The things you don’t see at market bottoms: China 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.

Two months has passed since I last published a post in a series of “things you don’t see at market bottoms”. That’s because market exuberance has significantly moderated. There are, nevertheless, signs of froth in non-US markets. Therefore I am publishing another post in the series. Past editions of this series include:

I reiterate my belief that this is not the top of the market, but investors should be aware of the risks where sentiment is getting increasingly frothy. Much of the froth can be found across the Pacific in China, starting with the China bears’ favorite chart.
 

 

Rising default risk

China’s ballooning debt has been well managed so far because much of the debt, whether issued by banks, state owned enterprises (SOEs), or local governments (LGFVs) have carried an implicit central government guarantee. It was said that Beijing would “never” allow the debt to default.

Bloomberg reported that the risks of defaults are now rising and there would be no Beijing Put:

As China’s President Xi Jinping steps up efforts to rein in excessive borrowing, the nation’s corporate bond market faces rising default risks as weaker firms and local borrowers struggle to roll over obligations.

The latest salvo came last month, when the top economic planning body said it will step up scrutiny of the public works-related assets held by companies seeking to sell bonds. The National Development and Reform Commission, or NDRC, also said it would further regulate bond sales by public-private partnership projects.

President Xi has vowed to make controlling financial risks a priority, and former central bank governor Zhou Xiaochuan warned last year of a Minsky Moment, where asset values plunge following an era of unsustainable credit growth. The attempts to cut leverage already slowed expansion of the corporate bond market to 4.6 percent last year from 21 percent in 2016, according to data from the People’s Bank of China.

As a result, LGFV financings are dropping, and it is an open question as to how these local authorities can roll over their obligations in the future.
 

 

Companies tied to local projects are facing similar difficulties:

“Some companies which previously relied on external support to meet the criteria for bond issuance won’t be able to do so given the latest requirements,” said Qi Sheng, chief fixed income analyst at Zhongtai Securities Co. “It should be much more effective this time compared with similar notices before, as the current policy environment won’t allow any counter measures or a loosening in implementation.”

For now, this development is not fatal to the Chinese economy. Tightening credit conditions just raises risks.
 

Speaking of debt…

Speaking of debt, Here is one ominous observation that speaks for itself. Three of the top 10 Chinese unicorns are loan sharks (Sina article in Chinese).
 

 

The new Fragile Five

I had highlighted the new Fragile Five (see The new Fragile Five to avoid). Loomis Sayles had warned that these countries are the new Fragile Five, because of real estate bubbles that were partly blown because of Chinese hot money driving up property prices.

Cracks are starting to appear in five highly leveraged economies: Canada, Australia, Norway, Sweden and New Zealand. For several years following the global financial crisis, these five countries all shared a common theme—a multi-year housing boom, fueled by low interest rates, which resulted in very elevated levels of household debt.

This boom is starting to dissipate in all five markets. House prices have largely reversed course, be it slowing appreciation or outright decline. Moreover, this is occurring even as interest rates remain at or near record lows and labor markets continue to be robust. Importantly, this is a correction that many thought could not occur given the otherwise strong economic growth backdrop in these countries. But we take a long-term view of house prices, and began highlighting affordability problems in these markets several years ago.

 

I went on to point out that these countries share the common characteristic of being dependent on natural resource exports. Should the Chinese economy slow because of a debt crisis, the economies of these countries would suffer disproportionately.

That is why, as a Canadian resident, I maintain some of my holdings in USD for precautionary purposes.
 

Trade war, Schmade war!

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A market triple whammy

Last week, the stock market was hit with a triple whammy of bad news.

  • Negative stories about market and momentum leader Facebook (FB);
  • A moderately more hawkish message from the Federal Reserve; and
  • The prospect of a trade war that could tank the global economy.

As a result, the SPX fell -6.0% for the week. The market is obviously stretched to the downside. The SPX is testing support at its February lows and the 200 day moving average (dma). The VIX Index has risen above its upper Bollinger Band, which is a short-term oversold signal. As well, the CBOE put/call ratio spiked to high levels indicating fear.
 

 

Is this enough to signal a short-term bottom? This week, I address the dual macro threats of Fed policy, and the possible effects of a trade war. There are many others who can much analyze FB better than me, and stock specific analysis is outside my scope.
 

A dovish hike?

The dot plots released by the Fed after last week’s FOMC meeting revealed a slightly more hawkish monetary policy outlook. While the 2018 median funds rate projection was unchanged, the mean for 2018, and the medians and means for 2019 and 2020 were raised. Nevertheless, it was interpreted by the markets as neutral to slightly more dovish than expectations. The white line in the chart below depicts the probability of three rate hikes in 2018, and the blue line the probability of four hikes. The probability of four rate hikes dropped to the bottom of its recent range after the FOMC meeting and Powell press conference.
 

 

Fed watcher Tim Duy interpreted the Fed statements as dovish because Powell stated that the 2% inflation target is symmetrical, and 2% is not a ceiling.

This persistent period of low unemployment feeds into the Fed’s forecast and comes out as faster inflation. The projections now show that central bankers expect inflation to surpass the target, rising to a high of 2.1 percent at the end of 2019.

In other words, the Fed is explicitly forecasting overshooting the inflation target. Policy makers could crank up the interest-rate forecast to eliminate that overshooting but instead have chosen a less aggressive policy path.

If Fed officials were determined to avoid an overshoot, they would need to act more aggressively to push unemployment up toward their estimate of the natural rate. That is a big move in this forecast, a 0.4 percentage point jump from where the rate stands today, and 0.9 percentage point higher than the 2019 forecast.

The Fed, however, has not proven able to nudge up the unemployment rate as much as would be required in this case without causing a recession. Hence, this forecast indicates the central bank is now at the point where policy makers don’t believe they could offset higher inflation without triggering a recession.

It remains to be seen how successful the Powell Fed will be in eventually raising the unemployment rate without triggering a recession. The Fed has been largely unsuccessful in such efforts in the past.

I interpret the Fed’s reaction function as dovish. In light of late stage expansionary phase of the economy, and undergoing an unusual program of fiscal stimulus, the Powell Fed is acting in an extraordinarily cautious fashion.
 

Trade war fears: Bark or bite?

The other major threat to the market is the risk of a major trade war. I refer readers to analysis written in January that outlined the possible scenarios (see Could a Trump trade war spark a bear market?). The headlines certainly appear to be ominous. Trump announced that he has instructed US Trade Representative (USTR) Robert Lightizer to impose about $50 billion in tariffs on Chinese imports, according to this USTR factsheet. The USTR will have 15 days to come up with a proposed list of products, and there will be a 30 day comment period before the tariffs are actually imposed.

CNBC reported that China has responded with tariffs on $3 billion of US exports on a targeted list of 128 products.

China’s commerce ministry proposed a list of 128 U.S. products as potential retaliation targets, according to a statement on its website posted Friday morning.

The U.S. goods, which had an import value of $3 billion in 2017, include wine, fresh fruit, dried fruit and nuts, steel pipes, modified ethanol, and ginseng, the ministry said. Those products could see a 15 percent duty, while a 25 percent tariff could be imposed on U.S. pork and recycled aluminium goods, according to the statement.

Take a deep breath. Firstly, the Chinese reaction has been surprisingly light, which is a signal that they are prepared to negotiate. The Trump administration’s actions on trade have so far been more bark than bite. Remember the steel and aluminum tariffs that were unveiled with great fanfare? Here is the latest list of countries given exemptions.
 

 

What about the threat to tear up the terribly “unfair” NAFTA trade pact? The Financial Post reported last week that there seems to be some progress based on some concessions from the American side on the issue of American content in auto production:

Canada’s ambassador to the U.S., David MacNaughton, suggested his newfound optimism was based on two developments in recent days: progress on the top U.S. priority of auto-parts rules, as well as a more general thawing of the frosty tone in earlier talks.

This comes as the United States appears increasingly keen on securing a quick agreement, with an upcoming round in Washington expected to feature a final push to obtain a deal before election campaigns in Mexico and in the U.S. Congress punt the process into 2019.

MacNaughton said the most recent American proposals could help the U.S. achieve its goal of safeguarding auto production there, potentially without a strict American-made content requirement in every car, an idea that has been a source of friction with Canada and Mexico.

He cautioned that the autos impasse isn’t completely sorted out yet.

“They came back with some ideas that if you take them to their logical conclusion would mean that you wouldn’t need that (American content) requirement,” MacNaughton told reporters after speaking at a Washington gathering of the American Association of Port Authorities.

“They put some interesting ideas on the table … which were actually quite creative. To which we sort of said, ‘Yeah, we can work with that.’… Did we get to somewhere where you could shake hands and say, ‘We’ve got a deal?’ Absolutely not… Whether or not we can get there I don’t know. But I took it as being a positive thing that they had another way of getting at that issue.”

In addition, there are a number of indirect ways to pressure the White House without directly resorting to additional tariffs. Former IMF chief economist Olivier Blanchard had one simple suggestion.
 

 

Here is another. Steel prices jumped by 35% from an American supplier.
 

 

Minneapolis Fed president Neel Kashkari stated in a Bloomberg interview that the biggest trade war risk is an erosion of confidence. Small business owners form a disproportionately large percentage of Trump’s voter base. How long before NFIB small business confidence falls on account of these tariffs?
 

 

There is resistance within the Republican Party. Already, Larry Kudlow is trolling his new soon-to-be boss. Trade deficits are a sign of economic strength, not weakness.
 

 

In short, the political pressure on the White House will be tremendous. It will come from all quarters, such as the Republican Party, and from small and large businesses that form Trump’s electoral base. As we approach the midterm election, don’t be surprised if the following implausible scenario starts circulating around the Beltway as another way of putting pressure on the Trump administration:

  • Tariffs start to hurt the economy and erode business confidence
  • The election turns on a referendum on Trump’s economic policies
  • Republican support tanks, and the Democrats win control of both the House and Senate
  • Mueller returns a recommendation to indict Trump
  • The House impeaches Trump, the Senate follows suit
  • Pence is sidelined (as he was involved in some of the meetings)
  • The speaker of the House is the next in line. Hello, President Pelosi.

The market is staring into the dark abyss and worst case scenario of a full-blown trade war. Don’t be so sure of such an Apocalyptic outcome.
 

Market nowcast still bullish

In the absence of these macro risks, the nowcast outlook for stock prices are still positive. Initial jobless claims have shown a remarkable inverse correlation to stock prices during this expansion, and initial claims continue to improve.
 

 

Calculated Risk reported that the Chemical Activity Barometer, which leads industrial production, is still rising.
 

 

Barron’s report of insider activity shows that this group of “smart investors” have been taking advantage of the current bout of stock market weakness to buy. While individual readings can be noisy and volatile, the pattern of consistent buying over the last few weeks is a vote of confidence in the stock market.

 

In effect, a bet on the market falling significantly from these levels is a tail-risk bet on a full-blown trade war.
 

How oversold is the market?

When the SPX falls -6.0% in a single week, it is no surprise to call it oversold. That said, oversold markets can become more oversold. How oversold is this market?

This breadth chart from Index Indicators show that it is oversold on a short-term (3-5 day) horizon. It has reached these oversold levels about three times a year in the last five years.
 

 

On a longer term (1-2 week) time horizon, the market has reached these oversold levels just under once a year in the last five years.
 

 

For another perspective, the market decline has created an oversold setup for a Zweig Breadth Thrust. While the oversold setups are relatively common, the actual ZBT buy signal, which occurs when the market rises on strong breadth after an oversold condition within a short period, is very rare. The middle panel of the chart below depicts the actual ZBT indicator signals. As the timing of that signal is delayed, the bottom panel shows the real-time estimate of the ZBT Indicator. As of Friday’s close, a ZBT indicator oversold setup has formed.
 

 

Here is a chart of the ZBT oversold conditions during the 2007-09 period. The blue vertical lines show the instances where the market became oversold according to this indicator and experienced a short-term rally afterwards. The red vertical lines show the instances where the oversold signal failed and the market continued to fall. The lessons from this period in history tells us about how oversold markets can become more oversold. It was mostly during the steep declines and terminal phases of the bear market when these oversold conditions failed as buy signals.
 

 

My Trifecta Bottom Spotting Model also flashed a buy signal as of the close last Thursday. While the signal was early, it was nevertheless an indication of a deeply oversold market that is due for a bounce.
 

 

Here is the track record of this model during the 2007-09 period. The term structure of the VIX Index was unavailable for much of 2007, and therefore we will have to make do with analyzing the performance of this model for 2008-09. This OBOS component of this model (bottom panel) went a little haywire because of the nature of the 50 and 150 day moving averages. Nevertheless, we can observe that the behavior of this model was similar to the ZBT oversold indicator. It did not perform well during the cascading bearish period when the oversold market became more oversold.
 

 

In essence, a bet on oversold mean reversion today is a bet that this is not the start of a major bear market. How likely is that?
 

The preconditions of a bear market

In my view, these are the preconditions of a bear market:

  • A high likelihood of a recession in 12 months
  • An exogenous event, such as a trade war
  • Technical deterioration

As I discussed in last week’s post (see When the story changes…), the likelihood of a recession remains low. New Deal democrat’s always useful review of high frequency economic indicators tell the story. As the stock market tends to focus mainly on the short leading indicator, their positive outlook is supportive of higher equity prices over the next few months.

The short term forecast is very positive, as corroborated by the recently very strong index of Leading Indicators, although gas and oil prices bear closer watching. The nowcast is also positive, despite weakening in several components.

