It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.
I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:
As a result, I am publishing another edition of “things you don’t see at market bottoms”.
$1,000 gold bagel
The Westin New York will start selling a bagel with white truffle cream cheese and sprinkled with gold flakes for $1,000. This item was last offered on the menu in *ahem* 2007.
The timing of this menu offering speaks for itself.
Euphoriameter at a cycle high
Callum Thomas of Topdown Charts has constructed a “Euphoriameter”, which is a combination of forward P/E, VIX and bullish sentiment. Readings are at a cycle high and it is near the peak seen in the last market cycle.
Cash is trash
We are seeing numerous signs that retail investors are all in on equities. Consider this comment from Morgan Stanley CEO James Gorman on the company’s earnings call:
“We saw more cash go into the markets, particularly the equity markets as those markets rose around the world. And we’ve seen cash in our clients’ accounts at its lowest level.” –Morgan Stanley CEO James Gorman
These readings have been confirmed by the AAII asset allocation survey, which shows cash at lows not seen since the top of the NASDAQ Bubble.
A similar level of investor enthusiasm can be found in mutual fund cash data.
The latest University of Michigan investor confidence survey shows that respondents have 100% confidence that the stock market will not decline in the next year.
ICOs are the new black
Finally, Bloomberg reported that Initial Coin Offerings (ICOs) have raked in $1 billion in two months, and their total market capitalization now exceeds $3 billion.
For a primer on ICOs, please see Appcoins are the new snake oil, by Daniel Krawisz, published at the Nakamoto Institute.
With that in mind, Humble Student of the Markets would like to announce an ICO offering…
Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities
Trend Model signal: Bullish
Trading model: Bearish (downgrade)
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
Good news and bad news
We are about halfway through Q3 earnings season, and the market saw its share of ups and downs last week.
The market rallied to fresh highs on Friday, and leadership was provided by large cap FAANG stocks. Beneath the surface, there was a mixture of both good news and bad news for investors.
The good news
Let’s start with the good news. John Butters FactSet pointed out that, with 55% of the SPX having reported results, both the earnings and sales beat rates are well above historical average. As well, forward 12-month EPS continues to rise, which is reflective of positive fundamental momentum (all annotations are mine).
Q3 GDP grew at +3.0%, which beat expectations. This was a continuing series of positive macro-economic surprises that has lifted the Citigroup Economic Surprise Index to new recovery highs.
In addition, the latest update from Barron`s of insider trading activity is constructive and could be supportive of higher stock prices.
The bad news
Unfortunately, there is lot of bad news. Despite the positive headlines from FactSet`s analysis, the sales beat rate deteriorated from 72% last week to 67% this week, though the EPS beat rate remained steady at 76%. As well, forward 12-month EPS was up an anemic +0.01% in the week, which is hardly anything to get excited about.
Another disappointment can be found in the market reaction to earnings results. FactSet observed that the market is barely rewarding earnings beats, but punishing misses.
Another worrisome macro and fundamental headwind can be found in the strength of the USD. FactSet found that companies with greater foreign exposure tended to see better sales and earnings growth.
However, much of those Q3 EPS gains can be attributable to USD weakness. As the USD strengthens, large cap multi-national companies are likely to see a reversal of the currency effect. In other words, don’t expect the same pace of sales and earnings growth in Q4 as Q3.
Another ominous theme from earnings calls is rising inflation. Higher input costs, such as wages and materials, are squeezing operating margins as companies have been reluctant to raise prices (via Avondale Investment Management).
“There is some commodity inflation, but the biggest drag that we’re facing right now is related to the labor investments that are being made.” —McDonald’s (Restaurants)
“The labor market in the U.S. is extremely tight, hard to find people.” —Manpower (Temp Staffing)
“we’re now estimating about a $300 million profit hit from higher commodity costs.” —Procter and Gamble (CPG)
“scrap price has moved up and we were unable to move plate prices up with scrap prices. So we started to see a margin compression and that’s where we live now. We’re living in a margin-compressed world today.” —Nucor (Steel)
“we continue to have a positive view on domestic steel consumption…This will be a solid foundation for a strong pricing environment as the macro market drivers continue to be persuasive…These dynamics could create a tight market and lead to significant price appreciation as we saw at the end of last year…I just see it setting up a very, very positive pricing environment for the first quarter of 2018 and all the way through 2018.” —Steel Dynamics (Steel)
“we are seeing a little bit of resistance at the higher price points because of affordability and I think that’s a broader concern that affects the entire business.” —Pulte Home (Homebuilder)
There is widespread anecdotal evidence of tightening labor markets. We will get a more complete picture when the October Jobs Report is released this coming Friday.
The bottom-up signs of rising inflationary pressures are supportive of the Fed’s decision to continue with its rate normalization policy. Expect more a hawkish tilt from the Fed, regardless of who is nominated as the chair.
Dark clouds in GDP report
There were also a number of negatives in the upbeat Q3 GDP report that beat Street expectations. New Deal democrat pointed out that the two components of his leading indicators from the GDP report are showing signs of weakness.
Proprietors’ Income, which is a data item that gets released before NIPA corporate profits, failed to achieve a cycle high for a second quarter in a row. Both proprietors` income and corporate profits appear to be rolling over, which is a negative sign for the economy.
Real private residential investment is also showing signs of peaking.
These reports are consistent with NDD’s weekly analysis of high frequency economic indicators that “the present and near future economy looks strong than at any time during this expansion. The picture among long leading indicators deteriorated further this week…confirms a neutral outlook one year out.” Combined with the prospect of a hawkish Fed, the outlook for equities is becoming increasingly cloudy.
Negative divergences everywhere
From a technical perspective, the equity outlook is equally fragile. Last week’s advance was accomplished with evidence of narrow breadth. Leadership was only provided by the megacap stocks. The mid caps, small caps, and even NASDAQ 100 stocks were either range bound or declining relative to the SPX.
An analysis of the relative performance of high beta groups tells a similar story. The relative performance of the High beta ETF (SPHB) vs. the Low volatility ETF (SPLV) appears to be rolling over. Except for the Social Media stocks, which is dominated by FB, the relative performance of all other groups, namely Biotech, NASDAQ Internet, and NASDAQ 100, are either rolling over or range bound.
There are also signs of negative divergences everywhere. Even though the SPX staged a breakout to new all-time highs, the RSI-5, RSI-14, and net new highs-lows are not confirming the new highs.
To be sure, the weekly chart of the SPX remains above its upper Bollinger Band, and the weekly RSI Indicator has not flashed a sell signal yet. That is a positive sign for the bulls.
Brace for volatility
Do all-time highs normally look like this? Sentiment Trader observed that the market is in uncharted territory. Despite all of the warning signs, the market is undergoing a slow melt-up phase and anything can happen.
Next week, there are numerous sources of event driven volatility.
The first charges from the Robert Mueller probe may be unsealed on Monday.
The GOP is expected to unveil its tax plan Wednesday.
The FOMC will conclude its meeting on Wednesday.
Trump is expected to announce the nomination of a Fed chair some time next week.
There will also be numerous key macro reports next week, including Core PCE (Monday), Personal Income (Monday), Employment Cost Index (Tuesday), ISM (Wednesday), and the Jobs Report (Friday).
My inner investors remains neutrally positioned, with his asset allocation at his investment policy target weight mandates. My inner trader initiated a small short position last week, and may add to it should the market rise further.
Mid-week market update: The SPX has been on an upper Bollinger Band (BB) ride on the weekly chart, and I have been waiting for a downside break on the weekly RSI-14 indicator as the signal that a correction is starting. Current readings show that the weekly RSI has not broken down below 70 tet.
However, a downside break could also be seen on the daily chart. RSI-5 has broken down below 70, which is a short-term sell signal. RSI-14 has also followed suit, which is another bearish sign. The index also experienced a bearish engulfing pattern on Monday, which is potentially ominous.
The bear case
Urban Carmel pointed out last weekend that the market is now in the seventh week of consecutive weekly gains, which historically has not ended well.
Equally disturbing are signs of diminishing breadth during the period where the RSI Indicator was exhibiting a “good overbought” condition (shaded region). At this point, only the megacap stocks are exhibiting any signs of market leadership.
A shallow correction?
The cautionary signs exhibited by a potential downside break from the weekly RSI signal has historically led to 2-5% downdrafts. However, I would expect that any correction to be fairly shallow. Jeff Hirsch of Almanac Trader found that the end of long winning streaks tend to resolve themselves with a short pullback, followed by a period of sideways consolidation.
In addition, one of outcomes of the recent period of low volatility has had the perverse effect of the VIX flashing an oversold buy signal for stocks on the shallow pullback this week. As shown by the chart below, the VIX Index has climbed above its upper BB, which is an oversold signal for the stock market. Past episodes, which are marked by vertical lines, have been buy signals for the market. Moreover, the BB width is not particular low by historical standards, and therefore the lack of recent volatility is not an excuse to ignore this signal.
As well, one little known indicator from the option market is showing a high degree of anxiety. The SKEW Index, which measures the price of tail-risk protection, is spiking. In the past, SKEW spikes when the market has pulled back (red arrows) have been reasonably good contrarian buy signals, but SKEW spikes when the market was rising (black arrows) have resolved themselves in relatively benign ways.
The Fed chair wildcard
One potential source of volatility is the announcement of the nomination of the Fed chair, which is expected to occur before the start of November. Bloomberg reported that Yellen is finding support in Trump himself, who stated in a Fox Business News interview, “I like her a lot”. However, Bloomberg also reported that Trump informally polled Republican senators yesterday as to their preferences for a Fed chair.
The president, in a lunch meeting with Senate Republicans on Tuesday, asked for a show of hands in support of Yellen and other contenders for the job — Stanford University economist John Taylor and Fed governor Jerome Powell. He didn’t announce a winner and most of the senators didn’t raise their hands. But of those who did, “I think Taylor won,” said Senator Tim Scott of South Carolina.
The market is already starting to price in the possibility of a more hawkish should the Fed take a more drastic change in direction. A Yellen renomination or a Powell nomination would be regarded as equity bullish because they represent the status quo. A Taylor nomination would be viewed as bearish, as he is believed to be considerably more hawkish (see What would a Taylor Fed look like?).
However, there are other scenarios where the market reaction would be difficult to predict. The bigger question is whether John Taylor is on the Fed board in some capacity. Imagine Yellen as chair, and Taylor as vice chair. Assuming that John Taylor would accept a position as vice chair, I believe that such an outcome would tilt policy in a slightly more hawkish direction. Market expectations would then move quickly towards the dot plot, which calls for one more rate hike in 2017, and three quarter-point hikes in 2018. Such a pace of rate hikes is well beyond current market expectations, and the presence of Taylor on the Fed board would likely be viewed as equity bearish.
The road forward
My base case scenario calls for a short and shallow sell-off in the next week. The historical evidence suggests that any weakness should be viewed as an opportunity to buy the dip.
For the time being, the “arrow” on the Trend Model is changing from a buy signal, or up arrow, to a down arrow, or a sell signal. My inner trader has sold his long SPX position and flipped to a small short position.
I had been meaning to write about this topic, but Barron’s beat me to it with a terrific article called “Breaking up Tech” which detailed the anti-trust vulnerability of Big Tech companies. The Barron’s article stands in direct contrast to a recent Josh Brown post which postulated that investors are rushing into the technology sector as a hedge against the obsolescence of their own skill sets:
A 45 year old married father of two with a mortgage and a pair of college educations to fund. The remote yet persistent threat of a nuclear war is not what keeps him up at night. In fact, he might almost see it as a relief should it come. He is a bundle of raw nerves, and each day brings even more dread and foreboding than the day before. What’s frying his nerves and impinging on his amygdala all day long is something far scarier, after all. He, like everyone else, is afraid that he doesn’t have a future.
He is petrified by the idea that the skills he’s managed to build throughout the course of his life are already obsolete…
We could be in the midst of the first fear-based investment bubble in American history, with the masses buying in not out of avarice, but from a mentality of abject terror. Robots, software and automation, owned by Capital, are notching new victories over Labor at an ever accelerating rate. It’s gone parabolic in recent years – every industry, every region of the country, and all over the world. It’s thrilling to be a part of if you’re an owner of the robots, the software and the automation. If you’re a part of the capital side of that equation.
If you’re on the other side, however – the losing side – it’s a horror movie in slow motion.
The only way out? Invest in your own destruction. In this context, the FANG stocks are not a gimmick or a fad, they’re a f***ing life raft. Market commentators rhetorically ask aloud what multiple should investors pay to own the technology giants. That’s the wrong question when people feel like they’re drowning.
What multiple would you pay to survive? Grab a raft.
Who is right?
A Big Data world
Here is some more flavor on this issue. Consider the fascinating article penned by Feng Gu and Baruch Lev for the Financial Analysts Journal entitled Time to Change Your Investment Model. Gu and Lev found that, even in hypothetical cases where an investor had perfect knowledge of reported earnings, the gains are shrinking very quickly.
Instead, they found that returns to this “earnings surprise” factor was a function of the intensity of intangible assets on the balance sheet. The higher the level of intangibles, the better earnings surprise models performed (assuming perfect foresight).
Here is an example:
Consider a pharmaceutical or biotech company that beats the consensus estimate and/or reports sales growth but has a thin “product pipeline” (drugs or medical devices under development), with no drugs in advanced development, clearly indicating that the good earnings/sales news will be short-lived.
In other words, it’s intellectual property that matters a lot more today than physical property, plant, and equipment. GAAP earnings doesn’t matter as much anymore in a winner-take-all world where intellectual property matters. Think the Big Data companies, or FANG, as prime examples.
Big Data eats the world
It is said that data is eating the world. The one who has the data, wins. Indeed, the dominance of Big Data companies is astonishing. As an example, web advertising is effectively a duopoly, and the dominant companies are reaping monopolistic-like profits.
Web Advertising Market Share
Remember all of the hand wringing over elevated profit margins? Much of that can be attributable to the current winner-take-all environment. Goldman Sachs found that profit margins are positively correlated to industry concentration.
