Page 64 – Humble Student of the Markets

Five reasons not to worry (plus 2 concerns)

Posted by Cam Hui - February 11, 2018

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

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

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

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

The latest signals of each model are as follows:

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

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

The Bob Farrell Rule #4 correction

Volatility has certainly returned to the financial markets as the Dow experience two 1,000 point downdrafts in a single week. The long awaited correction arrived as stock prices retreated 10% from an all-time high in just under two weeks. Over at Bloomberg, there were six separate and distinct explanations for the correction. I prefer a far simpler reason. Stock prices went up too far and too fast. Call it the Bob Farrell Rule #4 correction: “When prices go parabolic, they go up much further than you expect, but they don’t correct by going sideways.”

As the market cratered last week, subscriber mood began on an air of cautious optimism, which turned to concern, and finally panic. By the end of the week, I was getting questions like, “I know that the market is oversold, but could it go further like 1987, 1929, or 2008?”

Relax, most of the concerns raised are red herrings. Here are what I am not worried about:

Equity valuation,
Macro outlook,
Equity fundamentals,
Investor sentiment, and
Market technical picture, otherwise known as the “animal spirits”..

Here are a couple of areas where I have some concerns:

The inflation outlook and Federal Reserve policy, and
Possible changes in White House policy, such as trade and immigration.

Stocks are not expensive anymore

One of the risks that the bears have raised in the last few months is the overvaluation of stock prices. The good news is equity valuations are not stretched anymore. The Morningstar fair value estimate retreated from an 11% overvaluation in January to a 1% overvalued reading. Stocks are by no means cheap, but valuation no longer poses a headwind for prices.

Another way of approaching the valuation question is Ed Yardeni’s Rule of 20, which states that equity risk is heightened when the sum of the forward P/E and headline CPI exceed 20. The latest readings have retreated from its January high of 20.5 to 18.4, based on the latest FactSet report that forward P/E has fallen from 18.4 to 16.3.

If valuation is no longer a headwind, what about the outlook for based on macro and fundamentals?

A healthy macro outlook

One of the key questions for equity investors (not traders) is whether recession risk is rising. I suggested in last week’s post (see A house on fire?) that recession risk is low in 2018. The New York Fed’s recession odds estimate has been creeping upwards, but only stands at 10% for the next 12 months. Recessions are bull market killers, and every recession has seen a bear market, though not every bear market has resulted in a recession.

Another quick-and-dirty way of measuring the near-term equity outlook is through the use of initial jobless claims. This statistic has shown a near perfect inverse correlation to stock prices. The 4-week average of initial claims fell to a new cycle low last week, which is supportive of higher stock prices.

Strong fundamental momentum

In addition to bullish top-down macro picture, the bottom-up outlook is equally strong. The latest earnings update from FactSet reveals that bottom-up estimates continue to rise. EPS estimates have been rising for two reasons. First, the new tax bill provided a one-time boost to earnings. and bottom-up 2018 estimates have risen 6.4% since bill’s passage. The 6.4% increase is in the range of the 6-9% growth effect projected by top-down strategists. As most of the tax cut adjustments have been made, this component of positive EPS estimates is likely to slow dramatically in the near future. The second component of bottom-up EPS estimates stems from operational results, which can be seen in the latest Q4 earnings repots. Q4 EPS, which was unaffected by the corporate tax cuts, saw both EPS and beat rates well above the historical average. Equally bullish is forward Q1 guidance, which is much better than the historical experience.

In short, equity investors have little to worry about from the economy or the earnings front.

Washed out sentiment

As the market tanked last week, there was plenty of evidence that investor sentiment was nearing or at the capitulation stage. Bloomberg reported that 401k investors were selling into the panic. As this is a group that normally puts their allocation on autopilot, this kind of behavior indicates that robo-advisors were getting turned off and overridden as investors stampeded for the exits.

After racing into equities in January, they did an about-face as markets fell on Friday Feb. 2. Savers moved into money and fixed-income funds, trading at close to three times the norm, according to Alight Solutions’ 401(k) Index.

On Monday, when the Dow Jones Industrial Average plummeted 1,175 points, they repeated the pattern, this time trading at 12 times the typical pace. The next day, as the market recovered some losses, 401(k) savers kept selling stocks, trading at a rate of four times the usual.

The last time trading reached 12 times the norm was on Aug. 8, 2011, when markets dropped on concerns about a global debt crisis.

In a separate report, Bloomberg also reported that the 4-day outflows in SPY were the highest in its history.

As another sign that speculative excesses are being wrung out, the WSJ reported that the AUM of leveraged ETPs have plunged back to 2012 levels.

SentimenTrader pointed out that we saw a rare double last week, a CNBC “Market in Turmoil” report, and Trump tweets complaining about the stock market. Both events have historically been interpreted to be contrarian bullish.

I could go on, but you get the idea.

Possible technical bottom in sight

From a technical perspective, the market is oversold and poised for a relief rally. Even as the market sold off, it experienced a RSI-5 positive divergence and a minor RSI-14 divergence as it tested but violated technical support last Thursday. Friday saw the VIX fall below its upper Bollinger Band, which has been a reasonably good trading buy signal in the past.

The following chart of the 5 dma of the NYSE McClellan Oscillator (NYMO) also tells a similar story of an oversold market. If history is any guide, downside risk is limited from these levels.

What about risk appetite? It was a surprise that I found that risk appetite factors remain bullish and supportive of higher stock prices. As shown in the chart below, price momentum remains in a relative uptrend, and so is the high beta vs. low volatility ratio. As well, I am not seeing signs of a negative divergence in the relative performance of high yield, or junk, bonds (green line, top panel).

If and when stocks can catch a bid, there is potential for the major indices to recover and test their old highs.

The inflation boogeyman

Despite my generally bullish outlook, no review of the stock market would be complete without a discussion of the risks. One major risk is how rising inflation may affect stock prices.

A common explanation of the selloff 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.

In addition, average weekly hours dipped. The growth in annual growth average weekly earnings, which measures the net effect of hourly earnings and hours worked, remained tame.

I would prefer to wait for next week`s Consumer Price Index report for an additional read of the inflation picture. To be sure, inflation has recently exhibited positive surprise in a number of other regions around the world, but US inflation surprise remains tame – for now.

Rising inflation expectations would put pressure for the Fed to act in a more aggressive manner, as price stability is one of its key mandates. The latest Fed Funds futures show that market expectations of rate hikes dipped slightly since the January FOMC meeting, presumably in response to the latest market volatility.

Policy surprise risk

Other possible negative surprises that investors would have to consider is White House policy. In particular, trade tensions have the potential to spook markets (see How to lose a trade war even before it begins and Sleepwalking toward a possible trade war).

As well, the market may not have fully considered the labor market tightening effects of Trump’s immigration policy (see The market effects of Trump’s immigration policy). They have the potential to drive the unemployment rate to levels that forces the Fed to act to counteract any cost-push inflationary pressures that may arise.

Bigger questions

While I believe that the current downdraft is only a correction, the bigger issue is whether this correction is the beginning of a topping process. Here are a couple of questions to ponder:

Late cycle markets tend to rise in even as the Fed begins its tightening cycle (see Five steps, where’s the stumble?). That’s because the bullish tailwind of better growth expectations overwhelm the bearish headwind of higher rates. Did the latest uptick in bond rates signal an inflation point in market regime?
From a technical perspective, it is said that while bottoms are events, tops are processes. That’s because market bottoms are events marked by climactic and unbridled fear, while the fundamentals behind market tops develop more slowly. Was this leg down the start of a topping process?

One of the ways to answer the first question is to analyze the evolution of the yield curve as the Fed proceeds through its tightening cycle. A steepening yield curve reflects bond market expectations of accelerating growth, while a flattening yield curve is a signal of falling growth expectations. Even this idealized approach yields unsatisfactory answers. Which yield curve should we focus on? The 2-10 yield curve has been volatile throughout the latest risk-off episode, and it has been steepening. By contrast, the 10-30 yield curve has been flattening with only a minor reversal in the last two weeks.

Another question for investors is whether the market is undergoing a topping pattern. The history of major tops can be seen by an initial peak, followed by a retreat, and a rally to a second bull trap top marked by a negative 14-month RSI divergence. Could the current decline the first step to a long-term top? Stay tuned.

Keep an eye on how these charts develop.

The week ahead

Looking to the week ahead, the stock market is obviously very oversold.This chart from Index Indicators shows the historical perspective of how the market is stretched to the downside on the % above 10 dma, which has a 3-5 day time horizon.

As well, the average 14-day RSI, which has a 1-2 week time horizon, is similarly oversold.

The CNN Money Fear and Greed Index has plunged to 8 in the space of two weeks. While readings have been lower, it does show how quickly sentiment has changed in a short time.

Even though the market is highly oversold and poised to rally, my inner trader has a number of concerns. First, the historical evidence suggests that oversold breadth conditions tend to resolve themselves with V-shaped bottoms. In the last 10 years, we have seen nine instances where the % above the 50 dma have reached the oversold extremes seen last week. Of the nine, the market continued to fall in one case, it formed a V-bottom in three cases (red lines), and W-shaped bottom in the other six (blue lines), where the second bottom occurred anywhere from three to seven weeks after the initial oversold bottom. If history is any guide, the odds favor a market rally, followed by a decline to a second bottom some time between late February and March.

As well, some algos may not done fully selling yet, as the carnage has been so broad and global in scope. Anecdotal trading desk comments indicate that Commodity Trading Advisors (CTAs) have reacted to such broad based weakness by reversing their long positions to short ones. While the trading system of every CTA differs from each other, the broad based weakness suggests that there may be further risk-off selling ahead in the next week. This will create headwinds for equity and other asset prices. As an illustration, the following JPM chart is an estimate of the change in futures open interest of CTAs as a result of falling prices and VaR model mandated de-risking.

My inner investor remains constructive on equities. My inner trader reversed from short to long early last week. He is crossing his fingers and hanging on for another wild ride. During these periods of heightened volatility, traders are advised to scale their positions in accordance with their risk tolerances.

Disclosure: Long SPXL

The market effects of Trump’s immigration policy

Posted by Cam Hui - February 8, 2018

I had been meaning to write about this, but I got distracted by the latest bout of market volatility. With the debt ceiling problem defused, but no sign of a DACA deal, the issue of immigration is a worthwhile issue to consider for investors.

As I analyzed the latest JOLTS report and last week’s January Jobs Report, I reflect upon how Trump’s immigration policy may affect labor markets, and the secondary effects on monetary policy. The latest JOLTS report shows that hires remain ahead of separations, and the quits rate is rising, which are indicative of a strong labor market.

Immigration is a politicized issue and it is beyond my pay grade to express an opinion on the correct approach. Nevertheless, I can still estimate the likely effects of any policy, and its market effects.

Donald Trump’s philosophy to immigration is clear. Build a Wall to keep them out. Deport the illegals, starting with the DREAMers, or DACA eligible individuals residing in the United States.

Deporting the DREAMers

Imagine if all DACA eligible residents were to be deported tomorrow. What would be the labor market effects?

Let’s dive into the numbers. The Migration Policy Institute (MPI) estimates that there are 1.9 million people who are potentially eligible for DACA, and 1.3 million who are immediately eligible. John C. Austin at Brookings believes that deporting DREAMers would be a blow to the rust belt states, as immigrants have been the only source of population and business growth. Notwithstanding Austin’s opinions, we can calculate a DREAMer employment rate of 87% (=596K/685K) from his statistics.

FRED shows that the prime age civilian labor force, which is the age demographic that DREAMers fall into, is 103 million. Therefore DREAMers represents the labor force 1.3% to 1.6% of the prime age labor force after applying their employment rate (87%) to the total number of potential DREAMers (1.3 to 1.9 million) in the US.

The January headline unemployment rate print was at 4.1%. Removing all of the DREAMers would crater the unemployment rate to a sub-3% level. Sure, such a policy would create more opportunities for locally born Americans, but the market was already freaking out when Average Hourly Earnings rose to 2.9%. What would a 2-handle on the unemployment rate do to Fed policy, inflation expectations, and interest rates?

Rising labor shortages

Notwithstanding the Trump administration’s policy toward DREAMers, or DACA recipients, Michael Cembalist of JP Morgan Asset and Wealth Management voiced concerns over looming labor shortages over another facet of immigration policy.

The Administration has chosen to end the Temporary Protected Status program for El Salvador, Honduras and Haiti. As shown in the map, the highest concentrations of such people live in California, Texas and Florida, states which are in the process of rebuilding following Hurricane Harvey, Hurricane Irma and a series of wildfires. According to the National Association of Homebuilders, there are substantial labor shortages and project backlogs in Florida and Texas, where more than 30% of construction workers are foreign-born. Bottom line: ending the TPS program could exacerbate backlogs further, and result in higher wage inflation and/or a slower pace of economic recovery.

Similarly, the end of TPS status for El Salvador, Honduras and Haiti would create more opportunities for locally born Americans, but what are the likely effects on Fed policy?

Don`t forget one of the key causes of the Crash of 1987 was a series of staccato rate hikes that eventually tanked the stock market.

If you are convinced that the Fed will act, consider that even uber-dove Charlie “don’t raise until you see the whites of inflation’s eyes” Evans of the Chicago Fed stated in a recent speech that:

In contrast, suppose inflation picks up more assuredly, as many expect. Then, we still could easily raise rates another three or even four times in 2018 if that were necessary. And I would support such a faster pace if the data point convincingly in this direction.

The corporate response to labor market conditions

While I understand the philosophy behind Trump’s immigration policy, which is to keep them out and create more job opportunities for locals, how well would it actually work? What are the likely responses by employers, and the Federal Reserve?

I have already demonstrated that restricting labor supply in the current environment would likely result in a hawkish monetary policy response in the face of rising labor cost and cost-push inflation. How would employers respond? As Cembalist pointed out, such a policy would create labor shortages and push up wage rates in sectors where labor could not be offshored, such as construction. How would such a policy affect the corporate sector?

Even before the onset of these immigration proposals, the corporate sector had already responded with the formation of labor monopsonies. Marshall Steinbaum (see paper) found a high degree of monopsony concentration by federal antitrust standards.

Then there is the globalization effect to consider. Branko Milanovic has pointed out in his “elephant graph”, the last few decades of globalization has seen strong wage growth in the emerging market economies as jobs have gone offshore, and the top 1% have also won as they reaped the fruits of improved margins from globalized supply chains. The losers have been the middle class in the developed economies, and members of subsistence economies who could not participate in the globalization wave.

Could Trump’s immigration policy reverse the effects of globalization? As this chart of the global partners of the Boeing 777 shows, the parts of the aircraft are assembled all over the world.

As multi-nationals have supply chains that stretch around the world, it would be difficult to believe that rising wage rates and tight labor markets in the US would provide a significant net benefit to the suppliers of American labor. Still, these policies are likely to have the following effects that would be equity bearish:

A more hawkish monetary policy from the Federal Reserve;
Rising inflation and inflation expectations, which would put downward pressure on the USD;
Margin squeeze from higher labor costs; which may be partially offset by
Rising wages and higher household consumption; and
More offshoring.

The net effect would see higher interest rates, lower operating margins for domestically exposed industries, and P/E compression because of the competition from higher rates.

Risk on, or risk off?

Posted by Cam Hui - February 6, 2018

Mid-week market update: In view of this week’s market volatility, I thought that I would write my mid-week market update one day early. After the close on Monday, my Trifecta Market Spotting Model flashed a buy signal. As shown in the chart below, this model has been uncanny at spotting short-term market bottoms in the past.

Now the Trifecta model has flashed another buy signal as the market faces a possible meltdown from volatility related derivative liquidation. Is it time to take a deep breath and buy?

To be sure, it is hard to believe that a durable bottom has been made. As recently as Sunday, Helene Meisler tweeted the following anecdote of investor complacency.

Could complacency turn to fear that quickly for a washout bottom in just two days?

Echoes of 2015

The Trifecta buy signal is reminiscent of the events of August to September 2015. Stock prices cratered in August and created a Trifecta signal on August 25, 2015. It proceeded to rally and chop around for about a month before making a final bottom on September 29, 2015, which coincided with an Exacta (almost Trifecta) buy signal.

Still there are some key differences between the environment today and 2015. The rally leading up to the current selloff was marked by rising complacency, as measured by a steadily falling CBOE equity-only put/call ratio (CPCE). The 2015 selloff was preceded by a rising CPCE, indicating skepticism about the advance.