While a full-blown trade war is always possible, I have already pointed out that there are powerful obstacles in the way of a conflict, and the short history of the Trump administration on trade has been more bark than bite.

Finally, the history of past major bear markets has been preceded by signs of technical deterioration. Even as the SPX tests support at its February lows, there are no signs of negative breadth divergences and a few signs of positive divergences.
 

 

If the market were to make a major top at these levels, a more likely scenario would see a rally from current levels to test or exceed the old highs while internals exhibit signs of negative divergence. That hasn’t happened yet.
 

 

A Monday flush?

Looking to the week ahead, there have been some scary analysis circulating on the internet about what happens after a big Friday decline.
 

 

It is not my normal practice to engage in this kind of analysis as it borders on torturing the data until it talks. However, my own study using the same time frame shows that the market had a decent one-day rebound, and the rebound effect dissipated after 4-8 trading days. (Data and spreadsheet available upon request in the interest of full transparency).
 

 

Since we are torturing the data, let’s see what happens with a -2.0% down day on Fridays.
 

 

Here is the same analysis, based on -1.5% down days on consecutive Thursdays and Fridays. The sample size falls dramatically (N=15).
 

 

Bottom line: There is no truth to the myth of Friday weakness inevitably leads to a Monday sell-off.

My inner investor remains constructive on stocks. My inner trader was caught long, but he believes that the risk/reward favors the long the bulls in the short-term.
 

Disclosure: Long SPXL
 

Is the NASDAQ trend still your friend?

Posted by Cam Hui -

Mid-week market update: There have been a number of questions of whether the NASDAQ run is over. Marketwatch reported that Jim Paulsen of Leuthold Group highlighted the vulnerable nature of technology stocks. Paulsen pointed to the Tech/Utilities ratio as a way of showing that Tech is nearly as stretch as it was during the height of the NASDAQ bubble.
 

 

Chris Kimble also worried about the recent NASDAQ breakout, which was not followed by the major large cap averages, as well as a negative RSI divergence.
 

 

In addition, Kimble highlighted the huge weekly inflow into the NASDAQ 100 ETF (NDX), which could be interpreted as contrarian bearish.
 

 

If the NASDAQ falters, what would a loss of Tech leadership mean for overall stock prices?
 

Don`t panic

Traders should relax. Firstly, analysis from SentimenTrader showed that large inflows are not contrarian bearish.
 

 

Even if you thought that the large inflows was bearish, excitable traders withdrew nearly $13B from equity ETFs and $2B from NDX on Monday in the wake of the Facebook news. Is that contrarian bullish and a sign of incipient capitulation?
 

 

The market melt-up that began in late 2017 was powered by price momentum. The latest update of the momentum factor (MTUM/SPY ratio) shows that price momentum remains healthy.
 

 

The analysis of relative performance shows that NASDAQ 100 stocks remain in a relative uptrend. Even if it were to falter, the leadership baton could be taken up by mid and small cap stocks. Don’t despair just yet.
 

 

One last flush?

While the intermediate term outlook remains bullish, the short-term is cloudy. Investment News reported that a Bankrate.com survey revealed a lack of panic among individual investors during the February correction;

Just 6% of individual investors were net sellers during the February correction, according to a survey of 1,063 adults with investment accounts conducted by Bankrate.com. Another 15% added to their investments, while 60% intentionally did nothing. (Sixteen percent were unaware of the sell-off altogether.)

Sentiment readings in this week`s round of equity weakness ran short of capitulation levels, which may mean that sentiment is in need of a final flush. An analysis of my Trifecta Bottom Spotting Model tells the story. Monday’s sell-off saw the VIX term structure invert on an intra-day basis, but the VIX/VXV ratio did not close in fear territory. Similarly, TRIN neared a reading of 2, which is indicative of market capitulation, but did not close at that level.
 

 

If the market were to weaken, I would monitor different indicators for signs of positive divergence. As an example, will the Fear and Greed Index make a positive divergence if the market were to test the lows set in early March?
 

 

A number of breadth indicators are already displaying constructive signs of positive divergence.
 

 

My inner trader was caught long in the latest downdraft, but he remains cautiously bullish and believes that downside risk is limited at these levels.
 

Disclosure: Long SPXL

 

FOMC preview: Rising stress edition

Posted by Cam Hui -

The Federal Reserve is widely expected to raise interest rates a quarter-point this week at their FOMC meeting this week. Even though financial conditions remain at benign levels, there are a number of signs that stress levels are rising during the current tightening cycle.
 

 

Rising Libor-OIS spread

Bloomberg reported that stresses are showing up in the financial system as part of the Fed’s tightening process. The Libor-OIS spread is blowing out.
 

 

As a primer:

[The Libor-OIS spread is] regarded as a measure of how expensive or cheap it will be for banks to borrow, as shown by Libor, relative to a risk-free rate, the kind that’s paid by highly rated sovereign borrowers such as the U.S. government. The Libor-OIS spread provides a more complete picture of how the market is viewing credit conditions because it strips out the effects of underlying interest-rate moves, which are in turn affected by factors such as central bank policy, inflation and growth expectations.

The rising spread can be attributed to a number of factors:

  • Higher Treasury Bill issuance
  • The tax bill’s offshore cash repatriation provisions has shrunk the supply of overseas USD
  • Quantitative Tightening, or the Fed’s shrinking balance sheet

 

Flattening yield curve

The yield curve has continued their flattening path, which is the bond market’s way of anticipating slowing future economic growth. Inverted yield curves have been sure-fire signs of recessions, which have been equity bull market killers in the past.
 

 

On the other hand, Matt Boesler of Bloomberg pointed out that even though core PCE has started to rise steadily, its pro-cyclical components remain tame. This may be a factor that holds down inflation pressures for the rest of 2018 and restrain the Fed from becoming overly aggressive in its rate hike path.
 

 

At this point, the market does not have a good handle of the Powell Fed’s reaction function to data and risks. Ultimately, the question for investors is whether there will be a Powell Put for the markets in the manner of the Yellen Put, Bernanke Put, and Greenspan Put.

Stay tuned. The first act of this show opens on Wednesday.
 

When the story changes…

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A change in seasons

Bill McBride of Calculated Risk has had a remarkable record of calling turns in the economy. He correctly warned about the peaking housing bubble before it popped, and he has been consistently bullish since the market bottom in 2009. Recently, he warned that “the story is changing”:

But in 2018, the story is changing. We are seeing some economic tailwinds and some headwinds. Although the tax changes are poorly conceived, and mostly benefit high income earners, there should be some short term boost to economic growth. That might lead the Federal Reserve to raise rates a little quicker than anticipated.

He concluded:

I still think the economy will be fine in 2018, but the story is changing.

Bloomberg reported that Morgan Stanley cross-asset strategist Andrew Sheets highlighted a changing environment of weakening Purchasing Manager Indexes (PMIs) and rising inflation. Such regimes shifts have typically led to rising volatility.

Markets have traditionally been well-equipped to handle higher inflation when it comes alongside a pickup in growth, notes Sheets. But it’s the prospect of an inflection point away from the dominant narrative of “synchronized global growth” reflected in rising PMIs, and moribund price pressures that could cause investors angst.

 

 

Kevin Muir at Macro Tourist also highlighted NDR analysis that split Fed tightening cycles to fast and slow cycles. If history is any guide, this is the point where stock prices start to flatten out and weaken during a slow tightening cycle.
 

 

I agree 100%. Goldilocks is dying, but the probability of a recession in 2018 remains low. Risks and volatility are rising. It is time to review how “the story has changed”.
 

A recession watch review

As McBride’s analysis was focused on the economy, it is useful to review how recession risk is changing. My main analytical framework is the long leading indicators outlined in my Recession Watch, which are designed to spot recessions a year in advance. With that in mind, my recession watch indicators are divided into three categories:

  • Consumer and household sector
  • Monetary conditions
  • Corporate sector

 

Rising household and consumer stress

Starting with the consumer, this sector is starting to show some signs of weakness, but there is no clear and present danger just yet. Retail sales declined for three months in a row, and real retail sales peaked in December. However, the strength in retail sales late last year remarkable and the recent declines could be just a data blip.
 

 

While retail sales measure current consumption, data series such as housing starts are more indicative of durable goods demand. The latest update on housing starts reveal a market that has plateaued and may be peaking. The combination of rising mortgage rates, and material costs of lumber and steel from trade actions are becoming headwinds in this highly cyclically sensitive sector of the economy.
 

 

A tightening Fed

How is the Fed reacting to these incipient signs of consumer weakness? Inflation surprise has been ticking up in the US and elsewhere, and the Fed has adopted a more hawkish tone. The risk of a policy error is rising. The Fed is engaged in a delicate balancing act, and the chances of a Fed-induced recession is rising rapidly.
 

 

In the meantime, the tightness in monetary policy is showing up on money growth. In the past, real money growth, whether M1 or M2, has turned negative ahead of recessions. Today, real M2 growth is on pace to turn negative in the next few months, which would be a recessionary red flag.
 

 

We should get more clues about the direction of Fed policy from the FOMC statement next week.
 

Corporate sector still the bright spot

Over at the corporate sector, coincident market indicators such as forward 12-month EPS from FactSet is still rising. This is indicative of positive fundamental momentum, but this is an indicator that is coincidental to stock prices and do not forecast where the economy might be in the future.
 

 

NIPA corporate profits, which is another one of my long leading indicator, remains healthy.
 

 

While the latest NFIB small business optimism survey surged to new highs, its internals reveal a number of disturbing internals beneath the surface. The survey of “single most important problem” shows that labor quality has rising to be the biggest problem, which is indicative of an overheating labor market that will undoubted concern Fed officials.
 

 

As well, the NFIB survey of prices and labor compensation reveals inflationary pressures in both wages and prices, which is a sign of cost-push inflation that will also raise eyebrows at the Fed.
 

 

For now, credit conditions remain benign. Until lending standards tighten, the risk of recession is likely to remain low.
 

 

These readings are also consistent with the Fed’s own surveys of financial conditions, which have tightened marginally but remain at low levels.
 

 

In summary, a survey of leading indicators shows that recession risks are low, but rising. The consumer and household sector is under increasing stress, and monetary conditions are starting to tighten. However, the corporate sector remains healthy, and therefore the likelihood of a recession in 2018 is low.

New Deal democrat monitors high frequency economic releases and divides them into coincident, short leading, and long leading indicators. Here is his latest assessment of the US economy:

The nowcast and short term forecast are very positive. The long term forecast is weakly positive, with some improvement in the measures that have been fluctuating near neutral levels.

 

Be prepared!

One caveat to this analysis is it is focused on the economy. Since equity prices are leading indicators and recessions are bull market killers, investors will have far less warning than a year before a market peak and the onset of a bear market.

As “the story changes”, a shift from a bull to a bear market is likely ahead. Here is what I am watching to monitor downside risk in stock prices. Edward Harrison of Credit Writedowns worried about the risk of abrupt macro shocks:

I think of these credit shocks as being similar to how macroeconomic shocks happen. For example, I have often said that it is not the level of jobless claims that matter, it’s the change from one period to the next. So for example, every recession since unemployment insurance claims have been record has been led by or coincident with weekly initial jobless claims rising by 50,000 for a sustained period. There are no false positives either. That means that when the number of people who get thrown involuntarily out of work each week rises by 50,000 for a month or two, the loss of income is large enough to shock the economy into recession.

A shorter or smaller climb is digestible without recession. But, at some level, and I use 50,000 as the marker, it’s just too much of a shock to employment, income and consumption.

The same is true for credit. If the Fed raises rates too fast, the shock to speculative and Ponzi borrowers is too great for them to be able to hedge their bets. And they default. So it’s not the level that matters but the change in the level.

From a technical perspective, one clue of a market top may come from Chris Ciovacco’s trend models. Ciovacco monitors the 30, 40, and 50 week moving averages of the NYSE Composite. If they start turning down, then it would be a signal to reduce risk.
 

 

One drawback of Ciovacco’s models is their trend following nature, which are slow by design to spot market tops and bottoms. I am also watching for signs of a negative divergence in the 14-monthly RSI against the DJ Global Index, which will flash an early warning of a market top.
 

 

Should the market recover and rally either test the old highs or surge to new highs, a negative RSI divergence will give advance warning of heightened downside equity risk.
 

The week ahead

Looking to the week ahead, stock prices are likely to see a bullish bias. For one, CNBC reported that JPM derivative analyst Marko Kolanovic believes that the volatility storm has passed and market conditions are likely to return to normal.

The flow aspect of the sell-off had a striking similarity with the August 2015 sell-off: realized volatility caused derisking from volatility targeting strategies and forced covering of short volatility positions. Unless there is a recession, all of these flows tend to reverse within 1-2 months,

As my analysis has shown, the near-term risk of a recession is extremely low.

Arthur Hill identified a coiling formation in the DJIA and wrote that he “would still treat the consolidation as neutral and take [his] cue from the next directional break”.
 

 

As Hill waits for the directional break, we can get some clues as to the direction of the break by observing the other major US equity market indices, from large caps to small caps, as well as the NASDAQ. All have broken out upwards. All are above their 50 day moving averages (dma). The NASDAQ Composite staged an upside breakout and it is now testing the breakout level turned support.
 

 

From a tactical perspective, the bulls impressively held off an assault by the bears last week. As the hourly chart shows, the bears filled the gap from the previous Friday but could go no further. The SPX went on to rally through a short-term downtrend and the hourly RSI-5 indicator flashed a bullish divergence.
 

