conditions, an investor could be either bullish or bearish and be correctly positioned. It just depends on the investment time horizon.

Powerful momentum

Global equity markets are enjoying a macro-economic sweet spot. The world is seeing signs of synchronized global growth. Torsten Slok at Deutsche Bank pointed out that the number of countries in recession, or forecasted recession, is at a historical low.
 

 

The G10 Economic Surprise Index, which measures whether macro indicators are beating or missing expectations, is surging.
 

 

In the US, the latest update from Factset shows that the results from Q3 Earnings Season remain upbeat. Both the EPS and sales beat rates are well above historical averages, and forward 12-month EPS continues to rise. The Q4 negative guidance rate came in at 66%, which is below the 5-year average of 75%.
 

 

Despite the upbeat growth outlook, the bond market is flashing a warning. The 2s10s yield curve is flattening and readings are at a cycle low of 0.72%, though it is nowhere near an inversion. While the yield curve has been an uncanny recession warning signal in the past, it may not invert this time because of the effects that the Fed’s QE programs had on the bond market.
 

 

Stretched valuation

On the other hand, equity valuations are stretched using a variety of metrics. Morningstar estimates that the market is about 4% overvalued, which is roughly the degree of overvaluation seen at the 2007 top.
 

 

The Shiller P/E now stands at 31x, which is above of the 28x multiple seen at the last market peak in May 2007, and it is even ahead the levels reached before the Crash of 1929.
 

 

Ed Yardeni’s Rule of 20, which states that the market is overvalued when the sum of forward P/E (18.0, via FactSet) and headline CPI (2.1) is 20 or more, indicates that stock prices are stretched.
 

 

That said, valuation is not very effective as a short-term market timing indicator. The Morningstar analysis showed that the market went through stretches of overvaluation without entering into a bear market. As well, analysis from EconoPic found that high levels of CAPE was not an impediment to stock prices, as long as it was accompanied by positive price momentum.
 

 

Frothy sentiment

There is also little doubt that sentiment is getting overly frothy. I have been detailing how investor sentiment has gotten out of hand with my series, “Things you don’t see at market bottoms”:

Here is the latest example from Tracy Alloway.
 

 

While excessively bullish sentiment can provide a warning sign for investors, it is also not a very good short-term market timing indicator. As an example, there was some buzz last week about the bullish excesses seen in the level of Investors Intelligence bulls and bears. This chart from Yardeni Research shows current bull/bear ratio at such an extreme that it was only exceeded by readings before the Crash of 1987.
 

 

Further examination of this indicator reveals that stock prices can rise further even after the bull/bear ratio has reached crowded long levels.
 

 

By contrast, excessive fear has shown itself to be a much better signal of limited downside in stock prices, though the model failed in the bear market of 2008-09.
 

 

This is another example of the adage, “bottoms are events, while tops are processes”.

Nearing technical target, but no signs of a top

In a recent post (see Nearing upside target, now what?), I had outlined a range of S&P 500 upside target using daily, weekly, and monthly prices and a variety of assumptions (outliers shown in red). The consensus final target came to 2560-2580, which the market has exceeded.
 

 

On the other hand, the pre-conditions for a cyclical market top are not in place. The global reflationary rebound has lifted stock prices all around the world. As the chart below of the DJ Global Index shows, past peaks (N=3) have been marked by an initial top, a retreat, and a second rally that was characterized by a negative RSI divergence. We have not even seen the first pullback yet.
 

 

One clue for the timing of an ultimate market top came from Variant Perception, which found that the real Fed Funds rate leads the high yield (HY) credit spreads by 18-24 months. If this relationship continues into the future, then HY spreads, which is a proxy for risk appetite, would begin to widen in early to mid 2018.
 

 

Market vulnerable, but buy the dip

To summarize, the question of whether to be bullish or bearish depends on your investment time horizon. I believe that the market is in the process of making a long-term cyclical top. Valuations are stretched, and sentiment is frothy. New Deal democrat’s latest update of high frequency economic indicators reveals that coincident and short leading indicators are positive, while long leading indicators are neutral.

However, the nowcast of the economy is as close to perfection as any investor could ask. As an example, there is a close inverse correlation between initial jobless claims (blue line, inverted scale) and stock prices (red line). These readings suggest that the market is likely to grind higher over the next few months.
 