An academic study by Mordecai Kurz at Stanford tells a similar story. IT companies are enjoying monopolistic profits. Here is the abstract:
We show modern information technology (in short IT) is the cause of rising income and wealth inequality since the 1970’s and has contributed to slow growth of wages and decline in the natural rate.
We first study all US firms whose securities trade on public exchanges. Surplus wealth of a firm is the difference between wealth created (equity and debt) and its capital. We show (i) aggregate surplus wealth rose from -$0.59 Trillion in 1974 to $24 Trillion which is 79% of total market value in 2015 and reflects rising monopoly power. The added wealth was created mostly in sectors transformed by IT. Declining or slow growing firms with broadly distributed ownership have been replaced by IT based firms with highly concentrated ownership. Rising fraction of capital has been financed by debt, reaching 78% in 2015.
We explain why IT innovations enable and accelerate the erection of barriers to entry and once erected, IT facilitates maintenance of restraints on competition. These innovations also explain rising size of firms.
We next develop a model where firms have monopoly power. Monopoly surplus is unobservable and we deduce it with three methods, based on surplus wealth, share of labor or share of profits. Share of monopoly surplus rose from zero in early 1980’s to 23% in 2015. This last result is, remarkably, deduced by all three methods. Share of monopoly surplus was also positive during the first, hardware, phase of the IT revolution. It was zero in 1950-1962, reaching 7.3% in 1965 before falling back to zero in 1970. Standard TFP computation is shown to be biased when firms have monopoly power.
It is therefore no mystery as to why FANG stocks have surged. The winners of a winner-take-all competitive environment are reaping the profits of growth and high margins. The secret to Apple’s success isn’t just selling you a phone, or tablet, but to entice you inside their walled garden where they can sell you other products and services. Similarly, Amazon’s strategy is to learn as much as it can about its customers, and sell them more products and services through multiple channels.
These business models show the supremacy of scale in an era of Big Data and AI. Somewhere along the way to market dominance, these companies forgot Google’s original guiding principle: “Don’t be evil.”
The blowback is likely to be fierce. As the latest BAML Fund Manager Survey shows biggest manager overweight is in the technology sector, the blowback will also be painful.
Big Data = Big Brother
John Lanchester, writing in the London Review of Books, worried about the ubiquitous power of Big Data companies and the invasion of privacy. The narrative is quickly turning from “Facebook and Google are innovative” to “Facebook and Google are in the surveillance business”.
What this means is that even more than it is in the advertising business, Facebook is in the surveillance business. Facebook, in fact, is the biggest surveillance-based enterprise in the history of mankind. It knows far, far more about you than the most intrusive government has ever known about its citizens. It’s amazing that people haven’t really understood this about the company. I’ve spent time thinking about Facebook, and the thing I keep coming back to is that its users don’t realise what it is the company does. What Facebook does is watch you, and then use what it knows about you and your behaviour to sell ads. I’m not sure there has ever been a more complete disconnect between what a company says it does – ‘connect’, ‘build communities’ – and the commercial reality. Note that the company’s knowledge about its users isn’t used merely to target ads but to shape the flow of news to them. Since there is so much content posted on the site, the algorithms used to filter and direct that content are the thing that determines what you see: people think their news feed is largely to do with their friends and interests, and it sort of is, with the crucial proviso that it is their friends and interests as mediated by the commercial interests of Facebook. Your eyes are directed towards the place where they are most valuable for Facebook.
The recent ProPublica article about how users could use Facebook to target “Jew haters” was a wake up call for the public. Not only that, the stories about Russian interference in the US election using a Facebook platform doesn’t help matters. I would add that Google has similar targeting capabilities. Bloomberg reported that both Facebook and Google personnel were actively involved in an American led effort to convince voters that France and Germany was being overrun by Sharia law.
In the final weeks of the 2016 election campaign, voters in swing states including Nevada and North Carolina saw ads appear in their Facebook feeds and on Google websites touting a pair of controversial faux-tourism videos, showing France and Germany overrun by Sharia law. French schoolchildren were being trained to fight for the caliphate, jihadi fighters were celebrated at the Arc de Triomphe, and the “Mona Lisa” was covered in a burka…
Unlike Russian efforts to secretly influence the 2016 election via social media, this American-led campaign was aided by direct collaboration with employees of Facebook and Google. They helped target the ads to more efficiently reach the intended audiences, according to internal reports from the ad agency that ran the campaign, as well as five people involved with the efforts.
Facebook advertising salespeople, creative advisers and technical experts competed with sales staff from Alphabet Inc.’s Google for millions in ad dollars from Secure America Now, the conservative, nonprofit advocacy group whose campaign included a mix of anti-Hillary Clinton and anti-Islam messages, the people said.
We are quickly moving toward a Big Brother world where details about anyone is potentially for sale. Consider this CBC report about data vendors in China. The most amazing part of this story is data gathering is not done by the government, but by private companies – and that data is available to anyone at a small price:
There is an entire network — the internet inside China’s Great Firewall — designed to gather the information. And there’s an industry of private and state-owned high-tech enterprises serving it.
“You could go so far as to make the argument that social media and digital technology are actually supporting the regime,” says Ronald Deibert, the director of The Citizen Lab, a group of researchers at the University of Toronto’s Munk School of Global Affairs. They study how information technology affects human and personal rights around the world.
The lab has taken apart popular apps like WeChat, a messaging app that also does financial transactions designed specifically for the Chinese market by private software giant Tencent. It’s used by more than 800 million people here every month — virtually every Chinese person who is online.
Deibert’s team found it contains various hidden means of censorship and surveillance. Among other things, the restrictions follow Chinese students who study abroad.
Chinese authorities “have a wealth of data at their disposal about what individuals are doing at a micro level in ways that they never had before,” Deibert says.
“What the government has managed to do, I think quite successfully, is download the controls to the private sector, to make it incumbent upon them to police their own networks,” he says.
And now it seems, the data these firms collect is for sale.
An investigation by a leading Chinese newspaper, the Guangzhou Southern Metropolis Daily, found that just a little cash could buy incredible amounts of information about almost anyone. Friend or fiancé, business competitor or enemy … no questions asked.
Using just the personal ID number of a colleague, reporters bought detailed data about hotels stayed at, flights and trains taken, border entry and exit records, real estate transactions and bank records. All of them with dates, times and scans of documents (for an extra fee, the seller could provide the names of who the colleague stayed with at hotels and rented apartments).
All confirmed by the colleague. And all for the low price of 700 yuan, or about $140 Cdn.
Stories like this one about how Google’s smart speaker inadvertently recorded every sound that was in the room, even when it was supposedly turned off, raises enormous privacy concerns. The actions of Big Data companies are reminiscent of Lily Tomlin’s Ernestine the operator character from a bygone era (click this link if the video is not visible).
I would add that Amazon isn’t innocent either. Alexa forms part of its Big Data and Big Brother efforts and its smart speakers are the Trojan Horse for consumer AI. As well, Amazon’s patent to prevent shoppers from online price comparison in its own bricks and mortar stores, starting with Whole Foods, is an anti-competitive step to market dominance.
The scapegoats in the next recession
Don’t be surprised when the pitchforks gather at the gates of the Big Data companies in the next recession. Economic pain demands scapegoats. Big Data companies are the perfect candidates. They are not large employers in the United States and therefore they have no natural political constituencies that can stand up on their behalf.
The tech industry has also benefited for years from its enemies, who it cast — often accurately — as Luddites who genuinely didn’t understand the series of tubes they were ranting about, or protectionist industries that didn’t want the best for consumers. That, too, is over. Opportunists and ideologues have assembled the beginnings of a real coalition against these companies, with a policy core consisting of refugees from Google boss Eric Schmidt’s least favorite think tank unit. Nationalists, accurately, see a consolidation of power over speech and ideas by social liberals and globalists; the left, accurately, sees consolidated corporate power. Those are the ascendant wings of the Republican and Democratic parties, even before Donald Trump sends the occasional spray of bile Jeff Bezos’s way — and his spokeswoman declines, as she did in June, to defend Google against European regulators.
This has led to a kind of Murder on the Orient Express alliance against big tech: Everyone wants to kill them.
The New York Times recently published an article, Silicon Valley is not your friend. As well, CNBC reported that Netflix board member Rich Barton expects an inevitable government crackdown on Amazon:
Technology entrepreneur Rich Barton says government intervention on Amazon in the future is unavoidable.
Barton was asked about his views on Amazon in relation to the Department of Justice’s antitrust investigation of Microsoft during the 1990s in a Bloomberg podcast interview.
“I lived through that DOJ thing. It was really rough. It’s no fun. And I think it is inevitable as companies get really, really huge,” Barton said in the podcast interview published Friday.
“I think Jeff [Bezos] is probably well aware of that,” Barton said. Bezos “is trying to do everything he can to delay that as long as possible and to play within the rules, but eventually the tall poppy gets chopped in
In this era of Big Data, hacking incidents such as the one experienced at Equifax will undoubtedly raise the concerns of some Senate committee in the future. If these Big Data “surveillance” companies know everything about us, what steps are they taking to keep it safe, and what is the extent of their liability should their firewalls be breached?
The Microsoft template
Still, investors should not expect total disaster if Big Data companies face some form of political intervention. Should it occur, the most likely regulatory response would see the breakup of some of the target companies, such as the forced divestiture of AWS from Amazon, and so on, in the same way that the DoJ went after IBM and Microsoft. The Barron’s article went on to raise legitimate antitrust concerns for these companies:
Amazon, Facebook, and Google all benefit from the same sort of network effects that snagged Microsoft. The more people use Facebook, the more others feel they must use it, in a self-perpetuating fashion. Ditto for advertising on Google or selling goods on Amazon. Wall Street and investors may love this virtuous cycle, or, as it’s commonly known, the “flywheel” that keeps expanding their business.
But others, citing Fisher’s work, see exploitation and unfair leverage. They can argue that Amazon sells its Echo home speaker at roughly break-even prices to bring in more shoppers. It’s conceivable such leverage could be interpreted by regulators as predatory. Another example is Amazon’s bundling of its Amazon Prime membership, which offers free shipping and streaming videos, below Amazon’s cost to provide it. Google’s use of Androis to maintain its search engine as pre-eminent on mobile devices has been likened to the kind of “tying” that Microsoft tried with Internet Explorer.
Should the regulator decide to act, my working template is the Microsoft experience. As the chart below shows, MSFT became a market performer after the Justice Department initiation of the United States v. Microsoft Corp.
The path forward
If a political backlash were to occur, the most likely economic backdrop would be a recession. I can suggest a couple of analytical frameworks for investors to deal with the change in environment.
First, Marc Chandler suggested that the current growth problems can be attributable to an abundance of capital:
When farmers have a bountiful crop, and the price threatens to fall below the cost of production, governments often invent schemes to buy the crop and warehouse it and let the agricultural produce come to market at a better (i.e., lucrative) time. In some ways, QE can be understood as a similar strategy: Warehouse the surplus capital. This is not a permanent solution. There is a political push back on the grounds that it blurs monetary and fiscal policy. There is an ideological resistance to the “interference” with market forces. There are economic arguments against the distortion of prices and the mutation of printing signals.
Interest rates are low, not simply because central banks are buying bonds and maintaining large balance sheets by recycling maturing issues. Interest rates are low because there is too much capital. It is a recurring source of the crisis in market economies. We should anticipate that returns to capital will remain low until a new strategy to deal with the surplus is devised and accepted, and the risk is that we are still in denial.
An article in HBR outlined some corporate strategies in an environment characterized by an abundance of capital. Investors should look for companies that make many small bets, and don’t put all your eggs in a single basket:
Strategy in the new age of capital superabundance demands a fundamentally different approach from the traditional models anchored in long-term planning and continual improvement. Companies must lower hurdle rates and relax the other constraints that reflect a bygone era of scarce capital. They should move away from making a few big bets over the course of many years and start making numerous small and varied investments, knowing that not all will pan out. They must learn to quickly spot—and get out of—losing ventures, while aggressively supporting the winners, nurturing them into successful new businesses. This is the path already taken by firms innovating in rapidly evolving markets, but in an era of cheap capital, it will become the dominant model across the business economy. Companies that practice this strategy will have the edge so long as capital remains superabundant—and according to our analysis, that could be the case for the next 20 years or more.
Another effect might see the reversal of the tangible vs. intangible investment rates identified by Gu and Lev as a winner-takes-all environment erodes.
In that case, equity analysis might return to a more conventional framework, where a focus on earnings, and ROI on invested capital matter more to investment returns. In that case, we may see capex intensity return to historical norms.
In that case, a return to higher capex levels as the economy returns to “normal” wouldn’t be such a terrible outcome either.
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.
A China-led reflationary recovery?
Copper and industrial metal prices have been on a tear lately. Prices bottomed out in early 2016, and the latest rally has seen a recovery to levels last seen in 2014.
China is a major driver of commodity demand, and her economic growth has been surging recently. It is therefore no surprise that copper and industrial metal prices have been soaring.
The latest upside surprise in Chinese PPI prompted David Ingles at Bloomberg to ask if China is leading a bout of global reflation.
Callum Thomas at Topdown Charts also observed that China is at the epicenter of the global reflation theme.
The developed markets are also experiencing a synchronized upswing.
On the other hand, China is currently holding its 19th Party Congress. It doesn’t take a genius to understand that any bureaucrat who creates conditions that causes either a growth slowdown or financial instability during this critical period will have made his own life very difficult. In effect, Beijing has given a 19th Party Congress put option to the market, where nothing bad would be permitted to happen to the economy ahead of the meeting.
Skeptics could therefore ask if the current growth revival is real, or window dressing ahead of the Party Congress. What happens after the expiry of the 19th Party Congress Put as the meeting winds up next week?
Deleveraging with Chinese characteristics*
Despite the widespread concerns about the extended state of China’s debt levels and the lip service paid to deleveraging, Chinese authorities have been juicing the Chinese economy with credit driven growth ahead of the Party Congress. Tom Orlik had the perfect observation that describes China’s deleveraging efforts.