 

The Fear and Greed Index has fallen to 19, which is an oversold condition indicating a possible short-term sentiment washout.
 

 

Short term breadth indicators have turned upwards from an oversold reading, which is also short-term bullish.
 

 

The one wildcard next week is the FOMC meeting. Tim Duy thinks that they will continue to signal three rate hikes, but bump up the “dot plot” to hint at four hikes this year.

Recent employment reports combine to tell a story of an economy that can sustain a faster pace of growth without pushing past capacity boundaries. That argues for leaving the Fed’s expected policy rate path intact. But Federal Reserve Chairman Jerome Powell’s testimony pointed to “avoiding overheating” as a policy objective while Federal Reserve Govenror Lael Brainard discussed at length the shift of economic forces from headwinds to tailwinds. She drew a comparison to 2015-16, when the Fed sharply reduced the pace of hikes relative to the projected rate path. Together, these discussions suggest the Fed sees a shifting balance of risks to the outlook. They will try to manage the risks accordingly, bumping up estimates of future rates while leaving open the option to switch to a more sharply more aggressive path if needed.

My inner investor is starting to get nervous about stocks, but he is maintaining the investment discipline of his models. He has found in the past that anticipating changes in model readings can lead to poor results, and waits for actual changes before actually reacting. Therefore he remains constructive on stock prices for the time being.

My inner trader believes that the correction is over, and the balance of risks point to another test of the previous highs.
 

Disclosure: Long SPXL
 

A test of bullish resolve

Posted by Cam Hui -

Mid-week market update: Last weekend, I wrote that while I was intermediate term bullish, I expected some equity market weakness early in the week. The hourly RSI-5 had exceeded 90, which is an extremely overbought reading, which was not sustainable. Even during the January melt-up, such episodes resolved themselves with either a pullback or sideways consolidation. The downside risk is the 50 day moving average (dma) and the gap that was created when the market rallied on March 9, 2018.
 

 

Now that the market has declined to test the 50 dma, and the gap is filled, what now?
 

Buy the dip!

For now, I am inclined to give the bull case the benefit of the doubt. Measures of risk appetite remain healthy.
 

 

Breadth indicators are not exhibiting bearish divergences. They are either neutral or mildly bullish, as exemplified by the behavior of the NYSE A-D Line.
 

 

This chart of breadth by market cap presents a mixed but constructive picture. Both mid and small caps are staging comebacks relative to SPX, while megacaps (XMI) are underperforming. NASDAQ 100 is the clear leadership, though the equal weighted NASDAQ 100 is lagging the cap weight index. I interpret these readings of mid and small cap revival as bullish (troops leading generals). While some analysts have raised concerns about narrowness of NASDAQ leadership, the recent performance of the equal vs. cap weighted NASDAQ 100 shows that the smaller stocks in that index are keeping pace in this rally.
 

 

For the contrarian last word, Bloomberg reported that Dennis Gartman has turned bearish on stocks.
 

 

 

My inner trader remains bullishly positioned. He believes that the current bout of weakness is a great opportunity to buy the dip.
 

Disclosure: Long SPXL

The new Fragile Five to avoid

Posted by Cam Hui -

In the wake of my last post about whether USD assets and Treasury paper would remain safe haven and diversifiers in the next global downturn (see Will diversified portfolios be doomed in the next recession), I received a number of questions as to what investors should avoid. There is an obvious answer to that question.
 

 

Call them the new Fragile Five.
 

The pro-cyclical Fragile Five

Loomis Sayles made the case for these countries to be the New Fragile Five, based on unsustainable real estate bubbles:

Cracks are starting to appear in five highly leveraged economies: Canada, Australia, Norway, Sweden and New Zealand. For several years following the global financial crisis, these five countries all shared a common theme—a multi-year housing boom, fueled by low interest rates, which resulted in very elevated levels of household debt.

This boom is starting to dissipate in all five markets. House prices have largely reversed course, be it slowing appreciation or outright decline. Moreover, this is occurring even as interest rates remain at or near record lows and labor markets continue to be robust. Importantly, this is a correction that many thought could not occur given the otherwise strong economic growth backdrop in these countries. But we take a long-term view of house prices, and began highlighting affordability problems in these markets several years ago.

 

Here in Vancouver, I can personally attest to the insanity of local property prices. As an example, here is the cheapest listing of a single detached house that I could find. You can have this beauty for about USD 1 million!
 

 

Oh, don`t miss the view from the back.
 

 

In addition to highly elevated property prices, the New Fragile Five also suffers from the doubly pro-cyclical characteristic of being resource based economies. If the Chinese economy were to slow significantly, these economies would also be hurt by plunging commodity prices. As the chart below shows, these currencies are highly correlated to either oil prices. or the CRB Index, which are expected to fall in a pro-cyclical fashion during a global downturn.
 

 

Falling property price AND falling commodities in commodity sensitive economies? Ouch! As a Canadian resident, I will be maintaining a USD position in my portfolio for precautionary purposes.
 

 

Will diversified portfolios be doomed in the next recession?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Will Treasuries continue to be diversifiers?

Bloomberg recently reported that Sanford Bernstein declared the 60/40 portfolio to be doomed, because the prices of different asset classes, which were believed to be diversifying, are moving together.
 

 

This brings up an interesting point, will bonds do their part to diversify portfolio returns and cushion equity downside risk in the next bear market? In the last crisis, fixed income investments proved to be a poor diversifier as credit spreads blew out, and only Treasuries rallied. In the next bear market, will Treasuries be able to fulfill their role as diversifying investments?

In the wake of widespread worries over the Republicans’ latest fiscal experiment with tax cuts during the late phase of an expansion, a number of strategists have voiced concerns about the downward pressure that exploding fiscal deficits would put on the US Dollar. Macquarie pointed out that priming the fiscal pump during a period of low unemployment is highly unusual.
 

 

If history is any guide, then the USD is likely to face significant downward pressure in the future as deficits explode upwards.
 

 

The FT reported that Vasileiocs Gkionakis of UniCredit came to a similar conclusion.
 

 

That got me thinking. A falling USD implies that the market is losing confidence in the value of USD assets. If the greenback is going to be under such pressure, what happens in the next recession?

In the past, USD assets, and Treasury securities in particular, have been the safe haven asset of choice during periods of economic stress. If the USD and USTs lose their safe status, what happens to diversified portfolio returns? Will the decline in their asset values accelerate because bonds, and especially USTs, fall in value along with the price of other risky assets like stocks?
 

Dire projections

The projections look dire. The deficit is likely to surge by 5-8% of GDP in the next recession. Lawrence McDonald rhetorically asked who the buy of all the Treasury assets.
 

 

The market response in the next recession, whenever that occurs, could look like a gold bug fantasy.
 

What are the alternatives?

Let’s consider the possible range and supply of safe haven assets for major reserve managers. From a practical standpoint, the world has three major trade blocs, the US, Europe, and Asia, and two major currencies with sufficient liquidity to hold as reserves, the dollar and the euro. The other currencies do not trade in sufficient size for the reserve managers of a central bank to hold in size. Currencies such as the JPY and GBP can be best described as secondary holdings and cannot constitute the first or second largest weight in currency reserves, other than in the special case where that country is a major trading partner.

Swiss Francs (CHF)? Gold? Collectibles? Cryptocurrencies? You’ve got to be kidding. If any major central bank decided to devote a significant portion of its reserves to CHF, the Swissy would soar instantly. As for gold, the US Treasury is one of the biggest holder of physical gold reserves. If it were to sell off all of its reported reserves at current market values, and they are all available for sale and not lent out as theorized by a number of gold bugs, the sale would net a little over $300 billion. In other words, the sale of the Treasury entire gold reserves would not pay for a single year’s fiscal deficit. It’s a drop in the bucket. As for collectibles and cryptocurrencies, their liquidity are an order of magnitude worse than gold.

As well, consider the Triffin dilemma, which states that the country whose currency is the global reserve currency must be willing to supply the world with an extra supply of its paper to fulfill world demand for these foreign exchange reserves, thus leading to a current account deficit. Notwithstanding Trump`s obsession with trade deficits, foreigners have been financing US trade deficits by buying USD assets. As the chart below shows, it is no surprise that the two largest holders of US debt are China and Japan, which have been running sustained current account surpluses for years.
 

 

Stress points in the next recession

Imagine the following scenario. The Fed makes a policy mistake in 2018. It either finds itself behind the inflation fighting curve and steps on the monetary brakes to induce a recession; or it tightens too quickly into a slowdown. Fed chair Powell has already alluded to the possibility of four quarter-point rate hikes this year. Four rate hikes could easily invert the yield curve, which would be a signal of a recession in 2019.

With that in mind, let take a trip around the world to consider the issues facing each trade bloc and region, and evaluate where we may find safe haven assets.

Starting in the United States, former IMF chief economist Simon Johnson believes that the latest wave of financial deregulation puts the banking system at risk of Lehman Brothers II.

A serious legislative effort, supported by the Trump administration, is underway to reduce the level of scrutiny applied to banks that are on the verge of becoming systemically important. If congressional Republicans have their way, financial stability will be at greater risk than at any time since the 2008 crisis.

Edward Harrison of Credit Writedowns fretted about the risk of implosion by defined benefit pension plans, and public sector plans in particular:

Walters is talking about dire state and municipal finances during the best economic conditions of this business cycle. What happens when the economy turns down? And what happens in the next tough bear market in equities or bonds? The seven percent annual return assumption will look ridiculously optimistic then.

And California’s problems will be repeated throughout the country in places like Illinois and New Jersey. Those are two of the biggest states that have precarious municipal finances. And have you seen what’s happening in Oklahoma, with teachers working at Walmart on Mondays? That’s not the future that other states want to reckon with.

No one’s talking about this – at least not in my circles. I don’t hear it on the news or read about it in the paper. For me, the potential for a state and municipal fiscal and public pension crisis is a defining issue for the next downturn. Problems in this arena are guaranteed given the underfunding of public pensions throughout the United States. The question is whether the downturn in the economy and in financial markets crystallizes a crisis.

If we do have a pension crisis, it will be a systemic issue, both economically and politically. The issue with CalPERS tells you that.

If either of the scenarios outlined by Johnson or Harrison were to realize themselves in the next downturn, credit spreads would undoubtedly blow out in the corporate bond market and the municipal bond markets. Such episodes would detract from the attractiveness of USD assets.

One of the open questions in the next downturn is the reaction function of the Federal Reserve. They would undoubtedly lower interest rates in the face of economic weakness, but when happens at the zero bound? The solution so far, has been more quantitative easing. Edward Harrison suggested that the Fed could resort to more extreme forms of QE, such as the purchase of municipal bonds issued by states facing severe pension funding shortfalls. If QE isn’t proving to be effective, there is always helicopter money, otherwise known as “the government spends it, we’ll monetize the debt”. Ben Bernanke explained in his famous 2002 helicopter money speech:

A broad-based tax cut, for example, accommodated by a programme of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead rebalanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.

Another solution advocated by Marvin Goodfriend, Fed governor nominee, is the use of negative interest rates in lieu of QE in a Jackson Hole paper he presented in 2015. Goodfriend believes that the Fed can drive rates to significantly negative levels by breaking the link between the value of money in the banking system and paper currency. The Fed could take steps to either restrict or refuse the issuance of paper currency, e.g. $100 bills. It could also encourage banks to charge customers a fee if a depositor withdraws money in paper currency. Those steps would discourage customers from asking for currency and coins, and therefore remove the arbitrage between balances earning negative interest rates in a bank and taking the money out and putting it under a mattress.
 

Eurozone: Lingering problems from the last crisis

If investors were to flee from USD assets, one possible alternative is eurozone paper. Unfortunately, Europe has yet to fix the banking leverage problems left over from the last crisis. While the ECB managed to paper over the problem, bank leverage ratios remain highly elevated. The lack of an agreement on the socialization of risk in the eurozone has meant that the banks still own significant amounts of the sovereign debt of their own countries, e.g. Spanish banks own Spanish debt, while at the same time each sovereign is responsible for bailing out their own banks. (Wait a minute…if Italy gets into trouble, but Italian banks own Italian debt, how does Italy bail out its banks?)

The OECD data on banking leverage shows that European banks are highly levered by global standards. American banks, by comparison, have their leverage ratios well under control.
 

 

Analysis by V-Lab at the Stern School of long-term value-at-risk tells a similar story. European banks are highly exposed, while the leverage of American banks is much lower.
 

 

If the global economy were to slow, major cracks are likely to develop in the European banking system. As I pointed out in my previous post (see The rise of populism and the policy challenge for global elites), the formation of the Merkel government gives Europe a small window for the Macron-Merkel alliance to create fiscal shock absorbers to cushion the next economic downturn. If they fail, then the risk of political swings to populist governments in Europe rises dramatically.

Don’t expect the euro to become a safe haven currency under such circumstances.
 

China: Hard landing risk

What about China? Could the CNY become a safe haven currency?

There are two problems with that thesis. First, China is a current account surplus country. Countries with a history of current account surpluses will not, by definition, have any need of external debt. As a results, there is just not enough RMB sloshing around the global financial system for the RMB, or CNY, to be a significant reserve currency (see above discussion of the Triffin dilemma).
 

 

China bears also like to refer to their favorite chart of Chinese debt. Debt to GDP readings are already at levels consistent with past global financial crises. Since China is a major exporter to the US, it is unclear what the effects are should the US slow into recession. As the Chinese financial system is opaque, and it has not been fully stress tested under the current conditions, risk levels are at uncharted levels.
 