I interpret the current market environment as a bottoming process. Stock prices are likely to make a W-shaped bottom, perhaps with multiple Ws strung together, as it is difficult to believe that sentiment can be washed in such a short time. The stock market is likely to stage a short-term oversold rally over the next few days, but don’t be fooled by the bull trap. Sell the rips. Don’t buy them.

Tactically, the market is setting up for a bounce of unknown magnitude over the next few days. Subscribers received an email alert that my inner trader had covered his short positions and flipped long. However, he does not expect the duration of that trade to last significantly more than a week.

Opportunities in the bond market

The likely risk-off market tone over the next few weeks opens up a trading opportunity in the bond market. The chart below shows the stock/bond ratio (grey) and the 10-year Treasury note yield (green). The top panel shows the six-month rate of change of the stock/bond ratio. In the past, whenever the six-month ROC of the stock/bond ratio hit 20% and turned down, it has represented a good buying opportunity for the 10-year Treasury. The blue vertical lines marked instances when the 10-year yield has fallen (and bond prices rallied), while red lines marked instances when the 10-year yield rose (and bond prices fell).

The six-month stock/bond ratio’s rate of change flashed a buy signal recently. Does that mean investors should buy the bond market? How much risk does the recent backup in yields represent?

Consider the fundamentals. In a recent FT column, Gavyn Davies framed these risks as possible changes in the risk premium of going out in the yield curve. In other words, how much should investors get paid to extend the maturity of their fixed income holdings?

Since the overall bear market in US bonds started in mid 2016, the 10 year yield has risen by 130 basis points, from 1.5 per cent to 2.8 per cent. Most of this increase has been due to a rise in the nominal risk premium, and by far the majority of the increase in the nominal risk premium has come from the inflation component, with the real component rising only slightly.

What has happened, therefore, is that the tail risk of deflation that was being priced into bonds in early 2016 has gradually disappeared, and the inflation risk premium has returned to a fairly normal level around zero. All this has happened while the core inflation rate, and the expected path for future inflation, has barely increased at all. The recovery in real output growth (and commodity prices) seems to have reduced the market’s fear of future deflation, and that is what has driven the bear market in bonds.

Edward Harrison at Credit Writedowns decomposed yield risk as risk premium, Fed policy, and possible bond vigilante reaction over rising deficit spending:

The rise in interest rates so far is mostly about the term premium normalizing due to systemic risk receding after the endless succession of mini-crises has finally faded and global growth has returned. But, now that term premia have normalized, I don’t think we have to worry about a vicious bond bear market because of deficit spending. It’s inflation and the Fed’s response to perceived inflationary signs that will matter.

I believe the Fed will maintain its forward guidance unless the economy slows considerably. In fact, signs of inflation or wages rising more quickly or unemployment falling more quickly than the Fed has anticipated will accelerate the Fed’s timetable. There’s money to be made there in the short-term.

If the future health of the bond market is mainly in the hands of the Fed, here is what Fed watcher Tim Duy had to say about the likely direction of Fed policy:

Two central bankers spoke up during last Friday’s sell off. San Francisco Federal Reserve Bank President John Williams said that the economic forecast remains intact and hence the Fed should maintain the current plan of gradual rate hikes. He does not think the economy has “fundamentally shifted gear.” For what it is worth, it is my impression that Williams is slow to update his priors. His colleague Dallas Federal Reserve President Robert Kaplan also retains his base case of three rate hikes in 2018, but opened the door to more. My sense is that Kaplan is sensitive to the yield curve and will tend toward chasing the long end higher.

Also, if the economy is shifting gears, watch for St. Louis Federal Reserve President James Bullard to warn of an impending regime change in his model and with it a possible sharp upward adjustment of his dot in the Summary of Economic Projections.

Bottom Line: If as I suspect much of what we are seeing in the economy is a cyclical readjustment, then long term yields will likely reach more resistance soon while short term yields will continue to be pressured by Fed rate hikes this year and beyond. If the Fed turns hawkish here they will likely accelerate the inversion of the yield curve and the end of the expansion (this could be the ultimate impact of the tax cuts – a short run boost to a mature cycle that moves forward the recession). If a more secular realignment is underway, long (and short) rates have more room to rise. It is reasonable to be unable to differentiate between these two outcomes as this juncture.

In other words, Fed policy is likely to be relatively benign. Under those circumstances, the combination of a risk-off market atmosphere and a relatively friendly bond environment is supportive of higher bond prices and lower rates.

Disclosure: Long SPXL

A house on fire?

Posted by Cam Hui - February 4, 2018

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

The latest signals of each model are as follows:

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

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

Buy the dip, but not yet

We had some minor excitement in our household in the last week. We were at a show when I received a frantic text message that the neighboring building was on fire. Fire fighters were spraying our building as a preventive measure. Mrs. Humble Student of the Market rushed home to rescue the family dog. The house next door was burning to the ground and we were ordered to evacuate. We discovered the next day that our unit suffered water and smoke damage, and it would take several weeks to fix. While the whole episode was disconcerting, it was not a total disaster.

I am now living in a hotel and writing this publication on an older rescued laptop, so please forgive me if I am not up to my usual witty and erudite self.

As the stock market turned south last week, some traders were behaving as if their own houses were on fire, instead of the neighbor’s. Morgan Housel recently penned a timely article entitled It’s hard to predict how you’ll respond to risk:

An underpinning of psychology is that people are poor forecasters of their future selves. There is all kinds of research backing this up. Imagining a goal is easy and fun. Imagining a goal in the context of the realistic life stresses that grow with competitive pursuits is hard to do, and miserable when you can…

The same disconnect happens when you try to forecast how you’ll respond to future risks.

How will I respond to the next investing downturn?

[…]

You will likely be more fearful when your investments are crashing and more greedy when they’re surging than you anticipate.

And most of us won’t believe it until it happens.

CNBC had a similar perspective. Investors have been so used to a low volatility environment where stock prices have risen steadily. When the market environment normalizes, it raises the risk of a sharp short-term selloff should long positions in weak hands panic:

Market volatility has been low, meaning that stock prices have been stable for a long time.

Some investors have interpreted this as a sign of current market risk and that there could be a sudden correction in stock markets, meaning many people could be about to lose vast sums of money.

Should the stock market crater from here, don’t panic. This is not the start of a major bear market.

No major bear in sight

The chart below shows the history of major stock market declines. Bear market has either preceded or coincident with past economic recessions. If there is no recession in sight, then investors should not expect a major decline to begin. The corollary lesson to this history lesson is equity investor should be prepared for regular 10-15% corrections. If you can’t stand that kind of risk, then you should probably reduce your equity allocation.

My conclusion comes from the analytical framework of the long leading indicators used by my Recession Watch page, divided into three dimensions to measure the strength of the economy:

Consumer and household sector
Corporate sector
Monetary conditions

As well, I consider the state of the market from a chartist’s viewpoint.

Household sector: A late cycle expansion

As consumer spending accounts for the vast majority of GDP activity, the health of the American household sector is the linchpin of economic health. On the surface, the household sector looks strong. As the chart below shows, retail sales have peaked well before past recessions. Current readings show that retail sales are strong.

Some of the household internals, however, are not as healthy. Retail sales are only holding up because consumers are spending beyond their means through a combination of a falling savings rate and rising debt levels.

I am also concerned about housing, which is a consumer cyclical and one of the most economically sensitive sectors of the economy. Housing starts appeared to have plateaued. In addition, rising mortgage rates are also proving to be a headwind for the sector.

None of these readings are enough to sound the recession alarm, but they are indications of a late cycle expansion.

A healthy corporate sector

By contrast, the corporate sector is much healthier than households. NIPA corporate profits have tended to peak out before past recessions, and there is no sign of a peak in corporate profits for this cycle.

The latest update from FactSet also shows that strong profit expectations. Bottom-up forward 12-month EPS estimates have historically been coincident with stock prices, and they are rising at a robust clip. The latest round of EPS upgrades are driven by two components, a tax cut effect, and a cyclical effect.

Bottom-up analysts have been hesitant to upgrade their estimates before the actual passage of the tax bill, because they could not quantify the specific effects on the companies in their coverage universe. The latest figures show that bottom-up analysts have raised their 2018 estimates by 5.5% since the passage of the tax bill. Top-down strategists have not been as shy about estimating the aggregate tax cut effects, and most Street strategists have penciled in a 6-9% tax cut boost to 2018 EPS. This suggests that the bottom-up tax cut upgrades are nearing an end.

However, the cyclical effects of earning season remains strong. Both the EPS and sales beat rates are well above historical averages. As the earnings reports were for Q4 2017, they did not include any actual tax cut effects. These reports suggest that the near-term operating outlook still looks strong.

Historically, corporate bond yields have bottomed several years before recessions. Here, the evidence is mixed. The Baa corporate yield made a marginal new low in December 2017, though the Aaa bonds did not make a low that month and the low in August 2016 still stands for the current expansion.

In conclusion, the corporate sector is not flashing any signs of an imminent downturn. In fact, the recently passed corporate tax cuts are likely to provide an additional boost to this sector.

Monetary conditions a question mark

Monetary conditions, on the other hand, are a question mark. The markets took fright on Friday in reaction to the January Employment Report. The headline Non-Farm Payroll came in ahead of expectations, and average hourly earnings rose to 2.9%, a cycle high reading that is indicative of rising wage pressures.

In addition, temporary employment growth may be stalling. Temp jobs have historically led headline NFP growth, and this raises the risk that the Fed may be committing a policy error by tightening into a weakening economy.

As the Fed signaled at its last FOMC meeting that it is on track for three or more rate hikes this year, money supply growth continues to decelerate. In the past, real money growth, as measured by M1 or M2, has gone negative ahead of recessions.

Lastly, no observation of monetary conditions as recession indicators without some comment about the yield curve. In the past, the 2-10 yield curve has inverted ahead of past recessions. However, the yield curve is giving unusual signals in this cycle. The chart below shows the history of the decline in the 10-year Treasury note yield from 1990. Every test of the downtrend line, with the exception of 1994-95, saw the yield curve invert. Even though the yield curve did not invert during the 1994-95 period, it did flatten quite dramatically.

Friday’s market response to the January Employment Report saw the a dramatic rise in bond yields and a steepening yield curve. Another puzzle comes from the behavior of the 10-30 yield curve, which has been steadily flattening to 25bp, a cycle low.

I interpret these readings as tightening monetary conditions, but they are not indicative of an imminent recession.

To summarize the review of macroeconomic conditions, they indicate an economy that is in the late cycle of an expansion. While conditions are deteriorating, the nowcast of 12-month recession risk is still relatively low.

Technical analysis: Intermediate term bullish

Even though the latest market air pocket may appear as a shock to recent stock investors, the S&P 500 has only retreated 3% off its all-time highs, and corrections are to be expected as part of equity investing. From a technical viewpoint, the intermediate term outlook is still bullish.

As the chart below shows, even though the S&P 500 breached its narrow rising channel last week, its uptrend remains intact. Moreover, equity risk appetite, as measured by the price momentum factor and high beta vs. low volatility factor spread, remain in relative uptrends. Initial trend line support is evident at about the 2700 level, which represents a peak-to-trough correction of roughly 6%.

For a longer term and global perspective, past equity market tops have been characterized by double tops consisting of an initial top, market retreat, and a second rally marked by negative 14-month RSI divergences. As the chart of the DJ Global Index shows, the latest correction may be a sign that the market is making the first top. Even then, investors should not panic until this technical formation becomes more developed.

In short, the market is undergoing a garden variety correction. Equity weakness represents an opportunity to buy the dip.

The week ahead: Not enough fear

However, it is likely too early to be buying immediately. Late Friday, there was some chatter by the talking heads that the market had become extremely oversold. While short-term breadth had become oversold and a bounce is likely in the coming week, there are few signs of widespread fear and capitulation that are the hallmarks of a durable bottom.

As the chart of the CBOE equity-only put/call ratio shows, the market had been sliding into complacency for several months. It’s hard to believe that a single one-day 2% decline after a steady climb marks the end of the correction.

SentimenTrader also observed that small (retail) option traders were buying heavily into the latest decline. That does not sound like fear and capitulation to me.

The S&P 500 is oversold on RSI-5, which is a short-term indicator, but not oversold on RSI-14, which is more useful for traders with an intermediate term time horizon. Moreover, the market has not tested initial support at the 2680-2720 region, defined as the 50 day moving average and a trend line representing a peak-to-trough correction of about 6%. Further support can be found at the 200 dma and a second trend line at about 2550, which represents a 10% correction.

As well, the Fear and Greed Index has fallen, but readings are nowhere near the sub-20 levels seen in past bottoms.

Here is what I am using to watch for a durable market bottom. I rely on my Trifecta Bottom Spotting Model, which has had an uncanny record for identifying trading bottoms using the following three indicators:

VIX term structure: Watch for signs of inversion indicating rising fear (check)
TRIN: Watch for readings above 2 indicating a “margin clerk” liquidation market (not yet)
Intermediate term overbought/oversold: Watch for readings below 0.50 (not yet)

In the past, exacta signals, where two of the three conditions are triggered within a few days of each other, and trifecta signals, where all three conditions are triggered, have been uncanny bottom indicators. Readers who would like to follow this model in real-time can use this link.

Current conditions suggest that the market is sufficiently short-term oversold that it could bounce next week, but prices are likely to retreat further and retreat further until sentiment gets washed out. We are not there yet.

My inner investor remains constructive on equities. My inner trader remains short, but he is prepared to add to his short positions should the market stage a rally next week.

Disclosure: Long SPXU

A glass half full, or…

Posted by Cam Hui - January 31, 2018

Mid-week market update: I turned cautious on equities last Wednesday (see Out of words for ‘extreme’ and ‘unprecedented’). Since then, the market rallied, and fell for two straight days on Monday and Tuesday, ending the last five days slightly negative.

Is this the start of a downside break, or just a blip in a continuing market rally?

On one hand, investors have been buying the dip, indicating continuing confidence in the market. Eric Balchunas of Bloomberg pointed out that investors poured $8 billion into equity ETFs during the two day selloff.

On the other hand, this funds flow data poses a high degree of downside risk. Should the market continue to correct or consolidate, sentiment needs to wash out before a durable short-term bottom can be seen.

What’s the real story?

Mixed messages

In these pages, I have made the point that the latest melt-up is price momentum driven. Here, the market is giving mixed messages.

Here is the bull case, the chart below shows that the relative performance of momentum and the relative performance of high beta to low volatility stocks remain in uptrends. Until those relative uptrends are broken, dips are buying opportunities.

The bears can argue that sufficient technical damage has been done to the uptrend that usually signals a period of consolidation or correction. When stock prices fell for two consecutive days, capped by a 1% down day on Tuesday, it breached the upward sloping channel that the market had been on for all of January.

The bulls can point to the spike in the VIX as putting a floor on stock prices. If history is any guide, the weekly RSI levels indicate minimal downside risk for equities in the past (h/t Andrew Thrasher).

As well, the VIX rose above its upper Bollinger Band during the market selloff this week, which is indicative of an oversold condition. Reversions below the BB have proven to be good trading buy signals for the stock market.

The bears can point out that the neither the absolute level of the VIX, nor changes in the VIX are very relevant to future stock market direction. A better way to measure fear is to normalize the VIX by observing its term structure. Inverted term structures, where short-term implied volatility is higher than long term volatility, are much better indications of real fear. As the chart below shows, the term structure has not inverted, which is a signal of a lack of fear.

There are too many bull and bear arguments. My head hurts.

Inter-market and cross-asset signals

For some clarity, here are some clues to further market direction. I recently wrote about possible bottoms forming for interest sensitive vehicles and the USD (see The pain trade signals from the bond market). Since the publication of that post, selected interest rate sensitive ETFs have tested key support levels and bounced, though their downtrends remain intact.

In addition, the USD Index appears to be setting up for RSI buy signals should they mean revert above the oversold readings of 30.

Should these reversals occur, it could be indicative of a change in regime. By implication, such a regime change would coincide with a period of correction or consolidation for stock prices.

I don’t have any firm answers just yet, but I am closely watching developments. For the time being, my inner trader is giving the bear case the benefit of the doubt, and he remains short the market.

Disclosure: Long SPXU

How to lose a trade war before it even begins

Posted by Cam Hui - January 29, 2018

As we wait for Donald Trump’s first State of the Union address, investors are left to wonder which Trump will show up before Congress on Tuesday. Will it be Teleprompter Trump, whose well-crafted speech will be interpreted favorably by the markets, or Twitter Trump, whose utterances will spook the markets?