The latest September report of Total Social Financing (TSF), which represents the broadest measure of debt, rose 13% YoY and an astonishing 23% MoM. At a 13% growth rate, Christopher Balding pointed out that TSF growth has hardly slowed when compared to the past few years. Nominal TSF growth is well above nominal GDP growth, based on a real GDP growth rate of 6.8% and inflation rate of 1.6%.
This is deleveraging?
What`s even worse, the WSJ reported that the government has been supporting the real estate market by ordering local authorities to buy up surplus properties:
Under Beijing’s direction, more than 200 cities across China for the last three years have been buying surplus apartments from property developers and moving in families from condemned city blocks and nearby villages. China’s Housing Ministry, which is behind the purchases, said it plans to continue the program through 2020.
The strategy, supported by central-government bank lending, has rescued housing developers and lifted the property market, which accounts for a third of China’s economic growth according to Moody’s Investors Service…
China’s government used to build homes for families who lost theirs to development or decay. But last year, local governments, from the northeast rust belt to this city of 3.7 million amid the croplands of central Anhui province, spent more than $100 billion to buy housing from developers or subsidize purchases, according to Gavekal Dragonomics.
Underpinning the strategy is a cycle of debt. Cities borrow from state banks for purchases and subsidies, then sell more land to developers to repay the loans. As developers build more housing, they, too, accrue more debt, setting up the state to bail them out again. The burden on the state rises, as does the risk of collapse.
The government has tried other ways of filling apartments, such as offering cash subsidies to encourage rural migrants to buy in urban areas, but the program is the first large-scale case of the government becoming a home buyer itself.
Tom Orlik also pointed out that Beijing continues to follow the same-old same-old practice of infrastructure spending to drive economic growth.
Of the ten indicators included within our CMI 2.0 (see Fathom Consulting, ‘Our expanded China Momentum Indicator shows growth rebounding – for now’ for a detailed look at our CMI 2.0 indicator), half have expanded at significantly higher rates than in the slump of late 2015: railway and port freight, electricity consumption, real imports and the commodity price index. Meanwhile, growth in those indicators representative of the services sector of the economy remains subdued. This supports our call first presented to our clients in a note in the first half of 2016 (see Fathom Consulting, ‘China’s growth is bottoming out’) that Chinese policymakers have doubled down: recommitting to the model of export- and investment-led growth rather than a reorientation towards the consumer.
This amounts to a continuation of credit being channelled to unproductive assets within the economy. As we explained in a note sent to clients (See Fathom Consulting, ’Productivity puzzle the drugs won’t work’), the accumulation of non-financial debt beyond 250% of GDP stops being effective and starts to damage growth significantly. China passed this point in the third quarter of last year.
Translation: As China continues with its credit-driven growth model and makes little effort to rebalance its economy, the day of reckoning draws ever closer. Call this deleveraging with Chinese characteristics*.
Commodity bull with Chinese characteristics*
The current commodity bull may also turning out to be a bull with Chinese characteristics*. China Beige Book, which monitors the health of the Chinese economy from a bottom-up basis, recently wrote that the so-called “supply side reforms” of cutting commodity production capacity is a smokes and mirrors exercise. The withdrawal of supply is only a window dressing exercise ahead of the Party Congress:
Finally, and again contrary to government claims, China hasn’t slashed overcapacity in commodities sectors. Xi has incessantly touted what he calls “supply-side reforms,” which would seem to give Chinese companies very strong incentive to report results showing such cuts.
Yet for more than a year, firms have indicated the opposite. While some gross capacity has been taken offline to much fanfare, net capacity has continued to rise. From July through September, hundreds of coal, steel, aluminum and copper companies reported a sixth straight quarter of overall capacity rising, not falling.
This will soon come to a head. For over a year, blistering demand and flows of speculative capital have combined to keep metals prices rising and mask the lack of genuine supply cuts. In the third quarter, though, firms across sub-sectors reported poorer revenue and profit results. Most telling, domestic orders weakened sharply, signaling that there’s no quick rebound on the way. Unless true supply cuts are imposed, it’s a matter of when, not if, speculative inflows unwind and many investors find themselves running for cover.
More worrisome is the observation that it is Chinese speculative demand, not physical demand, that is driving the commodity rally. The WSJ reported that commodity trading volumes in China are overtaking traditional western venues, such as the LME, with *ahem* Chinese consequences:
Chinese speculation was “the key driver of the rally” in base metals this year, said Michael Widmer, chief metals strategist at Bank of America Merrill Lynch. “We’ve virtually not seen any improvement in underlying fundamentals.”
China has long been a focal point for commodities markets. The nation is the world’s largest metals consumer. But now, it has also become home to massive trading in metals. Because the government has taken steps to cool the property market and the country’s normally volatile stock market has calmed, Chinese retail investors have turned to base metals in recent years to generate rapid returns. Analysts said they prefer to trade on an exchange within the country because it is easier than trading on foreign exchanges like the LME…
On some days this year, the reactions in prices to reports left many in the metals market confounded. Prices rose even after information that typically sends copper and other base metals lower. On such days, some fundamental investors and analysts blamed speculators.
Data on Aug. 13 showed the pace of Chinese industrial output, retail and housing sales, and fixed-asset investments decelerated in July. Still, after two days of muted moves, prices of copper, aluminum and nickel went on to rally for the week and continued rising for the rest of August.
On Aug. 29, U.S. mining giant Freeport-McMoRan reached an agreement with the Indonesian government over a key mine—a potential blow to copper prices since disputes between the company and country had limited supply. Yet prices went on to advance in five of the next six sessions. Many analysts use copper as a benchmark to gauge the performance of the wider industrial-metals complex because of its widespread uses and prominence.
“Bullish news is being used to buy, but bearish news is being ignored,” said Daniel Briesemann, an analyst at Commerzbank .He said the 16% gain by an LME base metals gauge between May and August appeared largely driven by short-term players. Before then, the LME gauge had been roughly flat this year.
Copper prices have fallen 1.5% from a nearly three-year intraday high last month. After about a four-month rally earlier this year, prices of nickel and iron ore have each tumbled at least 8%. Still, prices of copper, aluminum and zinc are each up more than 20% this year.
One measure of the surge in Chinese speculative demand is the relative performance of the China Materials ETF (CHIM) against the global Materials ETF (MXI). If market dynamics are stable, then the pair should trade in a fairly narrow band. As the chart below shows, China Materials stocks have been rising against their global counterparts and the rally is coincidental with the rally in industrial metal prices. The CHIM/MXI pair is rapidly approaching a key relative resistance level, which may be a signal that the China driven commodity rally is about to stall.
Other market internals are also deteriorating. The China Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is falling.
As well, the AUDCAD currency cross has been trending downwards. Both Australia and Canada are commodity producers and therefore their currencies have similar levels of commodity sensitivity. Australian commodity exports are geared towards bulk commodities and China, while Canadian exports have a greater US sensitivity and more exposed to the energy sector. The downtrend in AUDCAD represents a negative divergence, particularly when industrial metals have been outperforming oil prices.
Call this a commodity bull, but with Chinese characteristics*.
Market implications
Business Insider reported that Goldman Sachs published a research note suggesting that the US stock market has an 88% chance of entering a bear market within 24 months.
The GS Market Risk Indicator has risen to levels seen at previous tops and stands at 67%, which indicates that there is an 62% chance that US equities will enter into a bear market within 12 months, and 88% chance of a bear market within 24 months.
The typical profile of a bear market looks like this. The market tops, corrects, and rallies to make a double top before the actual slide begins.
This is consistent with my own observation that stock prices tend to top out when the DJ Global Index makes a double top with a negative RSI divergence (see Market melt-up and crash?).
As well, it is consistent with my past analysis that late cycle bulls are characterized by inflation hedge sector leadership such as Materials (see Buy the breakout?). I am continuing to monitor the relative performance of the gold, energy and materials sectors to see how this scenario is playing out.
Ned Davis Research confirmed my late cycle thesis when they observed that SP 500 sales growth ex-energy has been rolling over. Unless the economy comes through with better than expected growth, the fundamentals are likely to start stalling next year (chart annotation is mine).
The path forward
From a tactical viewpoint, we have not seen the first downside break in stock prices, as shown in the Goldman Sachs chart of the idealized top, nor in my DJ Global Index chart above. However, the market is significantly overbought, but exhibiting signs of powerful positive momentum. It is impossible to know ahead of time what will trigger the downside break.
China’s 19th Party Congress winds up next week, and which will signal the expiration of the Party Congress Put. However, that doesn’t mean that the Chinese economy and commodity prices will instantly tank, but that could be one trigger of market weakness.
In the US, there is plenty potential for negative surprises. We could see the nomination of a hawkish Fed chair (see What would a Taylor Fed look like? and Melt-up and crash?). As well, Axios reported that it is a matter of when, not if, Trump sends a notice of withdrawal from NAFTA. Such a development would spark protectionism fears as the US has much to lose should it withdraw from NAFTA.
In the meantime, the stock market has not crossed my bearish lines in the sand. The latest update from John Butters of FactSet shows that Q3 earnings season results are beating both the top and bottom lines at an above average historical rates. Forward 12-month EPS is still rising, which indicates positive fundamental momentum. Butters also stated that “the market is rewarding upside earnings surprises more than average and punishing downside earnings surprises more than average”, which is an important indication of bullish undertones to market psychology.
The SPX remains above its weekly upper Bollinger Band, and overbought on its weekly RSI. My inner trader is nervously long, and watching for a downside break as his sell signal.
Any early warning of a downside break should come from the daily chart. It would be seen first from RSI-5, followed by RSI-14. Neither has happened.
My inner investor remains constructive on the market. In all likelihood, we have not seen the final top yet, and his equity weight is roughly at the target set by his investment policy.
* In case readers don’t understand the reference, Mao called his rule of China as Socialism with Chinese characteristics because it differed from the Soviet implementation of Marxist thought.
Mid-week market update: I wrote last weekend that there was a possibility that the stock market may undergo a melt-up, followed by a crash (see Market melt-up and crash?). That scenario may well be occurring, and I sent out an email to subscribers on Monday stating that my trading account had moved from all-cash to being long stocks.
There are a number of reasons for my tactical position. First, I had set a line in the sand on the weekend. The SPX was overbought, as evidenced by the combination of a weekly close above the upper Bollinger Band, and RSI-14 above 70. In the past, a mean reversion of RSI-14 below 70 was a signal for a correction of 2-5%. That sell signal has not occurred yet.
In fact, RSI-14 has not even mean reverted below 70 on the daily SPX chart.
A “good overbought” reading
My former Merrill Lynch Walter Murphy used to call these “good overbought” readings. Andrew Thrasher observed that three consecutive weekly closes above the upper BB are rare events. Such occurrences, which are marked by the dots below in the chart, have not historically been overly bearish.
Here is the history of the signals during the 1980-1997 period, which was even more bullish than the 1998-2017 time frame.
It illustrates my point that these are momentum thrusts, and upside momentum have a tendency to carry on for longer than anyone thinks.
Constructive sentiment
A funny thing happened as stock prices advanced, sentiment became more cautious, which is contrarian bullish. The Fear and Greed Index has retreated from nosebleed levels that was north of 90 and stands at 82 today.
As well, the term structure of the VIX began to flatten, indicating growing fear, even as the market rose. That`s another contrarian bullish sign.
Upside target
How far does the market rise from these levels? It’s impossible to know once the animal spirits start to run wild as they have today. However, I did point out two weeks ago that a combination of techniques pointed to an upside S&P 500 target of about 2600 (see Nearing upside target, now what?).
Jeff York also observed that the index is nearing an important pivot, with important resistance at 2573-2615. York found that “price fails at the Yr2 pivots 82% of the time. The average pullback is roughly 100 SPX points or 1,000 DJIA Points.”
The combination of these factors suggests that stock prices can continue to grind upward from current levels, though the potential upside is somewhat limited. My inner trader is tactically staying long, but keeping his stops tight.
Bloomberg reported that Donald Trump interviewed John Taylor for the position of Fed chair and “Trump gushed about Taylor after his interview”, as “Kevin Warsh has…seen his star fade within the White House”. The current list of leading candidates under consider are said to be Jerome Powell, John Taylor, Kevin Warsh, and Janet Yellen. Taylor’s rise in the candidate stakes is a bit of a surprise, as he had been regarded as a dark horse.
The question for investors is, “What would a Taylor Fed look like?”
Taylor is famous for the “Taylor Rule”, which is a rules-based method of determining the Fed Funds rate. The rules-based approach is a favorite of the Republican audit-the-Fed crowd, and therefore Taylor will have substantial support should he get nominated. The standard application of the Taylor Rule would see the Fed Funds target substantially higher than it is today.
Despite these dire projections, Matthew Boesler at Bloomberg argued that a Taylor led Fed would not be substantially different from a Yellen Fed, because Taylor would have difficulty bringing the members of the FOMC to such a hawkish tilt to monetary policy:
Resistance from the other participants on the rate-setting Federal Open Market Committee, which currently numbers 16 participants, is why investors need not worry too much about Chairman Taylor leading the Fed onto a much faster rate-hike path than the three rate increases next year penciled in by officials in quarterly forecasts updated in September.
“Taylor would have a very hard time persuading the rest of the FOMC to abide by the prescriptions of his original rule,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington. “In fact, he won’t be able to persuade hardly anyone — there isn’t much sympathy in the FOMC for a policy that blindly follows rules.”
On the other hand, uber-dove Neel Kashkari of the Minneapolis Fed argued that the application of a Taylor rule would have kept millions out of work:
In December, I wrote an op-ed in the Wall Street Journal explaining that forcing the Federal Open Market Committee (FOMC) to mechanically follow a rule, such as the Taylor rule, to set interest rates can cause tremendous harm to the economy and the American people. My staff at the Minneapolis Fed estimates that if the FOMC had followed the Taylor rule over the past five years, 2.5 million more Americans would be out of work today. That’s enough to fill the seats at all 31 NFL stadiums simultaneously, almost 6,000 more people out of work in every congressional district.
Who is right? How should we assess John Taylor as a potential Fed chair?
Interest rate policy
For investors, the market impact of a Fed chair should be evaluated on two criteria. How will the chair conduct interest rate policy under “normal” circumstances, and how would he behave under periods of stress? Note that this framework passes no judgment on whether any person has the correct approach to the conduct of monetary policy. Our only interest is the impact of policy.
