China’s cunning plan to defuse trade tensions and reduce financial tail-risk

Posted by Cam Hui -

About three years ago, I outlined China’s plan to extend its infrastructure growth without creating more white elephant projects in China (see China’s cunning plan to revive growth). Enter the One Belt, One Road (OBOR) initiative to create infrastructure projects in the region. OBOR projects were to financed by the Asia Infrastructure Investment Bank (AIIB), which many countries had been falling all over themselves to finance. The infrastructure projects were to be led by (surprise) Chinese companies, which would extend their flagging growth.

Fast forward to 2018, The Nikkei Asian Review and The Banker issued a report card of OBOR projects. Here are their main findings:

Project delays After initial fanfare, projects sometimes experience serious delays. In Indonesia, construction on a $6 billion rail line is behind schedule and costs are escalating. Similar problems have plagued projects in Kazakhstan and Bangladesh.

Ballooning deficits Besides Pakistan, concerns about owing unmanageable debts to Beijing have been raised in Sri Lanka, the Maldives and Laos.

Sovereignty concerns In Sri Lanka, China’s takeover of a troubled port has raised questions about a loss of sovereignty. And neighboring India
openly rejects the BRI, saying China’s projects with neighboring Pakistan infringe on its sovereignty.

None of these problems are big surprises. I had outlined in my 2015 post that Chinese led infrastructure projects tended to see inflated costs, and the geopolitical objective of OBOR was to extend China’s influence in the region.

Today, China faces two separate problems. The most immediate issue are rising trade tensions with the United States. The second and more pervasive issue is the growing mountain of debt, which are backed by less productive assets, which elevates financial tail-risk. The China bears’ favorite chart exemplifies that problem.

 

The latest developments indicate that Beijing has developed a cunning plan to defuse both trend tensions and reduce financial tail-risk.

Growing trade tensions

China’s current account surplus with the United States is a sore point with Donald Trump, but trade imbalances are in the eyes of the beholder. This analysis from Nomura indicates that China’s current account surplus would be greatly reduced if Hong Kong fund flows were to be included. Other analysts have pointed out that the advent of global supply chains overstate China’s trade surplus. For example, if Apple were to import an iPhone manufactured in China with a stated value of $1,000, many of the iPhone components are manufactured elsewhere, and so is the intellectual property value of the $1,000 phone. If you were to only include China`s value-added to the $1,000 iPhone, it would fall substantially.

 

China`s cunning plan

Still, there are a number of legitimate complaints about China`s mercantilist trade policies voiced not only by Americans, but by a growing chorus of other countries. In response, Xi Jinping made a speech on Tuesday at Boao Forum in an effort to cool trade tensions. While his concessions that he offered are not very new, his conciliatory tone cheered the markets. Here are the main points of his speech:

  • China will lower tariffs for imported vehicles and ease foreign restrictions on the ownership of auto manufacturing
  • China pledges to open a variety of industries to greater foreign investment: aviation, shipping, and financial services
  • China will strengthen property rights protection, including intellectual property rights

These proposals are nothing new, and general big picture statements are short on specifics. It remains to be seen whether these proposals will act to reduce trade tensions.

But wait! Did Xi say he would open financial services to foreign investment? One of the biggest problems faced by the China is the resolution of the growing debt bubble. Even though most of the debt is denominated in RMB, and popping the bubble will not result in a typical emerging market debt crisis where most of the debt is denominated in USD while a country’s currency tanks, resolving a future debt crisis will not be without costs. In all likelihood, Bejing will opt to socialize the debt, and the price of debt socialization will likely be a prolonged period of slow growth.

Enter “foreign investment in financial services”. If the foreign devils could be convinced to enter the Chinese market and lend in RMB, China will have managed to externalize financial tail-risk. The PBoC won’t have to socialize the cost, it will be the foreigners. Oh, please! Don’t throw me in the briar patch!

Some steps are already being taken. SCMP reported that foreigners are buying China’s onshore bonds in anticipation of Chinese inclusion in bond indices:

Chinese onshore bonds are becoming a larger part of global investors’ portfolios, suggesting their gradual acceptance as mainstream fixed income investment ahead of their anticipated official inclusion into one of the most followed international benchmark bond indexes.