Why tariffs won’t work

Trump will undoubtedly make comments about trade policy, which was a centerpiece of his campaign (see Sleepwalking toward a possible trade war). Former Morgan Stanley Asia chairman Stephen Roach recently penned a Project Syndicate essay entitled “How to Lose a Trade War”, where he complained about the misguided policies behind recent imposition of tariffs on solar panels and washing machines:

For starters, tariffs on solar panels and washing machines are hopelessly out of step with transformative shifts in the global supply chains of both industries. Solar panel production has long been moving from China to places like Malaysia, South Korea, and Vietnam, which now collectively account for about two-thirds of America’s total solar imports. And Samsung, a leading foreign supplier of washing machines, has recently opened a new appliance factory in South Carolina.

The problem goes beyond “unfair trading practices”, according to Roach. 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.

The Trump administration’s narrow fixation on an outsize bilateral trade imbalance with China continues to miss the far broader macroeconomic forces that have spawned a US multilateral trade deficit with 101 countries. Lacking in domestic saving and wanting to consume and grow, America must import surplus saving from abroad and run massive current-account and trade deficits to attract the foreign capital.

Consequently, going after China, or any other country, without addressing the root cause of low saving is like squeezing one end of a water balloon: the water simply sloshes to the other end. With US budget deficits likely to widen by at least $1 trillion over the next ten years, owing to the recent tax cuts, pressures on domestic saving will only intensify. In this context, protectionist policies pose a serious threat to America’s already-daunting external funding requirements – putting pressure on US interest rates, the dollar’s exchange rate, or both.

Roach believes that the way to address unfair trading practices is through the mechanisms set out by the WTO.

That doesn’t mean US policymakers should shy away from addressing unfair trading practices. The dispute-resolution mechanism of the World Trade Organization was designed with precisely that aim in mind, and it has worked quite effectively to America’s advantage over the years. Since the WTO’s inception in 1995, the US has filed 123 of the 537 disputes that have been brought before the body – including 21 lodged against China. While WTO adjudication takes time and effort, more often than not the rulings have favored the US.

If the WTO is the first place to address trade issues, then the recent US Representative’s 2017 Report to Congress on China’s WTO Compliance is eye opening. The first 25 pages is a spells out China’s transgressions to which the US believes it has valid grievances.

Industrial policies
Intellectual property rights
Services
Agriculture
Legal framwork

Under the section “Next Steps”, the report states:

The United States is determined to use every tool available to address harmful Chinese policies and practices, regardless of whether they are directly disciplined by WTO rules or the additional commitments that China made in its Protocol of Accession to the WTO. The United States will not accept any Chinese policies or practices that are unfair, discriminatory or mercantilist and harm U.S. manufacturers, farmers, services suppliers, innovators, workers or consumers. Americans have waited long enough. The time has come for China to stop its market-distorting policies and practices and finally become a responsible member of the WTO.

In other words, the term “every tool available” is code for a trade war. The markets won’t like that at all.

NAFTA blowback

Another source of trade tension for the markets are the NAFTA negotiations. Jorge Guajardo, who was Mexico’s ambassador to China, had the following perspective on the NAFTA negotiations.

If the US remains in NAFTA but stays out of the Trans Pacific Partnership (TPP), it creates incentives for companies to locate facilities in either Canada or Mexico in order to benefit from both NAFTA and TPP. If the US leaves NAFTA, then continental trade will tank, and destroy supply chains that were built up over decades.

In that case, nobody wins.

The pain trade signal from the bond market

Posted by Cam Hui - January 28, 2018

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

The latest signals of each model are as follows:

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

Important questions for the bond and stock markets

As the 10-year Treasury yield staged an upside breakout at 2.6%, and luminary investors such as Bill Gross, Jeff Gundlach, and Ray Dalio have declared the bond bull to be over, I have a number of key questions for the markets. First and foremost, “What’s the pain trade?”

How these questions are resolved will also have important implications for the future direction of stock prices.

Which signal do you believe?

One of the most important question for the bond market is, “Which signal do you believe?”

As the chart below shows, past tests of the downtrend in 10-year Treasury yields has coincided with yield curve inversions. The only exception was in 1994-95. Even then, that episode saw the yield curve flatten dramatically.

Fast forward to 2018. The yield curve is flattening, but nowhere near inversion. The 2-10 spread has been volatile and it has been bouncing between 50bp and 60bp. The 10-30 spread flattened to 25bp, which is a cycle low, but neither the 2-10 nor the 10-30 spreads are inverted.

Here is the critical question: “Do you believe the signal from the upside breakout in yield, or the yield curve?”

If you believe that the yield curve is flashing a false signal, and it should really be inverted because central bankers have distorted its shape with their endless QE programs, then the economy is nearing recession and investors should therefore adopt a risk-off posture in their portfolios. If, on the other hand, you believe in the validity of the yield curve signal, which indicates that the economy is far from an inversion and therefore a recession warning, then the upside breakout is a response to rising inflationary expectations, then the bond market is indeed entering a bear market.

A lurking growth disappointment?

Here is one way to resolve that conundrum. Experienced bond investors understand that bond yields are correlated with growth expectations. As the chart below shows, 10-year Treasury yields have been tracked the Citigroup US Economic Surprise Index (ESI), which measures whether macroeconomic releases are beating or missing expectations.

Here is another important question, “As economic data have disappointed and the ESI fallen in the last few weeks, why haven’t bond yields followed?”

Even before the Q4 GDP miss last Friday, Nordea Markets pointed that regional Fed indices were coming below expectations.

Last Friday, the headline Q4 GDP came in at 2.6%, which was well below Street expectations of 3.0%, the Atlanta Fed’s GDPnow nowcast of 3.4%, and the New York Fed’s nowcast of 3.9%. Moreover, the GDP Deflator came in ahead of expectations, indicating rising inflationary pressures. That’s growth bearish, right?

There was, however, some debate about the underlying strength of the American economy based on the internals of the GDP report. Ryan Detrick of LPL pointed out that growth was actually quite good once you strip out the inventory and trade effects.

David Rosenberg, by contrast, chose to focus on the negatives.

Rosenberg came to an ominous conclusion for stock and bond prices.

Who is right? There are signs that the market may see a downside growth surprise in the near future. The chart below shows the copper/gold ratio (red line), which is a highly sensitive indicator of cyclical growth, and the stock/bond ratio (grey bars), which measures risk appetite. The bottom panel shows the rolling one-year correlation of these two series, which validates the effectiveness of the copper/gold ratio indicator. As the chart shows, the copper/gold indicator is starting to roll over, which is a signal that global growth momentum may be stalling.

Nautilus Research also found that the stock/bond sentiment is at an extreme. Such conditions have historically signaled bond market rallies and weak stock markets.

Tiho Brkan also found a similar bullish bond market signal based on the stock/bond sentiment of the BAML Fund Manager Survey.

After the latest upside yield breakout and everyone loudly proclaiming the death of the bond bull, it appears that bond prices are poised for a rally based on disappointing growth expectations. That’s one pain trade the market is setting up for. Such a scenario is equity bearish. In light of the recent market melt-up, I remind readers of Bob Farrell’s Rule #4: “Parabolic markets go further than you expect, but they don’t correct by going sideways.”

Buy when bond blood is running in the streets

Admittedly, buying bonds and interest sensitive issues today is like trying to catch a falling knife. However, there are a number of other important investment implications to the bond rally thesis, and there are opportunities in crowded extreme positions where the proverbial blood is running in the streets (another pain trade).

The following chart provides a graphical illustration of the correlation between yields and commodity prices.

The chart below shows the relative performance of interest sensitive sectors of the stock market (top panel), and the inflation sensitive sectors of the market (bottom panel). If bond prices were to rally, then investors should focus on buying the former and avoiding the latter. Under such a scenario, inflation sensitive sector such as energy, gold, and mining may need more time to consolidate sideways relative to the market. Similarly, growth and momentum stocks are likely to lose their mojo and correct.

If commodity sensitive stocks were to underperform, another crowded trade that is likely to reverse is USD weakness. The latest Commitment of Traders report shows that large speculators are in a crowded short in the USD, and crowded long in the euro.

The USD Index is now testing a key long-term Fibonacci support level and a rally could occur at any time.

Tactically, interest sensitive vehicles are not showing signs of a bottom yet. While investors could take a partial position now, traders may wish to either wait for a test of support, or an upside breakout of the downtrend line before making large commitments. The long Treasury bond ETF (TLT) is one example of this technical pattern.

REITs are also showing a similar pattern of approaching technical support while a downtrend line defines a possible bullish breakout.

Utilities have a less well define downtrend, but the technical pattern is roughly the same.

Nearing an inflection point?

Looking to the week ahead, the environment continues to be dominated by the FOMO stampede to buy stocks. As a possible sign of capitulation, Jason Goepfert at SentimenTrader threw up his hands Friday morning. Historical studies of sentiment, breadth, and overbought/oversold indicators don’t seem to matter anymore.

Still there are some signs that market internals are starting to weaken. Risk appetite indicators, as measured by price momentum and high beta/low volatility performance, are weakening. If the rally is based on rising risk appetite and price momentum, negative divergences in these indicators are warning flags for traders. Moreover, the latest SPX rally has been well defined by a rising channel, and the market closed Friday at the top of the channel. At a minimum, it is likely to pull back or consolidate next week even the advance were to continue.

Schaeffer’s Research also highlighted the weak performance of the DJ Transports. The Dow has not performed well after such episodes.

For what it’s worth, Tom McClellan found an unusual relationship between Bitcoin prices and the DJIA, where BTC leads DJIA by eight weeks. If his analog is correct, then expect stock prices to top out the week of February 8, 2018.

That timeframe is consistent with the latest Q4 earnings season update from FactSet. Bottom-up consensus forward 12-month EPS estimates continue to scream upwards, and bottom-up 2018 EPS estimates are up 3.8% since the passage of the tax cuts. While company analysts have hesitated to raise their estimates until they knew the precise details of the tax bill and the specific effects on their companies, top-down strategists have not been so shy and they have penciled in a 6-9% increase in 2018 EPS. At the current rate of revisions, tax-related upward estimate revisions should level out in about two weeks, or the week of February 8.

To be sure, estimate revisions may continue to rise after the tax bill effects wear off as positive revisions are based on a combination of favorable tax treatment and the positive cyclical effects of higher growth expectations. Q4 earning season has seen above EPS beat rates, an off-the-charts sales beat rate, and an extremely positive guidance rates for Q1.

It will be an open question whether faltering top-down growth expectations can overwhelm positive bottom-up guidance. Next week will could see some event-based volatility. We can look forward to the State of the Union address (Tuesday night), Janet Yellen’s final FOMC meeting as Fed chair (Tuesday and Wednesday), and the January Jobs Report (Friday). Q4 earnings season is also continuing and there will undoubtedly be stock specific surprises. Watch for earnings reports from momentum favorites Amazon (AMZN), Apple (AAPL), Boeing (BA), Facebook (FB), Alphabet (GOOGL), and VISA (V) for sources of volatility.

My inner investor remains equity bullish and he is enjoying this melt-up. My inner trader took a small short position last week. He is nervously waiting to see if risk appetite will break downwards. Farrell’s Rule #4 suggests that any breakdown will be a doozy.

Disclosure: Long SPXU

Out of words for ‘extreme’ and ‘unprecedented’

Posted by Cam Hui - January 24, 2018

Mid-week market update: most of this rally (see Embrace the blow-off, but with a stop-loss discipline published last November), but the scale of the unrelenting grind-up has been breathtaking. I have run out of words to describe “extreme” and “unprecedented” conditions. In short, the market has been dominated by momentum.

Josh Brown recently highlighted analysis by Ari Wald outlining the positive price momentum gripping the stock market. The high level of monthly RSI readings is indicative of a “good overbought” condition that has led to further gains.

Positive momentum can also be seen from a fundamental viewpoint as well. Ned Davis Research observed that bottom-up aggregated FY2018 EPS has been displaying the unusual pattern of a surge in upward revisions. Historically, Street analysts have tended to be overly optimistic and publish overly high EPS estimates, and revise them downward as time passes. The upward revision was undoubtedly related to company guidance of the effects of the recently passed corporate tax cuts.

Despite the Fed’s tightening bias, financial conditions have also been extremely easy, which is also supportive of the market’s risk-on tone.

When will this all end? It may be soon, as some cracks are appearing in the foundation of this rally.

Upside exhaustion

As the market’s surge has been led by price momentum, one warning flag appeared this week when the price momentum factor began to falter. Even as the market rose, the price momentum ETF (MTUM) began to lag the market. The last time this happened was in late December, and it led to a minor pullback in early January. This time, the pullback may be deeper, but a full correction cannot be confirmed until the relative uptrend line is violated.

J. Brett Freeze of Global Technical Analysis identified a condition of monthly upside exhaustion in ES futures. That’s another warning flag.

Lastly, Luke Kawa at Bloomberg pointed out that the NASDAQ 100, which is the foundation of the price momentum rally, is highly overbought:

A net 39 of the Nasdaq 100 Index’s constituents are trading at a relative strength above 70 — the most since June 2. The last time the group was flashing an overbought signal that strong, the tech-heavy gauge took a 5 percent tumble over the next month.

Fundamental momentum stalling?

There are also indications that fundamental momentum, as measured by 2018 estimate revisions, are due to stall soon. As I pointed out last weekend (see Bubbleology 102: What could derail this momentum driven rally?), bottom-up FY2018 EPS is up 3.4% since the passage of the tax bill in December. While bottom-up analysts have hesitated to raise their estimates without precise guidance from their companies, top-down strategists have not hesitated to do so, and they have penciled in a one-time 6-9% boost to 2018 earnings from lower taxes. At the current rate of about 1.2% per week, bottom-up estimates should catch up to top-down estimates in about 2-3 weeks.

Readers should therefore expect positive estimate revision momentum to die down about the first or second week of February.

As well, a number of macro developments, such as the emergence of a possible trade war, is appearing (see Sleepwalking toward a possible trade war). The risks of some nasty surprises are rising and traders are advised to, at a minimum, take some profits on their long positions.

My inner trader has courageously gone short. Subscribers received an email alert today indicating that my inner trader had moved off the sidelines and taken a small and initial short position in the market. I would underline the words “initial” and “small”, as standing in front of this momentum rally is like standing in front of a freight train, but he is prepared to add to his short positions as the situation develops. (Don’t ask me what my downside objective is. I have no idea, because much depends on the nature of the bearish trigger.)

Disclosure: Long SPXU

Sleepwalking toward a possible trade war

Posted by Cam Hui - January 23, 2018

Sometimes misunderstandings can lead to enormous adverse consequences. In 1941, Japan believed that war was inevitable with the United States. The Americans had slapped a trade embargo on Japan, and made it clear that Japanese occupation of China was unacceptable. The Japanese High Command saw that America was a big industrialized country with resources that it could not defeat in the long run. The only solution was a quick strike to destroy American combat capabilities. The logical solution was a sneak attack on Pearl Harbor as a way of crippling American naval power. The rest, as they say, is history.

Tokyo just had one fatal misinterpretation of the American position. Washington did not consider Manchuria, which was China’s industrial heartland and the jewel of Japan’s occupation of the Chinese mainland, to be part of China. Had Japan withdrawn its troops from the south and remained in Manchuria, American entry into the Second World War would have been delayed for several years. Under that scenario, Nazi Germany would not have been forced to fight a two front war. Britain and her Commonwealth Allies would have been too weak to land in Italy in 1943, and the D-Day landings would have been out of the question. There would have been no Manhattan Project, or it would have been delayed for several years. Hitler might have been able to develop the Bomb. History could have been dramatically changed,

A similar scenario is setting up in Sino-American relations. Both sides seem to be talking past each other. The result could be a trade war with catastrophic results (see Could a Trump trade war spark a bear market?).

A belligerent America

The first shot was fired this week when the Trump administration slapped tariffs on Chinese solar cell manufacturers and Korean washing machines (see press release). Bloomberg also reported that the Commerce Department submitted a report to the White House that could lead to tariffs on Chinese aluminum. A similar report on Chinese steel is also due imminently. A Reuters article described how Trump is considering retaliation over Chinese intellectual property theft.

In addition, Trump will be at WEF in Davos, where he is expected to make an aggressive “America First” speech on trade. Observations like this one are likely to raise his level of belligerence.

China miscalculates

Underlying this potential trade conflict is a miscalculation by Beijing that these tensions can be dealt with using the same old tools. Consider this Reuters report entitled China looks to call bluff on Trump trade action:

As influential voices within the U.S. business community warn China that U.S. President Donald Trump is serious about tough action over Beijing’s trade practices, there is little sense of a crisis in the Chinese capital, where officials think he is bluffing.