 

Under those conditions, would anyone really want to hold CNY as a major safe haven asset?
 

Japan: Safe haven?

Finally, there is Japan. The JPY has been regarded by currency traders as a safe haven currency. However, the historical record is mixed at best. Up until the GFC, JPYUSD had weakened into recessionary periods. It has only been recently that JPY has been seen as a safe haven.
 

 

That said, the BoJ has taken a concerted effort to buy up the supply of JGBs during its numerous rounds of QE programs. This creates the problem of insufficient liquidity should investors decide to buy JPY during a recession or financial crisis.
 

Good news, bad news

In conclusion, this analysis reveals both good news and bad news. The good news is the USD will still be the least dirty shirt in the neighborhood during the next global slowdown. Expect that Treasury securities will retain their safe haven status in the next recession by virtue of their default-free characteristics and the status of the USD as a major reserve currency.

From a portfolio construction viewpoint, investors can relax. USTs will remain a diversifying asset class and tail-risk hedge in the next economic downturn, and serve to reduce the volatility of a diversified portfolio.

Here is the bad news. This analysis is silent on the behavior of USD assets while the global economy is not in crisis. Brad Setser at the Council for Foreign Relations summarized the problem by observing that the international demand for Treasury paper has been in decline.
 

 

With the fiscal deficit expected to balloon, financing rising debt levels will be increasingly challenging.
 

 

In a non-recessionary environment, it becomes an open question whether rising rates, a falling USD, or a combination of both would become the safety valve for these imbalances. That said, USD safe haven demand should still spike when the next crisis hits.
 

The week ahead

Looking to the week ahead, most indications suggest that the correction is over. The upside surprise from the February Jobs Report conveyed a message of strong non-inflationary growth. More importantly, temp jobs started growing again after a brief pause – and temp jobs have led headline NFP in the last two cycles.
 

 

In addition, the latest update from FactSet shows that forward 12-month EPS are continuing to rise, indicating positive fundamental momentum.
 

 

From a technical perspective, the SPX regained the 50 day moving average (dma) and rallied through a downtrend line. It is now testing a short term resistance level defined by the February highs. The near-term downside risk may see the market decline to close the gap set last Friday, which stands just above the 50 dma.
 

 

Breadth indicators are supportive of further gains. Both the NYSE Advance-Decline Line and New Highs-Lows are stronger than the SPX.
 

 

Next week is option expiry week (OpEx). Rob Hanna of Quantifiable Edges observed that March OpEx week is one of the most bullish OpEx weeks in the year.
 

 

In a separate post, Hanna also found that Friday’s NASDAQ market action on a Jobs Report day had bullish tailwinds for the following week.
 

 

As well, the latest update of insider activity from Barron’s is supportive of higher prices.
 

 

While the market is exhibiting strong “good overbought” momentum which is supportive of higher prices, there could be a brief pause or pullback early in the week. Breadth indicators from Index Indicators show that market is overbought at multiple time frames.
 

 

Hourly RSI-5 of the SPX has exceeded the highly overbought 90 level, which is not a sustainable condition. Even during the January melt-up, similar past episodes had seen the market either pause or weaken under such conditions.
 

 

My inner investor remains constructive on stocks. My inner trader is turning increasingly bullish. Should the market weaken in the near term, he is ready to buy the dip.
 

 

Disclosure: Long SPXL

The rise of populism and the policy challenge for global elites

Posted by Cam Hui -

This week saw the two examples of the triumph of populism. The Italian election saw the rise the Five Star Movement and Lega Nord, otherwise known as the Northern League. Both are Euroskeptic parties and Lega Nord has an anti-immigrant bias. Meanwhile in Washington, the news of the steel and aluminum tariffs put Trump’s America First policies front and center.
 

 

These instances of rising populism present a long-term development economic policy challenge for global elites.
 

Italian populism explained

As the electoral map shows, Five Star derives most of its strength from Italy’s poorer south, and Sardinia. One way of interpreting the vote is disillusionment with the European experiment and the ways that the less privileged have been left behind.
 

 

We can see a direct inverse relationship between regional GDP per capita and Five Star support.
 

 

 

The Grand Plan teeters

Back in 2012, Mario Draghi revealed the Grand Plan in a WSJ interview. The European Central Bank (ECB) would do its best to hold things together while member states restructured to create more flexible labor markets. In the interview, Draghi distinguished between good austerity and bad austerity.

WSJ: Austerity means different things, what’s good and what’s bad austerity?

Draghi: In the European context tax rates are high and government expenditure is focused on current expenditure. A “good” consolidation is one where taxes are lower and the lower government expenditure is on infrastructures and other investments.

WSJ: Bad austerity?

Draghi: The bad consolidation is actually the easier one to get, because one could produce good numbers by raising taxes and cutting capital expenditure, which is much easier to do than cutting current expenditure. That’s the easy way in a sense, but it’s not a good way. It depresses potential growth.

After austerity comes structural reform “because the short-term contraction will be succeeded by long-term sustainable growth only if these reforms are in place”.

WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population…

WSJ: Do you think Europe will become less of the social model that has defined it?

Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.

WSJ: Job for life…

Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.

While the ECB did uphold its end of the bargain, structural reform efforts were too slow and uneven. The rise of populist movements like Five Star are the result of those failures. Today, the budgets of every eurozone member state conforms to the 3% deficit limit specified by the Growth and Stupidity Stability Pact.
 

 

Today, Angela Merkel has cobbled together a coalition government and she has a governing mandate again. Emmanuel Macron, a pro-European president, is in the Élysée Palace. The window of opportunity for greater European integration to create further shock absorbers for the next downturn is very narrow.

This is the biggest challenge facing the European Establishment. If they fail, the Le Pens and other Euroskeptics are likely to gain further strength in the next recession, and put the European Project at risk.
 

Populism in America

Across the Atlantic, a similar parallel can be found in the last American election. While the relationship is less direct, the inverse relationship between job creation and the Clinton/Trump divide bears an eerie resemblance to the inverse relationship between GDP per capita and Five Star support.
 

 

The policy challenge

Call it what you want. Protest vote. Disillusionment. These are all manifestations of the “elephant graph” popularized by Branko Milanovic. The winners of 20 years of globalization since 1988 are the emerging market middle class, which is mostly Chinese, and the very rich, who profited from lower costs of production from globalization. The biggest losers were the middle class of the developed economies, who fell behind in real terms as jobs were offshored. They became the constituency for populist movements, such as Trump, Le Pen, Five Star, and so on.
 

 

Ray Dalio of Bridgewater recently fretted about what might happen in the next downturn because of the rising divide between rich and poor:

What is Different?
There are two important differences that concern me. They are that 1) there is such a big gap between the haves and the have-nots (which creates social and political sensitivities) and 2) the powers of central banks to reverse contractions are more limited than they have ever been (because interest rates are so low and QE is less effective). For these reasons, I worry about what the next economic downturn will be like, though it is unlikely to come soon.

This presents a unique development economic challenge for the global elites. If the income gap between the haves and have-nots are not closed soon, or sufficient fiscal and other shock absorbers are not put in place before the next downturn, the social environment is likely to turn ugly.

Otherwise, the level of economic, political, and asset price volatility in the next global downturn and recovery are going to be highly elevated by historical standards.

The long awaited W-shaped recovery?

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the short-term character of a market by the way it reacts to news. When the news of Gary Cohn’s resignation hit the tape after the close on Tuesday, ES futures cratered down over -1%. By the market closed Wednesday, SPX had traced out a bullish reversal after an early morning selloff and closed flat on the day.

 

Is that all the bears can do?

Signs of washout

The signs of a sentiment washout are showing up everywhere. The TD-Ameritrade Investor Movement Index (IMX) retreated dramatically in February to levels seen last spring, indicating retail investor capitulation.

 

In addition, Schaeffer’s Research found that the first time since the 4-week moving average of new highs/lows fall below 1.0 tends to be bullish.

 

Though the sample size is not large (N=10) and the study window is relatively narrow (from 2010), past episodes have tended to resolve themselves bullishly.

 

Despite the negative trade tension headlines, measures of risk appetite are still healthy, which is conducive to further equity price advances.

 

Putting it all together, none of this tells us much about how the market may react tomorrow or the day after. However, the intermediate term outlook favors a scenario where stock prices are move higher test the January highs in the coming weeks.

My inner trader remains bullishly positioned in anticipation of higher prices. He has some dry powder left so that if prices were to weaken, he is prepared to buy the dip.

Disclosure: Long SPXL

Beyond the headlines of the February Jobs Report

Posted by Cam Hui -

This Friday, the Bureau of Labor Statistics will release the February Employment Report. The consensus headline Non-Farm Payroll (NFP) figure is 200K, and consensus monthly change in Average Hourly Earnings (AHE) is 0.2%.

Johnny Bo Jakobsen observed that forecasts based on ISM employment points to a strengthening job market. Based on this analysis, I am tempted to take the the over on NFP and AHE.
 

 

Even as the market focuses intensely on NFP and AHE, there are far more important internals to watch beyond the headlines.
 

Leading employment indicators

Here are two important indicators that I am watching. First of all, what is happening to the momentum of job growth? New Deal democrat recently proposed a simple model of employment and interest rates. Whenever the YoY change in the Fed Funds rate has exceeded the YoY change in NFP, a recession has followed within 12-24 months.
 

 

One leading indicator of NFP growth momentum is the temporary job market. While we only have two complete cycles of data, temp job growth have historically led headline NFP growth. Temp jobs have flattened out since the November report, which could be an early warning that jobs market growth is becoming mature, or hitting capacity. Neither interpretation would be good news.
 

 

I have been saying that the American economy is in the late stages of an expansion. The February Employment Report will be another data point in that assessment. After that, recession probabilities is dependent on the Fed`s reaction function.

Stay tuned.

Tariff Tantrum, or Trade War Apocalypse?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

 

Trade chaos, or buying opportunity?

Trump’s tariff announcements in steel and aluminum last week were certainly a shock to the market, though they were not totally unexpected. I had written about this in early January when the market was melting up and suggested that 2018 would be the year of “full Trump” and a dramatic change in policy tone after the tax cut victory (see Could a Trump trade war spark a bear market?)

Trump went on to double down on his steel and aluminum tariff announcements with a “trade wars are good, and easy to win” tweet.

 

In the wake of the announcements, the charts of the market reactions to past major trade actions began circulating on the internet. Here is what happened when George W. Bush imposed tariffs on steel in 2002.

 

This chart shows the effects of the Smoot-Hawley tariffs during the 1930`s.

 

Is this fear mongering? It depends on your perspective. Trade wars had a major dampening effect on global growth, but the American economy were either in recession (2002) or in a Depression (1930’s) during these two episodes.

Is this a Tariff Tantrum that should be bought, or a Trade War Apocalypse that should be sold?

A trade policy analytical framework

For a better perspective, Tim Duy outlined a useful analytical framework as trade policy is just one of several moving parts to Trump’s initiatives. Investors should view the latest development by the Trump administration in a broader context in the form of:

  • Fiscal policy
  • Trade policy
  • Monetary policy

According to Duy, a good starting point is the tax cuts as the main element of fiscal policy. Despite concerns about fiscal overheating, the tax cuts might actually work to boost productivity and fuel non-inflationary growth:

Tax cuts and spending increases are projected to fuel an ill-advised federal budget deficit for 2019 in excess of $1 trillion. With the economy operating near full employment, the extra impetus from deficit spending could cause inflation to overheat. The Federal Reserve would respond with a rapid increase in interest rates that triggers a recession. The fiscal stimulus thus shortens the expansion.

There are good reasons to engage in this experiment. First, we don’t know the extent of any excess slack that might remain in the labor market. Low wage growth and inflation, despite a drop in the jobless rate, encouraged the Fed to reduce its estimate of longer-run employment in recent years. Perhaps further declines are possible, or there might be an opportunity for pro-cyclical growth in labor force participation. Moreover, tight labor markets might induce firms to invest in more labor-saving capital, boosting productivity. Running the economy hot might trigger a supply-side boom.

On the other hand, the contractionary effects of tariffs work against the expansionary effects of fiscal stimulus:

America’s trading partners serve as a pressure relief valve for the U.S. economy if the demand boost stretches beyond domestic capacity. Excess domestic demand may be “offshored” in the form of increased imports, which increase the trade deficit. The trade deficit thus provides room for a margin of error by limiting excess strain on domestic resources. This will limit inflationary pressures and reduce the risk of an aggressive monetary policy…

The Trump administration, however, could easily shift the odds against this outcome. President Donald Trump is reportedly considering imposing steep tariffs on steel and aluminum imports of 24 percent and 10 percent, respectively. It is difficult to overstate the destructiveness of such a policy. In recent years, imported steel has accounted for more than 30 percent of U.S. consumption. A steep tariff will undoubtedly impose higher costs on a large swath of the U.S. economy.

While steel companies will benefit from higher prices, manufacturing more generally will suffer. Manufacturers of goods from automobiles to washing machines will feel the pain — in the latter case, offsetting the benefit of recent tariff increases. The new tariffs might backfire in other ways as well. Manufacturers would have an incentive to offshore their production to take advantage of lower prices of materials in other countries. The construction industry, also a heavy user of steel, would be under pressure to push through higher costs to consumers. Our global trading partners may retaliate, limiting opportunities for U.S. exports. With this administration, there is a good chance that any retaliation would be met with fresh trade restrictions.