 

The longer term outlook is not as rosy. Long leading indicators are in neutral territory and readings are deteriorating. The risk of a Fed policy error that tightens the economy into a recession is high. In particular, the combination of a new Fed chair, a shift of votes from dovish to hawkish voting regional presidents in 2018, and likely newly appointed hawkish Fed governors will set monetary policy on a more aggressive course than current market expectations (see Is the Fed tightening into a stalling economy?).
 

 

In the short run, the market is tactically overbought and vulnerable to a pullback. I detailed the short-term negative divergences in my last post (see A market volatility update), and I will not repeat all of them here.
 

 

Tax bill uncertainty

Much of the near term equity outlook depends on the success of the Republican tax proposals. I am monitoring the reaction of major lobby groups and the degree to which they can mobilize effective and widespread political opposition. There has not been sufficient detail for all interest groups to fully study the implications of the proposals. Major business groups such as the Chamber of Commerce have issued non-committal statements indicating support with “a lot of works remains to be done” qualifiers. Rather than dwell on the Republicans apparent united front, here are a number of potential pitfalls for the proposal.

There were scattered complaints from groups who stand to lose from the bill. Not unexpected were the objections from the National Association of Home Builders and National Association of Realtors over the limited loss of mortgage interest deductibility. I am also watching whether the powerful AARP reacts to the elimination of medical expense deductions, which would hit nursing home residents very hard (via CNBC). The bill has also attracted opposition from the National Farmers’ Union.

A major potential sticking point is the opposition from the National Federation of Independent Business, which is composed of small-c conservative business owners, to the pass-through provisions in the bill. The House GOP proposal calls for the taxation of pass-through entities at a 25% rate, with a set of complicated rules to prevent abuse. Kansas governor Sam Brownback had eliminated all state taxes on pass-through entities, but those provisions had created an enormous hole in the state budget as Kansas residents converted themselves from employees to LLCs in order to take advantage of the loophole (see NY Times account). Congressional lawmakers learned from that experience and created “guardrails”, which consist of a number of arcane rules to reduce the abuse of the pass-through provision. The NFIB objected on the grounds that “the bill leaves too many small business behind”. Even though the details of these provisions are highly technical, the bill was drafted without any IRS input because of budget secrecy. This approach is highly likely to create problems, either in the immediate future during debate, or later during the implementation phase should the bill pass.

The elimination of the state and local tax deduction is another potential sticking point in the passage of the bill. This will hurt the residents of high state tax jurisdictions, and it is unclear whether Republicans in those districts could be relied upon to support the bill.

Bloomberg also reported that the House bill, as written, would run afoul of the Byrd Rule in the Senate and a sunset provision would therefore have to be inserted to the proposals:

In order to fast-track the tax legislation through the Senate without having to rely on support from Democrats, Republicans are using a budget process known as reconciliation. That means rather than needing 60 votes to keep the bill moving, Republicans — holding only 52 seats — can proceed with a simple majority of 51 votes to pass the legislation.

To qualify for the Senate’s reconciliation process, the bill must meet the terms of an adopted budget resolution and adhere to rules developed by and named for the late Robert Byrd, the West Virginia Democrat who served as majority leader from 1987 to 1989.

The House plan passes the first test. The fiscal 2018 budget resolution does not allow a tax bill to add more than a total of $1.5 trillion to deficits over 10 years, and the Joint Committee on Taxation’s initial assessment of the measure puts the bill’s cumulative shortfall at $1.41 trillion over a decade.

The red flag is raised after 2027. The nonpartisan joint committee’s analysis shows the plan adding $156 billion to the budget shortfall in that year, a sure sign that it will add to the deficit in 2028. That would trigger the Byrd rule, giving Democrats an opening to raise an objection to the bill on the Senate floor that would require 60 votes to overcome.

The Democrats have so far presented a united front in opposition. Assuming that the Byrd Rule problem is overcome, the Republicans can only afford to lose 22 House votes and 2 Senate votes. Bloomberg reported that Senator John McCain has called for “regular order and support for both parties” for tax reform. Bloomberg also separately reported that Republican senator James Lankford also opposes the bill because of excessive debt. The Republican margin in the Senate is now razor thin. The fate of the tax bill now hangs by thin thread and depends on the support of GOP mavericks like Bob Corker and Susan Collins.