In Beijing, many experts think Washington is unwilling to pay the heavy economic price needed to upset prevailing trade dynamics between the world’s two largest economies…

People in the U.S. business community say this growing gulf in expectations between Washington and Beijing is fueled in part by the dwindling frequency of talks on commercial issues. The resulting vacuum could set the two governments on a collision course over trade.

China has seen these threats before, and they can be dealt with using the standard negotiation tools:

Beijing suspects that even if Trump implements “targeted tariffs,” as some in the U.S. tech sector expect, they would likely amount to just a few percentage points of the more than $600 billion annual goods and services trade, Chinese experts have said.

For local governments in export-dependent areas, the threat is more worrying. One official in the export powerhouse of Zhejiang province expressed concern to Reuters about Trump’s possible actions, but declined to speak on the record.

The government in Beijing, however, remains stoic.

“Are Chinese officials getting nervous now amid a coming U.S.-China trade war? I don’t think so,” said Wang Jiangyu, a trade expert at the National University of Singapore.

The country has negotiated its way out of previous Section 301 investigations, including in 1992 and 1995.

And a person close to China’s Commerce Ministry, who asked not to be named because of the sensitivity of the matter, said tariffs from the Section 301 case would be self-defeating, and urged negotiation instead.

“We should sit down and discuss this. If their demands are reasonable, we don’t want to go to the WTO,” the person said.

That inclination to fall back on talks and the WTO to resolve frictions may be China’s miscalculation this time, people in the U.S. business community say.

Moreover, the Chinese are used to an emphasis on personal relationships and back channels to smooth tensions (see the New Yorker article Jared Kushner is China’s Trump Card). China believes that “state plus” receptions, such as the one Trump received in Beijing, can serve to flatter Trump and enhance relations. Moreover, it can send the likes of Jack Ma of Alibaba to the US and promise a million jobs as a way of easing trade tensions (via Bloomberg).

America’s strategic pivot

Beijing’s miscalculation lays in a basic misunderstanding of Trump’s resolve. Trump’s conviction about unfair trade is part of his DNA, and nothing will move him off that belief. Now that he has achieved his main Republican priority of a major tax cut in his first year, expect Trump to be more Trump in trade policy.

Moreover, the newly released National Security Strategy of 2017 (NSS) refocuses and redefines America’s approach to foreign policy and trade. Economic security is now national security. China is now a strategic competitor. These views are not the results of midnight tweets, but a policy statement developed by staff within the Trump administration.

Daniel Rosen summed up the latest NSS this way:

While the competitive aspect of the US-China relationship has been creeping up for years, what really created foreboding at the end of 2017 was the connection of economic affairs to the China national security equation in the NSS. The Strategy suggests that hundreds of billions of dollars of commercial technology are nefariously conveyed to China every year, taking advantage of the permissive US attitude in the economic relationship. The strategy pledges to end this, and this line is already evident in policy: trade actions against imports, action to make investment screening stricter, and disengagement from government to government dialogues are happening, now. President Trump will tie these threads together (and likely add to them) in his State of the Union address January 30.

So to sum up what has changed:

China: No longer maintains ambiguity about the nature of the Chinese system and whether it will converge with OECD norms: it emphasizes the differentness and says it won’t.

The US: Now defines China as a strategic competitor, not a transitional nation converging with our norms, and sees economic dynamics as core to this competition: engagement is now a verb – sometimes the right action – not a noun describing policy.

Rosen went on to outline the implications of this policy pivot:

Some consequences of a strategic shift are already evident. Of four bilateral dialogues President Trump kicked-off at Mar-a-Lago, three are frozen (economics, law-enforcement, and people-to-people: only the military-to-military channel is still operational, largely on the topic of North Korea). Dozens of agency-to-agency channels of engagement set up over the past decades are in hiatus. Very few American officials are visiting China. China is not alone in this regard, but the US-China bilateral agenda is more important that virtually any other. This reduces the channels for managing and delivering solutions on the broad spectrum of bilateral issues in the future.

The strategic redirection means stepped-up trade and investment confrontation. It remains unclear whether US economic policy will be tailored and specific, or very broad. Tailored looks like high dumping duties on specific types of steel and aluminum products; broad means arguments such as that Chinese capital costs, energy prices, land rents, intellectual property costs and other fundamentals are all inherently subsidized, and should be countervailed by high duties on virtually anything shipped from China (including goods from US firms in China).

Likewise on the direct investment (FDI) front, the US could reasonably step-up screening for truly security-relevant concerns and yet still leave plenty of room for a multifold rise in inflows (this is essentially current policy); or, it could go beyond narrowly security-oriented issues and make it hard for Chinese investors to do even basic deals in mature industries. That would satisfy the US appetite for “reciprocity”, but it might not do the US any good.

How any of this plays out, no one knows:

Where on the spectrum these US policies come out in practice over the coming months will make all the difference. Steps by Beijing to compromise may yet help mitigate the outcome, although so far there is little indication that this is in train. China will of course retaliate, to different degrees depending on the breadth of US actions and its own strategic analysis.

A recent New Yorker article pointed out that Sino-American competition is not just on trade, but in military terms:

The Defense Department is trying to change that, an effort reflected in its latest National Defense Strategy. Syntactically, the document is fairly straightforward: the Pentagon wants more money to buy more stuff. But the type of war it plans to fight is novel. In short, the Pentagon is trying to move on from the war on terror. “Inter-state strategic competition, not terrorism, is now the primary concern in U.S. national security,” the strategy, which is being released later today, reads. China and Russia are now America’s “principal priorities.”

The DoD is sounding the alarm about how American military forces are configured to fight small wars, much in the same way that British forces were configured for small counter-insurgency conflicts such as the Boer War early in the 20th Century when it was caught offside when it entered the First World War:

Some Defense officials see the continued focus on post-9/11 foreign interventions as problematic over the long term. While hundreds of thousands of Americans were fighting religious zealots in the desert, the Chinese and Russians were building new rockets and satellites. “There’s always an opportunity cost. The forty-five billion that we’re spending a year in Syria and Afghanistan would fill a lot of holes in our arsenal,” the senior Defense official said. “A professional boxer who trains against lesser opponents doesn’t improve.”

Doug Wise, a former C.I.A. paramilitary and operations officer who served in the Middle East before becoming the deputy director of the Defense Intelligence Agency, said counterterrorism missions were critical, but came with a cost. The deaths caused by suicide bombers and maniacs who shoot up night clubs were “terrible tragedies,” he said, but, in the end, “Can ISIS destroy the American way of life? Probably not.” He went on, “You want to talk about an existential threat? How about China’s hypersonic glide missile, which can travel at multiple times the speed of sound and could take out an aircraft carrier before you could even blink? If the entire Pacific Fleet was at the bottom of the Pacific Ocean, that would pose an existential threat.”

As China has become more powerful, she has become more assertive in her foreign policy. The latest NSS of 2017 is heightening the risk of a military conflict in the South China Sea.

Risks are rising

Davos attendees were polled on changes in risk levels in 2018 compared to 2017. The biggest increase came from the category of “political or economic confrontations/friction between major powers”. The second was “state on state military conflict or incursion”.

For now, the markets appear to shrugging off these protectionist threats. I wrote about some of the likely consequences of a trade war (see Could a Trump trade war spark a bear market?). When does the market start to discount these concerns?

¯\_(ツ)_/¯

Tactically, these risks have a way of not mattering until they matter, especially in an environment dominated by price momentum. The Goldman Sachs Risk Barometer has now risen to a record level that exceeds the market highs seen in 2000 and 2007.

Rob Hanna at Quantifiable Edges discovered six instances since 1960 where momentum has been this powerful. He found that prices have continued to rise, but with the sample size this small (N=6), and only a single episode in the last 30 years, he concluded that the study “make me a little more wary of trying to short into this strength”.

Tactically, traders would be best served by waiting for the downside break before getting overly bearish.

Bubbleology 102: What could derail this momentum driven rally?

Posted by Cam Hui - January 21, 2018

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

The latest signals of each model are as follows:

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

Looking for the bearish trigger
Last week, I wrote about how the price momentum factor is dominating equity returns (see Bubbleology 101: How to spot the top in a market melt-up). Most intermediate term tops, even with a parabolic market, saw double tops that are marked by negative technical divergences at the second top. As stock prices continue to rise, we have not even seen the first retreat yet.

What is likely to spark the first pullback? Recently, a number of extreme overbought readings have appeared, indicating risk levels last seen before the major market crashes in 1929 and 1987. Callum Thomas highlighted analysis by Sven Henrich, otherwise known as Northman Trader. Henrich found that you would have to go back to pre-crash 1929, before the RSI indicator was invented, to see weekly RSI as high as they are today.

Callum Thomas also highlighted this chart from Ed Yardeni which indicated that the II bull/bear ratio has not seen these heights since pre-crash 1987.

Are the appearance of these ominous signs warnings of an imminent market crash?

Beware of red herrings

I beg to differ about these depictions of excessive market risk.

First, the appearance of high RSI extremes is a red herring. I wrote in last week’s post (see Bubbleology 101: How to spot the top in a market melt-up) that extremely high RSI readings should really be interpreted as “good overbought” readings that characterize momentum thrusts. If history is any guide, these kinds of overbought conditions have led to multi-month rallies to substantially high prices.

Yardeni’s chart of II bulls and bears also has to be viewed in the context that crowded long sentiment readings do not represent actionable sell signals. The chart below shows the history of the market, with the red zones indicating when the II bull/bear ratio exceeded 3. The leftmost part of the chart shows the market staged a minor pullback after the first II bull/bear ratio extreme, but went on to advance before crashing. In addition, the market did not decline immediate during past periods where the bull/bear ratio was above 3.

The market action in 1987 serves as a good case study for the analysis of market tops. Stock prices generally don’t enter bear market spontaneously without a reason. In 1987, it was the aggressive action of the Federal Reserve to raise interest rates by about 1% in the space of two months.

Bearish triggers

Fast forward to today’s momentum driven market frenzy. What are the fundamental and macro driven catalysts that could spark an equity pullback?

There are three obvious sources of negative surprises on the horizon:

Rising trade tensions
Negative macro surprises
Rising inflation and rising bond yields

Let’s consider each, one at a time.

Trade tensions

While a trade war is not my base case scenario, I recently wrote about the likely fallout from trade tensions (see Could a Trump trade war spark a bear market?). Here are some key news developments that have occurred since the publication of that post:

China’s surging exports widen trade surplus with the US (CNN Money)
Trump considers big “fine” over China intellectual property theft (Reuters)
Trump says terminating NAFTA would like “best deal” in re-negotiations (Reuters)

The most disturbing comment from Trump came from the Reuters story about Chinese trade action:

Trump said he would be announcing some kind of action against China over trade and said he would discuss the issue during his State of the Union address to the U.S. Congress on Jan. 30.

Asked about the potential for a trade war depending on U.S. action over steel, aluminum and solar panels, Trump said he hoped a trade war would not ensue.

“I don’t think so, I hope not. But if there is, there is,” he said.

American trade action against China would come at a particularly troublesome time for the Chinese economy. Business Insider reported that China is becoming increasingly dependent on exports as a source of economic growth, as Beijing acts slow down domestic credit growth.

China’s reported gross-domestic-product growth held up at 6.8% in Q4, but the perplexing story in the numbers is that China’s domestic economy is slowing down under purposely tighter economic conditions.

Societe Generale called this “an uneven picture of very strong external demand and weakening domestic demand” and noted that net exports’ contribution to GDP increased during 2017. At the same time, both domestic consumption and investment saw their contributions to GDP decline from 2016.

Chinese officials are tightening credit to slowly ween the country’s financial and corporate sectors off of debt financing. Now, this isn’t to say policymakers have taken a hatchet to the system or anything, but what little they have done is starting to make an impact.

This makes the economic health of the rest of the world incredibly important to China, because as its domestic economy slows it will depend on demand from the rest of the world to keep its economy going. It also means Trump’s promises to control imports from China to the US could make things particularly painful — if he follows through.

If the Chinese economy were to slow, it would drag down her Asian trading partners, as well as resource exporting countries such as Australian, Brazil, Canada, and South Africa. None of these developments would be equity friendly.

Negative macro surprises

Another possible negative surprise that may not be in anyone’s spreadsheet model is an abrupt loss of macro momentum. The US Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, has shown a seasonal tendency to peak out early in the new year. It does not appear that 2018 will be an exception.

Already, there are some cracks appearing in the edifice of macro strength. Initial jobless claims has shown a remarkable inverse correlation with stock prices this cycle. The latest data shows that initial claims are starting to roll over, while stock prices continue to rise. Is this negative divergence just a temporary data blip? If not, how long can stock prices defy gravity?

Another example of a negative macro surprise came from the housing report last week. Housing starts appear to be plateauing, and possibly rolling over. The sector is further pressured by rising mortgage rates. While the deterioration in these indicators are not immediate harbingers of doom and recession, negative developments in cyclically sensitive sectors like housing will eventually feed through to consumer and investor confidence.

Rising inflation risks

Finally, investors need to be wary of rising inflation as it could spark a mini-panic. The inflation theme should be no surprise to institutional investors. The latest BAML Fund Manager Survey lists “inflation and bond crash” as the top market tail risk.

Inflationary pressures is already rising. Nordea Markets observed that the New York Fed’s Underlying Inflation Gauge appears to lead core CPI by about 15 months.

Over in the bond market, inflation expectations are rising as breakeven rates climb.

None of these developments are surprising. That’s because the economy is starting to run hot and above potential.

Inflationary pressures are also manifested by rising commodity prices. Notwithstanding the Fed’s use of core inflation gauges, commodity price movements have historically been correlated with CPI and PPI.

James Hamilton is known for his excellent work documenting the link between oil shocks and recessions. Hamilton found that “every recession (with one exception) was preceded by an increase in oil prices, and every oil market disruption (with one exception) was followed by an economic recession.”

The chart below depicts the 20-year history of oil prices. Whenever the year/year change in oil prices reaches 100%, a recession and bear market has ensued. (I discount the 2010 episode because of the low base effect as the economy had fallen into recession in 2009).

If oil were to reach $85-90 by July, we could see a similar warning signal from the crude oil market.

Is $85-90 oil possible by this summer? The WSJ recently published a story entitled “Whispers of $80 oil are growing louder”, which is supportive of higher prices:

Byron Wien, vice chairman of the Private Wealth Solutions group at Blackstone, put $80 West Texas Intermediate on his annual list of 10 surprises in store for markets this year.

“Demand is going to continue to increase faster than supply,” he said in an interview. “It’s out of consensus, but people are underestimating the expanding middle class in the developing world and their resultant demand.”

Shrinking inventories, commitment by the Organization of the Petroleum Exporting Countries to cut output through the year, and only modest production growth from outside the group could all also push prices higher, he said.

Production cuts by OPEC and other major producers and unexpectedly strong demand were a potent mix last year, helping pull prices out of a three year downturn.

Citigroup also said $80 is a possibility. In a note Tuesday, the bank said the right combination of geopolitical crises could tip crude prices into the $70 to $80 range. With supplies already so tight, any unexpected disruption could cause prices to surge.

Oil analyst Peter Tertzakian pointed out that, historically, $60 has not been an equilibrium price for oil. Either it rises dramatically, or falls back because of the supply response to prices.

Iil service giant Schlumberger stated in its Q4 2017 report that it is seeing a supply response to low oil prices. Production is showing “signs of fatigue after three years of unprecedented underinvestment”:

Looking at the oil market, the strong growth in demand is projected to continue in 2018, on the back of a robust global economy. On the supply side, the extension of the OPEC- and Russia-led production cuts is already translating into higher-than-expected inventory draws. In North America, 2018 shale oil production is set for another year of strong growth, as the positive oil market sentiments will likely increase both investment appetite and availability of financing. At the same time, the production base in the rest of the world is showing fatigue after three years of unprecedented underinvestment. The underlying signs of weakness will likely become more evident in the coming year, as the production additions from investments made in the previous upcycle start to noticeably fall off. All together this means the oil market is now in balance and the previous oversupply discount is gradually being replaced by a market tightness premium, which makes us increasingly positive on the global outlook for our business.

Another possible short-term bullish development is the likely launch of oil futures trading in China (via Platts). In the past, China’s great big ball of liquidity has rolled from the property market, to the stock market, and metals market. Just wait until Chinese speculators start trading oil futures.