For newbies, it’s important to expand on Duy’s comments about “America’s trading partners serve as a pressure relief valve for the U.S. economy if the demand boost stretches beyond domestic capacity”. I had written about this point before (see How to lose a trade war before even it  begins):

The deeper problem stems from the propensity of Americans to spend and their lack of willingness to save. This creates a current account deficit, which manifests itself in large imports of foreign goods. In other words, as long as Americans keep on spending and don’t save, the trade deficit will migrate to other countries if the US imposes tariffs on China.

Trade deficits are only the symptom of a different malaise. As long as Americans spend beyond their means, the USA will run a current account deficit. If it’s not with China, it will be with another country. No amount of tariffs can solve that problem.

The third element, according to Tim Duy, is the Fed. What does the Fed do in the face of fiscal stimulus in a late cycle expansion and the supply shock of protectionist measures? The Trump tax cuts are highly unusual in the current phase of the expansion. In the past, federal deficits have been correlated with the unemployment rate, but the current round of fiscal stimulus is occurring when unemployment is falling. Cutting taxes during the late stages of an expansion when there is little economic slack would only fuel inflation.

 

Duy rhetorically asked if the Fed would stand idly by and allow the economy to “run hot”, or does it preemptively act to choke off those inflationary pressures by stepping on the monetary brakes?

Trump ran on a promise to reduce the trade deficit. Following through on this promise in the face of a stimulus-induced economic boom will only reduce the prospects for U.S. growth by aggravating the supply-side constraints on the economy, forcing inflation rates higher and putting the Fed in the position of choking off growth or letting inflationary pressures build. Both outcomes would render the great fiscal policy experiment a failure.

All are unenviable choices for Fed policy makers. In addition, this abrupt shift in trade policy will make it more difficult to fill Fed positions. It is unclear who Trump could find to fill the post of Fed vice chair, as well as other governor positions, who are supportive of trade protection measures.

Policy pushback

Despite all of the protectionist fears, not all is lost for the bulls. First of all, NBC News reported that the tariff announcements last Thursday was impromptu and unplanned as Trump met steel and aluminum industry executives. This decision is reminiscent of the travel ban fiasco during the early days of Trump`s tenure. The travel bans had to be revised and reversed because of a lack of coordination between departments, and implementation difficulties.

There were no prepared, approved remarks for the president to give at the planned meeting, there was no diplomatic strategy for how to alert foreign trade partners, there was no legislative strategy in place for informing Congress and no agreed upon communications plan beyond an email cobbled together by Ross’s team at the Commerce Department late Wednesday that had not been approved by the White House.

No one at the State Department, the Treasury Department or the Defense Department had been told that a new policy was about to be announced or given an opportunity to weigh in in advance.

Secondly, the steel tariffs are not hitting their Chinese targets. The biggest exporter of steel to the United States is Canada, followed by Brazil, South Korea, and Mexico. China isn’t even in the top 10.

 

The presence of Canada and Mexico as sources of steel brings up the issue of NAFTA negotiations. As the chart below shows, the Republican leaning farm states would bear the brunt of the trade losses if NAFTA were to collapse. The political blowback to the Republican Party would be enormous. Count on a major loss in the midterm elections (see Relax! NAFTA isn’t going to collapse).

 

As the details of the tariffs are not fully written yet, one mitigating factor could see the trade protection measures become targeted tariffs instead of the much feared broad based ones. Exemptions for American allies and trading partners like Europe and NAFTA partners could be carved out. Moreover, what types and grades of steel and aluminum are included in the trade action? The tariff battle isn’t lost yet, and the possibility of damage containment hasn’t been discounted by the market.

Another encouraging sign is China’s muted reaction. CNBC reported that Chinese officials have urged restraint, and Bloomberg reported that Liu He, who is Xi Jinping`s top economic advisor, is still in fact finding mode. In other words, figure out who we should be talking to, what you want, and then tell us:

Liu said that he had three requests for the Trump administration: Establish a new economic dialogue, name a point person on China issues and hand over a specific list of demands, the person said. Liu pointed out that different U.S. administrations have wanted various things, the person said, with George W. Bush focused on monetary policy and Barack Obama emphasizing investment.

By contrast, the response from major allies has been far more belligerent. Bloomberg reported that Canada has vowed to retaliate, and the EU has unveiled 25% tariffs on $3.5 billion of American goods in a highly targeted retaliatory measure. Harley-Davidson is based in House Speaker Paul Ryan’s home state of Wisconsin. Bourbon whiskey is made in Senate Majority Leader Mitch McConnell’s home state. Levi Strauss is headquartered San Francisco, which is House Minority Leader’s Nancy Pelosi’s district.

 

The latest announcements on trade policy finally made the WSJ editorial team turn on Donald Trump:

Mr. Trump seems not to understand that steel-using industries in the U.S. employ some 6.5 million Americans, while steel makers employ about 140,000.

The political pressure from Republicans will be unrelenting in the next few days. Don’t be surprised if the White House either backtracks or waters down the effects of the tariffs.

Not enough panic

Back on Wall Street, there are insufficient signs of market panic, which could suggest that the selling is incomplete. When equity futures were deeply in the red in the pre-open Friday, I sent an email alerting subscribers to a possible Trifecta Bottom Spotting Model buy signal. When the market turned around and closed on Friday, the signal had evaporated like the morning mist. The term structure of the VIX, which had been inverted indicating a high level of fear, had eased. Moreover, the OBOS Model had neared an oversold signal, but readings turned up with the late day market rally.

 

The “buy the dip” crowd had won the day, but it is less clear if they had won the war. If this was the second bottom of a W-formation, it seemed a little too easy. The second leg of W-shaped pullbacks do not just occur because traders will it to happen, but because of some OMG-we-have-to-sell-everything event or news.

Many indicators are bothering me. The Fear and Greed Index may be setting up for a bearish negative divergence. Past instances of W-shaped bottoms had seen positive divergences in the index, but this index bottomed last week at 8, which equaled the low set in the initial sell-off, though the SPX had yet to test its February lows yet.

 

A comparison of the Fear and Greed Index and the RSI of the SPX tells a similar story. We probably haven’t seen the bottom yet.

 

The Citigroup US Economic Surprise Index (ESI), which measures whether high frequency economic data is beating or missing expectations, has experienced a series of Q1 negative seasonality. The downturn in ESI is showing up right on cue this year, which could lead to growth disappointments.

 

The deterioration in ESI is consistent with the signal from the cyclically sensitive copper/gold ratio, which has historically been correlated with the stock/bold ratio, which measures risk appetite.

 

Another cautionary signal comes from weekly report of insider activity from Barron`s. Even though this data series is noisy and volatile, the latest readings indicate that while insiders did buy the first dip, they are not showing a high degree of enthusiasm at current levels.

 

Then there’s the Fed. The Fed has not been standing idly during this period of market volatility. It has responded by altering its messaging. Ann Saphir of Reuters reported that the title of Fed governor Lael Brainard’s speech in the coming week has been changed from “Navigating Monetary Policy as Headwinds Shift to Tailwinds” to a more neutral “Economic and Monetary Policy Outlook”. This may be a subtle signal that the Fed is expressing its concerns about the offsetting effects of trade policy over the stimulative effects of tax cuts.

 

The bulls can call it a wall of worry, but I interpret these risks as a possible minefield that traders will have to traverse in the weeks ahead. For the last word, I refer readers to Jeff Hirsch of Trader’s Almanac, who found that the seasonal pattern in March tends to see choppiness early in the month, followed by a late month rally.

 

In a separate post, he found that March returns tend to be positive when January is up and February is down.

 

My inner investor remains constructive on stocks. Barring an unexpected recession or massive all-out trade war, equity prices should be able to strengthen to further highs in 2018.

My inner trader is braced for more choppiness. While he still has a small long position, he is getting ready to buy more should prices weaken and test the lows set in early February.

Disclosure: Long SPXL

The animal spirits are back, but which ones?

Posted by Cam Hui -

Mid-week market update: Just when the V-shaped bottom was becoming evident, something comes along and derails that train. The SPX decisively blasted through its 61.8% retracement resistance levels on Monday, but saw a bearish outside reversal day Tuesday, and the market continued to weaken.

 

After the panic bottom in February, it appears that the animal spirits have returned to the market, but which ones? As a reminder, animal spirits can be both good and bad.

Cautiously bullish

For now, my inner trader remains cautiously bullish, though he is open to the possibility of a minor pullback at these levels. From an intermediate term viewpoint, the “good” animal spirits are reviving. Risk appetite, as measured by junk bond performance, price momentum, and high beta vs. low volatility, remain in strong uptrends.

 

Moreover, TRIN ended the day above 2 yesterday (Tuesday). Readings above 2 tend to be indicative of panic price-insensitive selling, which is contrarian bullish.

 

The Fear and Greed Index remains in fear territory at 17. Should stock prices pull back, however, I would be watching for signs of positive divergence that have occurred at past W-shaped bottoms.

 

Moreover, breadth indicators from Index Indicators are flashed short-term overbought readings and have started to pull back, which is suggestive of some near=term downside, or at least some choppiness, ahead. (This chart was generated based on Tuesday night’s close and Index Indicators has not updated their charts as of publication time, and readings are likely to have deteriorated further as of Wednesday`s close).

 

Animal spirits = Rising volatility

The theme of rising volatility, or choppiness, is consistent with the past experiences of how the market behaves when volatility spikes after a period of calm. Overall volatility tends to be elevated in the post-spike period, and does not return to the subdued levels before the spike.

 

My inner trader is constructive on stocks, and he has a partial long position in the market. His base case scenario calls for some near-term choppiness. In the absence of major market events, he would be adding to his long position at current levels in the 2660-2730 range.

Disclosure: Long SPXL

What Xi’s ascendancy means for China’s growth

Posted by Cam Hui -

The announcement was not totally unexpected, according to the BBC, but it did come as a shock. China’s Communist Party announced the Central Committee proposed that the term of the President and Vice President may serve beyond their 10-year terms:

The Communist Party of China Central Committee proposed to remove the expression that the President and Vice-President of the People’s Republic of China “shall serve no more than two consecutive terms” from the country’s Constitution.

The announcement prompted both bullish and bearish reactions. China bulls warmed to the prospect of stability and predictability in the Chinese leadership and highlighted this chart. China is likely to continue on its steady growth path.

 

China bears pointed to the rising risks in the country’s growing debt load, which is already at nosebleed levels.

 

Virtually everyone on social media embraced this interpretation of Xi as the next emperor, or compared him to Mao Zedong.

 

How should investors react to this political development?

Lessons from Deng

Notwithstanding the objections over human rights violations and political repression in China, I refer readers to the opinion piece written by Bloomberg’s Tom Orlik soon after China’s 19th Party Congress. Orlik reminded us about how Deng Xiaopeng launched China on its vaunted growth path and what Xi Jinping could learn from Deng:

The first, from the early years of Deng’s leadership, is that the market is the surest path to growth. It wasn’t the government’s 10-year economic plan — with its grandiose aim to drive rapid development by importing whole industrial plants — that propelled China’s expansion. It was a grass-roots overhaul of the agricultural system that freed the industry and enterprise of hundreds of millions of farmers. For Xi, making good on commitments to give the market a “decisive role” in China’s economy will likewise be the key to sustaining growth.

A second lesson is that it’s OK to step back from unrealistic targets. The ambitions of the 10-year plan had to be scaled back when petroleum exploration failed to deliver the revenue necessary to pay for imported industrial plants…

Third, short-term costs are acceptable and inevitable…

Finally, leadership choices are critical.

In other words, trust market forces, downgrade the urge for central planning. Orlik gave the 19th Party Congress initiatives a mixed review:

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.

The most worrisome is the trend away from a reliance on market forces and towards central planning by giving more power to SOEs.

Policy lessons from the Anbang debacle

If the continuation of the Xi presidency represents continuity of current policies, the case of Anbang Insurance is troubling. This Bloomberg article summarized events well:

China’s government seized temporary control of Anbang Insurance Group Co. and will prosecute founder Wu Xiaohui for alleged fraud, cementing the downfall of a politically connected dealmaker whose aggressive global expansion came to symbolize the financial overreach of China’s debt-laden conglomerates.

The surprise move furthers President Xi Jinping’s anti-corruption and de-leveraging campaigns while providing a government backstop for the high-yield investment products that Anbang sold to hordes of Chinese citizens. It suggests that after months of clamping down on acquisitive tycoons, China is increasingly focused on insulating the economy from their shaky finances.

It’s a remarkable turn for Anbang, which burst onto the global scene in 2014 with the purchase of New York’s Waldorf Astoria hotel and only a year ago was in talks to invest in a company owned by the family of Jared Kushner, U.S. President Donald Trump’s son-in-law and senior adviser. With 2 trillion yuan ($315 billion) of assets, Anbang represents China’s largest-ever takeover of a privately owned company.

 

In truth, Anbang was a bank masquerading as an insurance company. Though most of its savings products were in theory long-term, they could be redeemed within months of investing. Moreover, its operations were burdened with negative cash flows, which had to be financed by the banking system. Combine those finances with a wild overseas buying spree, something had to give. This Christopher Balding tweet illustrates the insane pace of Anbang’s growth path.

 

Instead of allowing market forces to be ascendant with the use of well known banking resolution solutions by splitting the company into a “good bank” and “bad bank”, the Beijing authorities resolved this problem with a bailout.

In a bailout, who pays? China bulls may answer that the government has deep pockets and can afford it. If the same events happened in America, or any Western industrialized country, would the same bulls tell the same story? In America, it would be the taxpayers who pay for the bailout. In China, it is the household sector.