Stay tuned for the full reaction. None of the obstacles presented are necessarily fatal to the bill. It just means that there will be a lot of bargaining and modifications ahead. However, if the market believes that the tax package is becoming a repeat of the healthcare fiasco, it would be the spark for a correction of unknown magnitude.

Correction, then a year-end rally

Putting it all together, my base case scenario calls for a shallow pullback in the next few weeks, followed by a rally into year-end. Evidence of robust growth and emerging inflationary pressures will prompt the Fed and other major central banks to adopt a tightening policy, which will result in an economic slowdown in late 2018 or early 2019. Already, we are seeing evidence that inflation trends are bottoming and starting to turn up around the world.
 

 

My inner investor is constructive on stocks, and he is neutrally positioned at the asset mix specified by his investment policy. Should equity prices sell off, he is prepared to add to his positions.

My inner trader is tactically short the market in anticipation of a pullback.

Disclosure: Long SPXU

A market volatility update

Posted by Cam Hui -

Mid-week market update: In my weekend post (see Good news, bad news from Earnings Season), I had identified several sources of potential market volatility this week:

  • Mueller indictments
  • GOP tax plan
  • FOMC decision
  • Fed chair nomination
  • Key macro-economic reports

It’s time for an update, and it spells caution for the bulls.

Mueller indictments

I don’t consider my job to judge whether the Mueller indictments are right or wrong, whether it is a legitimate act of government inquiry or simply a political witch hunt. My job is to consider their effects on the market.

It is unclear how much of an effect the Mueller indictments had on presidential approval. Gallup shows Trump’s approval rating fell to to a low of 33% before recovering to 35% on Tuesday.
 

 

NDR Research has found that stocks don’t perform well when presidential approval falls to 35% (annotations are mine).
 

 

Here is a more recent chart from Bespoke showing stock market performance and presidential approval that show a similar effect (annotations are mine).
 

 

GOP tax plan

The markets got spooked on Monday when news leaked that the GOP was considering a phase-in of a corporate tax cut to 20%, indicating that stock prices are being held up by the expectations of a tax cut. The latest news indicates that the House tax plan unveiling is delayed until tomorrow (Thursday). Politico reported yesterday that the House Republicans are still having trouble figuring out how to pay for their tax cut wish list without a firestorm of special interest opposition:

But not 24 hours before the bill’s big reveal, lawmakers had yet to settle on one of the most sensitive questions of all: How to pay for their proposed $5.5 trillion in tax cuts, since any major revenue-generator is certain to antagonize some powerful lobby or group of lawmakers who could defeat it.

I have no idea of how much of the potential effects of any tax cuts has been discounted. However, there are a couple of ways of measuring the market reaction to a tax plan. The top panel of the chart below shows the relative performance of the high beta ETF against the low volatility ETF. Based on the experience with the healthcare bill fiasco, high beta underperformed from late 2016 because the market believed no tax cuts were getting done. It only began to rally again in late August on the hopes of a tax package getting through Congress.
 

 

Another sure winner of any tax cut package would be gold prices, as the increases in fiscal deficits would be judged to be inflationary. The bottom two panels show the price of gold and the relative performance of gold stocks to the market. Both have been range-bound and shown little leadership characteristics. For some context, consider these comments from former IMF chief economist Simon Johnson:

Name the country. Its leader rails against foreigners, erects various import barriers, and pushes for low interest rates and lots of cheap credit for favored sectors. Government debt is already high, but the would-be strongman in power decides to pile on even more by increasing the budget deficit, arguing that this will boost prosperity to previously unattainable levels. While the government claims to represent the common people, state contracts are awarded to friends of friends.

Surprise! The answer is Argentina:

The answer, of course, is Argentina under Juan Perón, who was in power from 1946 to 1955 (and again briefly in 1973 and 1974), and many of his successors. One of the richest countries in the world around 1900 was laid low by decades of unsustainable economic policies that made people feel good in the short run but eventually ended in disaster, such as runaway inflation, financial crisis, and periodic debt defaults.