Is $85-90 oil by this summer a possibility? Definitely. Spiking oil prices would be a signal of a global boom and inflationary pressures, which would force the Fed to react with a faster pace of rate hikes.

Bond market tantrum?

Already, the yield on the 10-year Treasury note reached 2.66% last Friday, which represents an upside breakout in yields that could spook the equity market.

If the bond market were to throw a tantrum because of rising inflationary expectations, then any yield spike could be exacerbated by demand-supply pressures from the effects of the recently passed tax bill. Bloomberg reported that Deutsche Bank strategist Torsten Slok warned about excess Treasury supply flooding the market because of rising US deficits:

A “dramatic” increase in U.S. bond supply over the next year risks unhinging global markets from their bullish foundations, warns Torsten Slok at Deutsche Bank AG.

The supply of U.S. government debt will almost double to $1 trillion this year to finance a widening budget deficit as the Federal Reserve whittles down its holdings. Unless new buyers emerge, the overhang could be far-reaching.

“If demand for U.S. fixed income doesn’t double over the coming years then U.S. long rates will move higher, credit spreads will widen, the dollar will fall, and stocks will likely go down as foreigners move out of depreciating U.S. assets,” the chief international economist at the German lender wrote in a note Tuesday. “And this could happen even in a situation where U.S. economic fundamentals remain solid.”

A separate Bloomberg report warned about American multi-nationals redeploying offshore corporate cash that is mainly invested in USD paper to dividends and buybacks.

The implications for the financial markets are huge. The great on-shoring could prompt multinationals — which have parked much of their overseas profits in Treasuries and U.S. investment-grade corporate debt — to lighten up on bonds and use the money to goose their stock prices. Think buybacks and dividends.

It’s hard to say how much money the companies might repatriate, but the size of their overseas stash is staggering. An estimated $3.1 trillion of corporate cash is now held offshore. Led by the tech giants, a handful of the biggest companies sit on over a half-trillion dollars in U.S. securities. In other words, they dwarf most mutual funds and hedge funds.

Equity valuation warning

At this point, we can only guess at the magnitude of these effects on bond yields and credit spreads. At best, the effects will be benign. At worst, bond yields will rise and spook equity prices. Antonio Fatas recently updated his calculation of the US equity risk premium based on a 10-year Treasury yield of 2.64%. Readings are falling, and they are approaching the levels seen at the last market peak in 2017.

Dwaine Van Vuuren of RecessionAlert came to a similar conclusion about equity market valuation. His 10-year forecasts of equity returns have an astounding r-squared of 0.89. Investors can also back out a one-year forecast from his 10-year forecast by using the past returns of the last 9 years. The one-year forecast has an r-squared of 0.40, which is also quite remarkable. The latest forecast have one-year returns plunging to 0%.

Ouch!

The bull and bear cases

Putting it all together, are stock prices like to rise or fall? Here are the short-term bull and bear cases.

On one hand, the market is undergoing a powerful momentum driven FOMO rally. As I pointed out in last week’s post (see How far can this momentum rally run?), the latest BAML Fund Manager Survey indicates that institutional investors have not fully capitulated to the FOMO stampede. If this is indeed a melt-up and market blow-off, then there is considerable upside potential for the animal spirits to run up stock prices.

Moreover, fundamental earning momentum have further to run. The latest report from FactSet shows that bottom-up forward 12-month consensus EPS are still surging, and the rise is mainly attributable to the tax cuts. Top-down strategists have already adjusted their 2018 estimates, and most estimates indicate a 6-9% boost to 2018 EPS. Bottom-up analysts are roughly half way through their own upward estimate revisions, as their 2018 aggregated EPS is up 3.4% since December. If estimate revisions were to continue at the current pace, bottom-up tax cut related improvements would exhaust themselves by early February.

On the other hand, there are a number of serious technical and sentiment cracks in the short-term outlook. Schaeffer’s Research observed that 40% of the SPX hit 52-week highs two weeks ago. This is a rare condition (N=8) that has led to poor subsequent market returns.

The history cited by Schaeffer’s has four observations that overlap. Eliminating those leaves an even smaller sample size (N=4). Near term returns have not been positive under those historical conditions.

Rob Hanna at Quantifiable Edges studied past instances when SPX and VIX rose together to new highs. Past returns were negative, but Hanna went on to warn about the small sample size (N=4), which is an indication of the unusual circumstances that the market faces today.

Along with Rob Hanna, I continue to be concerned about the spike in SPX-VIX correlation. Past episodes have seen the market struggle to advance.

What does this all mean? Here is how I put the bull and bear cases into context. Canaccord Genuity strategist Tony Dwyer found that a low level of II bears have not bee contrarian bearish. If history is any guide, expect heightened volatility and higher highs.

That sounds about right. My base case scenario calls for some chop ahead, but the momentum rally to continue. I am awaiting possible bearish catalysts that can derail this bull. The most likely trigger will by a Trump administration action to impose tariffs on China later this month.

My inner investor remains bullish on equities. My inner trader is stepping aside from the potential volatility for the moment. Even though the trading model remains on a buy signal, I cannot characterized it as a high conviction buy. The prudent course of action is to stay in cash for the moment – and be “data dependent”.

Stay tuned.

Trump’s one-year report card

Posted by Cam Hui - January 18, 2018

As we approach the one-year anniversary of Donald Trump’s first year in office, I am seeing numerous commentaries assessing his first year in office (see FiveThirtyEight, The Economist and BBC) . About a year ago, I laid out my criteria for his success (see Forget politics! Here are the 5 key macro indicators of Trump’s political fortunes) using the criteria that Newt Gingrich specified in a New York Times interview:

“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”

“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”

As Trump has “kept America safe”, because, like it or not, mass shootings such as the one in Las Vegas doesn’t politically count as a terrorist incident. From a strictly economics viewpoint to judge whether he “created a lot of jobs”, I used the Bloomberg Intelligence economic criteria to judge Trump on his economic record.

Despite all of the outrage of the anti-Trumpers, Trump`s economic record has been quite good in the past year.

Trump’s economic record

The hard evidence indicates that the economy performed very well in Trump’s first year. Here are the five economic metrics that I laid out in my past post.

The prime age labor force participation rate rose in the past year as more people re-entered the workforce. Give him an A for this.

Similarly, Trump promised good jobs. Full time workers as % of the labor force is rising, which is also good news for the economy. Give him another A.

What about manufacturing jobs. The bad news for the Trump administration is manufacturing workers in the economy has been flat in the last year. The good news is they have been in secular decline, and the decline stopped in the last twelve months. Call it a C+.

Here is another piece of good news. CapEx is edging upwards after several years of decline. Give him a B.

Lastly, I rely on the combination of NFIB small business confidence and Gallup economic confidence to see if the Trump administration has re-ignited the economy’s animal spirits. NFIB small business confidence surged shortly after the election and it has plateaued.

The NFIB reported that both expected and actual sales have surged…

Though small business earnings have not followed suit. This could be attributable to a gap between expectations and actual results.

A similar pattern of rising optimism can be seen in the Gallup economic confidence index.

Give him an A- for “animal spirits”, with a caveat about possible disappointment in the future.

In conclusion, the Trump administration has earned a lot of A’s in its first year. Call it an A-.

Grading on a curve

To be sure, much of the surge in economic growth and rising stock prices can be attributed to a global growth revival. If we were to grade on a curve, US equities have underperformed the MSCI All-Country World Index since the inauguration. Their returns have been choppy and only slightly ahead of global stocks since the election, but down from Inauguration Day.

As well, the Gallup presidential approval ratings has fallen since the inauguration and they have been range bound between 35% and 40% since last summer, which is in the low of the historical range for presidents.

The bottom line is, based strictly on economic performance, the Trump administration has performed well on an absolute basis, though his approval rating remain mired in the low side of the historical range. I will update these figures later this year just before the midterm elections.

How far can this momentum rally run?

Posted by Cam Hui - January 17, 2018

Mid-week market update: How far can this momentum rally run? Already, the momentum frenzy is exceeding the pace set during the height of the Tech Bubble.

The WSJ recently published an article about the dominance of price momentum: “The Momentum Game Has Returned to the Stock Market”.

Forget fundamentals: Momentum is back in the stock market. For the first time since the 2008 financial crisis a simple strategy of buying the stocks that had already gone up the most delivered a remarkable outperformance last year. Is it a sign of excess or the start of a new bull run?

Momentum is a formal way to capture two old Wall Street dictums: The trend is your friend until the end, and let your winners run. It can be measured over any period from microseconds to years, but investment strategies typically look for three-, six- or 12-month trends.

The article went on to lay out the bull and bear cases for momentum, and, by implication, the latest bull run:

There are two prevalent explanations for momentum, and today the choice will make you more or less worried about the power of the trend.

The bearish explanation is that investors put far too much weight on the past, and buy what has gone up without properly assessing whether that is likely to continue. Momentum is created by this blind buying, and pulls prices further and further away from where they should be, until they snap back and crush those chasing gains.

The bullish explanation is that it takes time for investors to price in a new environment.

On this view prices rose as investors slowly woke up to the unexpected global economic strength and slowly came to believe in higher profits. Perhaps company analysts still haven’t included U.S. corporate tax cuts in their profit forecasts due to their complexity, which could mean still more good news to come as the earnings season brings tax guidance from CFOs.

Certainly, a number of sentiment indicators are looking stretched. Bloomberg reported that the prices of call options are extremely expensive relative to the price of put option protection.

Strategist Jim Paulsen, who had been very bullish, sounded a word of caution in a recent CNBC interview:

The stock market has incredible price momentum and broad participation but the challenges are “truly increasing,” widely followed strategist Jim Paulsen told CNBC on Tuesday.

In fact, he called the optimism of late “really overwhelming.”

“It’s so striking because we haven’t had it in the entire recovery. The wall of worry was probably the cornerstone of this bull market. … That is gone,” the chief investment officer at the Lethold Group said in an interview with “Power Lunch.”

“That opens you up to the bear’s bite,” he added.

Is the combination of a pause in stock prices Tuesday and the carnage in crytpocurrencies* represent a warning that the momentum run is nearing an end? If so, does that mean the stock market is destined to suffer a near-term correction?

* Sorry, the cryptos aren’t tanking, that’s just a dead-cat bounce in the value of the fiat paper currencies.

How crowded is the momentum trade?

Consider the intermediate term evidence on price momentum. This chart from the WSJ article is certainly suggestive that outperformance of this factor is stretched on a historical basis.

The latest evidence from January 2018 BAML Fund Manager Survey (FMS) is mixed. On one hand, the latest results indicate that fund managers have thrown caution to the wind and discarded the tail-risk hedges in their portfolios, which can be interpreted as contrarian bearish.

As well, fund managers are now excessively bullish on equities. On the other hand, the historical evidence indicates that these crowded long conditions can persistent for a long time. In fact, these conditions could be interpreted as supportive of a melt-up scenario, as these sentiment readings represent only the start of a momentum thrust in the market.

In addition, managers remain skeptical about the dominance of price momentum. They still believe that high quality stocks will outperform.

If this is truly a melt-up and momentum frenzy, then managers need to capitulate and go all-in on price momentum as a factor. That hasn’t happened yet.

Short-term volatility ahead

Subscribers received an email notification that my trading account had taken profits in its long positions and it had gone to 100% cash. That’s because a short-term spike in SPX-VIX correlation has historically resulted in some short-term sloppiness. Since that alert, the 10-day correlation has continued to rise.

This week is option expiry week. Rob Hanna at Quantifiable Edges found that returns during January OpEx has been weak and volatile. Jeff Hirsch at Almanac Trader came to a similar conclusion and described January OpEx as “choppy”.

While I am getting ready for some short-term volatility, my inner trader is not prepared to turn bearish on this market yet. As long as momentum is holding up, which it is…

…and credit market risk appetite remains positive, which it is, I am inclined to give the bull case the benefit of the doubt.

Unless these factors turn south, my inner trader is getting ready to buy any significant dips.

Bubbleology 101: How to spot the top in a market melt-up

Posted by Cam Hui - January 14, 2018

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

The latest signals of each model are as follows:

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

Come over to the Dark Side

I have a confession to make. I’ve gone over to the Dark Side. Valuation doesn’t matter. Excessively bullish sentiment doesn’t matter. Overbought readings don’t matter. The only thing matters is the Melt-Up (see Embrace the blow-off, but with a stop-loss discipline and Jeremy Grantham’s call for a market melt-up).

If the market is indeed undergoing a blow-off rally, then investors should be mindful of Bob Farrell’s Rule #4: “Parabolic markets go up further than you think, but they don’t correct by going sideways.”

Nevertheless, there are a number of simple techniques of spotting the top in a parabolic move.

How parabolic tops resolves themselves

When a market goes parabolic, standard analytical techniques don’t matter. The only factor that matters is emotion. Under these conditions, I rely on technical analysis to spot the top on an intermediate term basis.

One of the common patterns that occurs when a market tops out in a buying frenzy is the double top. The market will make a first high, retreat, and then rally to a second high several months later. One of the more notable double tops was the 1980 generational top in gold prices, when it briefly touched $850 in January on the news of the Soviet invasion of Afghanistan in December 1979, the Hunt brothers’ attempt to corner the silver market, which pushed up gold prices, and rising inflationary expectations that the Volcker Fed eventually stamped out with a series of painful interest rate hikes.

Another frenzied top occurred in 2000 when the NASDAQ staged an upside blow-off. While the double top was less discernible in the chart of the NASDAQ Composite, the pattern is far clearer in the SPX, which saw a negative RSI divergence as stock prices rallied after the initial top.

This same pattern of double top and negative RSI divergence can be found in the chart of DJ Global Index. This chart illustrates an important point that was missing in the previous two charts, namely that the second high may or may not exceed the first high. The latest reading shows that the index is highly overbought, but it has not made the initial top yet. Wait for the decline, and watch for the negative divergence, if any, as an intermediate term signal of a blow-off top.

A similar pattern of negative divergences at major market tops can be found in Callum Thomas’ Euphoriameter, which is the combination of Forward P/E, VIX, and Bullish Sentiment (chart annotations are mine).

No signs of an imminent top

Current readings show no signs of an imminent top.

Even as Jeremy Grantham called for a possible melt-up, Mark Hulbert pointed out that James Montier, who is part of GMO’s asset allocation team, pointed out that price momentum is dominant during the formation of an asset bubble:

But the more I examined the issue, the more I discovered a different possibility: It’s not necessarily irrational to continue investing in the market even as the odds of a bubble increase — even if it’s not for the faint of heart.

I owe this insight to James Montier, a member of the asset allocation team at Boston-based GMO. In a study he conducted several years ago, he pointed out that investing in a bubble can be rational so long as the market delivers ever-higher returns as the odds of its bursting also increase. It’s just a matter of risk and reward: If the reward is great enough, virtually any risk can be tolerated.

Though Montier doesn’t use this analogy, it’s akin to playing Russian Roulette with your money. Each successive month in which the bubble doesn’t burst is akin to the gun firing a blank. Of course, that only increases the odds even more that the bursting will happen in the subsequent one. To continue playing the game, investors need to be promised a bigger and bigger payoff.

Montier’s model helps to explain why the market’s advance becomes parabolic right before a bubble bursts. Just recall the market’s rise in the final stages of the internet bubble: In the last six months before that bubble burst in March 2000, the Nasdaq Composite doubled in value.

This is also part of the reason why Montier’s colleague, Jeremy Grantham, is advising clients to ready for themselves for a “melt-up” in the stock market before the current bubble bursts. He points out that, strong as the stock market has been over the last year, it hasn’t risen at the near-parabolic rates that were produced in the latter stages of past bubbles.

If momentum is a characteristic of bubbles and melt-ups, then the behavior of this factor indicates that the blow-off is not at an end. MTUM, which is the price momentum ETF, remains in a healthy relative uptrend to the market.

In this momentum mad environment, some of the traditional technical and sentiment indicators that would normally indicate caution can have unexpectedly bullish interpretations. This chart of 14-month RSI shows that the market is wildly overbought and stretched to the upside, but these readings can be seen as “good overbought” conditions indicating positive momentum. Indeed, such conditions have led to substantially higher prices in the past.

Similarly, Nautilus Research found that a crowded long in the AAII sentiment survey has historically been bullish.

…and an absence of bears in the II survey has similarly led to higher equity returns in the past.

There are also signs of fundamental momentum at work as well. Ned Davis Research pointed out that the typical pattern of aggregated consensus EPS estimates is they start high, and then slowly decay over time. That`s because analysts tend to be overly optimistic, and cut their estimates as the actual earnings reporting dates approach. This year, 2018 EPS estimates unusually rose, possibly due to the effects of the recently tax cuts.