Foreign investors’ participation in yuan-denominated Chinese onshore bonds rose to 1.09 trillion yuan (US$172.9 billion) in March, up from 1.07 trillion yuan in February and from 761.6 billion yuan in March 2017, according to data from China Central Depository & Clearing. The increase in foreigners’ holdings however is from a low base – foreign ownership remains only about 2 per cent of China’s US$12 trillion bond market.

The initiative to open Chinese domestic capital markets even got Ray Dalio all excited (see Bloomberg interview). Both Dalio and the Chinese leadership are known to have long time horizons and play the long game.

Who is right? Who has the cunning plan?

Evaluating Jim Paulsen’s market warning

Posted by Cam Hui -

I have been a fan of Jim Paulsen for quite some time. The chart below depicts the track record of my major market calls. His work formed the basis for my timely post in May 2015 (see Why I am bearish (and what would change my mind)), which was received with great skepticism at the time.
 

The track record of my major market calls

 

This time, though, I believe that Jim Paulsen’s warning for the equity market outlined in this Bloomberg article is off the mark. Paulsen’s cautionary signal for the stock market is based on his Market Message Indicator, which has rolled over. The indicator is described in the following way:

The gauge takes five different data points into account: how the stock market is performing relative to the bond market, cyclical stocks relative to defensive stocks, corporate bond spreads, the copper-to-gold price ratio, and a U.S. dollar index. The goal is to devise a gauge that acts as a proxy for broad market stress.

I have annotated (in red) in the chart below the subsequent peak in the stock market after this indicator gave a sell signal. This indicator is far from infallible, but the market has weakened the last few times this indicator peaked and rolled over. During the study period that begins in 1980, some sell signals simply did not work, or there were long delays between the sell signal and the actual peak.
 

 

Here is what I think Paulsen is missing.
 

A cyclical and stress indicator

The Market Message Indicator uses five components to time stock prices, namely the stock/bond ratio, cyclical/defensive stock ratio, corporate bond spreads, copper/gold ratio, and the USD. These components mainly measure cyclical strength and stress.

While these components capture economic and global cyclicality well, they don’t tell the entire story of the risks facing stock prices.

Consider, for example, the copper/gold ratio as a way of measuring global cyclicality. The copper/gold ratio is a useful metric of the global cycle. Copper has both inflation hedge and hard asset qualities and cyclical qualities, while gold is mainly an inflation hedge. A rising copper/gold ratio can be an indication of global growth acceleration, while the reverse is a signal of growth deceleration.

The following chart shows that the copper/gold ratio is more useful as an asset allocation indicator than a stock market timing indicator. Gold/copper is more correlated to the stock/bond ratio (grey bars, top panel) than the stock market (bottom panel). In fact, there have been three separate episodes where both the copper/gold ratio and stock/bond ratio fell, indicating that bonds outperformed stocks, but stock prices did not fall.
 

 

The same remarks are applicable to the other components of the Market Message Indicator.
 

 

What Paulsen is capturing

I believe that much of the cyclical slowdown captured by the Market Message Indicator can be attributable to a deceleration of Chinese growth. Only 2 out of 10 of the Fathom CMI indicators of Chinese growth are in expansion mode, the rest are either falling or rolling over.
 

 

The Citigroup China Economic Surprise Index, which measures whether high frequency economic indicators are beating or missing expectations, is rolling over from a very high level.
 

 

A series of macro data disappointments in Europe may have also contributed to anxieties about a global slowdown.
 

 

By contrast, US ESI is holding up well at elevated levels.
 

 

Incipient fears about non-US cyclical weakness may be sufficient to cause a correction in US equities, but are they enough to spark a bear market?

 

What Paulsen is missing

The answer is no. Sustained bear markets are usually caused by recessions. Even though my Recession Watch long leading indicators are showing some signs of weakness, the immediate risk of a recession is still quite low.
 

 

The one missing ingredient for a recession is an overly aggressive monetary policy that tightens a fragile and weakening economy into a slowdown. That is why I emphasized the focus on monetary policy in my post yesterday (see Watch the Fed, not the trade war noise).

Further, I also observed in yesterday’s post that the stock market appeared to be starting to ignore bad news. Sentiment models are flashing crowded short readings, which is an indication that downside risk may be limited. I highlighted this normalized equity-only put/call ratio, which reached an overly pessimistic level and started to roll over, which is usually interpreted as a buy signal.
 

 

In short, Paulsen’s model has identified nascent cyclical weakness. As stock prices have pulled back from their January highs, the downside risk highlighted by his model may have already happened, and sentiment models are already overly bearish, indicating low downside risk.