For now, the jury is still out on the GOP tax plan. But watch equity risk appetite and gold prices for the instant market verdict. Should the tax plan fail to materialize, or if it becomes apparent that it will not pass because it turns into ACA Repeal 2.0, then don`t be too surprised to see presidential approval fall further (see above analysis for the market consequences of ultra-low approval ratings).

The future direction of Fed policy

As expected, the FOMC decision turned out to be a yawn. The Fed has hiked three times in the past 12 months, but financial conditions implies that they cut rates. They therefore remain on track to raise rates at its December meeting.
 

 

More importantly, the question of the future leadership of the Fed is unknown. Trump is expected to name the Fed chair tomorrow (Thursday). I have already written about what a Taylor Fed would look like, but there are a number of nuances that are unappreciated by the market.

The latest news indicates that Trump is likely to name Jay Powell as the new Fed chair. If true, then the initial market reaction would be euphoric, as Powell would largely represent the continuity of the Yellen Fed’s monetary policies. That said, there are a number of key differences between how a Powell Fed might operate compared to the Yellen Fed.

First, Powell differs from Yellen on regulation. FT Alphaville highlighted a recent Powell speech on Fannie Mae and Freddie Mac, where Powell blamed the mortgage melt-down on these GSEs, while FT Alphaville made the case that it was the private label mortgage insurers that was the main problem. Powell’s solution called for greater privatization of mortgage finance, and a shift of government guarantees from institutions such as Fannie and Freddie to mortgage securities. If Congress were to undertake such an initiative today, then we can expect greater downside volatility in the next crisis.

Business Insider also featured a revealing commentary about Powell, as he is a lawyer and investment banker, and not an economist, by training:

“He has been in line with the leadership on monetary policy in recent years,” Julia Coronado, a former Fed board economist who worked on Wall Street before founding the research firm MacroPolicy Perspectives, told Business Insider. “His comfort zone and leadership has been in getting his hands dirty on regulatory and financial sector plumbing issues. He is smart and collegial and knows how to lean on the staff’s expertise.”

She added he would probably be a different kind of Fed chair than Yellen “in that he will be forging a consensus more than driving it on monetary policy.” She continued: “His depth on financial infrastructure could come in handy if and when the FOMC needs to confront decisions on balance sheet policy again.”

Powell is likely to be a consensus builder on monetary policy. While he is not an economist, the combination of his experience in finance and his years as a Fed Governor will likely make him to initially adopt a stay the course policy of the Yellen Fed. Such a management style, however, indicates a subtle shift of more power to the other members of the FOMC. The market should therefore pay greater attention to the composition of the FOMC and the Federal Reserve Board of Governors. The voting rotation of the regional Fed presidents, from the dovish Evans and Kashkari to the more hawkish Meester and Williams, already guarantee a more hawkish FOMC in 2018.

Then there is the issue of the Fed Board. If Janet Yellen does not serve out the remainder of her term as a Fed governor, then there are five out of a possible seven open seats on the Board. It would be a golden opportunity for Trump to shape future Fed policy. Assuming that Trump focuses on Republican candidates, then there are very few candidates who are likely to steer the Fed in a direction that is more dovish that the current Yellen Fed (see A Fed preview: What happens in 2018?). Moreover, most Republican candidates are likely to favor a rules-based approach to monetary policy, which would push the Fed Funds target much higher than it is today.

Currently, the market is discounting a quarter-point rate hike in December, and roughly two quarter-point hikes in 2018. By contrast, the Fed’s dot-plot calls for three rate hikes in 2018. In light of the likely more hawkish tilt of the FOMC in 2018, expect the three rate hike to be a floor and not a ceiling for the evolution of monetary policy next year.

Macro data = Fragile economy

I had written before that my greatest fear is that the Fed is tightening into a slowdown (see Is the Fed tightening into a stalling economy?). The latest set of macro data releases confirms that view.

On Monday and Tuesday, we got the latest on Personal Consumption, Savings Rate, and Employment Cost Index. As the chart below shows, increases in wages are not keeping up with personal consumption. As a result, households are running down their savings in order to finance their spending.
 

 

One alternative is to send more people in the household into the labor force. We will see an update of this in the Jobs Report on Friday, but with the labor market already tight, I have my doubts as to how much the Labor Force Participation Rate could improve.