To quantify the tax cut effect, FactSet reported that forward EPS has risen an astonishing 1.90% in one week, and 3.02% since December. Moreover, 2018 estimates have risen 2.2% from December 20 to January 11. The increase in these bottom-up aggregates only began when the actual details of the tax bill became known, as company analysts would not raise their estimates until they could calculate the precise impact of the corporate tax cuts on the companies in their coverage universe.

However, we can get an idea of the magnitude of the tax-cut effect another way. Top-down strategists have not been shy about estimating the impact of the tax bill, and most top-down forecasts call for an increase of 6-9% in 2018 EPS. As FactSet reported that 2018 EPS estimates have only risen 2.2%, the upward momentum in bottom-up EPS revisions is likely to continue.

Come over to the Dark Side. Don’t turn bearish too soon.

The week ahead

Looking to the week ahead, the tactical technical picture remains positive. Despite many readings of an extended market, which can be ignored, some of my key indicators are not flashing short-term sell signals yet.

During the market rally, the term structure of the VIX Index moved to an extreme complacent reading on January 3. As the stock market continued its advance, this sentiment indicator retreated to neutral indicating cautiousness. In other words, the market is climbing a wall of worry.

We can see a similar effect in the VIX Index last week. As stock prices rose, the VIX Index unusually rose along with the market. I am in debt to Jesse Felder, who pioneered the use of the 10-day SPX-VIX correlation as an indicator. In the past, spikes in SPX-VIX correlations has seen the market struggle to maintain its advance. Current readings are not in the danger zone yet.

In addition, credit markets are not showing any signs that risk appetite is one the wane. The price action in investment grade (IG), junk bonds, or high yield (HY), and emerging market (EM) bonds are all confirming the equity market advance.

Rob Hanna of Quantifiable Edges published the following study on Thursday after the market briefly paused its advance. He confirmed my own analysis about the persistence of price momentum under the current circumstances (see Can the melt-up continue?). If history is any guide, the market advance is likely to continue.

I would nevertheless like to offer a word of caution. Breadth indicators from Index Indicators are flashing overbought conditions. However, overbought markets can continue to stay overbought, and momentum surges have led to higher prices in the past.

Lastly, I found an encouraging reading from the Commitment of Traders (COT) data. My conclusion of analysis of COT data has found that COT analysis of the SPX and Russell 2000 was not effective at forecasting future directional moves. However, extreme readings in the NASDAQ 100 was a useful contrarian signal, as NASDAQ 100 index represent a highly liquid instrument to make high beta bets.

The latest report from Hedgopia found that large speculators (read: hedge funds) are moving off a crowded short position in the NDX. This suggests that some people in the fast money crowd got caught offside as the market rose. Traders who got caught are likely feeling a lot of pain in this updraft, indicating that there is potential buying power as risk managers force hedge fund traders and portfolio managers to cover their short NDX positions.

Come over to the Dark Side! Party on!

My inner investor remains bullishly positioned, and my inner trader added to his long positions after the brief pause that he anticipated (see Can the melt-up continue?). In a future post, I will detail the risks that may derail this blow-off. Stay tuned for Bubbleology 102.

Disclosure: Long SPXL

Can the melt-up continue?

Posted by Cam Hui - January 10, 2018

Mid-week market update: The week began on a bullish note this week as the melt-up theme dominated early in the week (see Jeremy Grantham`s call for a possible melt-up, and my own views published last November: Embrace the blow-off, but with a stop loss discipline). On Monday, the market rose for a fifth consecutive day, which flashed a First Five Day (FFD) buy signal. Ryan Detrick at LPL Financial detailed the historical evidence of this momentum effect for the remainder of the year.

In addition, analysis from Jeff Hirsch of Almanac Trader showing a shorter positive momentum effects of the FFD for the remainder of January, shown as JB in the table below (January Barometer). Since 1950, whenever the first five days was positive, the rest of January went on to be positive 86% of the time, with an average return of 2.6% and median return of 2.1% for the remainder of the month (N=29).

The market celebrated with another win on Tuesday, making its winning streak an astounding six consecutive days. The risk-on rally came to a screeching halt when China reported was considering slowing down or halting its purchases of Treasury paper. The initial reaction saw the yield on 10-year Treasury note spiked and a steepening of the yield curve, though both ended the day roughly unchanged. At the same time, the stock market took a risk-off tone. Here is the Bloomberg report:

Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.

Arguably, the response from Beijing was a warning shot to the Trump administration over the prospect of a trade war (see Could a Trump trade war spark a bear market?).

China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly.

Is this the end of the momentum rally?

Making sense of the China announcement

Frankly, neither the China announcement nor the bond market’s reaction makes much sense to me. The only plausible explanation is that this represents a preemptive negotiating tactics in anticipation of possible American imposition of tariffs on Chinese aluminum and steel exports later this month.

Here is some simple math. As long as China runs a trade surplus with the US, it receives USD for the sale of its exports. In turn, China could either sell the USD and buy CNY, which would drive up the CNYUSD exchange rate and make Chinese exports less competitive, or it could opt to hold USD assets. Alternatively, it could choose to hold other assets, such as euros (good luck buying Bunds with negative yields). If it chose to hold USD assets, then the PBoC can either choose Treasury securities, or more risky alternatives such as MBS or corporate bonds.

Brad Setser also pointed out that China’s UST holdings have tended to match changes its foreign exchange reserves. As long as China is running a significant US trade surplus, the threat to either stop buying USTs is therefore an empty one.

Another paradoxical reaction to the news is the steepening of the yield curve in response to the news. Matthew Klein at FT Alphaville pointed out the following anomaly. The chart below depicts the maturity profile of outstanding Treasury securities.

Klein observed that foreign central banks tend to underweight the long end of the curve and concentrate their holdings in the short end:

Foreign governments, in the aggregate, only keep around 3 per cent of their US Treasury holdings in bonds that take 10 years or more to mature, even though these instruments have consistently constituted about 13 per cent of the total over the past decade. Foreign reserve managers are also underweight the long end even if we focus on the narrower category of bonds in the 10-20 year sector: 1.4 per cent of their portfolio in 2014 vs 3 per cent of the total outstanding.

If China and other central banks were to sell USTs, then the short yields should be rising faster than long yields. In other words, the yield curve should flatten, not steepen, in response to the latest China news.

I therefore conclude that the latest risk-off episode is only a hiccup and not the start of a sustainable bear phase.

Momentum lives!

For a different perspective on stock prices, I tweeted the following analysis yesterday and the conclusion still holds. The market had been rising for six consecutive days and conditions were becoming overbought. If history is any guide, it is due for a minor pause in the rally, but don’t count the price momentum effect out just yet. The latest momentum thrust should peak out in around two weeks, after a brief 1-2 day pause.

The China bond market news was the ideal catalyst to spook the market at the right time. My inner trader remains bullishly positioned.

Disclosure: Long SPXL

Things you don’t see at market bottoms: Retail stampede edition

Posted by Cam Hui - January 8, 2018

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

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Five steps, where’s the stumble?). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:

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. Jeremy Grantham of GMO recently penned an essay calling for a market melt-up. Investors should also remember Bob Farrell’s Rule #4: “When markets go parabolic, they rise further than you think, but they don’t correct by going sideways.”

As a result, I am publishing another edition of “things you don’t see at market bottoms”, as exemplified by the mood captured by this recent magazine ad.

Retail bullish stampede

We are seeing increasing evidence of a retail stampede into stocks. The TD Ameritrade Investor Movement Index (IMX), which tracks the behaviour of TD Ameritrade customers, is an all-time bullish high.

Unfortunately, the history of IMX only begins in 2010; therefore, we have no multi-cycle history of this sentiment metric. However, Charles Schwab maintains a history of client cash, and cash levels are at an all-time low.

These low cash readings are also confirmed by Merrill Lynch’s data on private client cash.

Bullish retail sentiment is also confirmed by the AAII December 2017 asset allocation survey, which found that equity allocation is at the highest since 2000. The latest level of cash at 13% is the third lowest on record. The only two other lower readings were in December 2000 (12%) and March 1998 (11%). Chart via Meb Faber:

I would caution readers to distinguish the AAII weekly sentiment survey against the monthly asset allocation survey. I believe the asset allocation survey is more reflective of retail sentiment because it indicates what investors are doing with their money, rather than how they “feel” about the market.

Retail bullishness + Leverage = ???

I have made the point before that excessive bullishness is a condition indicator, and not a contrarian sell indicator. A crowded long reading is only indicative of risk, and it does not necessarily mean that stock prices decline immediately.

On the other hand, investors should be afraid, very afraid, when excessive bullishness is combined with financial leverage, especially in the *ahem* more speculative parts of the market.

It is therefore with some trepidation that I found a cryptocurrency exchange willing to lend against crypto positions. In addition, Reuters also reported that Direxion has filed a prospectus for 2x leveraged long and short Bitcoin ETFs. The Financial Times also revealed that investors can trade Bitcoin with 15x leverage in Tokyo.

The next frontier? I am waiting for 2x and 3x leverage ETFs on weed stocks.

Hedge funds pile in

If that level of euphoria isn’t enough, Bloomberg reported that gross leverage by long/short equity hedge funds approaching new highs, though net leverage is still elevated.

The rise in hedge fund leverage makes perfect sense. After all, the Sharpe Ratio of the SP 500 was 3.2, the second highest on record. Why not pile in while the returns are good and volatility is low?

Feed the ducks…

There is an expression on Wall Street, “Feed the ducks when they’re quacking.” When there is so much investor enthusiasm, bankers are creating the products to “feed the ducks”.

Callum Thomas recently pointed out that IPO activity is surging to levels comparable to the previous market peak.

If you are looking for IPO frenzy, look no further than Hong Kong. Bloomberg reported that a recent IPO was 1,500 times oversubscribed.

Don’t get too bearish just yet

Despite these signs of froth, I would advise traders against becoming overly bearish. Surges in bullish sentiment is bullish, at least in the short run. The AAII weekly survey of investor sentiment shows fresh highs in bull-bear spread. As the chart below shows, high levels of AAII survey bullishness has been correlated with price momentum, and it cannot be interpreted as a contrarian sell signal.

Enjoy the party. Just don’t forget Bob Farrell’s Rule #4: “When markets go parabolic, they rise further than you think, but they don’t correct by going sideways.”

Could a Trump trade war spark a bear market?

Posted by Cam Hui - January 7, 2018

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

The latest signals of each model are as follows:

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

Staying ahead of the curve

It is gratifying to be ahead of the curve and anticipate the changes in the market narrative. The two themes du jour are Jeremy Grantham’s call for a market melt-up (see Embrace the blow-off, but with a stop-loss discipline), and concerns about rising inflation, which I have been writing about endlessly (as an example, see Five steps, where’s the stumble?).

What’s next?

How about the risk of rising protectionism? The news site Axios reported that 2018 will bring “full Trump”, with a dramatic change in policy tone after the legislative tax cut victory:

Trump keeps asking for tariffs — on steel and aluminum, in particular. He wants a trade war, and has for many years. His economic and diplomatic advisers persuaded him to delay trade actions in 2017.

Those advisers recognize that the day of reckoning will come in 2018, regardless of whether economic adviser Gary Cohn and Secretary of State Rex Tillerson — who advocated restraint — stay or go.

Cohn and Treasury Secretary Steve Mnuchin successfully persuaded Trump not to do anything rash while tax reform was being negotiated.

Trump also saw the advantage of trying to use that as leverage with China to get help on North Korea. He said yesterday in an interview with the N.Y Times: “China’s hurting us very badly on trade, but I have been soft on China because the only thing more important to me than trade is war. O.K.?”

And he tweeted yesterday, in response to Chinese ships secretly delivering oil to North Korea: “Caught RED HANDED – very disappointed that China is allowing oil to go into North Korea. There will never be a friendly solution to the North Korea problem if this continues to happen!”

The Washington Post also reported that the Trump Administration is close to imposing trade sanctions on China in January:

The Trump administration is setting the stage to unveil tough new trade penalties against China early next year, moving closer to an oft-promised crackdown that some U.S. business executives fear will ignite a costly battle.

Several corporate officials and analysts closely tracking trade policy said that President Trump is expected to take concrete actions on a range of disputes involving China within weeks.

Trump is due by the end of January to render his first decision in response to petitions from U.S. companies seeking tariffs or import quotas on Chinese solar panels and washing machines manufactured in China and its neighbors.

The Trump Administration’s newly unveiled National Security Strategy reframes the China relationship in an adversarial fashion. As a result, the latest anticipated pivot on trade policy is therefore not an unexpected development, though the scale of the reaction is likely to surprise the market:

White House action is due on a separate Commerce Department probe triggered by worries about the national security impact of rising imports of Chinese steel and aluminum.

“Their intent is to bring shock and awe,” said Scott Kennedy, an expert on Chinese trade at the Center for Strategic and International Studies. “They’re not kidding around.”

My base-case scenario calls for an equity market melt-up, supported by a combination of fundamental growth momentum and technical price momentum. It would end with aggressive Federal Reserve action to cool an overheated economy. In other words, an equity bear market would begin with a classic Fed-induced slowdown.

What if the economic slowdown is not caused by monetary policy but by trade policy? What would happen if the growth outlook slowed because of a trade war? What would be the damage, both to the economy and stock prices?

While I am not forecasting a trade war-induced bear market, good investors engage in scenario modeling in order to be prepared for different possibilities. I explore the ramifications of a trade war as an exercise in investor preparation.

Modeling a trade war

In September 2016, the Petersen Institute published an analysis of the effects of a Clinton and Trump Presidency on trade policy. Part of that study was to estimate the likely effects of a trade war using a model developed by Moody’s Analytics (Zandi et al. 2016). While that analysis is a little dated, as economic growth exceeded expectations in 2017, that model can still provide some clues on the likely consequences of a trade war. The study modeled three trade war scenarios:

In the full trade war scenario, the United States imposes a 45-percent tariff on nonoil imports from China and a 35-percent tariff on nonoil imports from Mexico. China and Mexico respond symmetrically, imposing the same tariffs on U.S. exports.
In the asymmetric trade war scenario, China and Mexico do not retaliate symmetrically with an across-the-board tariff. China retaliates on specific U.S. goods and services. With the dissolution of NAFTA, Mexican tariffs on all U.S. goods would snap back to their MFN levels, which currently average about 8 percent. The modeling in this scenario is not contingent on the Moody’s macro model or the imposition by the United States of across-the-board tariffs of a specific level on China and Mexico.
In the aborted trade war scenario, U.S. tariffs are imposed for only a single year, because China and Mexico concede to U.S. demands, the U.S. Congress overturns the action, or President Trump loses in the courts, or the public outcry is such that the administration is forced to stand down.

The author of the study cited three important limitations to the model. First, the simulation is unable to model the effects of widespread effects of global supply chains. As well, it is difficult to predict the substitution effects. As an example, Petersen Institute’s discussion with the executives of multi-national corporations indicated that, in the event of a breakdown in NAFTA, they would seek to relocate plants from Mexico to other countries. In addition, the model cannot forecast the secondary effects of the loss of corporate confidence and the effects on investment.

With those caveats in mind, the effects on economic growth are shown in the chart below. In a full trade war, GDP growth would flatten out for two years and the economy would enter a mild recession. The aborted trade war, on the other hand, would see growth slow, but the economy would be able to avoid recession.

The numeric forecasts are shown in the table below (annotations are mine). In particular, I focus on the effects of a full and partial trade war on the unemployment rate.

While I find it quaint that the 2016 modeled unemployment rate for 2017 was 4.9%, when the actual November 2017 stood at 4.1%, this analysis nevertheless provides valuable insights into the like effects of a trade war. Under the full trade war, unemployment rises dramatically and does not begin to decline until the fourth year. The limited trade war sees the unemployment rate rising by 1% over two years, and then begins to fall in the third. Even then, the non-recessionary conclusion of the limited trade war model may be overly optimistic. New York Fed President Bill Dudley pointed out in a 2016 speech that the economy “has always ended in a full-blown recession” whenever unemployment has risen by 0.3% to 0.4%.

None of the scenarios are equity friendly, and those are just the first order effects.

Trade war second order effects

The second order effects are even more difficult to model, and therefore they become open questions for investors should a trade war develop.

First and foremost, how does Beijing react? Investors must have been hibernating for the last 10 years not to realize that China’s debt load has skyrocketed since the Great Financial Crisis, and levels are consistent with readings seen at past major economic crises. Should a trade war push China into a hard landing, then all bets are off.