That said, even the Taylor Rule has several input parameters that lead to very different results, depending on the model assumptions.
Imagine that John Taylor is the new Fed chair, and he may have some difficulty in forming a consensus on the FOMC on how quickly to normalize policy. As a way of conducting sensitivity analysis on the various models, the Cleveland Fed has a monetary policy tool that determines a Fed Funds target under different assumptions. The median Fed Funds target for December 2018 is 2.24%, which is a reasonable estimate for a compromise solution in light of the differences in opinion.
I would then point out that the median 2.24% 2018 year-end target is higher than the current dot-plot projection of 2.13%. Moreover, the current dot-plot projection is substantially higher than market based expectations for the Fed Funds rate.
That’s just the base case scenario. I pointed out in my last post (see Market melt-up and crash?) that the FOMC is likely to adopt a more hawkish tilt in 2018, irrespective of the identity of the chair. Virtually all Fed governor candidates favor rules-based approaches to monetary policy, which would put the Fed on a more hawkish path than it is today. As well, the rotation of votes among regional Fed presidents indicate a more hawkish shift, from Evans and Kashkari to Meester and Williams.
In short, the appointment of John Taylor as Fed chair is likely to see a far more hawkish Fed than under Yellen.
Crisis management
The other criteria for the evaluation of a Fed chair is how he is likely to react under stress. As interest rates have barely lifted the zero lower bound, how will the Fed behave in the next recession?
For some clues, we turn to the past writings of John Taylor. On November 15, 2010, Taylor was a signatory to the Open Letter to Ben Bernanke which urged the Fed to refrain from engaging in quantitative easing.
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
We subscribe to your statement in The Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
At about the same time, Taylor penned a joint opinion letter with Paul Ryan which laid the blame on the Financial Crisis on the Fed’s failure to follow a rules-based regime:
Quantitative easing is part of a recent Fed trend toward discretionary and away from rules-based monetary actions. The consequences of this trend are clear: The Fed’s decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble. And while the Fed did help to arrest the ensuing panic in the fall of 2008, its subsequent interventions have done more long-run harm than good.
QE1 failed to strengthen the economy, which has remained in a high-unemployment, low-growth slump, and there is no convincing evidence that QE2 will help either. On the contrary, QE2 will create more economic uncertainty, stemming mainly from reasonable doubts over whether the Fed will know exactly when and how to contract its balance sheet after such an unprecedented expansion.
Not only were Taylor and Ryan opposed to QE2, which was about to begin, but QE1, and interpreted QE as a way of bailing out fiscal policy:
QE1 involved the Fed in areas of fiscal policy, such as credit allocation, that are properly (and constitutionally) the domain of Congress. QE2 would double down on these expansions, as the planned purchases of Treasury securities would constitute a large fraction of soon-to-be-issued federal debt.
This looks an awful lot like an attempt to bail out fiscal policy, and such attempts call the Fed’s independence into question.
For the sake of the argument, let us assume that Taylor was correct in his assessment that the Fed’s easy monetary policy blew an asset bubble in the years leading up to the GFC, and that it fell behind the curve in its efforts to control inflationary pressures. He would be put in a similar situation today should he become the new Fed chair, as the economy is already in the late cycle phase of an expansion.
Taylor stated in a Bloomberg interview on March 27, 2017 that he believed that the Fed was behind the inflation fighting curve. A Taylor Fed would then aggressively tighten in 2018, which is likely to send the economy into a slowdown. How would he react in the downturn?
As interest rates are already relatively close to zero bound, what would a Taylor Fed do? He has stated on the record that he is opposed to unconventional monetary policy, such as QE. In that case, radical steps of helicopter money would be out of the question.
In conclusion, John Taylor nomination as a Fed chair would be a surprise, despite the reports of Trump’s gushing. While Taylor is a Republican and likely to look favorably upon financial deregulation, which is one of Trump’s priorities, a Taylor Fed would be more hawkish than the Yellen Fed and see greater economic volatility during a recession. Taylor most certainly does not fit Trump`s desire for a “low interest guy”. However, Fox Business News reported that VP Mike Pence, Heritage Foundation economist Steve Moore, conservative economist Larry Kudlow, and former Reagan adviser Arthur Laffer are involved in the search for the new chair, which could tilt the odds in Taylor’s favor.
Janet Yellen is scheduled to meet with President Trump on Thursday. Stay tuned for further developments.
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.
The challenges of a late cycle bull
I have been making the point that the American economy is in the late stages of an expansion. This presents some investment challenges as an inflection point may be near. As the chart below shows, while every equity downdraft has not signaled a recession, every recession has seen an equity bear.
The question is, “How far away are we from a recession?” I try to answer that question this week by focusing on three components of the economy using the leading indicators in my Recession Watch Monitor:
The household sector;
The corporate sector; and
Monetary conditions.
Further, I analyze the nowcast of the economy and the market outlook from both macro and technical viewpoints. The market may be setting for a scenario where stock prices melt-up, followed by a market crash of unknown magnitude.
Signs of a late cycle expansion
The market was pleasantly surprised on Friday by the better than expected retail sales figure, and tamer than expected CPI release. As well, consumer sentiment surged to a new cycle high.
While Friday’s data represents good news in the short term, the combination of strong retail sales (red line) and the lack of wage growth (blue line) means that the household sector will eventually have trouble supporting consumer spending at the current pace.
There are a number of ways that the household sector can cope. More members of the household can find jobs. Employment statistics remain strong, though the pace of improvement is decelerating. While a deceleration in non-farm payroll employment is not a warning of recession, it does indicate that the economy is well past the mid-cycle phase of its expansion.
Another way the household sector can keep on spending is by cutting back its savings rate.
Finally, households can take on more debt as a last resort to maintain spending patterns. I call this the “keeping up with the Joneses” effect. As the chart below shows, household debt levels are rising again after deleveraging in the wake of the last financial crisis.
The stresses are already showing up in big ticket consumer durable purchases. Auto sales appear to have peaked for this cycle, though the latest spike is probably related to the replacement of hurricane damaged vehicles.
The housing sector, which is an important cyclical part of the economy, has also peaked for this expansion.
In summary, while headline retail sales remain strong, internals reveal signs of underlying weakness. By themselves, none of these indicators are signals to hit the panic button. They are just signs of a late cycle expansion.
Rising corporate stress
The corporate sector is another story. NIPA corporate profits have peaked for the current expansion and they are starting to roll over.
As well, the debt financing costs of corporations have bottomed for this expansion. Corporate bond yield bottoms have generally occurred ahead of past recessions.
The corporate sector has also re-levered its balance sheet to levels seen at past cycle peaks. The combination of consumer spending poised to turn down, peaks in corporate profits, and bottom in debt financing costs makes the companies vulnerable to a downturn.
Still, these are not reasons to hit the panic button just yet. They just represent a “this will not end well” investment thesis, with no obvious clues on timing.
An easy Fed
The one single factor that is still holding up the US economy is Fed policy. Despite the Fed’s professed desire to normalize rate, monetary policy remains loose. As the chart below shows, real money supply growth is falling but still positive. If history is any guide, nominal money growth has fallen below CPI inflation (black line) ahead of recessions in the past.
In addition, the yield curve has not inverted. An inverted yield curve has been a surefire signal of recession in the past. The possibility exists that the yield curve may not invert this time because of the Fed’s balance sheet normalization program. By the Fed’s own estimates, its QE programs flattened the yield curve by about 100 bp. The reversal of that program should have a steepening effect on the yield curve, and therefore this indicator may not be as effective recessionary signal as it had been in the past.
Financial conditions are not showing much signs of stress. This underscores New York Fed president Bill Dudley’s point that, as long as financial conditions are not stressed, the Fed should continue to normalize monetary policy.
Future Fed policy as wildcard
In effect, the future trajectory of Fed policy will be the wildcard for determining capital market returns. That is where a lot of policy uncertainty comes in.
It is said that the Trump administration will announce the nomination for the Fed chair in the next few weeks. By all accounts, Janet Yellen is unlikely to be re-appointed. The two front-runners are said to be Jerome Powell and Kevin Warsh. It appears that Donald Trump will look for three qualities in a Fed chair. In no particular order, they are:
Deregulation bias
Easy money bias
Personal chemistry and loyalty
No candidate is perfect and ticks off all the boxes. Kevin Warsh is well-connected and he is likely to score well on the “personal chemistry” criteria. and if anyone is able to offer Trump personal loyalty, it would be Warsh. He is the son-in-law of major Republican contributor and Estée Lauder heir Ronald Lauder. Warsh believes in aggressive deregulation of the financial sector, but his speeches reveal him to be a rules-based monetary hawk. Wall Street would view a Warsh appointment as a negative, as the consensus view is he has a history of being behind the curve on monetary policy. A Warsh Fed is likely to introduce a higher degree of volatility to the US economy. For more, see this devastating takedown of Warsh by Sam Bell.
By contrast, Jerome Powell is viewed as the compromise candidate. Jerome Powell is a Republican technocrat and unlikely to offer Trump his personal loyalty. He has shown himself to be mildly in favor of further deregulation. A Powell Fed would represent continuity with the Yellen Fed’s direction in monetary policy. The markets would view a Powell nomination as an equity bullish outcome.
Regardless of what happens, it is important to look behind the headlines of a Fed chair nomination. The Fed in 2018 is likely to be more hawkish than the Fed in 2017. As I pointed out last week (see Is 3% for 6 months enough to take equity risk?), not only is the Fed chair unknown, there are three vacant seats on the Fed’s Board of Governors out of a total seven seats. Virtually all Fed governor candidates favor rules-based approaches to monetary policy, which would put the Fed a more hawkish path than it is today. As well, the rotation of votes among regional Fed presidents indicate a more hawkish shift, from Evans and Kashkari to Meester and Williams. If you think that there is a gulf between the Fed’s dot plot and market expectations of monetary policy today, wait until the full composition of the FOMC is known.
If the Fed turns significantly more hawkish, that’s when investors should batten down the hatches. That will be the signal of an inflection point for the economy and the markets.
Nowcast vs. forecast
For investors, navigating a potential turning point like this is problematical. The nowcast of the economy, such as consumer confidence and retail sales, are bright, but leading indicators are deteriorating. I agree with New Deal democrat’s latest weekly assessment of economic conditions:
After several months of boring sameness, the weekly indicators are beginning to show a change in trend. The short leading indicators are literally ALL positive. Coincident indicators except for LIBOR are also all positive. The present and near future economy looks stronger than at any time I can recall during this entire expansion (although job growth is decelerating and wage growth is still paltry).
But enough of the long leading indicators (including monthly and quarterly ones) have deteriorated to neutral or even negative for me to downgrade the longer term outlook to neutral. The change in real M2 may prove ephemeral, as the oil-fired surge in inflation abates, But on the other hand, even nominally, M2 has been decelerating. As usual, I will remain entirely data driven.
As one example of upbeat nowcast condition, the most recent update of Q3 earnings season is positive. Even though 6% of index components have reported, John Butters at Factset pointed out that both the earnings and sales beat rates are well above historical averages, and forward 12-month EPS continues to rise.
That said, Butters also stated that “the market is not rewarding earnings beats”, which is a warning flag of investor psychology. In addition, the forward P/E is now 18.0. Combined with a headline CPI of 2.2%, the sum of the two violates Ed Yardeni’s “Rule of 20“, which states that the market is at risk of stalling when the sum of the two exceeds 20.
Possible melt-up and crash
CNBC recently reported that Ed Yardeni put the probability of a market melt-up, followed by a market crash at 55%. Such a scenario is well within the realm of possibility.
Here is what I am watching from both an intermediate term and shorter term basis. The US equity market has been buoyed by evidence of synchronized global growth, and it will be difficult for stocks to decline without signs of deterioration around the world. Past global equity tops have seen negative RSI divergences, which has not occurred.
If global stock markets were to make a cyclical top, the most likely scenario would see a correction, followed by a rally to test the old high or make a marginal new high which is unconfirmed by RSI. That pattern was evident even during the Tech Bubble melt-up. Current conditions show that while the index is overbought on RSI, we have not seen the first correction yet. So it’s far too early to panic.
At the same time, Callum Thomas of Topdown Charts observed that global market breadth is deteriorating. Keep in mind, however, that breadth deterioration is an inexact sign of a market top. It can take months for breadth to top out before the broader averages actually does.
In the shorter term, I pointed out that the combination of the SPX trading above its weekly upper Bollinger Band and overbought on RSI-14 made it vulnerable to a pullback (see Peak small cap tax cut euphoria?). Such corrections have been relatively mild, in the order of 2-5%. While the market remains overbought, and we have not seen the sell signal yet when the weekly RSI falls below 70. To be sure, the RSI indicator cannot stay elevated forever and a retreat can occur at any time.
Should the market continue to grind upwards and stay overbought, the melt-up and crash scenario comes into play. The sentiment backdrop for a major top is already in place. As a reminder, I have detailed extensively in the past how sentiment is getting overly froth with my series “Things you don’t see at market bottoms”.
My inner investor remains constructive on equities. Even though the trading model is flashing a buy signal, my inner trader is stepping aside as he does not believe the risk-reward is in his favor. He is waiting for market weakness to buy the dip.
Mid-week market update: The intermediate term technical trend remains bullish, it`s hard to argue with the strong momentum that the market has displayed. Ari Wald recently pointed out that the market is experiencing a “good overbought” condition (my words, not his) that has the potential to carry the market much higher.
However, the current market environment may be setting up for a short correction. The SPX is trading above its upper weekly Bollinger Band (BB). Past episodes, when viewed in isolation, have been relative benign. The market has either continued grind upwards, or move sideways. That said, I am monitoring the weekly RSI-14 indicator when the market is above its upper BB. Past breaks below the 70 after an overbought reading have seen the market pull back. (Note that the weekly RSI reading remains above 70, and therefore no sell signal has been generated.)
I am watching the evolution in small cap leadership, which may be in the process of breaking down. Such a development could be a signal of near term market weakness.