Market breadth

In the meantime, the major averages are within a hair of their all-time highs, but the internals are signaling caution. Risk appetite, as measured by high-yield bonds, is flashing a minor negative divergence.
 

 

As well, the equity advance has been extremely narrow. Leadership is concentrated in the megacap stocks, and large cap NASDAQ issues, while mid and small caps lag.
 

 

Similarly, RSI-5, RSI-14, net 52-week highs-low, and 10 dma of advance-declines are also flashing negative divergences, indicating a loss of momentum and a possible change in market direction.
 

 

While I remain constructive on stocks for the remainder of the year, the market is vulnerable to a short term pullback. My inner investor is neutrally positioned at his investor policy weight of stocks and bonds, while my inner trader is short equities in anticipation of a 2-5% correction.

Disclosure: Long SPXU

Things you don’t see at market bottoms: Halloween edition

Posted by Cam Hui -

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.

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:

As a result, I am publishing another edition of “things you don’t see at market bottoms”.

$1,000 gold bagel

The Westin New York will start selling a bagel with white truffle cream cheese and sprinkled with gold flakes for $1,000. This item was last offered on the menu in *ahem* 2007.
 

 

The timing of this menu offering speaks for itself.

Euphoriameter at a cycle high

Callum Thomas of Topdown Charts has constructed a “Euphoriameter”, which is a combination of forward P/E, VIX and bullish sentiment. Readings are at a cycle high and it is near the peak seen in the last market cycle.
 

 

Cash is trash

We are seeing numerous signs that retail investors are all in on equities. Consider this comment from Morgan Stanley CEO James Gorman on the company’s earnings call:

“We saw more cash go into the markets, particularly the equity markets as those markets rose around the world. And we’ve seen cash in our clients’ accounts at its lowest level.” –Morgan Stanley CEO James Gorman

These readings have been confirmed by the AAII asset allocation survey, which shows cash at lows not seen since the top of the NASDAQ Bubble.
 

 

A similar level of investor enthusiasm can be found in mutual fund cash data.
 

 

The latest University of Michigan investor confidence survey shows that respondents have 100% confidence that the stock market will not decline in the next year.
 

 

ICOs are the new black

Finally, Bloomberg reported that Initial Coin Offerings (ICOs) have raked in $1 billion in two months, and their total market capitalization now exceeds $3 billion.
 

 

For a primer on ICOs, please see Appcoins are the new snake oil, by Daniel Krawisz, published at the Nakamoto Institute.

With that in mind, Humble Student of the Markets would like to announce an ICO offering…

Good news, bad news from Earnings Season

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. Past trading of the trading model has shown turnover rates of about 200% per month.
 

 

The latest signals of each model are as follows:

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

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

Good news and bad news

We are about halfway through Q3 earnings season, and the market saw its share of ups and downs last week.
 

 

The market rallied to fresh highs on Friday, and leadership was provided by large cap FAANG stocks. Beneath the surface, there was a mixture of both good news and bad news for investors.

The good news

Let’s start with the good news. John Butters FactSet pointed out that, with 55% of the SPX having reported results, both the earnings and sales beat rates are well above historical average. As well, forward 12-month EPS continues to rise, which is reflective of positive fundamental momentum (all annotations are mine).
 

 

Q3 GDP grew at +3.0%, which beat expectations. This was a continuing series of positive macro-economic surprises that has lifted the Citigroup Economic Surprise Index to new recovery highs.
 

 

In addition, the latest update from Barron`s of insider trading activity is constructive and could be supportive of higher stock prices.
 

 

The bad news

Unfortunately, there is lot of bad news. Despite the positive headlines from FactSet`s analysis, the sales beat rate deteriorated from 72% last week to 67% this week, though the EPS beat rate remained steady at 76%. As well, forward 12-month EPS was up an anemic +0.01% in the week, which is hardly anything to get excited about.

Another disappointment can be found in the market reaction to earnings results. FactSet observed that the market is barely rewarding earnings beats, but punishing misses.
 

 

Another worrisome macro and fundamental headwind can be found in the strength of the USD. FactSet found that companies with greater foreign exposure tended to see better sales and earnings growth.
 