Goodbye Rebalancing, Hello Middle Income Trap

To be sure, the PBoC has many ways to cushion a financial crisis, as reserve ratios remain well above GFC levels. China has the levers to avoid a catastrophic economic collapse. However, taking such steps would mean abandoning the policy of rebalancing growth towards the consumer and household sectors.

 

If that is the Xi Administration’s preferred policy, China can say goodbye to rebalancing, and hello to the Middle Income Trap, or Lewis turning point. I had written about the challenges that China faced with its Middle Income Trap in 2014 (see China’s inequality and growth imperative).

For those who don’t understand what a “middle-income trap” is. It is also known a a Lewis turning point when it runs out of cheap labor and growth becomes constrained because it can’t move up the value-added ladder.

I had also referred to a paper by Akio Egawa that warned about these risks facing China:

A sensitivity analysis for three Asian upper-middle-income countries(China, Malaysia and Thailand) also shows that the situation related to a middle-income trap is worse than average in China and Malaysia. These two countries, according to the result of the sensitivity analysis, should urgently improve access to secondary education and should implement income redistribution measures to develop high-tech industries, before their demographic dividends expire. Income redistribution includes the narrowing of rural urban income disparities, benefits to low-income individuals, direct income transfers, vouchers or free provision of education and health-care, and so on, but none of these are simple to implement.

In conclusion, Xi’s ascendancy to permanent leader is unlikely to have short term effects on China’s growth path. In the long run, the direction shown by his Administration suggests that China’s growth path will start stalling in the years to come.

No, Mr. Bond, I expect you to die

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Focusing on the wrong bond?

“No, Mr. Bond, I expect you to die!”

That was the classic line from the film Goldfinger, which is aptly named considering today’s conditions. The market is concerned about rising inflation expectations, which is bullish for inflation hedge vehicles like gold, and bearish for bond prices (click on this link for video if the clip is not visible).
 

 

Just as James Bond escaped the perils he faced in many films, bonds may be able to escape their perceived risks. That’s because the market may be focused on the wrong bond. The top panel of the following chart shows the yield 10-year Treasury note, which has violated a trend line that stretches back to 1990, and the yield of the 30-year Treasury, which has not.
 

 

As market anxiety over inflation has picked up, the spotlight has turned to the 10-year yield. As experienced market analysts know, excess focus on a benchmark could lead to the invalidation of that benchmark.
 

Fiscal overheating anxiety

As inflation expectations have begun to heat up, the latest worry du jour is the prospect of fiscal overheating. Goldman Sachs put out a research note warning that the latest round of tax cuts represented “uncharted territory”:

Federal fiscal policy is entering uncharted territory…

The Treasury continues to borrow at low rates and it should be able to do so for a while even if market rates move higher in our view, thanks to a nearly 6-year average maturity of outstanding debt. … In the past, as the economy strengthens and the debt burden increases, Congress has responded by raising taxes and cutting spending. This time around, the opposite has occurred. …

The Goldman team warned that while GDP growth is likely to experience a fiscal boost of 0.7% in 2018 and 0.6% in 2019, the effects are temporary and the economy will have the pay the piper later.

The fiscal expansion should boost growth by around 0.7pp in 2018 and 0.6pp in 2019, but will likely come to an end after that … the growth effect comes from the change in the deficit … some of the recent deficit expansion relates to changes unlikely to be repeated, such as the temporarily large effect of certain tax provisions.

Edward Harrison of Credit Writedowns fretted about how such a pro-cyclical fiscal policy could affect monetary policy and the business cycle:

With Jerome Powell, a new Federal Reserve Chairman at the helm, there is a lot of uncertainty. If the Fed reacts with the same caution it has so far, long-term interest rates will remain low. And that could allow for continued growth in the economy and in corporate earnings, which ultimately helps stocks too. But since pro-cyclical policy amplifies the business cycle, it could cause overheating. if inflation rises or the Fed becomes more aggressive, the Trump Administration’s stimulus could boomerang. That would mean an initial bump in growth is followed by a steep fall. And the pain would spread beyond asset markets, to the real economy too.

Fed watcher Tim Duy had a more nuanced take that leaned slightly hawkish:

There are many, many moving pieces as the economy moves deeper into the economic cycle. It is a complex environment made only more so by the fiscal stimulus barreling down on the economy. My general takeaways: 1.) The data flow is generally supportive of the Fed’s forecast, 2.) the risk is that the Fed moves at a faster than anticipated rate of hikes 3.) that said, the Fed will not overreact to any one data point 4.) the Fed will adjust policy as necessary to maintain the inflation target over the medium run, 5.) the current policy operating environment of low and anchored inflation expectations leaves open the possibility that the Fed does not need to choke off fiscal stimulus even if it threatens to overheat the economy, 6.) fiscal stimulus does not increase the risk of recession in 2019 as much as in subsequent years if it is revealed that the Fed fell behind the inflation curve, 7.) fiscal stimulus though makes the Fed’s 2019 and 2020 rate forecast more likely.

 

A crowded bond short

In response to increasing anxiety, the market moved to a crowded short position in bonds. The January 2018 BAML Fund Manager Survey shows that institutional managers bond weights are at historically low levels.
 

 

The latest update of the Commitment of Traders report from Hedgopia shows that large speculators, or hedge funds, are in a crowded short in the 10-year Treasury note.
 

 

Up until recently, the record short in the 10-year had been offset by a neutral reading in the long Treasury bond, which was a hint that the market was positioned for a flattening of the 30-10 spread. But the latest readings show that large speculators are also near a crowded short position in the T-Bond contract too, and the flattening bets got unwound.
 

 

Hedgopia warned that negative sentiment was getting a little too stretched to the bearish side:

In less than six months, rates have also backed up quite a bit. The 10-year (2.87 percent) yielded 2.03 percent early September last year. In a leveraged economy, this in and of itself should help slow down economic activity. Plus, growth in M2 money supply is decelerating drastically.

It is hard to imagine the long end continuing on the current trajectory. At least a pause – if not an outright reversal – is probable. In fact, many fixed-income managers may find three percent – or thereabouts – on the 10-year an attractive level to go long bonds.

Near term, an equally important level to watch is 2.62 percent, which the 10-year broke out of in January. This also represents the neckline of a reverse-head-and-shoulders pattern. This is where a bull-bear duel likely gets fought.

 

Washed out Sentiment = Poised for a bond rally

Bloomberg also reported that JPM’s derivative quant Marko Kolanovic believes that these record short positions are setting up the market for a bond rally:

Short positioning in Treasury futures has climbed to a record, increasing the potential for an unraveling of trades betting on further declines in bond prices, Marko Kolanovic wrote in a note to clients. There’s also been an extreme swing in sentiment, with investors unduly focusing on higher inflation risks, said Kolanovic, who heads the team in New York.

“When there is such a large short position, there is always risk of profit taking, or worse, a proper short squeeze,” he wrote. “We also note extreme sentiment swings and the media playing into fears of inflation, while largely ignoring important points such as those most recently voiced by the Fed’s Harker and Bullard,” he said, referring to Federal Reserve district bank presidents Patrick Harker and James Bullard.

In the short run, the market may be setting up for a dovish surprise. Newly appointed Fed governor Randall Quarles recently gave a speech giving qualified support to the latest round of fiscal boost:

The tax and fiscal packages passed in recent months could help sustain the economy’s momentum in part by increasing demand, and also possibly by boosting the potential capacity of the economy by encouraging investment and supporting labor force participation…

Regardless, given the importance of productivity growth for the long-run potential of the economy and living standards, it is vitally important that policymakers pursue policies aimed at boosting the growth rate of productivity.

Despite his perceived hawkish leanings, Quarles was not willing to tilt monetary policy in a more aggressive manner. For now, he appeared to be content to stay with a “run a hot economy” policy in hopes of seeing productivity gains:

Against this economic backdrop, with a strong labor market and likely only temporary softness in inflation, I view it as appropriate that monetary policy should continue to be gradually normalized.

We are likely to get further clarify when Fed Chair Powell testifies before Congress next week.
 

What rising inflation expectations?

From the market’s perspective, there are a number of anomalous readings on inflation expectations. Sure, the 5-year breakeven rates have been rising steadily, which is reflective of the bond market’s expectations of rising inflation.
 

 

The message from the stock market is totally different. If inflation expectations are rising, then we would expect that the hard asset sectors, which perform well as inflation hedges, to be performing well. As the chart below shows, gold and energy stocks are not performing well relative to the market.
 

 

Another offbeat indicator of hard asset returns is the relative performance of Sothebys Holdings (BID), which benefits from rising demand and prices of collectibles in an inflationary era. Sadly, the relative performance chart of BID is setting up to form a head and shoulder formation. If the neckline were to break, it would be a bearish signal for the relative performance of this stock.
 

 

In short, the message from the stock market is, “What rising inflation expectations?”
 

Technical conditions supportive of bonds

Bond prices are also setting up for a possible rally from a technical perspective. The chart below of the 7-10 year Treasury ETF (IEF) is flashing a clear positive divergence on RSI-5, and a less clear signal on RSI-14.
 

 

The positive divergence is more visible in this chart of the long Treasury bond ETF (TLT). The difference between IEF and TLT could be chalked up to an excessive market focus on the 10-year Treasury note yield, which violated the downtrend line from 1990, compared to the long bond yield, whose long-term downtrend remains intact.
 

 

Stock market implications

As bond prices have historically been inversely correlated to stock prices, a bond price rally would imply some near term stock market weakness. This is consistent with the analysis by Jeff Hirsch of Almanac Trader, who found that the end of February tends to be seasonally weak for stocks.
 

 

Last week’s market pattern was disappointing for the bulls. The window for a Zweig Breadth Thrust expired on Friday without a buy signal. The ZBT Indicator did not achieve a 61.5% reading within the 10 day time frame.
 

 

Moreover, the daily pattern of strong opens and weak closes also indicated that the bulls were unable to take control of the tape. The charts below of the major US indices gives us an indication of the strength and breadth of the rally. The SPX did manage to stage a rally Friday that regained its 50 day moving average, and tested a 61.8% Fibonacci retracement resistance level on weak and unconvincing volume. The DJIA and midcap stocks have not shown sufficient strength to test the Fibonacci resistance level, though the small caps have. The market rally is being led by NASDAQ stocks, which has powered above all retracement levels.
 

 

This chart leads to a glass half full-half empty interpretation. The half full bullish view is the rebound leaders are the high beta and momentum stocks, which is indicative of a renewal of risk appetite. The half empty bearish view is the combination of narrow leadership and middling breadth is not the foundation of a sustainable rally.
 

 

My base case scenario calls for more near term choppiness and consolidation, though I would become more bullish should the market show more strength early in the week. Despite my near term caution, I remain intermediate term bullish. Fundamental momentum remains intact. The latest update from FactSet shows that the one-time tax cut related surge in forward EPS estimates have largely petered out, but organic cyclical revisions remain healthy.
 

 

In addition, initial jobless claims (blue line) has shown a close inverse and coincident correlation to stock prices (red line). Initial claims continue to improve and show no signs of weakness, which is equity bullish.
 

 

The latest update of COT data for the high beta NASDAQ 100 shows that large speculators are in a crowded short position, which is intermediate term bullish. However, COT data is an inexact market timing indicator. In the past, the market had made double dip bottoms after extreme bearish readings was observed.
 

 

My inner investor is constructive on the market, and the risk profile of his portfolio is at the neutral position between stock and bonds, as mandated by the target asset mix specified by his investment policy. My inner trader has a small long position. He is prepared to either buy the dip, or the breakout.
 

Disclosure: Long SPXL

Opportunity from Brexit turmoil

Posted by Cam Hui -

There has been much hand wringing over the Brexit process. Deutsche Welle reported that Angela Merkel stated that Brexit would leave a very challenging €12 billion hole in the 2021-27 EU budget. Across the English Channel, Politico reported that Brexit Secretary David Davis assured businesses that “the UK will not become a ‘Mad Max-style world borrowed from dystopian fiction’ after it leaves the EU”.

The U.K. will not undercut EU businesses on workers’ rights and environmental protections, David Davis will pledge on Tuesday.

Speaking to an audience of business leaders in Vienna, the U.K. Brexit secretary will insist that Brexit will not “lead to an Anglo-Saxon race to the bottom,” committing the country to “meeting high standards after we leave the EU.” But he will call for a post-Brexit trade deal in which British regulations are recognized by Brussels as comparable to its own.

 

 

Now we find out that the UK has proposed to stretch out the end of the Brexit transit period from December 2020 to *ahem* as long as it takes (see proposal here).

In other words, we have the usual European chaos and the latest act of European Theatre. But in chaos, there may be investment opportunity.
 

Capitulation

As a result of the uncertainties surrounding Brexit, investors have utterly given up on UK equities. The latest BAML Fund Manager Survey shows that UK equity allocations have bottomed out at historically minimum levels.
 

 

The relative performance of UK equities relative to MSCI World has also been in a steady downtrend (all figures are in USD). However, there is a ray of hope, as relative performance is testing a relative support level and may have bottomed.
 

 

This is looking like a washout to me.
 

The bullish catalyst

Enter a possible bullish catalyst. Business Insider reported that Pantheon Macroeconomics analyst Samuel Tombs, who was alone in calling the June 2017 general election, thinks there is a 40% chances of a second Brexit referendum, and therefore a 25% chance that Brexit doesn’t happen.

Tombs’ assumption is that macroeconomic conditions drive politics in Britain. His successful 2017 election prediction was based on the correlation between consumer confidence (which was falling before the vote) and whether a sitting government gains or loses seats in a general election.