Small caps as tax cut plays
Small cap stocks have been on a tear lately, largely because of tax cut hopes. Small cap companies tend to be more exposed to the domestic economy and should therefore benefit more from corporate tax cuts. The market was encouraged when the House of Representatives approved a fiscal 2018 spending blueprint to help advance an eventual tax bill that can be passed by a simple majority vote in the Senate. At about the same time, the Senate Budget Committee approved its own budget resolution and sent it to the full Senate for a vote. In addition, news broke that the centrist “blue dog” Democrats were open to discussions on tax reform (see Bloomberg). CNBC reported that Goldman Sachs assigned a 65% probability that some form of tax reform would get passed.
Corporate tax cut math
Notwithstanding how the horse trading winds up in Washington, Matthew Yglesias made the point of a basic problem with aggregate picture of corporate tax cut math. Currently, the effective corporate tax rate is much lower than the statutory rate of 35%, but above the targeted rate of 20%. It is impossible to lower the rate to 20% and pay for it by cutting loopholes (easier said than done) and achieve revenue neutrality at the same time.
Assuming that the eventual agreed upon rate settles in at above 20%, achieves revenue neutrality and closes loopholes, then the net tax effect would be zero. To be sure, there will be winners and losers under the new tax code, but don’t expect much in the way of aggregate boost to net earnings under such a scenario.
Should that the Republicans abandon the revenue neutrality constraint and let the fiscal deficit to rise, current rules allow for an incremental $1.5 trillion in deficit spending in the next 10 years. The current proposal of corporate tax cuts and middle class tax cuts leaves a hole of $2.2-2.5 trillion, depending on the sources of the estimates. That’s only the base case assumption, before individual legislators lobby to keep their favorite tax deduction, such as the deduction for state and local taxes.
Tax reform is hard, just as healthcare reform is hard. FiveThirtyEight pointed out that the different wings of the Republican party have not come to agreement on three key questions, which makes the tax cut and reform process especially difficult:
How much does increasing the deficit matter?
Is it temporary tax cuts or permanent tax reform?
Who gets the cuts?
Tax cut euphoria
Meanwhile, on Wall Street, investors seemed to have forgotten to differentiate the individual companies’ tax regimes in their stampede to buy small cap stocks for their higher potential tax cut exposure. Ned Davis Research observed that there was no performance spread between high and low tax stocks within the small cap index.
A similar analysis by Business Insider of the relative performance of high tax large caps found a similar effect.
Waning confidence
I have no idea of when or whether small cap bullishness will break, but one sign of a deterioration in confidence comes from the latest NFIB small business. NFIB reported that small business optimism slid in September, and the decline was widespread across the country and not just related to hurricane related events.
Small business confidence surged in the wake of the election of Donald Trump, but the most recent pullback could be the sign of the start of a post-Trump hangover. In particular, actual sales and sales expectations have been falling, which is reflective of actual conditions on Main Street.
Ed Yardeni demonstrated that investor confidence is highly correlated to consumer confidence. If small business confidence is sliding, can consumer and investor confidence be far behind?
Deep in the recesses of my memory from my youth, I recall reading an Ernest Hemingway quote that went something like this:
How did you go bankrupt?
Two ways. Gradually, then suddenly.
From The VIX Also Rises
The VIX closed at an all-time low last week. Anyone who bought volatility in the last couple of years would have suffered the same fate outlined in the Hemingway novel.
To be sure, there are good reasons for the VIX decline. One reason is the drop in pair-wise correlation between stocks. When this happens, the diversification effect of owning different stocks rises, which depresses index volatility relative to individual stock volatility.
It isn’t just the VIX, but the volatility of other asset classes have also fallen. The MOVE Index, which measures interest rate volatility, is also at depressed levels.
Charlie Bilello recently asked if shorting volatility is a free lunch. The answer is an emphatic “no”, because traders who take on that trade have to live with the possibility of 90%+ drawdowns. Bilello went on to state that drawdowns from a short VIX position “is not a question of if but when”, though he was silent on the timing, or the trigger for such an event.
With overall realized volatility at historically low levels across all asset classes, the trigger for a VIX spike might come from a non-equity asset class.
How the Fed may spike volatility
An obvious trigger might come from the Fed, as it prepares to wind down its balance sheet. The Fed’s Quantitative Tightening (QT) program is likely to have an outsized effect on the mortgage market, when compared to the effect on the Treasury market. Here is the base case projections of MBS holdings from the New York Fed.
The issue is MBS convexity. For investors unfamiliar with bond math concepts, the duration of a bond measures the sensitivity of bond prices to interest rates. As rates rise, bond prices fall, and vice versa. Everything else being equal, duration (rate sensitivity) rises as coupon rates fall. As well, duration also rises as time to maturity lengthens. The convexity of a bond is the sensitivity of duration to changes in interest rates.
Here is why convexity matters for MBS holders. The Fed is committed to raising rates as part of its process of normalizing monetary policy. Assuming a parallel shift in the yield curve, fixed income portfolios will get hurt as rates rise. The duration and convexity characteristics of plain vanilla Treasury paper are well known. On the other hand, mortgages will experience prepayment risk if rates fall, which makes MBS paper negatively convex. The duration (rate sensitivity) rises as rates rise, but declines as rates fall. It’s the worst of both worlds.
As the Fed begins raises rates and normalizes its balance sheet, it will introduce greater volatility to the MBS market. Here is FT Alphaville:
The Fed’s effect on the market is even bigger when you consider its dominant position as a buyer of newly-issued agency MBS. In 2009, 2013 and 2014, the central bank bought about half of all new issuance.
Some of that spending came from the large-scale asset purchases but much of it came from the decision in October 2011 to reinvest prepaid mortgage principal into new bonds. Since then they have spent more than $1.8 trillion rolling over their portfolio — on top of what was bought during the third round of large-scale asset purchases. There has been about $8.2 trillion of new issuance over the same period, so the Fed bought more than a fifth just through reinvestments. So far this year the Fed has bought nearly 30 per cent of new issuance.
Under the baseline scenario the Fed will return about $1 trillion in agency MBS to private investors by 2025. It will have switched from selling cheap options that protect against interest rate volatility to effectively buying them back. The extra risk will have to be borne by the private sector. Fed economists think this could add nearly a percentage point to longer-term interest rates.
How Wall Street problems migrate to Main Street
In short, expect volatility to rise in the MBS market in 2018. How much of the higher volatility gets transmitted to the other asset classes is anyone’s guess. However, here is one way higher MBS vol will eventually affect the real economy.
For now, mortgage rate spreads against Treasury yields remain tame. Investors have not demanded much of a premium to be in the MBS market. Expect risk premiums to widen as MBS volatility rises.
Now imagine what rising risk premiums in the MBS market might do to a fragile housing market.
A downturn in the economy’s most cyclically sensitive sector will not be good news, for either Main Street or Wall Street. But that’s a problem for later. Here at Humble Student of the Markets, we try to teach readers how to fish. Consider this as a teachable moment of where the fish might be in late 2017 or early 2018.
Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. 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.
A lukewarm buy signal
Mark Hulbert recently updated the market forecast of former Value Line research director Sam Eisenstadt. Eisenstadt has had a remarkable record of forecasting equity returns, according to Hulbert.
The reason to take this projection seriously is Eisenstadt’s track record. Consider a statistic known as the r-squared, which measures the degree to which one data series predicts or explains another. If the first series perfectly predicted the second, the r-squared would be 1.0; if the first series had absolutely no predictive ability the r-squared would be zero.
For the data plotted in the chart below, the r-squared is 0.31, which is significant at the 95% confidence level that statisticians often use when determining if a pattern is genuine. Though you might be disappointed that this r-squared isn’t higher, you should know that most of the models that get attention on Wall Street and in the financial press have r-squareds that are far lower—if they’re not actually zero.
Eisenstadt`s latest six month SPX forecast is 2620 to 2640, which represents a gain of about 3%. The chart shows Eisenstadt`s forecasts, as documented by Hulbert, since 2013. The forecast levels are shown in blue, with the actual below (black if the market beat his target, red if it missed).
Hulbert wrote that Eisenstadt has two critical inputs to his forecast, both of which are mildly bullish:
Eisenstadt constructs his model to include all factors he has found to have an ability to project the stock market’s subsequent six-month return. Though his model is proprietary, Eisenstadt has told me that two of the more important inputs are low interest-rates and market momentum. Both factors are mildly positive right now.
No forecast is complete without some understanding of the risks to the forecast. When I peek under the hood of the Eisenstadt’s model, interest rates and momentum represent sources of both risk and opportunity to the market. Investors will have to judge for themselves whether a potential 6-month gain of 3% is worth the risk.
Can interest rates support stock prices?
Warren Buffett recently stated that equities remain attractive, but interest rates represent the most important factor in determining valuation.
“The most important thing is future interest rates,” Buffett said. “And people frequently plug in the current interest rate saying that’s the best they can do. After all, it does reflect the market’s judgment. And the 30-year bond should tell you what people are willing to put out money for 30 years and have no risk of dollar gain or dollar loss at the end of the 30-year period. But what better figure can you come up with? I’m not sure I can come up with a better figure. But that doesn’t mean I want to use the current figure, either.”
The current rate environment is a good news and bad news story. Long rates are falling, which is supportive of equity valuations. On the other hand, the yield curve is flattening, which is a signal that the bond market expects slower growth.
The key question for equity valuations then becomes a question of how interest rates will change in the future. Current market expectations for Fed Funds envisages a Federal Reserve that is considerably more dovish that the September dot plot.
There has been much speculation about the identity of the next Fed chair, and whether the new chair will be dovish or hawkish. While the news of who gets nominated will get the headlines, the more important dynamic is the composition of the FOMC next year. The rotation of voting regional Fed presidents is going to see the replacement of doves (Kashkari and Evans) with hawks (Williams and Meester). Moreover, there are three vacancies (not counting Janet Yellen if she doesn’t get re-appointed) at the Federal Reserve Board of Governors out of a total of seven seats. Randal Quarles, who was just confirmed by the Senate as vice chair for bank regulation, is known to have hawkish views. Virtually all rumored potential nominees are known to be rules-based Republicans with views who are more hawkish than the current board.
The current Fed’s expectations calls for a December rate hike, with three more quarter point hikes next year. Notwithstanding the views of any new Fed chair, a more hawkish Fed could see four or more hikes in 2018, and it is difficult to see how the 2018 FOMC could become more dovish than the 2017 FOMC. That translates to a negative rate surprise in either late 2017 or early 2018.
That said, the equity market still has a safety cushion. The June 2017 BAML Fund Manager Survey (last time the question was asked) indicated that institutional equity investors are unlikely to panic unless 10-year yields rises to 3.5-4.0%, which is slightly over 1% from current levels.
However, the more hawkish tone from the Fed has strengthened the USD, which is likely to pose a headwind to the earnings of large caps with foreign operations.
John Butters at Factset pointed out that companies with greater foreign operations are seeing much better earnings and sales growth than ones with a domestic focus.
For now, all of these concerns are 3-6 months in the future. The current environment is dominated by positive momentum, which is causing a surge in stock prices.
Strong momentum
There is no doubt that both the stock market and the US economy is enjoying strong positive momentum. Virtually all of the major market averages have seen new all-time highs last week. As Jonathan Krinsky pointed out, strength begets more strength.
As well, top-down macro indicators have been stronger than expected. The Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, have regained the zero line and it is entering a period of positive seasonality.
Examples of positive surprises included continued strength in both ISM Manufacturing and Services.
As well, the latest update of earnings expectations from Factset shows that forward 12-month EPS continue to grind upwards, indicating positive fundamental momentum from Wall Street.
Too far too fast?
Despite the onslaught of positive price, macro, and fundamental momentum, the recent risk-on stampede calls into question of how much has been discounted by the market. The Fear and Greed Index is now at a nosebleed 92, which represents a minor retreat from last Thursday’s close of 95. How much more upside is there?
Kevin Muir, writing at The Macro Tourist, believes that sentiment has turned so much that the pain trade is now down. (Incidentally, I was bullish six months ago.)
Think back six months. Do you remember all the warnings from the legendary hedge fund managers about the impending stock market doom? Paul Tudor Jones, Scott Minerd, Larry Fink, Seth Klarman, the list is long but distinguished. At the time I penned It’s too easy to write bearish pieces. Even in late summer, gurus like Gundlach were bragging about the 400% he would make on his S&P 500 put purchases – Billionaire Bears. Given the atmosphere, I knew posts about the coming collapse would be greeted with tons of words of encouragement. Yet if I wrote something about the stock market continuing higher, crickets… Or worse yet, remarks about my cluelessness regarding the problems in the global financial system. I didn’t think stocks were going higher because everything was roses, no in fact just the opposite. Stocks were being pushed higher because everything was so FUBAR’d. Central Bank balance sheet expansion was pushing risk assets higher, and for the longest time, everyone wanted to fade it.
Fast forward to today. Even the most ardent bears have given up and embraced the idea Central Bank buying will push stocks higher. Investors that were previously doom and gloomers are now speaking of blow off-tops. I can hear the capitulation in their voices. No more brave predictions of the coming collapse. Instead, meeker forecasts of a high volume runaway euphoria. There are no bears left. None. Not a soul.
The bears have been replaced by gloating bulls that are openly bragging about how high the S&P 500 futures will gap up Sunday night. They are mocking the bears with taunts of how much money will they lose fighting the rally. They joke about buying the dip, which increasingly is becoming more and more nothing more than a couple of downticks.
I might not know much, but I know the Market Gods do not take kindly to that sort of behaviour. What was that quote from Bernard Baruch? “The main purpose of the stock market is to make fools of as many men as possible.”
Muir points to contrarian indicators such as the latest cover of The Economist as a bearish indicator.
Remember the last time this happened?
To be sure, a past study cited by the Buttonwood blog at The Economist found that Economist cover indicators work well as a contrarian indicator at a one year horizon, but have little or no utility in the short run.
Interestingly, their analysis finds that after 180 days only about 53.3% of Economist covers are contrarian; little better than tossing a coin. After 360 days, the signal is a lot more reliable—68.2% are contrarian. Buying the asset if the cover is very bearish results in an 18% return over the following year; shorting the asset when the cover is bullish generates a return of 7.5%.