 

However, much of those Q3 EPS gains can be attributable to USD weakness. As the USD strengthens, large cap multi-national companies are likely to see a reversal of the currency effect. In other words, don’t expect the same pace of sales and earnings growth in Q4 as Q3.
 

 

Another ominous theme from earnings calls is rising inflation. Higher input costs, such as wages and materials, are squeezing operating margins as companies have been reluctant to raise prices (via Avondale Investment Management).

“There is some commodity inflation, but the biggest drag that we’re facing right now is related to the labor investments that are being made.” —McDonald’s (Restaurants)

“The labor market in the U.S. is extremely tight, hard to find people.” —Manpower (Temp Staffing)

“we’re now estimating about a $300 million profit hit from higher commodity costs.” —Procter and Gamble (CPG)

“scrap price has moved up and we were unable to move plate prices up with scrap prices. So we started to see a margin compression and that’s where we live now. We’re living in a margin-compressed world today.” —Nucor (Steel)

“we continue to have a positive view on domestic steel consumption…This will be a solid foundation for a strong pricing environment as the macro market drivers continue to be persuasive…These dynamics could create a tight market and lead to significant price appreciation as we saw at the end of last year…I just see it setting up a very, very positive pricing environment for the first quarter of 2018 and all the way through 2018.” —Steel Dynamics (Steel)

“we are seeing a little bit of resistance at the higher price points because of affordability and I think that’s a broader concern that affects the entire business.” —Pulte Home (Homebuilder)

There is widespread anecdotal evidence of tightening labor markets. We will get a more complete picture when the October Jobs Report is released this coming Friday.
 

 

The bottom-up signs of rising inflationary pressures are supportive of the Fed’s decision to continue with its rate normalization policy. Expect more a hawkish tilt from the Fed, regardless of who is nominated as the chair.

Dark clouds in GDP report

There were also a number of negatives in the upbeat Q3 GDP report that beat Street expectations. New Deal democrat pointed out that the two components of his leading indicators from the GDP report are showing signs of weakness.

Proprietors’ Income, which is a data item that gets released before NIPA corporate profits, failed to achieve a cycle high for a second quarter in a row. Both proprietors` income and corporate profits appear to be rolling over, which is a negative sign for the economy.
 

 

Real private residential investment is also showing signs of peaking.
 

 

These reports are consistent with NDD’s weekly analysis of high frequency economic indicators that “the present and near future economy looks strong than at any time during this expansion. The picture among long leading indicators deteriorated further this week…confirms a neutral outlook one year out.” Combined with the prospect of a hawkish Fed, the outlook for equities is becoming increasingly cloudy.

Negative divergences everywhere

From a technical perspective, the equity outlook is equally fragile. Last week’s advance was accomplished with evidence of narrow breadth. Leadership was only provided by the megacap stocks. The mid caps, small caps, and even NASDAQ 100 stocks were either range bound or declining relative to the SPX.
 

 

An analysis of the relative performance of high beta groups tells a similar story. The relative performance of the High beta ETF (SPHB) vs. the Low volatility ETF (SPLV) appears to be rolling over. Except for the Social Media stocks, which is dominated by FB, the relative performance of all other groups, namely Biotech, NASDAQ Internet, and NASDAQ 100, are either rolling over or range bound.
 

 

There are also signs of negative divergences everywhere. Even though the SPX staged a breakout to new all-time highs, the RSI-5, RSI-14, and net new highs-lows are not confirming the new highs.
 

 

To be sure, the weekly chart of the SPX remains above its upper Bollinger Band, and the weekly RSI Indicator has not flashed a sell signal yet. That is a positive sign for the bulls.
 

 

Brace for volatility

Do all-time highs normally look like this? Sentiment Trader observed that the market is in uncharted territory. Despite all of the warning signs, the market is undergoing a slow melt-up phase and anything can happen.
 

 

Next week, there are numerous sources of event driven volatility.

  • The first charges from the Robert Mueller probe may be unsealed on Monday.
  • The GOP is expected to unveil its tax plan Wednesday.
  • The FOMC will conclude its meeting on Wednesday.
  • Trump is expected to announce the nomination of a Fed chair some time next week.
  • There will also be numerous key macro reports next week, including Core PCE (Monday), Personal Income (Monday), Employment Cost Index (Tuesday), ISM (Wednesday), and the Jobs Report (Friday).