Since then, he has argued repeatedly that no government can withstand the economic pain of leaving the EU with a bad deal (or a “hard Brexit”), and thus politicians will cave and either choose a soft Brexit or weasel out of leaving the EU entirely.

Tombs concluded that:

“It is becoming increasingly clear, however, that none of the forms of Brexit that the EU is willing to tolerate can command enough support from her own party’s MPs, or would please enough of the population for the current government to stand a realistic chance of winning the next election. Mrs. May might find that the only way to break the log-jam and save her premiership is to consult the country again,” Tombs says.

“Accordingly, a second referendum will become an appealing option for Mrs. May towards the end of this year or in early 2019. It would have to be held once she has negotiated a deal with the EU, with the options presented to the public being accepting the deal or staying inside the EU. She could claim that the first referendum was held when the public didn’t have the full facts, and she could argue that the decision was so momentous that the public should be allowed to voice their opinion again. It’s not guaranteed that parliament would vote for a second referendum-at present, Labour does not advocate one-but it would be hard for MPs to claim that the public should be prevented from having another say.”

Mind you, it’s only at 25% chance of a Brexit reversal, but a 40% chance of a second referendum which would spark a risk-on stampede. Tombs likely timing of such a development is late 2018 or early 2019, but the tea leaves would be apparent before the announcement.

From a chartist’s viewpoint, the technical conditions of lagging UK equity relative performance is starting to show a bottom. UK equities need time to start building a base before a period of relative performance can be sustained.

Be prepared.

A pause at 61.8%

Posted by Cam Hui -

Mid-week market update: After much indecision, the SPX paused at its 61.8% Fibonacci retracement level.
 

 

The 50 day moving average (dma) which could have acted as support did not hold. I had also previously identified a possible Zweig Breadth Thrust buy signal setup. Unless the market really surges in the next two days, the ZBT buy signal is highly unlikely to be triggered.
 

 

This market looks like it is setting up to form a W-shaped bottom.
 

Short-term headwinds

Rob Hanna at Quantifiable Edges identified two short-term headwinds for US equity prices. First, he pointed out that the week after a option expiry (OpEx) week where prices rose strongly tended to see price reversion.
 

 

In a separate post, Hanna observed that last Wednesday`s market surge was an IBD follow-through day, but on weak volume. Such episodes have tended to resolve themselves bearishly in the short run.
 

 

Despite these short-term hurdles, I wouldn’t get overly bearish just yet.
 

Buy the dip

There are plenty of reasons to be intermediate term bullish. Mark Hulbert reported that market timers have turned extremely bearish in a short period, which is a contrarian bullish:

Consider the average recommended equity exposure level among a group of short-term stock market timers I monitor who focus on the Nasdaq market (as measured by the Hulbert Nasdaq Newsletter Sentiment Index, or HNNSI). When I last wrote about this average, three weeks ago, it had just dropped 46 percentage points in only one week’s time, to 42.9%. That was enough of a drop to convince contrarians that the bull market was yet alive.

Believe it or not, the HNNSI today is even more negative, at minus 21.9%. That’s more than 64 percentage points lower than it was then, despite the market’s rally since its Feb. 8 lows. So contrarians are even more upbeat today than they were at the beginning of February.

 

The Commitment of Traders report also tells a similar story. The Hedgopia analysis of COT data shows that large speculators, or hedge funds, have moved to a crowded short position in the high beta NASDAQ 100, which is another contrarian bullish sign.
 

 

The market rally off the bottom has been led by high beta momentum stocks that are overweighted in the NASDAQ 100. Risk appetite is alive, and how long before hedge funds capitulate and engage in a short covering rally?
 

 

In conclusion, my inner trader is wary about being overly bearish in order to catch a few percentage points on the downside. The risk/reward is not favorable, and shorts could get their faces ripped off by a rally at any time.

That said, my inner trader did take some partial profits on his long positions late last week, and he is waiting for a dip to buy back in. Rather than specify specify support levels, I would prefer to watch for signs of positive RSI and breadth divergences as buy signals.
 

 

The market action in the next few weeks is likely to be choppy and treacherous. Traders should therefore scale their bets in accordance with the higher volatility environment – and be careful out there.

Disclosure: Long SPXL

Powell Fed: Market wildcard

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A change of the guard at the Fed

Is the bond market telling us that it’s all over? Stock prices got spooked when the 10-year Treasury yield approached the 3% mark, which was the “line in the sand” drawn by a number of analysts that indicated trouble for equity prices. As the following chart shows, the 10-year yield had violated a trend line that stretched back from 1990. One puzzle is the mixed message shown by the yield curve. Historically, both the 2-10 yield curve, which represents the spread between the 10 and 2 year Treasury yields, and the 10-30 yield curve both inverted at the same time on the last three occasions to warn of looming recessions. This time, the 2-10 yield curve has been volatile and steepened recently, which the 10-30 yield curve stayed on its flattening trend.
 

 

What’s going on? We can get better answers once we have greater clarity on the future direction of the Powell Fed.

  • How will the Powell Fed’s reaction function to inflation differ from the Yellen Fed? The risks of a policy mistake are high during the current late cycle expansion phase of the economy. Adhere to overly strict rules-based models of monetary policy, and the Fed risks tightening too much or too quickly and send the economy into a tailspin. Allow the economy to run a little hot with based on the belief of a symmetrical 2% inflation target, inflation could get out of hand. The Fed would consequently have to step in with a series of staccato rate hikes that guarantee a recession. 
  • What about the third unspoken mandate of financial stability? Will there be a “Powell put” that rescues the stock market should it run into trouble?

Those are all good questions to which no one has any good answers. No wonder the yield curve is sending out confusing messages.

Many opinions, no real answers

There are many opinions, though. Fed watcher Tim Duy believes that the Powell Fed is unlikely to give the market a put, at least in the short-run. Instead, it is more likely to focus on the long-term outlook implications of monetary policy:

I suspect the challenge for the Fed will be to keep market participants focused on their medium-term forecast. If, as many believe, wage growth and inflation make an appearance this year, the Fed will have the opposite problem from 2017. Then they struggled to keep the focus on gradual rate hikes despite disappointing data. In retrospect, I think the dovish policymakers did us few favors last year, tamping down rate hike expectations that then were quickly reversed in recent weeks.

In 2018, we should be cautious of the opposite, of rising rate hike expectations (to four and beyond). To be sure, this is the risk to the forecast. But policymakers will likely send a message that they will not overreact to higher inflation just as they did not overreact to lower inflation in 2017. I don’t think anyone could be faulted for believing that two percent is a ceiling, not a target. This would be the opportunity for the Fed to disabuse us of that notion and prove that the inflation target is symmetric. I suspect this message would be well received by market participants fearful that the Fed is going to accelerate rate hikes at the slightest provocation.

Gillian Tett of the Financial Times is also skeptical of the existence of a Powell put. She believes that the Fed is likely to be more hawkish than market expectations:

These days, with a new governor — Jay Powell — in charge, nobody knows exactly where policy will head next. But Mr Powell does not seem a natural dove: he has previously said that he is concerned that loose monetary policy has created bubbles in fixed income, and last year stressed that it is “not the Fed’s job to stop people from losing money”.

His colleagues do not seem dovish right now either. This week Bill Dudley, head of the New York Fed, dismissed the equity market falls as “small potatoes”.

It is also important to note that the staff of the mighty Fed — who appear to be rising in power now, since Mr Powell is not an economist — are determined to keep the institution immune from political pressure. Every time President Donald Trump tweets about the stock market, this determination rises.

This means that it will be hard for the Fed to sit on its hands if inflation keeps rising — even if equity markets tumble. Or to put it another way, in the past the Fed might have tolerated the idea that there was a “put”, since price pressures were weak. Now, the Fed put is withering away, or has been reset at a much lower level…

The key point is that 10 years after the Great Financial Shock, a regime change is now under way, in terms of the intellectual framework of the Fed. It would be a mistake to presume that Mr Powell will ride to the rescue if share prices do slide. Even (or especially) in an era when Mr Trump has made stock prices a bellwether of his success.

For some perspective, financial conditions are still loose despite the recent market hiccup. There is little necessity for a Powell put, at least for now.
 

 

Still, everyone is speculating and making informed guesses about the likely path of Fed policy. No one knows very much. This level of uncertainty is raising risk levels for the markets.

The Yellen Fed baseline

However, we are not completely in the dark about Fed policy. We have a reasonably good idea how the Yellen Fed would react to current conditions. From that baseline, we can project likely policy based on assumptions about whether the Powell Fed would be more hawkish or dovish than the Yellen Fed.

Today, there are signs of looming inflationary pressures. Consider, for example, the CPI print that spooked the market. Even though January’s core CPI rose 0.3%, which was ahead of market expectations of 0.2%, the WSJ pointed that actual core CPI rose 0.349%. Had it increased by as little as 0.001% and core CPI would have rounded up to 0.5%, which would have spooked the markets even more. In addition, headline CPI was up 0.5448%, another 0.0012%, it would have rounded up to 0.6%.

Other inflation metrics are indicative of rising inflation pressures. The New York Fed’s Underlying Inflation Gauge came in at 3.0%, which is significantly ahead of the Fed’s 2% inflation target.
 

 

The Philly Fed’s prices paid diffusion index has been a rough leading indicator of core inflation pressures. The Empire State has a similar prices paid index, which correlates highly with the Philly Fed index but it is not shown because it has a much shorter history.
 

 

What about the closely watched wage inflation, which is part of the Phillips Curve and a key component of Fed policy? Deutsche Bank pointed out that the small business plans to raise worker compensation leads the Employment Cost Index by about nine months. As the chart below shows, this leading indicator is pointing to rising wage pressure.
 

 

These conditions suggest that the Yellen Fed’s dot-plot projection of three rate hikes would represent a floor on the number of hikes in 2018.

Likely policy changes

What’s more, those projections are based on the actions of the Yellen Fed’s 2017 FOMC. The evolution of the votes of the regional Fed presidents in the 2018 FOMC makes it more hawkish than the 2017 FOMC. In 2018, the votes of dovish regional presidents such as Evans and Kashkari have been replaced by uber-hawk Mester, and Williams, who is centrist but tilts slightly hawkish.

For further clues as to the evolution in monetary policy, I would watch two developments, the fate of Fed governor nominee Marvin Goodfriend, and who the Trump White House nominates to fill the position of vice chair.

I wrote extensively about Marvin Goodfriend (see A Fed preview: What happens in 2018?). Gavyn Davies had endorsed Goodfriend’s nomination for Fed governor and characterized him as a rules-based monetarist in the Republican mold:

  • 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’s confirmation as Fed governor is not a done deal. He squeaked past the Senate confirmation committee by one vote as the committee voted along party lines, with Republicans in support and Democrats against. The next hurdle is the confirmation vote by the full Senate, where the Republicans hold a narrow 51-49 majority. Already, Republican senator Ron Paul has voiced his opposition to Goodfriend’s confirmation. If Goodfriend is confirmed as a Fed governor, expect FOMC policy to tilt in a more hawkish fashion.

The other development to watch is the identity of the Fed vice chair, which is vacant since the resignation of Stanley Fischer. Various names have been floated for the position, and the latest is Cleveland Fed president Loretta Mester. Mester’s history indicates that she would also steer Fed policy in a more hawkish direction. Other leading candidates include John Taylor, who would be dogmatic and hawkish, and Mohamed El-Erian, who is centrist and pleasing to the market.

In short, while there is much we don’t know about the likely path of monetary policy, we do know that the latest Fed chair is not an economist, and he would lean on the advice of other major figures in the FOMC. There are two most likely paths for FOMC policy direction, neutral or hawkish.

At a minimum, expect three rate hikes this year. Five would not be out of the question. In the past, real money supply growth, as measured by either M1 or M2, has turned negative in advance of recessions. M2 growth (red line) is already decelerating rapidly, while CPI has a stable to upward bias. How much more inflation and monetary tightening before real M2 growth turns negative?
 

 

Bullish short-term

For the time being, the short term stock market outlook remains bullish. The latest FactSet update of earning expectations is positive. Forward 12-month EPS continues to rise, which is reflective of positive fundamental momentum.
 

 

That said, bottom-up EPS upward revisions are starting to slow from their former torrid pace, as company analysts have largely factored in the positive effects of the tax cuts. 2018 EPS estimates are up 6.8% since the passage of the tax bill, which is roughly in line with top-down projections of a 6-9% earnings boost.
 

 

Q4 earnings results have been nothing short of spectacular. Both EPS and sales beat rates are well ahead of expectations, and a record number of companies are issuing positive guidance for 2018.
 

 

The latest update of insider activity from Barron’s is flashing a buy signal. However, these readings have tended to be noisy and therefore should be treated with some caution.
 

 

In addition, the sentiment backdrop is intermediate term bullish. The following chart measures how far the number of standard deviations the NAAIM Exposure Index deviates from its 20-week average (blue line). Historically, readings below -2 are contrarian bullish and have marked short-term market bottoms.
 

 

There is, however, one dark cloud on the horizon. The Commerce Department “found that the quantities and circumstances of steel and aluminum imports threaten to impair the national security” and recommended a series of tariffs or quotas on steel and aluminum. Commerce Secretary Wilbur Ross gave President Trump three options on steel:

  1. A global tariff of at least 24% on all steel imports from all countries, or
  2. A tariff of at least 53% on all steel imports from 12 countries (Brazil, China, Costa Rica, Egypt, India, Malaysia, Republic of Korea, Russia, South Africa, Thailand, Turkey and Vietnam) with a quota by product on steel imports from all other countries equal to 100% of their 2017 exports to the United States, or
  3. A quota on all steel products from all countries equal to 63% of each country’s 2017 exports to the United States.