The correction has already happened. It may be too late to sell.
 

Watch the Fed, not the trade war noise

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Fade the trade war jitters

“Fool me once, shame on you. Fool me twice, shame on me.” We’ve seen this movie before on trade. The White House begins the process with tough and inflammatory rhetoric, only to see the threats walked back or watered down later.

Consider the case of the steel and aluminum tariffs, which were levied for national security reasons. The initial announcement shocked the market, but the Trump administration eventually walked back most of their effects by providing exemptions for Canada, Mexico, the EU, Australia, Argentina, Brazil, and South Korea. Um, those exemptions account for over half of American steel imports. What “national security” considerations are we referring to?

The KORUS deal is another example. The agreement was hailed as a great victory by the Trump administration, but the tweaks were only cosmetic in nature. The South Koreans agreed to two concessions. In return for an indefinite exemption from the steel and aluminum tariffs, Seoul agreed to a steel export quota to the US, but the quotas are toothless because they are contrary to WTO rules and could be challenged at anytime. In addition, South Korea doubled the ceiling on American cars that don’t conform to Korean standards which could imported into that country. The ceiling increase was meaningless because US automakers were not selling enough cars under the old ceiling. In other words, the KORUS free trade deal was a smoke and mirrors exercise and a face saving out of a potential trade war.

The NAFTA negotiations followed a similar pattern of using bluffs as a tactic, and reacting afterwards. Trump began the process by declaring the free trade agreement “unfair” and “terrible”. He then threatened to tear up the treaty. The latest news from Bloomberg indicates that American negotiators are pushing very hard to have an agreement in principle in place by the Peru Summit of the Americas that begin April 13 next week. How much leverage will the American side have if the other negotiators know that Trump wants a deal by next week? Much work needs to be done before an agreement in principle can be made, but watch for more climbdowns and a declaration of “victory” by the White House.

So why worry about a possible trade war with China? Investors worried about equity downside risk should instead focus on the likely direction of monetary policy. New Deal democrat recently outlined a simple recession model which states that whenever the YoY change in the Fed Funds rate rose above the annual change to employment, a recession has followed within a year.
 

 

As the Fed normalizes monetary policy, it is on the verge of making a policy error where it tightens into a weakening expansion and crashes the economy. Recessions have invariably translated into equity bear markets in the past. That’s why investors should look past the trade war noise and focus on monetary policy.
 

Trade war: Strong offense but weak defense

In the wake of last week’s news of China’s retaliatory tariffs, and Trump’s response to consider an additional $100 billion in tariffs on Chinese goods, there has been no shortage of analysis of the relative positions of both sides. The best summary comes from the Washington Post, which correctly characterized the US as having the upper hand on trade (offense), but China having the upper hand on political resilience (defense):

China has more to lose economically in an all-out trade war. The Chinese economy is dependent on exports, and nearly 20 percent of its exports go to the United States. It sold $506 billion in stuff and services to the United States last year. In contrast, the United States sold $130 billion to the Chinese.

“In a serious economic battle, the U.S. wins. There is no question about it,” said Derek Scissors, a resident scholar at the American Enterprise Institute who has helped advise the administration on China.

But this isn’t just an economic fight, it’s also political, and there’s a strong case that President Trump would be less able to sustain a protracted conflict than the Chinese — especially with the 2018 midterm elections coming.

The following chart depicts US soybean production, which is a major target of Chinese retaliation. Of the 10 biggest soybean producing states, Trump won eight in the last election. A full-blown trade war will impose serious electoral pain upon the Republican Party in the upcoming midterms.
 

 

By contrast, Beijing has the financial and political capacity to to keep their economy afloat until November.
 

 

Moreover, the past leadership of the Chinese Communist Party showed it was capable of starving millions of its own citizens in order to achieve their political objectives. Xi Jinping’s “president for life” status is a signal that he has the political capital and sufficient control of the political apparatus that the Chinese economy could sustain a high level of suffering. Now imagine how a similar level of pain would play out in battleground states such as Iowa, Ohio, and Wisconsin.

The WSJ reported that Trump’s new economic advisor Larry Kudlow walked back some of the Apocalyptic tone of the trade rhetoric:

There’s no trade war here. What you’ve got is the early stages of a process that will include tariffs, comments on the tariffs, then ultimate decisions and negotiations. There’s already backchannel talks going on.