On the other hand, the PBoC has plenty of ammunition left to cushion the effects of a downturn. Should the PBoC dramatically loosen monetary policy, the yuan exchange rate will crash, and would that spark another round of Trump Administration trade retaliation? What happens to Chinese capital flows under such a scenario? Would China impose some form of foreign exchange controls?

These are all good questions that I have no answers to.

What about the Fed? How would it react to a trade war? On one hand, it would likely pause its monetary policy normalization in the face of a slowdown in growth. If the growth outlook deteriorated sufficiently, it would take action to ease.

On the other hand, how would it react should inflationary pressures strengthen even as trade tensions rise? The historical evidence indicates that USD strength is correlated with differences in economic growth. Supposing that multi-nationals respond to tariffs by shifting production to other countries not affected by trade sanctions, such a development would lower the relative US growth potential against other countries, and therefore put downward pressure on the greenback.

The latest report shows that eurozone manufacturing PMI ending 2017 at record highs, with all-time highs seen in Germany, Austria, and Ireland. Will Europe outperform the US should a trade war erupt? How this question of relative growth rates resolves itself will matter the the direction of the USD, inflation, and Fed policy.

A falling USD puts upward pressure on inflation because of the higher cost of imports. The Fed would be caught in a dilemma. On one hand, trade policy is slowing growth, and the normal reaction function would be to ease. On the other hand, a falling currency puts upward pressure on inflation, and the Fed needs to be mindful of its price stability mandate.

My head hurts from all this thinking. There are too many moving parts to accurately forecast the future.

What to watch for

I resolve this dilemma by using the following framework. The prospect of trade sanctions and protectionism is likely to be a shock to the stock market. Should such a scenario unfold, the most likely outcome is Petersen Institute’s “aborted trade war”, whose first order effects sees growth slow, but the economy avoids a recession. The stock market would likely react by entering a correction.

From a macro and fundamental perspective, I would then monitor the reaction of the Chinese authorities. As well, I would monitor developments in inflation and inflationary expectations in order to better forecast the Fed’s reaction function in order to determine the likelihood of an equity bear market.

Bloomberg has helpfully provided a trade policy calendar for the coming weeks that is a useful guide. The KORUS discussions will give us some clues and could set the tone for the Trump administration’s approach to trade policy.

As well, technical analysis can provide some clues. The global stock market historically did not top out spontaneously in the last two cycles. Instead, the topping process saw an initial peak, a correction, followed by a second rally to either test the previous highs or make a new high, but with a negative divergence on the 14-month RSI. If a trade war were to spark a bear market, I would look for a similar technical pattern seen in previous major tops.

The weeks ahead: Momentum, momentum!

As a reminder, the trade war scenario that I have outlined is not a forecast, but scenario analysis for investment planning purposes. Looking to the weeks ahead, both technical and fundamental momentum are dominating the market action in early January.

The analysis from Jeff Hirsch of Almanac Trader of January’s market action is particularly revealing. Hirsch has three indicators, the Santa Claus rally indicator, which covers the seven trading days that ended January 3 (SC Rally), the first five days of the year indicator (FFD), and the January Barometer, based on the return of the market in January (JB).

While not everyone believes in the January Barometer, which states that January sets the tone for the rest of the year, the historical evidence shows a definite price momentum effect based on the first five days (FFD) for the rest of January. The above table shows that there were 29 instances where the FFD was positive. Out of that sample, the return for the rest of January (JB – FFD) was positive 26 times (86%), for an average return of 2.6% and median return of 2.1% for the rest of January.

As the SPX is up 2.6% for the first four days in January, the market would have to really crater on Monday for FFD to be negative for 2018. If history is any guide, the SPX is likely to be up between 4.5% to 5.0% in January 2018.

The case for fundamental momentum is equally compelling. The latest update from John Butters of FactSet shows that forward 12-month EPS was up an astounding 1.1% in the last two weeks, indicating a surge in earnings expectations. The weekly rise in forward EPS is normally in the 0.10% to 0.20% range, so a 1.1% increase is quite extraordinary.

Looking ahead to the upcoming Q4 2017 earning season, earnings expectations are upbeat. Company analysts have had a historical tendency to be overly optimistic in their earnings estimates, and then revise down slowly as time progresses. Butters observed that we are seeing the smallest cut in quarterly EPS estimates in seven years.

It does not appear that the optimism in Q4 earnings estimates is attributable to the recently passed tax cuts. The effects of any tax cut would not take effect until 2018. As well, analysts began revising Q4 estimates upwards in mid-November, which was a period when there was still a high degree of uncertainty over tax legislation. I therefore conclude that the optimism over Q4 2017 earnings is a cyclical effect due to the synchronized global rebound.

As earnings season progresses, expect company analysts to begin revising their 2018 EPS upwards as companies give guidance about the expected effects of the newly passed corporate tax cuts. Bottom-up oriented company analysts cannot revise estimates upwards because they don’t have the exact details of tax cut effects. However, top-down strategists have already incorporated these effects, and they amount to a 6-9% boost to EPS in 2018.

As long as the market can sidestep potential potholes like a trade war, expect strong fundamental momentum in the next couple months in the form of boosts to EPS estimates from cyclical strength, and the one-time benefit from tax cuts.

What about the signs of excessively bullish sentiment outlined in my last post (see A frothy rally, but…)? It appears that some of the signs of over the top greed is in retreat. The VIX Index, which usually moves inversely to the market, rose for the last two days, even as the market ground upwards to fresh highs.

The term structure of the VIX is also showing signs of a retreat in greed. I interpret these conditions as sentiment correcting sideways, which suggests further possible near term upside in light of the powerful price momentum historical analysis from Jeff Hirsch.

At the same time, risk appetite remains healthy. High beta stocks are in a relative uptrend against low volatility stocks, and price momentum is in a well-defined relative uptrend.

Credit market risk appetite metrics are also confirming the new all time highs set by the major stock market indices.

Despite the strong momentum, all breadth indicators from Index Indicators, are overbought. From short term (1-2 day time horizon)…

…to long term (1-2 week time horizon). These conditions suggest that either a brief and shallow pullback or sideways consolidation may be in order.

Two weeks ago, I wrote that the market was undergoing a melt-up characterized by a series of “good overbought” conditions (see A sector review reveals animal spirits at work). So far, market action is following the path I set out for it. Expect further intermediate term upside ahead.

My inner investor is bullish on equities. My inner trader is also long the market and, barring any trade policy surprises, he is prepared to buy any weakness that may appear next week.

Disclosure: Long SPXL

A frothy rally, but…

Posted by Cam Hui - January 3, 2018

Mid-week market update: The stock market began the year by roaring out of the gate. This was not a big surprise. Rob Hanna at Quantifiable Edges tweeted on New Year’s Eve that the market has rallied strongly when it closed at a 10-day low at the end of the year.

Though the sample size is small (N=4), past episodes has been stock prices advance for a minimum of four consecutive days before pausing.

Hanna followed that tweet with a post which observed that positive momentum on the first day of the year usually leads to follow through for the next two days (which would be tomorrow, or Thursday).

Another bullish seasonal sign come from Jeff Hirsch of Trader`s Almanac.

The first indicator to register a reading in January is the Santa Claus Rally. The seven-trading day period begins on the open on December 22 and ends with the close of trading on January 3. Normally, the SP 500 posts an average gain of 1.3%. The failure of stocks to rally during this time tends to precede bear markets or times when stocks could be purchased at lower prices later in the year.

The SPX returned 1.1% during the seven-day period, which is positive but below average. This is a preliminary sign which should be enough to get traders and investors excited about 2018.

What happens now? Can equities continue to rise after these seasonal tailwinds?

Frothy sentiment

In the short run, sentiment is getting frothy. The CBOE equity put/call ratio (CPCE) closed at an astoundingly low 0.47 reading yesterday. As of this writing, the interim estimate is 0.75. In the last 10 years, CPCE has fallen below 0.50 only four times. Past returns have been mixed, as the market weakened shortly after these readings in two instances, and continued to advance in two others, though the cases where the market rose were clustered together.

There were very few historical episodes where CPCE saw such low readings. I went back to 2003, where the CPCE data set began, and looked for cases where both CPCE and the 10 day moving average of CPCE fell below 0.60. If history is any guide, the market weakened for 4-5 trading days, rallied, and then fell further with a bottom in the 10-15 day time frame.

Normalized CPCE is showing a similar level of complacency. Even though these readings do not guarantee a correction, past episodes has seen the market struggle to advance.

SentimenTrader came to a similar conclusion as my analysis of option sentiment.

The VIX term structure is another way of analyzing option sentiment. Readings are also at extreme levels indicating greed. In the past, the market has encountered difficulty from these term structure levels.

In conclusion, option sentiment can only be described as frothy.

Negative divergences

Another disturbing signs for the bulls is the appearance of negative divergences in both 5 and 14 day RSI as the market rallies to fresh highs.

These negative divergence can also been seen in the NASDAQ 100…

…and the small cap Russell 2000.

Pay attention to risk management

What does this mean? Is the market about to correct?

The experience in 2017 showed that we are in a momentum dominated environment. Despite these technical and sentiment warnings, it may not be prudent to go short without some visible sign of a downside break. On the other hand, traders who are long may wish to pay close attention to risk management. Either tighten up on your stops, or pay attention to factor behavior.

As long as price momentum remains in a relative uptrend, which it is…

And credit market risk appetite remains healthy, which it is…

Any weakness is likely to resolve itself with either a sideways consolidation, or shallow correction.

My inner trader is long the market, but he may lighten up his positions should stock prices continue to rally into the weekend. As ever, he remains “data dependent”.

Disclosure: Long SPXL

My 2017 report card

Posted by Cam Hui - December 31, 2017

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

The latest signals of each model are as follows:

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

Marking my 2017 calls to market

As 2017 draws to an end, it’s time to mark my 2017 forecasts to market. Overall, the stock market in 2017 was remarkable. What if I told you that you could have had returns with a Sharpe Ratio of 3.2, using the 3-month T-Bill as the risk-free rate? As it turns out, you could have achieved that with a simple buy-and-hold long position in the SPX, whose Sharpe ratio is the second highest in its history in the last 59 years (via Vincent Deluard of NDR).

Indeed, US equities rose steadily in 2017. The drawdown was only 3% in the year, which is a feat that was last achieved in 1995.

With that in mind, I review my inner investor and inner trader calls of 2017. My inner investor gave himself a grade of B+, and my inner trader gave himself an C+ for the year.

My inner investor: Never bearish

When I reviewed my the investment calls for my inner investor persona in 2017, I struggled to find periods when I turned bearish. While I was cautious at various times, my inner investor was either bullish, or neutral, which indicated an asset allocation that is in line with investment policy weights. (If the investment policy called for a 60% stock/40% bond target mix, a neutral position would see the portfolio rebalance by taking profits in equity positions and buying bonds back to 60/40 mix.)

In August 2016, my original base case scenario called for a stock market top in late 2017 (see The roadmap to a 2017 market top).

By December, I changed my mind and I was bullish on how Trump may affect stock prices (see How Trumponomics could push the SP 500 to 2500+).

By February, I began to think about the possibility that this bull may resolve itself with a blow-off top (see A blow-off top or a wimpy top).

I began to get a little cautious in March, but never pushed the sell button (see A toppy market, but not THE TOP). At the time, I observed that “the music is still playing”. Similarly, I outlined A market top checklist in May, and concluded that “there are no signs of an intermediate market top”.

In October, I highlighted former Value Line Research Director Sam Eisenstadt’s SPX forecast of 2620 to 2640 by March (see Is 3% for 6 months enough to take equity risk?). I was cautious about a combination of overbought conditions, and excessive bullishness, but nevertheless believed in buying the dip, should it occur. About 10 days later, I reversed my cautious outlook and concluded that the market was in a process of a slow grind upwards (see A slow grind upwards).

By November, I threw caution to the wind and began to see the blow-off top as the most likely outcome (see Embrace the blow-off (but with a stop-loss discipline)). The combination of price and fundamental momentum leading to a risk-on stampede had become my base case scenario.

Even though I never turned outright bearish sentiment was becoming increasingly frothy. I initiated my series “What you don’t see at market bottoms” in mid-2017. However, I did recognize that overly bullish sentiment represents an inexact market timing signal.

Overall, my inner investor would give himself a B+ for 2017. The stock market went up, he never turned bearish, but he penalized himself for turning neutral at various times during the year.

My inner trader: Who needs market timing?

My inner trader was not so fortunate. When you are trading a market that goes straight up, why do you need a market timing model?

Still, the year 2017 was not without its trading highlights. In April, I correctly issued two trading calls to buy the market (see A capitulation bottom and Buy signals everywhere). I also correctly turned cautious in early August (see Bullish exhaustion and Correction ahead). While prices did decline, the market barely weakened and I was a little late in turning bullish (see Correction over, wait for the blow-off top). Such are the hazards of trying to market time when corrections are shallow and brief.

Over the years, I had received a number of requests to quantify the returns on my trading system signals that are shown in the chart below. I was reluctant to do so, largely because there are a number of key factors involved in calculating the returns of a portfolio and publishing a single number would mask the dispersion from any actual results (see From alpha to actual returns: Why your mileage will vary):

When and what do you buy and sell?
How much do you buy and sell?
How do you time the trade?

As a compromise, I calculated the trading record of “my inner trader”, whose history began when I started to issue trading alerts to readers on 4-Mar-2016. From now on, these results will be updated weekly on the website at My inner trader. These returns are purely hypothetical and do not represent the performance of any trading account. In other words, your own mileage will vary.

The return calculations shown are based on the following assumptions:

The instrument traded is the S&P 500, regardless of whether the trade alert was on any other index. This return series was calculated as a way to measure the long or short systematic direction of the trade, whereas the instrument selected (usually either NASDAQ 100 or Russell 2000) was purely discretionary.
Execution is done at the closing price on the day of the signal.
There are no transaction costs.
There are no dividends.
The account allocates 100% of the value to the trade, i.e. it goes fully long or short.
If the account holds cash, the cash earns no interest.

A chart of the history of the account value is shown below.

There were a total of 15 trades in 2017. The success rate for completed trades was 67%, with an average profit of 0.4% per trade. As the chart below shows, the success rate in 2017 was roughly the same as it was in 2016.

The history of the trading signals are as follows:

04-Mar-16 Buy
10-Mar-16 All cash, sell long
23-Mar-16 Buy
14-Apr-16 All cash, sell long
20-Apr-16 Buy
11-May-16 Short
26-May-16 Buy
10-Jun-16 Short
13-Jun-16 All cash, cover short
21-Jun-16 Buy
18-Nov-16 All cash, sell long
01-Dec-16 Buy
29-Dec-16 Short
25-Jan-17 Buy, P/L: -2.5%
08-Feb-17 All cash, sell long, P/L: -0.3%
28-Feb-17 Short
10-Mar-17 All cash, cover short, P/L: -0.3%
06-Apr-17 Buy
05-May-17 All cash, sell long, P/L: 2%
08-May-17 Short
19-May-17 Buy, P/L: 0.9%
31-May-17 Short, P/L: 1.4%
28-Jun-17 All cash, cover short, P/L: -0.7%
05-Jul-17 Buy
24-Jul-17 Short, P/L: 2.4%
11-Aug-17 Buy, P/L: 2%
16-Aug-17 All cash, sell long, P/L: 1.7%
18-Aug-17 Short
05-Oct-17 All cash, cover short, P/L: -4.2%
16-Oct-17 Buy
25-Oct-17 Short, P/L: 0.8%
17-Nov-17 Buy, P/L: 0%
24-Nov-17 All cash, sell long, P/L: 1.7%
30-Nov-17 Short
07-Dec-17 All cash, cover short, P/L: 1.2%
08-Dec-17 Buy

I went further by performing some sensitivity analysis by asking the question, “What would the returns be if the executed price was the average of the open/high/low/close, instead of the closing price?” The results were not significantly different.

Another form of sensitivity analysis involves the question, “What would the returns be if the trades were done 1, 3, and 5 days after the signal? (where t=0 is the signal date)”

As it turns out, the trading system was not very good at pinpointing exact entry and exit points. There were instances where trading 3-5 days later yielded better returns. However, the positive relative performance was mostly attributable to poor trade timing in early 2017.

This analysis indicates that the trading system is most effective as for swing trading, and it is not good at exact market timing. This is roughly the result I expected in light of my previous reservations about publishing returns (see From alpha to actual returns: Why your mileage will vary).