My inner investors remains neutrally positioned, with his asset allocation at his investment policy target weight mandates. My inner trader initiated a small short position last week, and may add to it should the market rise further.

Disclosure: Long SPXU

Minor turbulence ahead

Posted by Cam Hui -

Mid-week market update: The SPX has been on an upper Bollinger Band (BB) ride on the weekly chart, and I have been waiting for a downside break on the weekly RSI-14 indicator as the signal that a correction is starting. Current readings show that the weekly RSI has not broken down below 70 tet.
 

 

However, a downside break could also be seen on the daily chart. RSI-5 has broken down below 70, which is a short-term sell signal. RSI-14 has also followed suit, which is another bearish sign. The index also experienced a bearish engulfing pattern on Monday, which is potentially ominous.
 



 

The bear case

Urban Carmel pointed out last weekend that the market is now in the seventh week of consecutive weekly gains, which historically has not ended well.
 

 

Equally disturbing are signs of diminishing breadth during the period where the RSI Indicator was exhibiting a “good overbought” condition (shaded region). At this point, only the megacap stocks are exhibiting any signs of market leadership.
 

 

A shallow correction?

The cautionary signs exhibited by a potential downside break from the weekly RSI signal has historically led to 2-5% downdrafts. However, I would expect that any correction to be fairly shallow. Jeff Hirsch of Almanac Trader found that the end of long winning streaks tend to resolve themselves with a short pullback, followed by a period of sideways consolidation.
 

 

In addition, one of outcomes of the recent period of low volatility has had the perverse effect of the VIX flashing an oversold buy signal for stocks on the shallow pullback this week. As shown by the chart below, the VIX Index has climbed above its upper BB, which is an oversold signal for the stock market. Past episodes, which are marked by vertical lines, have been buy signals for the market. Moreover, the BB width is not particular low by historical standards, and therefore the lack of recent volatility is not an excuse to ignore this signal.
 

 

As well, one little known indicator from the option market is showing a high degree of anxiety. The SKEW Index, which measures the price of tail-risk protection, is spiking. In the past, SKEW spikes when the market has pulled back (red arrows) have been reasonably good contrarian buy signals, but SKEW spikes when the market was rising (black arrows) have resolved themselves in relatively benign ways.
 

 

The Fed chair wildcard

One potential source of volatility is the announcement of the nomination of the Fed chair, which is expected to occur before the start of November. Bloomberg reported that Yellen is finding support in Trump himself, who stated in a Fox Business News interview, “I like her a lot”. However, Bloomberg also reported that Trump informally polled Republican senators yesterday as to their preferences for a Fed chair.

The president, in a lunch meeting with Senate Republicans on Tuesday, asked for a show of hands in support of Yellen and other contenders for the job — Stanford University economist John Taylor and Fed governor Jerome Powell. He didn’t announce a winner and most of the senators didn’t raise their hands. But of those who did, “I think Taylor won,” said Senator Tim Scott of South Carolina.

The market is already starting to price in the possibility of a more hawkish should the Fed take a more drastic change in direction. A Yellen renomination or a Powell nomination would be regarded as equity bullish because they represent the status quo. A Taylor nomination would be viewed as bearish, as he is believed to be considerably more hawkish (see What would a Taylor Fed look like?).

However, there are other scenarios where the market reaction would be difficult to predict. The bigger question is whether John Taylor is on the Fed board in some capacity. Imagine Yellen as chair, and Taylor as vice chair. Assuming that John Taylor would accept a position as vice chair, I believe that such an outcome would tilt policy in a slightly more hawkish direction. Market expectations would then move quickly towards the dot plot, which calls for one more rate hike in 2017, and three quarter-point hikes in 2018. Such a pace of rate hikes is well beyond current market expectations, and the presence of Taylor on the Fed board would likely be viewed as equity bearish.

The road forward

My base case scenario calls for a short and shallow sell-off in the next week. The historical evidence suggests that any weakness should be viewed as an opportunity to buy the dip.

For the time being, the “arrow” on the Trend Model is changing from a buy signal, or up arrow, to a down arrow, or a sell signal. My inner trader has sold his long SPX position and flipped to a small short position.

Disclosure: Long SPXU