Dana Lyons also pointed out that the University of Michigan Survey indicated a historically high level of bullishness. Such episodes have not ended well in the past.
The slow stochastic of the NYSE Common stock Summation Index is now overbought. In the past, the market advance has tended to stall when readings reached these levels.
For short-term traders, Tom McClellan warned that the lack of market volatility, as measured by the McClellan Oscillator, could be indicative of near-term market weakness.
Party now, pay later?
The combination of positive momentum, overbought conditions, and excessive bullishness suggests a market that is likely to either consolidate or pull back from current levels. In light of the powerful momentum backdrop, dips should be bought, barring some unexpected exogenous event, such as the one alluded to by Donald Trump’s “calm before the storm” remark. That remark was followed by potentially ominous tweets about North Korea.
My base case scenario calls for a brief period of consolidation or correction, followed by a rally into year-end. Stock prices could conceivably temporarily overshoot Eisenstadt 2620-2640 target before stalling and pulling back to the low 2600 area.
My inner investor remains constructive on stocks. He has taken some profits and rebalanced his portfolio back to investment policy target weights. My inner trader covered all shorts last week. He is waiting for a dip to buy back in. Despite the trading system’s “buy signal”, the market is too extended to get too long right now.
The situation in Catalonia is a mess. Catalan frustrations are understandable. The region is the most prosperous of all in Spain, and shares similar characteristics as norther Italy to the rest of Italy, or North Rhine-Westphia and Bavaria to Germany.
Here at Humble Student of the Markets, we try not to take political positions, but we stand in principle against the suppression of democracy. However, the independence referendum was ruled to be unconstitutional, but the heavy-handed reaction of the Rajoy government did not help matters.
Where do we stand now?
King Filipe IV has condemned the vote, as he has taken the position that it is unconstitutional. Catalan President Carles Puigdemont is offering mediated talks, but threatened to declare independence perhaps as soon as this weekend.
The price of independence
While the slogan “Madrid nos roba” (Madrid is robbing us) may appeal to the populists, there is a price to independence. Imagine if Puigdemont took the plunge and declared independence. Here is what that would mean:
An independent Catalonia would no longer be part of the EU, and it would have to apply for membership that could be vetoed by any EU member, such as Spain. Roughly two-thirds of Catalan exports go to the EU, how would it cope without EU membership?
What about the debt? The Catalan government owes €77bn at the last count, or 35% of the region’s GDP. Of that, €52bn is owed to the Spanish government.
An independent Catalonia would no longer be part of the eurozone. Any Catalan banks would automatically lose ECB support. Already, Catalan banks CaixaBank SA and Banca Sabadell SA are considering changing their domicile in case of independence.
If Catalonia were to gain European Union membership, it would be one of the more wealthy countries in the EU. Instead of sending funds to Madrid and supporting the rest of Spain, it would be sending money to Brussels and supporting the rest of Europe.
From the view of the capital markets, point 2 would have the most immediate impact. A declaration of independence would cut any Catalan lender from ECB support right away, and cause a bank run as depositors transfer their funds into the rest of Europe. The BoS and ECB are under no obligation to support those institutions should a bank run occur.
The price of opportunity
All of this uncertainty is creating an opportunity. The chart below shows the relative performance of Spain stocks (IBEX) against eurozone stocks (Euro STOXX 50). The IBEX is currently testing the lower end of a historical range, which presents an opportunity for speculative position to profit from the panic.
The pattern for the US listed ETFs (EWP vs FEZ) is similar.
The Spanish bond market has already begun to recover.
In all likelihood, the Catalan referendum and its aftermath is another manifestation of European theatre. When the German publication Bild interviewed Puigdemont (English translation at Business Insider), one of the concerns raised was if FC Barcelona would continue to play in the Spanish league after independence, so the problems can’t be that intractable. Hopefully, cooler heads will prevail and the crisis subsides.
That said, I’ve been wrong before. I took a similar optimistic view before the Brexit vote.
Mid-week market update: Back on July 19, 2017, I wrote about using point and figure charting as a way of projecting an upside SPX target when the index stood at 2473 (see What’s the upside target in this rally?). Using different sets of inputs that represent different time horizons and risk tolerances, I arrived at a target range, and a median upside target of 2561. The final targets were roughly the same whether outliers (highlighted in red) were removed or not.
Now that the index is within about 1% shy of the median target, what now?
Revised targets
I re-ran the point and figure charts on stockcharts.com and came up with some updated targets, with the outliers highlighted in red. The upside objectives are now about slightly higher. The new final target range is now 2587-2596, up from 2561-2563.
The Rule of 20
Another way of thinking about a price target is Ed Yardeni’s Rule of 20, which calculates a target P/E ratio by subtracting headline CPI inflation from 20. Yardeni credits the rule to his friend and former CJ Lawrence colleague Jim Moltz.
The latest CPI inflation rate is 1.9, which make the target P/E ratio 18.1. Factset reports that the forward P/E is 17.7. Based on those figures, we can then derive a Rule of 20 price target of about 2600.
Limited upside potential
Surprisingly, these two wildly different estimation methods surprising arrive at very similar conclusions. I therefore conclude that the market advance is likely to start stalling at about 2600.
While these estimation techniques are inexact disciplines, this exercise does highlight limited upside potential in stock prices. Momentum is strong, and there is undoubtedly there are further gains for equity investors, but the party may be starting to wind down.
Frothy sentiment
BAML recently updated their “Sell Side Indicator”, which uses Street strategists’ asset allocation as a contrarian signal, and flashed a surprisingly bearish message. The standard interpretation of the Sell Side Indicator uses a 15-year rolling average of the Street consensus. Current readings are neutral, though they have risen quite rapidly.
However, the BAML strategy team found that shortening the time frame from 15 to 4 years yielded a far more cautious picture.
While we view the 15-year rolling periods as appropriate for capturing secular shifts in sentiment, we have found a better historical track record for sell signals based on shorter time horizons. Specifically, the model yields the lowest expected 12-month returns and higher percentage of negative returns when using a four-year rolling history.
Current readings are at a crowded long: “The current indicator near a six-year high, it is nearly two standard deviations above the four-year average, suggesting weaker returns over the next 12 months”. Note that the backtested results in the table below shows returns when they are 1 standard deviation above the 4-year average.
From a short-term viewpoint, sentiment is getting a little giddy and short-term upside potential may be limited. Ned Davis Research`s Trading Sentiment Composite is in the excessive optimism zone. Historically, the market has struggled when readings have been this high.
The Fear and Greed Index exceeded 90 this week, which represents an extremely greedy reading. Even if you are bullish, are you sure you want to be buying here?
My base case scenario calls for a short-term consolidation or pullback from current levels. The market is likely to then continue grinding upwards towards its ultimate top after a pause. These conditions suggest that investors and traders should refrain from getting overly greedy at these levels.
As China approaches its 19th Party Congress, there has been no shortage of analysis about what to watch for. Here are a couple of examples worth reading:
The meeting that could seal Xi’s grip on China (Bloomberg)
Beijing’s Game of Thrones: Signaling loyalty before the Party Congress (China Focus)
Of particular importance is the Reuters report that the Party plans to amend its constitution at the Party Congress as a sign that Xi Jinping is tightening his iron grip:
China’s ruling Communist Party is expected to amend its constitution at a key party congress next month, state media said on Monday, in a sign that President Xi Jinping aims to enshrine his guiding ideological doctrine in the charter.
Since assuming office almost five years ago, Xi has rapidly consolidated power, with moves such as heading a group leading economic reform and appointing himself military commander-in-chief, although as head of the Central Military Commission he already controls the armed forces.
The Politburo, one of the party’s elite ruling bodies, deliberated a draft amendment to the constitution to be discussed at the congress that would include “major theoretical viewpoints and major strategic thought”, the official Xinhua news agency said.
For investors, the main focus is how China plans to continue its objective of rebalancing growth from the old credit driven infrastructure building model to an economy based on household consumption. As the IMF recently noted, some progress has been made, but the transition has been slow.
Reform with Chinese characteristics
One lurking surprise for investors is Beijing’s change of reform direction, as reported by SCMP. The economy is headed towards greater state control, not less, as SOEs are expected to reassert their economic dominance.
China’s government is speeding up a massive ownership change among its largest state-owned enterprises designed to make them richer, bigger and stronger, a process that may reshape the future landscape of the Chinese economy by cultivating a group of influential “national champions”.
The government is encouraging state financing institutions and the country’s private technology giants to invest in weak state enterprises grappling with debt and inefficiency under its “mixed ownership reform”.
The state parent of China Unicom, the weakest of the country’s three telecom operators in profitability, sold a combined 35.2 per cent equity stake to more than a dozen investors as part of a 78 billion yuan (US$11.9 billion) deal. Among the new investors are Tencent Holdings, JD.com, Baidu and Alibaba Group, which owns the South China Morning Post.
China Railway Corp, with outstanding debt of more than US$700 billion, says it wants to undergo similar mixed ownership reform and it has sent “invitations” to a number of potential investors, including FAW Group, the country’s state-owned car maker. Private courier SF Express said it would “seriously study and proactively participate” in the railway firm reforms.
China’s top state-run firms told to become joint stock corporations by year’s end…
The deals are taking place in answer to President Xi Jinping’s call for China to have a group of powerful and loyal state enterprises. Unlike the former Soviet Union in the 1990s when Moscow decided to fully privatise former state assets and the ongoing privatisation push in Brazil, Beijing’s latest shakeup of ownership of its state industrial enterprises is intended to be anything but a loosening of the Communist Party’s party’s grip on state assets.
What happened to the Third Party Plenum economic goal of allowing market forces to play a more “decisive role” in the economy? The effort to create “national champions” is reminiscent of western government failed efforts at “industrial policy” of the 1960’s and 1970’s. We know what happened next.
These initiatives are disappointing inasmuch as they are likely to create headwinds to the rebalancing process. It is unclear how reverting to the command economy model is likely to address China’s economic challenges.
Indeed, Bloomberg reported that China Beige Book has observed that the Chinese economy is only rebalancing in name only:
Capacity cuts in steel and other commodities aren’t happening in reality
Corporate borrowing continues to rise; deleveraging is a myth
The economy isn’t re-balancing to services from manufacturing
China isn’t reflating in the sense of faster growth, but profits are up
China’s challenges
To reiterate, here are some of challenges presented by her growing credit bubble.
The credit bubble does not just stop at China’s borders. It has migrated to Hong Kong and other countries in the region.
Here is the good news. Growth has been re-accelerating, possibly because of the Party Congress “put”. Collapse is imminent.
However, much of the growth is coming from real estate. Is this what rebalanced growth looks like?
While the longer trend of rebalancing has been in the right direction, Chinese rebalancing has stalled in the last few years.
Waiting for the Minsky Moment
Growing Chinese indebtedness has been worrying investors for years. Year after year, China bears have been waiting for that Minsky Moment, or the sudden collapse after a long period of stability. For now, the upcoming 19th Party Congress has provided a put option to the market.
John Authers, writing in the FT, thinks that investors should look to the US, specifically the Fed, as the trigger for a possible collapse. Simply put, the weak USD has created a flood of liquidity into Asia.
Asian stocks outside Japan have performed fantastically so far in 2017. MSCI’s Asia excluding Japan index has gained 30 per cent year to date, beating developed world stocks by almost 15 percentage points. This has been done despite little evidence of inflationary growth, outside of mainland China.
The lack of inflation across the region is startling. In Thailand, consumer price inflation has dropped to zero. And expectations remain very contained. Most countries in the region do not have inflation-linked bond markets, so it is difficult to obtain a market forecast. But 10-year inflation break-evens in South Korea suggest that investors see slow non-inflationary economic activity long into the future, with average inflation below 1 per cent.
Where has the rally come from, then? It appears to emanate from the Federal Reserve. The correlation between the euro-dollar exchange rate and the MSCI Asia excluding Japan index has topped 90 per cent this year. As the dollar has cheapened, so the dollar value of Asian central banks’ reserves has increased, while liquidity has flowed into the region.
Correlations so strong are reminiscent of the synchronised markets that preceded the crash in 2007 and 2008, and they suggest that the greatest concern in the near term is not a Minsky moment in China, but rather a hawkish surprise from the Federal Reserve.
So what happens if Fed policy becomes more hawkish than market expectations, which sends the USD soaring? These words were ominously written before the announcement of the GOP tax proposals, which has sparked a risk-on Trump rally.
This raises the risk that a couple of policy surprises that hurt the dollar could also send Asian assets into reverse. Judging by the extreme underperformance of relatively highly taxed companies in the US so far this year, the US stock market has given up any hope of corporate tax cuts in 2017. That may not be wise; a failure of a Republican president and two Republican houses of Congress to agree on a tax cut would be remarkable, even in a nation that is growing used to political miscues.
Auther’s cautionary comments have echoes of Ray Dalio’s recent warning about a possible Fed policy error that could see a repeat of the 1937 collapse in growth (via Business Insider):
In my opinion, the risks are asymmetric on the downside. In other words, if you tighten monetary policy, certainly by more than is discounted in the market — and what’s discounted in the market is very minor rising market — that will reverberate through asset class prices, as well as then you can have a situation in terms of the economy. So, what’s similar in that: interest rates are close to zero, not much room on the downside, obligations are large, there was a political division, there is more populism. Therefore there’s more conflict. And therefore we need to be very careful at this moment. That’s what I’m basically saying.
What to watch
Current conditions show that the stock markets of China’s Asian trading partners are struggling. With the exception of Shanghai, all other markets are struggling with their 50 day moving averages.
The USD Index has reversed a downtrend and begun a relief rally. At the same time, the American economy is in the late stages of an economic expansion, where inflationary pressures start to manifest themselves. Such conditions have seen emerging leadership shown by late cycle inflation hedge stocks, such as energy, mining, and golds. Similar episodes has seen the Fed respond with rate hikes to cool off the economy.
