What Xi’s ascendancy means for China’s growth

Posted by Cam Hui -

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

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

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

 

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

 

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

 

How should investors react to this political development?

Lessons from Deng

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

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

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

Third, short-term costs are acceptable and inevitable…

Finally, leadership choices are critical.

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

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

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

Policy lessons from the Anbang debacle

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

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

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

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

 

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

 

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

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

Goodbye Rebalancing, Hello Middle Income Trap

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

 

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

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

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

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

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

No, Mr. Bond, I expect you to die

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Focusing on the wrong bond?

“No, Mr. Bond, I expect you to die!”

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

 

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

 

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

Fiscal overheating anxiety

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

Federal fiscal policy is entering uncharted territory…

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

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

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

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

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

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

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

 

A crowded bond short

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

 

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

 

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

 

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

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

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

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

 

Washed out Sentiment = Poised for a bond rally

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

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

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

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

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

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

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

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

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

What rising inflation expectations?

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

 

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

 

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

 

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

Technical conditions supportive of bonds

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

 

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

 

Stock market implications

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

Opportunity from Brexit turmoil

Posted by Cam Hui -

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

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

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

 

 

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

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

Capitulation

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

 

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

 

This is looking like a washout to me.
 

The bullish catalyst

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

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

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

Tombs concluded that:

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

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

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

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

Be prepared.

A pause at 61.8%

Posted by Cam Hui -

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

 

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

 

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

Short-term headwinds

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

 

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

 

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

Buy the dip

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

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

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

 

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

 

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

 

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

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

 

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

Disclosure: Long SPXL

Powell Fed: Market wildcard

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A change of the guard at the Fed

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

 

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

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

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

Many opinions, no real answers

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

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

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

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

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

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

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

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

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

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

 

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

The Yellen Fed baseline

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

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

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

 

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

 

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

 

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

Likely policy changes

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

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

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

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

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

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

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

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

 

Bullish short-term

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

 

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

 

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

 

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

 

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

 

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

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

And three options on aluminum:

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

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

The week ahead

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

How the market could fool us again

Posted by Cam Hui -

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

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

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

 

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

A V or W shaped bottom?

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

 

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

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

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

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

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

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

 

Watching for the Zweig Breadth Thrust

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

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

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

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

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

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

 

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

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

Disclosure: Long SPXL

Did risk-parity funds crash the bond market?

Posted by Cam Hui -

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

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

 

The evolution of risk-parity fund exposures

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

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

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

Risk parity bond sensitivity less than popularly thought

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

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

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

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

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

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

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

Bonds outperformed in the latest risk-off episode

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

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

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

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

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

 

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

Equity market implications

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

 

Hang on, the Vol Tantrum should be over soon.

Five reasons not to worry (plus 2 concerns)

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

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:

  1. 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?
  2. 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 -

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 -

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 -

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

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

 

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

The latest signals of each model are as follows:

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

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

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 -

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 -

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 -

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

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

 

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

The latest signals of each model are as follows:

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

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

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 -

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 -

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 -

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

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

 

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

The latest signals of each model are as follows:

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

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

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 -

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 -

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 -

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

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

 

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

The latest signals of each model are as follows:

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

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

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