My inner trader is giving himself a C+ for the year. The win rate of 87% for the year was excellent, but the absolute return was disappointing. It was hard to time the market when all stock prices did was to go up.

The weeks ahead: As good as it gets?

Looking to the weeks ahead, risks are starting to rise after the market rally in December. The inability of the market indices in the different market cap bands to break up through technical resistance is disturbing.

Jeff Hirsch at Almanac Trader observed that equity returns in past Januaries of midterm election years have been less than impressive.

The Citigroup Panic-Euphoria Model is now euphoric, which may limit near-term upside potential.

In addition, the Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, has shown a seasonal tendency to weaken in Q1.

From a macro perspective, the most likely negative surprise for the markets is an uptick in inflation. As the chart below shows, inflation surprise has been bottoming in every region in the world except for the eurozone.

As inflation surprises have risen, so have market based inflationary expectations. At what point does this spook the bond market, which then depresses stock prices?

Another possible macro surprise is the prospect of rising protectionism. After achieving the cherished tax cut legislative victory, Donald Trump is likely to turn his sights to his favorite objective of righting the wrongs of “unfair trade”, according to this Washington Post article:

The Trump administration is setting the stage to unveil tough new trade penalties against China early next year, moving closer to an oft-promised crackdown that some U.S. business executives fear will ignite a costly battle.

Several corporate officials and analysts closely tracking trade policy said that President Trump is expected to take concrete actions on a range of disputes involving China within weeks.

Trump is due by the end of January to render his first decision in response to petitions from U.S. companies seeking tariffs or import quotas on Chinese solar panels and washing machines manufactured in China and its neighbors.

Presidential tweets like this one is unhelpful if Trump is determined to punish China on trade.

The Washington Post warned that the magnitude of tariff actions could be a shock to the market:

White House action is due on a separate Commerce Department probe triggered by worries about the national security impact of rising imports of Chinese steel and aluminum.

“Their intent is to bring shock and awe,” said Scott Kennedy, an expert on Chinese trade at the Center for Strategic and International Studies. “They’re not kidding around.”

The macro backdrop may be as good as it gets. Brace for a more volatile market in Q1.

Despite these concerns, both my inner investor and inner trader are giving the bull case the benefit of the doubt. As long as both fundamental and price momentum holds up, neither is ready to turn bearish.

Subscribers received an email alert indicating that my inner trader took profits on his small cap long positions last week. He remains long large caps, but he is starting to get nervous. He may take profits on his remaining long positions next week should either the market or internals deteriorate further.

Disclosure: Long SPXL

What you should and shouldn’t worry about in 2018

Posted by Cam Hui - December 27, 2017

The end of December is filled with analyst forecasts for the following year. I would like to take this time to debunk some of the doomster myths about the stock market, and to outline some of the true risks that I worry about in the year to come.

One of the major myths that have been trotted out is the relationship between the Fed’s balance sheet and stock prices. While this chart appears impressive, it is an illustration of the adage about correlation does not equal causality.

Instead, investors could be much better served to focus on earnings, with does have a direct causal effect on stock prices. Forward 12-month EPS is coincident with stock prices, and they are rising.

Fed balance sheet effects on housing

Instead of worrying about the absolute effects of the Fed’s Quantitative Tightening (QT) program on the stock market, I am much more concerned about the effects of QT on the mortgage market, which affects the cyclically sensitive housing sector. That’s because the Fed is a big player in the mortgage market.

So when happens when the MBS holdings roll off the Fed’s balance sheet in a rising rate environment? Can the market handle the extra supply? Already, we are seeing spreads on 15 and 30 year mortgages edge up. While the spread remain range bound, this is a situation I am keeping an eye on.

Housing is an important cyclically sensitive consumer durable sector of the economy. It has already been hit with a combination of higher lumber prices from tariffs on Canadian lumber, and the partial loss of mortgage interest deductibility from the new tax bill. It doesn’t need an extra headwind from higher mortgage rates because of the Fed’s QT program.

Worry about a more hawkish Fed

One of my concerns going into 2018 is the likelihood of a monetary policy that is tighter than current market expectations. Larry Meyer et al at Monetary Policy Analytics recently tried to put names to the Fed’s dot plot, and the analysis graphically illustrates the hawkish direction that the Fed is expected to take in 2018.

The analysis, which is based on the current membership of the FOMC in 2018, indicates that voting members expect 3 rate hikes and 2019 ending Fed Funds rate of 2.125%, compared to the mean of 2.7 rate hikes and 2019 ending rate of 2.016%. This stands in contrast to approximate a market expectation of roughly 2 rate hikes in 2018. That projection does not include Marvin Goodfriend, who has been nominated to the Fed Board of Governors. Goodfriend is a staunch monetarist and he is likely to be at least as hawkish as the median voting member, if not more.

The latest analysis shows that the US economy has closed the output gap, when inflationary pressures appear. Therefore Fed officials are unlikely to tilt in an overly dovish direction. Any disagreements are likely to be on tactics and timing of monetary policy normalization, not about the general direction.

Edward Harrison also raised the point that there may be a subtle shift that may occurring at the Fed. In light of the Trump administration’s bias towards deregulation, Harrison speculated that the Powell Fed may have to use monetary policy to meet their third mandate of financial stability, as the old tools of macro prudential policies are getting taken away:

To me, that means the Fed has a third mandate, if you will. It means that financial stability is always a fundamental issue that the Fed is addressing with monetary policy. With Jay Powell, the question is whether he steers the Fed to address financial stability via macroprudential tools as the BIS suggests or whether he uses rate policy more actively.

Let me address that this way: My sense is that the Trump Administration is working actively to reduce regulation in a way that will increase financial instability concerns at the Fed. Look at what’s happening at the Consumer Financial Protection Bureau or at the Department of Transportation or at the Office of the Comptroller of the Currency. All of the regulatory moves the Trump Administration is making move in the direction of fewer regulations and less regulatory oversight on a wide range of issues. In terms of the financial system, this will mean that the Fed cannot count on macroprudential tools to do the heavy lifting of ensuring financial stability. Only to the degree that the Fed reaches into the financial system directly, mandating tighter regulatory control in its role as regulator, could we expect the Fed to use macroprudential tools. But people like Dan Tarullo who favour this approach are gone.

I believe the preponderance of evidence indicates that the Fed will have to use rate policy to address financial stability concerns. And if they do, this could mean more rate hikes than currently anticipated by financial markets.

Translation: It could mean even higher interest rates.

The effects of higher rates

If interest rates are rising, then a key question for investors is, “What are the effects of higher rates?”

Michael Leibowitz recently penned an article called “Squeezing the Consumer from Both Sides”, where he estimated the effects of a 25 bp rise in short-rates added about $7 billion to household interest payments from floating rate debt, while the banks have barely passed through any rate hikes to savers.

While $7 billion may sound like a lot, this chart from FRED shows that Q2 2017 consumer debt service payments came to $784.8 billion. So who is worried about a 1% increase in debt service costs if rates rise 0.25%? Even if short rates rise 1% next year, will a 4% rise in household debt service cost tank the economy?

While I am not worried about the direct effects of rising rates on the household sector, I am concerned about the state of corporate balance sheets. Corporate treasurers have gorged themselves on cheap debt in the wake of the Fed’s QE programs, and corporate leverage have returned to pre-crisis levels.

I am also concerned about offshore linkages, especially if the Fed engineers a mild slowdown in the American economy. In particular, Chinese debt levels are at stratospheric levels seen at past financial crisis.

Chinese companies received an unwelcome Christmas present when short rates spike to new highs on Christmas Day. Chinese companies, the shadow banking system, and small banks are particularly vulnerable as they have a tendency to be financed with short-term debt that needs to be rolled over continuously.

A possible false sell signal from junk bonds

Lastly, I would like to warn about a possible false equity market sell signal from the junk bond market. Tiho Brkan observed that trouble in the junk bond, or high yield (HY), market, in the form of widening spreads, has preceded equity market tops.

However, the new tax bill will limit corporate interest expense, up to 30% of a company’s EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). This provision will stress and penalize highly indebted companies. In other words, these are the lowest credit borrowers, or junk bond issuers. The market will no doubt adjust and re-price junk bond prices. Expect HY spreads to blow out early in 2018, but don’t mis-interpret that effect as a loss of risk appetite from the credit market.

Instead, I would urge readers to focus on confirmation signals from other segments of the credit market, namely investment grade (IG), and emerging market (EM) bonds. If those markets also start to deteriorate, then batten down the hatches.

In conclusion, there are many things to be wary of in 2018, but there are also a number of red herrings. Don’t spend all your time over at Zero Hedge, and focus on the more important indicators of economic and equity market health.

A sector review reveals animal spirits at work

Posted by Cam Hui - December 24, 2017

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

The latest signals of each model are as follows:

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

Here comes the animal spirits

Josh Brown composed an insightful post last week entitled, Trump’s Singular Accomplishment:

I mean this without a trace of sarcasm, not being a fan of the President’s or pretty much anything he stands for…

Donald Trump’s singular accomplishment, in my view, is the ignition of Animal Spirits in the stock market and the real economy. Small business confidence measures shot up from the week of his inauguration and have remained elevated ever since. PE multiples expanded throughout the course of the year, which was not solely due to his tax policy – it was also about his swagger and I-don’t-give-a-f**k persona.

Indeed, the animal spirits in the stock market began to run wild starting in September, when the weekly RSI became overbought and stayed overbought. My former Merrill colleague Walter Murphy called this a “good overbought” condition, where the market continues to advance while remaining overbought. Since 1990, there have been two episodes when the market flashed a series of overbought readings. One lasted 10 months, the other lasted 14 months. In both instances, stock prices were significantly higher afterwards.

LPL Research quantified the “good overbought” effect on market returns using data that went back to 1950. They found that past episodes of weekly RSI above 80 has been bullish for equity returns, though the sample size is still low (N=13). The table below from LPL, which I edited and annotated, shows that the excess return from the price momentum effect fades out after six months. The incremental return from six to twelve months when when weekly RSI > 80 is not significantly different from the “at any time” returns.

This week, I review the sector leadership of the stock market. The analysis reveals a late cycle market characterized by price momentum leadership, and expectations of increased capital expenditures, as well as emerging leadership from inflation hedge sectors.

A sector review

The analytical framework for sector leadership analysis is the rotation cycle. Here is how an idealized cycle works. In the initial phase of an expansion, central banks lower rates to boost the economy, and the market leaders are the interest sensitive stocks. As the cycle matures, leadership rotates into consumer stocks, followed by capacity expansion, which leads to capital goods sector leadership. The late phase of the cycle is characterized by tight capacity and rising inflation, which is an environment where asset plays and commodity extraction industries outperform.

There is an important caveat to this form of analysis. While the market cycles thematically parallel economic cycles, they are different. Market undergo mini-cycles of changes in sentiment whose length are much shorter than economic cycles. Nevertheless, the broad principles of market cycle analysis remain valid today.

With that in mind, here is a review of the sectors of the market, starting with the market leaders first. Each of the charts shown will show the relative performance of the sector to the market on the top panel, and the relative performance of the equal weight sector to the equal weighted market in the second panel. In some cases, the equal weighted analysis can be revealing as it can show the breadth of the leadership in the sector.

Technology: The momentum play

As the animal spirits have run rampant, technology stocks have been the primary beneficiary of this trend. Both the float and equal weighted sectors are in well defined relative uptrends, and the bottom panel shows the strong relative uptrend of momentum stocks that draw mostly from the technology sector.

As long as technology and price momentum remain strong, I am inclined to stay intermediate term bullish.

Financials: Breaking out, but…

The financial sector is another heavyweight sector in the index. While the equal weighted sector has staged a relative breakout (bottom panel), the relative performance of this sector has historically been correlated to the yield curve (top panel). The divergence between the strength in these stocks and the flattening yield curve makes me somewhat cautious. However, Reuters reported that analysis from Wells Fargo states found that banks pay the highest effective tax rate at 27.5%, and therefore they should benefit disproportionately from the lower corporate tax rate.

As long as heavyweight sectors such as technology and financials exhibit strong relative strength, they should act to propel the major market indices higher.

Industrials: A capex revival?

One sector that is starting to shows signs of relative strength is the capital goods heavy industrial stocks. While the relative performance of the float weighted index (top panel) remains range bound, as it was dragged down by the poor returns of heavyweight GE, the equal weighted sector has staged an upside relative breakout.

This is a signal that the market expects a capex revival.

Materials: Emerging leadership

The technical condition of material stocks is similar to the technical condition shown by industrials. The float weighted index remains range bound relative to the market (top panel), but the equal weighted index has staged an upside relative breakout.

I interpret the equal weighted relative breakouts of industrials and materials as a message that the economy is at the stage where capacity is starting to get tight, and a capex cycle is necessary to alleviate those bottlenecks. Indeed, Nordea Markets pointed out that the American economy has finally closed the output gap.

At the same time, inflationary pressures are likely to start showing up, which should benefit inflation hedge vehicles like materials and mining shares. The bond market is confirming these expectations of higher inflation. Scott Grannis pointed out that both the real Fed Funds rate and 5-year inflation expectations on TIPS are starting to edge up.

Eventually, these heightened inflationary expectations will pressure the Fed to become more hawkish, but not yet. Enjoy the party for now.

Energy: An inflation hedge laggard

If inflation hedge stocks are starting to strength, shouldn’t investors be piling into energy? As it turns out, the energy sector has been an inflation hedge laggard despite these macro tailwinds, largely because of the overhang of rising supply from US fracking. The relative strength of these stocks are still basing and it is premature to make a strong commitment to this sector just yet.

Consumer Discretionary: Tame wage growth a drag?

One sector that should be rising strongly during this phase of the expansion are consumer discretionary stocks. However, they have not performed well, and their relative strength ratios are only technically basing.

Defensive sectors: Needs more time

The relative strength technical conditions of traditionally defensive sectors such as health care and consumer staples are showing up as market laggards. While they are showing up as breaking up out of relative downtrends, they need time to base before they can become market leaders.

The poor performance of the defensive sectors is an indicators that the bulls are in control of the tape. Until momentum begins to falter, and defensive sectors begin to exhibit some relative strength, stock prices can go higher.

Interest sensitive sectors: Avoid

The relative performance of interest sector sectors such as utilities and REITs can only be described by one word: ugly.

The poor condition of the interest sensitive stocks is confirmed by the upside breakout of 10-year Treasury yield. Next resistance level is 2.6%.

A likely melt-up ahead

In conclusion, a review of the sector relative strength reveals a market preoccupied by growth and momentum, and dominated by the animal spirits of a late cycle expansion. In my post last week (see Five steps, where’s the stumble?), I wrote that, at the current pace, the yield curve could invert by mid-2018, but the period preceding a yield curve inversion has historically been equity bullish. If history is any guide, that suggested a SPX target of 2860 to 2970 in 6-9 months.

That target range would be what would occur in a normal market cycle. The passage of the corporate tax cuts can boost stock prices even further. Consider that the latest update from FactSet shows that bottom-up derived forward 12-month EPS continues to rise, which is a cyclical effect, and does not incorporate the effects of a lower tax burden from the passage of the tax bill.

I would expect analysts to upgrade their estimates in the next two months as companies provide guidance on the tax bill’s effects on earnings. Most of the top-down estimates indicate an earnings boost of between 6-9% for 2018. Applying a 7.5% boost to earnings for 2018, and assuming no further P/E multiple expansion, that translates to an SPX target in the 3075 to 3200 range – and this would all happen in H1 2018.

Just remember Bob Farrell’s Rule #4: “Parabolic advances usually go further than you think, but they do not correct by going sideways”.

Is 3200 in six months considered enough of a melt-up?

The week ahead

Looking to the week ahead, next week will see an extremely slow and illiquid tape, but with a seasonally bullish bias. Jeff Hirsch at Trader’s Almanac found that the three days after Christmas has historically seen a bullish tilt.

Callum Thomas also pointed out that the market is tracking its seasonal pattern of a strong December very well, though strength in December tended to be followed by a peak in early January.

My own analysis of small cap seasonality also shows that small cap stocks are rallying according as expected. As well, expect further strength from small caps as smaller companies tend to be domestically oriented, which are likely to see a greater benefit from lower corporate taxes.

Despite Friday’s minor market weakness, I was encouraged that the credit market’s risk appetite remained intact, which is a bullish sign for next week.

My inner investor remains constructive on stocks. My inner trader is aggressively long equities.

Disclosure: Long SPXL, TNA