For investors, the risk is that Fed hawkishness not only slows the American economy, but begins to unravel China and the rest of Asia as well. Under these conditions, it is especially important to monitor the evolution of the trajectory of the USD, as well as the relative performance of inflation hedge stocks, both in the US and Europe.
Continued leadership by inflation hedge vehicles would signal market confidence in the resilience of the Asian and global economy. On the other hand, significant underperformance by these stocks would be a warning that the China Minsky Moment may be at hand.
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: Neutral
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.
A typical late cycle advance
In a recent post (see Equity lessons from the bond market), I urged equity investors to monitor the signals from the bond market as they contained important and often overlooked information about the future direction of stock prices. In particular, the yield curve was an important indicator, as past instances of an inverted yield curve, where short rates trade above long rates, was an uncanny signal of recession, and equity bear markets.
While the shape of the yield curve is an important indicator, I may have discovered an indicator that leads the yield curve signal. As the chart below shows, the copper/CRB ratio has risen strongly ahead of yield curve inversions in the last two cycles. The copper/CRB ratio is valuable because copper is a cyclically sensitive commodity, and the ratio filters out the noise from changes in overall commodity prices.
This ratio has worked well in both disinflationary and inflationary eras. The top in the late 1990’s was a disinflationary period characterized by falling commodity prices (see bottom panel). But the copper/CRB ratio rallied out of a relative downtrend (green line, middle panel) just before the yield curve inverted (top panel). During the inflationary era that ended in 2007-08, the copper/CRB ratio flashed a parabolic climb ahead of the last yield curve inversion.
Fast forward to 2017. The copper/CRB ratio has staged a relative breakout in late 2016 and early 2017 and roared ahead, which is an indication of a late cycle blow-off. The yield curve has not inverted yet, and it may not necessarily invert this cycle because of the Fed’s extraordinary measures of the past few years. By the Fed’s own estimates, its QE program has depressed the term premium on the 10-year Treasury note by 100 basis points. Unwinding QE will put upward pressure on long dated yields, which has the effect of delaying an inversion signal – until it’s too late.
The analysis of sector and industry rotation confirms the thesis of a late cycle rotation. The Relative Rotation Graph (RRG) is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again. The latest RRG chart of the US market shows leadership by late cycle inflation hedge groups such as energy, mining, and gold stocks.
The same pattern of inflation hedge leadership can also be found in Europe. While US technology has revived and revised into the top right leadership quadrant, European technology stocks have weakened, which makes the tech rally suspect.
In short, the current market action has the feel of a bull market blow-off top. For investors and traders, the question is whether they should jump on the rally, with an emphasis on inflation hedge groups. This week, I examine the bull and bear cases, first for the equity market, then address the question of sector exposure.
The bull case
The bull case is easy to make. It’s hard to argue against momentum. The major US averages all achieved new highs last week. More importantly, past laggards such as the Russell 2000 small caps, and the DJ Transports (forget any hand wringing over Dow Theory non-confirmation) have hit new highs.
Fundamental momentum is also supportive of the bull case. The latest update from FactSet shows last week’s decline in forward 12-month EPS as a data blip. Forward 12-month EPS is advancing again. As well, the lower than average rate of Q3 2017 guidance is a positive sign for earnings season, which is about to start.
Credit market risk appetite has also confirmed the new highs in equity prices. The relative price performance of HY against duration equivalent Treasuries hit new highs in conjunction with equity prices.
As well, Callum Thomas pointed out that we are past the dreaded negative September seasonal period.
What is anyone so worried about? Risk on!
The bear case
The bear case is more difficult to make. However, there are a number of disturbing signs beneath the surface of the current equity market rally.
Firstly, a number of global markets are not behaving well. The markets of China’s Asian trading partners are all struggling with their 50 day moving averages (dma), which could be a signal of imminent Chinese economic weakness.
Commodity prices are also starting to roll over. In particular, industrial metals have breached an uptrend, which is worrisome. The CRB Index has been strengthening recently because of the rise in oil prices, but that index is also showing signs of weakness and testing a key support level.
European equities have also shown signs of struggle. The FTSE 100 rallied on Friday but remains below its 50 dma, though those problems could be attributable to Brexit difficulties. The one shining beacon for the bulls has been the Euro STOXX 50, which represents large cap eurozone equities.
Even then, the eurozone may face a number of near term hurdles. If Europe is to avoid future problems, the French and Germans will have to take the lead, with more common policies and, hopefully, greater fiscal integration. In the wake of the German elections, Angela Merkel will have a tough time achieving some of those goals, as one of her main political partners, the FDP, has voiced opposition to the idea of a single EU finance minister, they favor a multi-speed north/south eurozone, and oppose any fiscal transfers to weak states like Greece. Macron’s grand plans for more Europe may be dashed, and the EU is likely to pay the price in the next economic downturn.
In addition, the Catalan independence referendum is likely to cause a constitutional crisis in Spain, and add to the centrifugal forces pulling apart Europe. Looking forward into next year, the Italian election will also be a wildcard for the future of Europe.
A crowded long
As well, psychology has become overly bullish. The Fear and Greed Index closed at 85 after hitting an intra-day high of 90 on Friday. If history is any guide, such levels has seen the market advance either consolidate sideways or pull back.
The latest NAAIM survey of RIAs paints the picture of a bullish stampede. The “most bearish” response, which has a range from -100 (bearish) to 200 (bullish), stands at 90, which is the most bullish reading in the history of the survey that began on July 5, 2006. The second highest reading is 60. Let that sink in for a moment.
The table below is sorted by the “first quartile” reading, which represents the first quartile of bull/bear responses in the history of the survey. This week’s reading of 94 puts it in the top 1% of bullishness in the entire history of the survey. While the sample size is small (N=6), subsequent returns after such episodes indicate disappointing performance.
Michael Batnick also pointed out that the SPX has never experienced a maximum drawdown as low as this, ever.
Even if you are bullish, do you want to play those odds?
The lines in the sand
I resolve the bull and bear debate as a debate of time horizon. The combination of positive price and fundamental momentum leads to a bullish conclusion on an intermediate term time frame. The bull still lives, and equity prices are likely to be higher by year-end.
In the short term, however, sentiment is a little overdone, and the market has become overbought very quickly. The SPX closed above its upper Bollinger Band. In the past, such episodes has seen the market pause and consolidate its advance.
Here are my lines in the sand. The stock market has managed to stage upside breakouts in the major averages, but breadth indicators remain in a downtrend indicating an unconfirmed breakout. I will be watching the breadth indicators below to see if they can strengthen sufficiently to break up through the downtrend lines. Another possibility is the market weakens and the breadth indicators decline down to support before a blow-off rally can occur.
As for the question of sector allocation, much depends on how the near term psychology of the market evolves. The current rally has a similar feel as the post-election Trump rally, where companies that are likely to benefit from tax reform rose, such as Financials, highly taxed companies, and so on. We may see disappointment set in as the GOP tax proposals suffer a similar fate as healthcare reform. Tony Nitti wrote that the current proposals envisage about $5 trillion in tax cuts, but the GOP needs to find another $1 trillion in extra revenues after incorporating all of the outlined revenue proposals. Already, the WSJ reported that Republicans are rebelling against the provision to eliminate the state and local tax deduction.
Tax reform is hard. Just as healthcare reform is hard.
In all likelihood, the character of the market will revert back to the template of a late cycle expansion, where inflation hedge vehicles lead. However, the recent strength in the USD could prove to be a headwind for these stocks, as the USD has historically been inversely correlated to commodity prices. I will be monitoring whether these stocks can continue to outperform in the face of USD strength. If so, that will be a vote of confidence for my late cycle commodity leadership scenario.
My inner trader remains constructive on stock prices. This is not the top, and the best is yet to come for equity prices.
Unfortunately, my inner trader was caught short in this rally. Under the circumstances, it is far too late to cover and go long because of excessive bullish sentiment. He is staying short, and hoping for some weakness so that he can buy the dip. However, he does have a risk control discipline based on the aforementioned breadth indicators, namely the NYSE net highs – lows, % above the 50 dma, and % above the 200 dma.
It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.
I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:
As a result, I am publishing another edition of “things you don’t see at market bottoms”.
CFO sentiment: 83% believe market to be overvalued
A recent Deloitte survey of Chief Financial Officers (CFOs) found that 83.1% believe the equity market to be overvalued, which is the highest level in the history of the survey. To be sure, CFO sentiment is an inexact market timing indicator, as this reading has been elevated for some time.
Leveraged loans are back!
The WSJ reported that leveraged loans are back. Issuance in both the US and Europe are set to top pre-crisis levels.
As an example of how credit standards have fallen, unemployed teenage students and dogs receive credit card offers.
To be sure, the Toys “R” Us bankruptcy filing was a warning for investors who have stretched for yield. This apparent appetite for risk has depressed credit spreads to historically low levels, but trouble is brewing beneath the surface. Bloomberg highlighted analysis from Morgan Stanley indicating that the dispersion of credit spreads is rising, even as headline spreads have fallen.
Unprofitable IPOs are rising
As experienced investors know, market psychology is constantly oscillating between fear and greed. Today, the percentage of IPOs with negative earnings has only been eclipsed by the period preceding the NASDAQ Bubble top. Is this a manifestation of fear, or greed?
BAML also recent reported that private client bond and cash allocations have fallen to historically low levels. Is this fear, or greed?
Cristiano Ronaldo, CFD spokesman
Finally, I see that Real Madrid star Cristiano Ronaldo is promoting Contract For Difference, or CFD, trading.
For newbies, CFDs are lightly regulated or unregulated derivative contracts that allow for leverage of anywhere from 300:1 to 1000:1. Bloomberg reported that a number of European soccer clubs have partnered with CFD firms.
For now, I believe the frothy excess that I cited in this and past report represents a “this will not end well” narrative without an obvious bearish trigger. However, sentiment doesn’t function well as precise market timing tools. BAML strategist Savita Subramanian pointed out that the last year of an equity bull can be rewarding and can be painful to miss.
Now if only I could achieve that 1000 to 1 leverage in that final bull leg…
Political operative and former Clinton advisor James Carville once quipped that he wanted to be reincarnated as the bond market so that he could intimidate everybody. Equity investors and traders are well advised to remember that comment, as there is much to be learned from a cross-asset, or inter-market, viewpoint from bond market action.
For example, the relative performance of junk bonds is a terrific indicator of overall risk appetite.
The relative performance of financial stocks is also related to the yield curve, with the caveat that any analysis using a single variable can lead to erroneous conclusions as there may be other factors at play.
The shape of the yield curve is also correlated with the relative performance of value and growth stocks. That relationship makes sense, as a flattening yield curve (falling green line) is the bond market’s signal of slowing growth expectations. In an environment where growth is scarce, growth stocks should outperform, and vice versa.
So what is the bond market telling us now?
Tax cut reaction
The American economy is in the late stage of an expansion. Such episodes tend to be marked by a tension between the bullish forces of rising growth and the bearish tendency for the Fed to raise interest rates. The market reaction to the GOP tax cut announcement is a perfect example of this.
As the tax cut proposals was revealed, bond yields spiked and bond prices fell on the prospect of higher structural budget deficits as there are no details of any offsetting revenues to the US Treasury. By contrast, equities rallied as investors focused on the higher earnings potential of the tax cut proposals.
The Fed’s soft landing scenario
Longer term, however, the key issue for fixed income investors today is the direction of Fed policy. Matthew Klein at FT Alphaville recently analyzed the FOMC’s economic and interest rate projections and outlined how the Fed expects to achieve a non-recessionary soft landing as inflation begins to “overheat”.
First, note that the economy’s growth rate is expected to slow down by more than half a percentage point. Ideally, this would mean that the gap between actual output and its theoretical “potential” will have gently closed by the end of 2020 — a “soft landing”. Several policymakers seem to think the US economy will already be growing by less than its potential as early as 2019, however, which suggests a bit more turbulence.
What happens next should be worrying. Most policymakers seem to think the jobless rate will continue to be well below its “longer run” level even by the end of 2020. Either the “longer run” forecast will be revised lower, or these central bankers are expecting to push the unemployment rate up by perhaps as much as a full percentage point. That’s never been done before outside of a recession.
The most interesting detail of the forecast, however, is that the policy interest rate band is expected to be above its “longer run” level by the end of 2020.
Wait! The economy slows, but unemployment stays well below NAIRU for an extended period, and monetary policy stays tight and Fed Funds is above its long run rate in 2020? What kind of fantasy thinking is that?
The Fed vs. the bond market
The latest dot plot has the Fed raising rates once at its December meeting, with three more quarter point hikes in 2018. The bond market is discounting a far more shallow path for Fed Funds in the next year. Who is right, and what does that mean for the economy, and the stock market?
The key indicator is the yield curve. Claus Vistesen thinks that while the Fed still has its hand on the tiller, it may not be able to affect the long end of the curve.
The persistent flattening of the yield curve—despite the fact that the Fed is moving slowly by historical comparison—is reflected in the gulf between markets’ forecast for interest rates, and the FOMC members’ infamous dots. The first chart below—shamelessly copied from the BBG terminal—shows that the FOMC is pencilling in a relatively steep vector in the policy rate, in stark contrast to the rates implied by market prices. Put differently; the market sees a lower “terminal rate” than the Fed.
If the dot plot is to be believed, then traders should be shorting the 2-year Treasury in size. How the yield curve behaves at the long end is another matter.
Whatever you might think about the curve, the trade is simple if you believe that the Fed is taking charge. In that version of the world, markets are wrong, and front-end rates are too low. You should sell FF futures and two-year notes in size.
What happens to rates further out the curve then? If the Fed defies markets on the front end, it is reasonable to expect them to voice their objection on the long end. This doesn’t necessarily mean that long-term yields will fall, but it suggests that they will be sticky.
Vistesen believes that the long end of the curve will largely be determined by the action of other major central banks. Even as the Fed begins a tightening cycle, the other major central banks of the world are still expanding their balance sheets, though the ECB is expected to start tapering their purchases in the near future. It is difficult to believe that US long rates can rise significantly in such an environment.