And three options on aluminum:

  1. A tariff of at least 7.7% on all aluminum exports from all countries, or
  2. A tariff of 23.6% on all products from China, Hong Kong, Russia, Venezuela and Vietnam. All the other countries would be subject to quotas equal to 100% of their 2017 exports to the United States, or
  3. A quota on all imports from all countries equal to a maximum of 86.7% of their 2017 exports to the United States.

The market largely shrugged off the news of the Commerce findings on steel and aluminum, which hit the tape at noon on Friday. Notwithstanding any fears over a possible trade war, the combination of short-term positive fundamental momentum, washed out intermediate term sentiment, and probable rising hawkishness from the Fed paints a scenario of a short-term equity market rally, followed by heightened downside risk later this year.

The week ahead

Looking to the week ahead, the risk/reward of the short-term trading outlook is turning more cautious. The SPX has rebounded very rapidly in a short period, and it may be showing signs of stalling at its 61.8% Fibonacci retracement level. Moreover, the market ended on Friday with a gravestone doji, a bearish reversal formation.
 

 

Measures of risk appetite are showing some early signs of weakness. The relative performance of price momentum (middle panel) and the relative returns of high beta vs. low volatility are rolling over. The one positive sign is the continued confirmation of the equity recovery by the relative price performance of junk bonds against duration equivalent Treasuries, despite the news of mass redemptions out of investment grade and high yield ETFs.
 

 

The current momentum surge isn’t totally unprecedented, but past rallies that have exhibited such power have marked the end of bear markets or corrections. While the market has gone on to new highs on an intermediate term basis, the historical record suggests that a pause is in order (via OddStats).
 

 

Still, I haven’t totally given up on the idea that the market may form a V-shaped bottom. I identified a possible Zweig Breadth Thrust buy signal setup (see How the market could fool us again). The clock is ticking, and the market has until February 22 to complete the momentum thrust.
 

 

My inner investor remains constructive on equities. My inner trader took some partial profits on his long positions late last week, but he remains long the  market. He will add to his position should the market weaken and test the lows while flashing positive breadth divergences, or if market surges and the ZBT flashes a buy signal.

Disclosure: Long SPXL

How the market could fool us again

Posted by Cam Hui -

Mid-week market update: I can tell that a stock market downdraft is a correction and not the start of a major bear market when the doomsters crawl out of the woodwork after the market has fallen (see Is the ‘short volatility’ blowup Bear Stearns or Lehman Brothers?) and analysis from SentimenTrader shows that their smart and dumb money sentiment indicators are at an extreme. As a frame of reference, SentimenTrader defines each term in the following way:

The dumb money indicators are typically made up of retail traders and trend-followers. This is NOT to say that all (or even most) retail mom-and-pop investors, and certainly not most trend-followers, are “dumb”. In fact, they are by definition correct during the bulk of a trend.

The smart money indicators are mostly made up of institutional accounts. These traders are often hedging day-to-day moves in the market, and therefore are often trading against the prevailing trend. Again, it is only when these traders move to an extreme that a market is most likely to reverse in their direction.

 

Sure, this could be the start of a bear market, but bear markets usually begin with technical deterioration, which are not present today.

A V or W shaped bottom?

Yesterday, the S&P 500 tested the first Fibonacci retracement level and powered through it today, despite the hotter than expected CPI print. The index is now approaching its 50% retracement level.
 

 

What’s next? Is it time for the stock market to take a breather? Is this correction a V or W shaped bottom? Urban Carmel, writing at The Fat Pitch, explained the difference between the two formations this way:

Corrections during bull markets have had a strong propensity to form a double bottom. Since 1980, only 16% of corrections have had a “V bounce” where the low was never revisited.

The current bull market has been different. Since 2009, about half of the corrections have had a “V bounce.” So what happens this time?

Sentiment can be reset through both time and price. It’s a good guess that if price recovers quickly, sentiment will again become very bullish, making a retest of the recent low probable. A slower, choppier recovery will keep investors skeptical, increasing the odds that the index continues higher.

He concluded that the odds of a V bounce amounts to a “coin toss”.

I am on record that current conditions are reminiscent of the W-shaped corrective bottom of 2015 (see Risk on, or risk off?). Stock prices fell suddenly in August 2015 and my Trifecta Bottom Spotting Signal flashed a buy signal, and the market proceeded to bounce and trade in a choppy manner for about a month before staging a sustainable rally.
 

 

Watching for the Zweig Breadth Thrust

Here is what’s bothering me. The consensus among technicians is the market is in process of forming a complex W-shaped bottom. If that`s the consensus, could we all get fooled and see a V-shaped rebound?

I am open to the possibility of the V formation, but the hurdles for such a market surge are not easy. We would need to see a Zweig Breadth Thrust. As of Friday, February 9, 2018, the market was setting up for a possible Zweig Breadth Thrust (ZBT) buy signal.

To explain, the Zweig Breadth Thrust is a variation of an IBD follow-through day pattern, but on steroids. Steven Achelis at Metastock explained the indicator this way:

A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

The Breadth Thrust is a rare but powerful bull signal that presages significant gains ahead for the stock market, should its conditions be satisfied. Day 1 was Friday, February 9. Here is the chart so far and the Breadth Thrust Indicator has 10 trading days to accomplish its task of reaching over 61.5%. The second panel in the chart below depicts the ZBT Indicator, as calculated by Stockcharts. As the Stockcharts signal update is often delayed, the middle panel depicts our own estimate of the ZBT Indicator. As the composition of the NYSE Composite is significantly different than the S&P 500, I constructed my own ZBT Indicator based on the SPX components in the bottom panel.
 

 

Readers who would like to follow along at home in real-time can use this link.

The market has until February 22 to achieve a ZBT buy signal. The clock is ticking.

Disclosure: Long SPXL

Did risk-parity funds crash the bond market?

Posted by Cam Hui -

When the markets crash unexpectedly, everyone is on the lookup for culprits. One of the leading theories behind the latest downdraft in stock prices is the rise in bond yields, which spooked the stock market. Derivative analysts have pointed the finger at Risk-Parity funds as the leading actors in the bond market rout. They contend that the combination of leverage use in these funds and forced selling because of changes in market environment have exacerbated the rise in bond yields.

I considered the effects of Risk-Parity funds on the bond market. Using three different analytical techniques, we concluded that Risk-Parity strategies did not exacerbate the downturn in bond prices (picture via Cliff Asness).
 

 

The evolution of risk-parity fund exposures

I considered the question of how the bond market exposure of Risk-Parity funds are evolving. As global bond prices have sagged, one of the questions for investor is the potential for a disorderly unwind of bond holdings in leveraged Risk-Parity portfolios.

I am skeptical that Risk-Parity strategies have significant near-term potential to tank the bond market for three reasons:

  • Interest rate sensitivity of Risk-Parity portfolios is less than popularly thought.
  • While virtually all asset classes declined in the latest risk-off episode, bonds outperformed equities.
  • My sensitivity analysis of the AQR Risk-Parity Fund as a proxy for the strategy reveals that bond market beta was flat to up during the latest risk-off episode.

Risk parity bond sensitivity less than popularly thought

For some understanding of Risk-Parity strategies sensitivity to the bond market, consider this 2015 post by Matthew C. Klein in FT Alphaville, who worked at Bridgewater researching the benefits of the Bridgewater All-Weather Fund, which is the firm’s Risk-Parity offering:

The most common — and least sophisticated — criticism of “risk parity” is that it’s just a levered bet on bonds.
This bet supposedly looks smart in retrospect only because bonds have done very well since the early 1980s as nominal interest rates collapsed. However, the argument goes, that kind of performance can’t happen again unless rates keep falling far below zero. Some people go further and argue that interest rates are bound to rise from today’s levels (we think we’ve heard that one before), which will hit “risk parity” investors on the asset side at the same as borrowing costs hit the funding side of the strategy.

First of all, “risk parity” isn’t about levering up bonds. Rather, it’s about constructing the best possible risk/reward tradeoff you can at the portfolio level and then levering that. In our experience, the bonds were bought outright, some of the most liquid ones were used as collateral to borrow in the repo markets, and the exposure to equities and commodities was bought with futures. There was generally some cash left over that could be used to cover margins and redemptions. The idea was to minimise trading costs while preserving liquidity.

We struggle to imagine how this arrangement could ever lead to forced sales. Recall that the biggest players managed to endure the collapse of the repo markets in 2007-8 with aplomb.

While the investment process for every Risk-Parity strategy is different, also consider this 2013 Bloomberg article, Dalio Patched All Weather’s Rate Risk as U.S. Bonds Fell:

As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.

Westport-based Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the firm had sold off $37 billion of All Weather’s most rate-sensitive assets, Treasuries and inflation-linked bonds, according to fund documents and data provided by investors.

Bonds outperformed in the latest risk-off episode

Another reason why I am skeptical that a forced liquidation of bonds by Risk-Parity strategies sparked the latest sell-off.

The conventional explanation of the sell-off was the market was spooked by the strong Average Hourly Earnings (AHE) print in the January Employment Report. Strong wage gains puts greater pressure on the Federal Reserve to act and raise interest rates. Bond yields spiked, which spooked the stock market.

That explanation would be satisfying except for a few details. First, while headline AHE was strong, AHE for the working stiffs (production and non-supervisory employees) was rather tame. Therefore, the increase in AHE could be attributable to bonuses and other incentives paid to managers.
 

 

Second, the stock market was already weak before the Non-Farm Payroll (NFP) report. Moreover, interest-sensitive issues outperformed the stock market during the sell-off, which contradicts the theory that the weakness was fixed-income inspired.
 

 

While not Risk-Parity funds are alike, we do have a highly visible risk parity mutual fund with daily prices, the AQR Risk Parity Fund (AQRIX), which can form a basis for the analysis for this class of strategy. Morningstar reports that the AQRIX is levered 2x, with a 106% long exposure to the bond market, 49% long exposure to equities and 44% long exposure to other asset classes, which are likely commodity-related assets.
 

 

The following chart also shows that during the latest risk-off episode, bonds and commodities outperformed AQRIX NAV.
 

 

If AQRIX is representative of the behavior of Risk-Parity strategies, I find it hard to believe that it aggressively sold bonds, which outperformed, even as the fund value declined.

AQRIX implied bond exposure flat to up in latest risk-off episode

My heuristic analysis of factor exposures also revealed that the bond market factor exposure of AQRIX was flat to up in the weeks leading up to the latest risk-off episode, while the factor exposure to equities and commodities was sliding.

I developed a simple heuristic for decomposing fund factor exposures in real-time while analyzing hedge funds in 2005 (original research and methodology available upon request). Briefly, here is how the methodology works.

Imagine that we had the daily returns of a market neutral fund. Here is how we would discover whether the fund had a positive or negative market beta:

  1. Put the daily fund returns into two buckets. The first bucket contains the returns of the fund on the days when the stock market rose, and the second contains the returns of the fund when the stock market fell.
  2. Calculate a moving average of the two buckets.
  3. Calculate the spread of the two buckets.
  4. Calculate and analyze a moving average of the spread. If the average spread is consistently positive, the fund is performing better when the market is rising, and we can conclude that it has a positive market beta. Conversely, if the average spread is consistently negative, we can conclude that the fund has a negative beta and it is short the market.

While this heuristic is useful, this technique has a number of limitations.

  • It is sensitive to how the daily alpha is defined. In our example, we used the daily returns of a market neutral fund. We could also apply the same technique to a plain vanilla equity or bond fund, and replace the daily return in the analysis with the daily alpha, which is defined as the fund return less the benchmark return.
  • It is sensitive to the lookback period, or the number of days in the moving average window. The lookback period should ideally be tuned to the turnover of the portfolio in order to minimize the noise of the analysis.
  • It is better at estimating the direction of factor exposures rather than magnitude. In our example, I put the fund returns into two buckets, one when the stock market rose, and one when the stock market fell. This methodology does not distinguish between returns when the market is up 0.01% or 2% on the day.

With those caveats, I analyzed the factor exposure of AQRIX. We defined the daily alpha of AQRIX as the returns of the fund against a portfolio of 30% S&P 500, 20% EAFE, 10% MSCI Emerging Market Index, 30% US Aggregate Bond Index and 10% CRB Index. I also used a six-month lookback period to estimate factor exposures.

The following chart shows the estimated factor exposures of AQRIX for the past year. Estimated equity exposure had been declining from early November into the latest risk-off episode, while estimated commodity exposure also peaked in December and fell in the same period. By contrast, estimated bond market exposure was flat to up in the same period, and spiked during the risk-off episode, indicating that the fund bought bonds during that period. However, I view that conclusion with a degree of skepticism as I indicated that this technique is less revealing of magnitude than direction of exposure, especially during periods of high market volatility.
 

 

In conclusion, it is difficult to believe that Risk-Parity strategies had an adverse effect on bond prices. As demonstrated, I arrived at that finding based on three separate and independent analytical techniques.

Equity market implications

As a postscript, there is also a bullish equity market implication to this analysis. The spike in stock market volatility has not been matched by bond market volatility. A study by Nautilus Research found that these conditions have tended to be equity bullish, though the same size is small (N=6).
 

 

Hang on, the Vol Tantrum should be over soon.