A Fed on the move is consistent with a shift in global monetary policy. The Bank of Canada is hiking, the ECB is set to reduce the pace of QE, and the Bank of England has prepared markets for a hike later this year. It should be easier for the Fed to get the job done when the rest of the world is moving in the same direction…my base case is that it will be tricky for the Fed to get traction on long rates if indeed it continues to push short rates higher. This indicates that a change in ECB/BOJ rate policies or expectations is the policy move to look out for.
Watch the yield curve. If the Fed stays on the dot plot trajectory, then an inversion is not that far off. In the past, an inverted yield curve has been a surefire recession, and equity bear market signal.
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: Neutral
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.
The risks to the bond market
The Fed has spoken. Janet Yellen made it clear that the Fed is ready to normalize monetary policy, come hell or high water. This tone to US monetary policy begs the question of how much interest rates can rise.
The Citigroup Economic Surprise Index (ESI), which measures whether high frequency economic releases are beating or missing expectations, has been on a tear for the last few months. In the past, rising ESI values have put upward pressure on bond yields (blue line). How far can they go up this time, and what kind of effects will they have on stock prices?
Moreover, there are a number of indications that the Fed will become increasingly hawkish, and the trajectory of interest rate increases discounted by the market are well below actual Fed actions.
Higher growth = Higher rates
The historical relationship between GDP and inflation indicates that rising growth translates to higher inflation. If the Fed is this determined to raise rates when inflation appears to be nonexistent, how determined will it be when inflation becomes apparent?
The growth recovery is not just confined to the US alone. The South Korean economy is known as the global canary in the coalmine because of its cyclical sensitivity. The latest pickup in Korean exports will likely translate into better global growth in the near future.
For now, equity investors will likely treat rising growth as good news. On the other hand, higher growth and inflation are likely to pressure the Fed to raise rates at a rate faster than market expectations, which will eventually be bearish for stock prices. Keep an eye on how the shape of the yield curve is evolving. Past yield curve inversions have been recessionary signals, but the yield curve may not invert this time ahead of the next recession because of the Fed’s Quantitative Tightening program. Nevertheless, a steepening yield curve is still a signal that the bond market expects faster growth ahead, and a flattening curve indicates slower growth.
I have read a number of commentary about renewed strength in Financial stocks. Historically, the relative performance of this sector has been closely correlated to the shape of the yield curve. The flattening yield curve is setting up a negative divergence that creates downside risk potential for Financial stocks.
In short, the current economic environment is raising the risks of a Federal Reserve misstep.
1937 all over again?
In an recent interview with Business Insider, Bridgewater’s Ray Dalio indicated that the risks of a 1937 style policy error is high:
In my opinion, the risks are asymmetric on the downside. In other words, if you tighten monetary policy, certainly by more than is discounted in the market — and what’s discounted in the market is very minor rising market — that will reverberate through asset class prices, as well as then you can have a situation in terms of the economy. So, what’s similar in that: interest rates are close to zero, not much room on the downside, obligations are large, there was a political division, there is more populism. Therefore there’s more conflict. And therefore we need to be very careful at this moment. That’s what I’m basically saying.
As a reminder, the Fed tightened monetary policy into a recession in 1937.
Tony Nangle, writing at Principles and Interest, put a slightly different spin on Dalio’s concerns. Central bankers shouldn’t just focus on inflation, but rising financial leverage as a source of instability:
Claudio Borio, Head of the Monetary and Economic Department of the Bank of International Settlements, wrote an interesting paper in 2013 arguing that the idea of the output gap had kind of gone astray. Typically, monetary policymakers seek to identify potential economic growth with reference to non-inflationary economic growth. Borio argued that this is, if not bogus, too restrictive: the pace of economic growth may be unsustainably strong, and the economy operating beyond capacity, if financial imbalances (aka leverage) are building up. In other words, Borio argues that changes in the price level (inflation) and changes in the stock of private nonfinancial credit (leverage) are each important in determining the sustainable pace of economic growth.
I’ve got some sympathy with Borio. If this sounds a bit abstract think of China today: inflation is not a problem, but credit growth is rampant, perhaps to the extent that it might point to faster growth than is ultimately sustainable. Central bank mandates in many – perhaps most – developed economies are meaningfully oriented towards delivering low levels of price inflation, variously defined. Why? Because inflation is a form of monetary instability. And preventing monetary instability so that people can get on with their lives rather than obsess over the nature of money – via the creation and execution of an inflation-targeting mandate – seems a pretty reasonable thing for a monetary sovereign to do.
Central bankers should worry much more about credit growth as well as inflation:
In the speech Vlieghe [of the BOE] introduced what he called the Finance Theory of the Equilibrium Real Rate (ERR). At it’s simplest it is an intuition that interest rates are low and the risk premia attached to equities are high when the world is risky. Few would disagree. ‘Risky’ in this context means consumption growth has a lot of volatility, and (importantly) negative skew and kurtosis. The intuition is demonstrated with an historical econometric analysis of a couple of hundred years of UK data, and different regimes are identified – some with a high ERR and some with a low ERR. The different regimes have some shared characteristics of credit growth, realised equity risk premia, realised nominal rates and inflation, as well as distributions of consumption growth (expressed in terms of mean, standard deviation, skewness and kurtosis). I would urge you to read it and make up your own mind whether it says more than real policy rates are very low and equity returns are very strong in periods following economic busts. I think that it does.
How is this linked to thinking about the current state of monetary policy? Importantly, Vlieghe’s Finance Theory of the ERR doesn’t actually help define where the ERR might be, ex ante. But one of the things he associates with high or low ERR regimes is the change in the stock of household credit. If households are deleveraging, chances are that you are in a low ERR regime, and even an ultra-low nominal Bank Rate might not be very far below the ERR. But if households are releveraging, maybe you’re moving *out* of a low ERR regime, and Bank Rate might be very far below the ERR.
What is the state of financial leverage today? JPM Asset Management reported that corporate leverage is already approaching levels seen at the height of the last cycle.
While the household sector had been deleveraging since the GFC, the latest figures show that debt service ratios are starting to move up. The state of household balance sheets is changing from a tailwind to a headwind.
In other words, the risk of central banking policy errors are high when rising financial leverage is combined with tight monetary policy.
A more hawkish post-Yellen Fed?
Bloomberg recently reported that most of the candidates to replace Janet Yellen as Fed chair are Republicans who favor rules based approaches to the conduct of monetary policy. Already, there is a significant disconnect between market expectations and the Fed’s own projections of monetary policy under a rules based regime.
The Cleveland Fed offers a tool that calculates the Fed Funds target using the Taylor Rule using a variety of inputs. While this tool shows wide ranges for interest rates under different assumptions, the current median projection for 3Q 2018 is 2.24%.
By contrast, here are the latest market expectations of Fed Funds for the August 2018 FOMC meeting. You have to squint to see the implied probability of a 2.24% Fed Fund rate.
You see the problem here. The markets would freak out if the consensus suddenly shifts to a 100 basis point hike in the next year. Even the current more dovish “dot plot” is projecting a 0.75% increase in the Fed Funds rate, which is well above market expectations.
The credit markets need to be prepared for a nasty surprise in the days ahead.
Near term turbulence ahead
Looking to next week, the short term trend favors the bears. Both the VIX Index and its term structure are showing signs of complacency. While I have never been a big fan of using the absolute value of the VIX as a market timing device, past complacent readings of VIX term structure has seen the market either stall out or stage minor pullbacks.
As a result, my bearish tactical outlook outlined in my last post (see NAAIM buy signal update) still stands. The Trade Followers sell signal that was generated when all sectors became overbought has historically been a highly effective sell signal. The chart below shows past sell signals, and only one out of five past signals has failed in the past.
In addition, we are in a period of negative seasonality between Rosh Hashanah, which began last Wednesday, and Yom Kippur, which ends this coming Friday. Jeff Hirsch of Almanac Trader found that this period has shown historically poor returns. The Dow has falling a median -0.5% during that period, and only 20 out of 46 episodes showing market gains.
Another possible bearish factor can be seen from earnings estimate revisions. FactSet reported that forward 12-month EPS fell last week. Forward 12-month EPS has historically been a coincidental indicator of stock prices, but the latest reading may be a data blip as FactSet also observed that a record number of companies have issued positive Q3 guidance.
The latest update from Barron’s of insider activity shows that this group of “smart investors” is showing little enthusiasm for equities. While these readings tend to be volatile, the current level of activity is not a great vote of confidence for the stock market.
If the market were to weaken next week, then any pullback is likely to be mild. The first technical support level can be found at about 2483, the site of past resistance now turned into support. Should that level fail, there is also trend line support at about 2450.
My inner investor is neutrally positioned in his portfolio, as his equity weight is at his investment policy asset mix target weight. My inner trader remains short the market.
I had highlighted an unusual contrarian buy signal in my last post (see Round number-itis at 2500). NAAIM sentiment, which is reported weekly, turned anomalously bearish last week and fell below its lower Bollinger Band. Past episodes of such occurrences have turned out to be very good contrarian buy signals.
The reading last week was anomalous because every other sentiment indicator had become more bullish, while NAAIM RIAs got more bearish. This week, NAAIM managers turned more bullish, while the AAII survey became more cautious.
Was last week’s contrarian buy signal for real, or a data blip?
A dive into the data
For another perspective, the bearish extreme reading disappears when we apply a 4-week moving average to the NAAIM readings.
We can get further clues when we dive into the data. Here is the data table as published by NAAIM:
Here are my main takeaways:
Last week, the average NAAIM exposure fell, but the median exposure (difference between quartile 2 and 3) rose.
Last week, the quartile 1 break fell dramatically. This led me to speculate that the decline in the average exposure (compared to rising median bullishness) was attributable to a data error, possibly because of an erroneous data entry of zero for a manager.
NAAIM has admitted on their website that their sample size is not large: “Although the number of participating managers, known as NAAIM Trend Setters, is steadily growing the sample size is not large and therefore may be less reflective of actual market conditions.”
This week, average NAAIM exposure rose, and the quartile 1 break recovered significantly.
This week’s readings are consistent with my hypothesis of a data entry error last week. In all likelihood, a sentiment response was keyed in improperly last week, which dragged down the average reading. In light of the near universal rise in bullishness last week from all other sentiment surveys, I interpret last week’s NAAIM survey response as a data blip and not a legitimate contrarian buy signal.
Still tactically bearish
That said, my inner trader remains tactically bearish, though he recognizes that the stock market remains in an intermediate bull trend.
In particular, one contrarian sell signal from Trade Followers has been particularly effective. This signal is flashed whenever all sectors are showing bullish Twitter breadth readings, which they did last Friday.
Excluding the current signal, there were six similar sell signals since 2015. In five of the six instances, the market either declined or stalled. There was only one failed signal, which occurred in March 2016, though the market did decline slightly the week after that signal. Here is a list all of the past Trade Follower posts of with similar sell signals:
In addition, Tom McClellan recently warned about short term stock weakness due to subdued volume in XIV. Past episodes of low XIV volume have been signals for traders to be cautious.
As a result of these factors, my inner trader is maintaining his short term short exposure to equities.
Mid-week market update: I normally write my mid-week market update on Wednesday, but the market action on FOMC decision days tend to be wildcards and not necessarily indicative of future market direction, therefore I am writing my commentary a day early.
I agree with Jonathan Krinsky of MKM Partners when he wrote that the stock market is likely to encounter some resistance at SPX 2500, but the intermediate term remains bullish.
There are a number of strong negative seasonal factors at work, as well as some short-term overbought indicators that point to either a period of consolidation or shallow pullback. That said, I discovered a little noticed but unusual sentiment buy signal that has historically resolved itself bullishly in the past.
Negative seasonality
Rob Hanna at Quantifiable Edges highlighted the negative seasonal pattern in the week after September option expiry (OpEx). Here are the returns for the period 1990-2016.
Hanna further graphically illustrated the negative seasonality for this week by showing the post-September OpEx weekly returns in this chart.
David Bergstrom found a similar negative seasonal effect at this time of the year (note highlighted dates in red).
For what it`s worth, Wednesday night is the start of Rosh Hashanah. Just remember the trader`s adage of “Sell Rosh Hashanah, Buy Yom Kippur”.
Overbought market
As well, Trade Followers, which follows trader sentiment on Twitter, found that all sectors were overbought last week. This is almost a surefire sign of a short-term top, or, at a minimum, a period of sideways market action.
I hadn’t noticed this until Monday, but NAAIM sentiment, which measures the sentiment of RIA portfolio managers, registered a contrarian buy signal last Thursday. In the past, whenever NAAIM sentiment has fallen below its lower Bollinger Band, it has been a very good buy signal (see vertical lines).
I missed the NAAIM sentiment buy signal because it was so unusual. NAAIM sentiment became more bearish even as all other sentiment surveys got more bullish last week. As an example, here is the AAII bull/bear spread.
Here is a chart of the Market Vane bulls.
Here is the CNN Money Fear and Greed Index, which has strengthened to levels consistent with past sentiment peaks.
I could go on, but you get the idea. A dive into the the NAAIM data breakdowns revealed some suspicious readings.
Here are my main takeaways from the data analysis:
Average sentiment fell, or got more bearish (red box), but median sentiment rose (black box), which is unusual.
The divergence can be explained by a decline in quartile 1 sentiment and a rise in quartile 2 sentiment.
The decline in NAAIM sentiment, or increasing bearishness, could be the result of a data error. Median sentiment became more bullish, which is consistent with the results of the other sentiment surveys. However, the decline in the average sentiment could be attributable to either one or two respondents becoming extremely bearish, or a data entry error where someone mistakenly entered a survey response as “0”.
If we were to assume that the NAAIM contrarian buy signal is correct, then a study of past signals reveal astoundingly bullish results for this buy signal. Returns appear to top roughly six weeks after a buy signal.
I will therefore be watching carefully if this anomalous reading persists when NAAIM releases its next survey on Thursday. The evolution of the first quartile figure will be of particular importance. If last week’s NAAIM average was the result of a data error, then the first quartile reading should rise back to the high 60s or low 70s, and standard deviation should also decline from its relatively elevated level of 52.95.
In the meantime, my inner trader remains tilted towards the short side, pending a resolution of the NAAIM data puzzle.
Disclosure: Long SPXU
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