Undoubtedly there are lots of backchannel discussions to find a face saving solution for both sides. Relax, and buy the trade war panic.
 

A focus on monetary policy

Instead, the real risk that equity investors face is monetary policy. The economy is at capacity and starting to run “hot”. The questions for equity investors is how quickly the Fed tightens, and what effect will that have on profits, growth, and P/E multiples.
 

 

 

In the wake of the surprisingly weak March Jobs Report, Fed chair Jay Powell gave a speech last Friday with a dovish tone to signal three rate hikes in 2018. By contrast, Reuters reported that former Fed chair Janet Yellen gave a far more cautious message to investors in a speech to Jefferies clients indicating that the growth and inflation risks are tilted to the upside:

Monday’s larger forum for Jefferies clients, she expressed the view that three or four rate rises were likely this year, and that recent U.S. tax cuts and a boost in government spending posed at least some risk of running the economy hot, according to the first source, who requested anonymity.

Jamie Dimon also sounded a similar cautionary tone on the future path of interest rates in his annual message to JPM shareholders:

Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal. We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate — reacting to the markets, not guiding the markets. A simple scenario under which this could happen is if inflation and wages grow more than people expect. I believe that many people underestimate the possibility of higher inflation and wages, which means they might be underestimating the chance that the Federal Reserve may have to raise rates faster than we all think. While in the past, interest rates have been lower and for longer than people expected, they may go higher and faster than people expect.

He continued:

It would be a reasonable expectation that with normal growth and inflation approaching 2%, the 10-year bond could or should be trading at around 4%. And the short end should be trading at around 2½% (these would be fairly normal historical experiences). And this is still a little lower than the Fed is forecasting under these conditions. It is also a reasonable explanation (and one that many economists believe) that today’s rates of the 10-year bond trading below 3% are due to the large purchases of U.S. debt by the Federal Reserve (and others).

A more hawkish Fed? A 4% 10-year Treasury yield? Yikes!
 

The impact of tight monetary policy

Here is what is at stake. As the Fed normalizes monetary policy, money supply growth tends to slow. Historically, whenever real money supply growth, whether M1 or M2, goes negative, a recession has followed. At the current pace of deceleration, real M2 growth is likely to flash a recession signal by Q4 2018.
 

 

One consequence of monetary tightening can be seen in the evolution of the yield curves. Both the 2-10 and 10-30 yield curves are flattening. A further two quarter-point rate hikes are likely to result in inversions. While there was a long lag between the yield curve inversion and equity market top in the 2007, the previous two cycles saw the market top out between 2-6 months after the event.
 

 

We can also see the effects of tighter monetary policy in the financial condition indices. Financial stress is starting to rise, but there are no signs of a credit crunch yet.
 

 

Goldilocks is still in the house

For now, not-too-hot and not-too-cold Goldilocks conditions are still prevalent. Scott Grannis pointed out that buoyant ISM Manufacturing readings are indicative of better GDP growth.
 

 

The latest update of EPS estimates from FactSet shows that forward EPS continuing to rise, which is indicative of fundamental momentum ahead of Q1 earnings season. Moreover, FactSet reported that a record number of companies are issuing positive Q1 earnings guidance, which is also bullish.
 

 

The upbeat assessment is not just confined to US equities. Ed Yardeni observed that forward revenues are rising globally.
 

 

To be sure, core PCE is showing strong upward momentum. It is only a matter of time before the Fed turns more hawkish.
 

 

More worrisome for equity investors was Fed governor Lael Brainard’s speech on financial stability last week, which signaled the fading of a Powell Put. Brainard stated that monetary policy should not be the tool to achieve financial stability:

The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy). The objective of financial stability policy is to lessen the likelihood and severity of a financial crisis. Guided by that objective, our financial stability work rests on four interdependent pillars: systematic analysis of financial vulnerabilities; standard prudential policies that safeguard the safety and soundness of individual banking organizations; additional policies, which I will refer to as “macroprudential,” that build resilience in the large, interconnected institutions at the core of the system; and countercyclical policies that increase resilience as risks build up cyclically.

In other words, don’t count on monetary policy to ride to the rescue should the markets fall apart.
 

Echoes of 2011

Looking ahead to the remainder of April, the market backdrop is reminiscent of the summer of 2011. The political environment was highly uncertain, and dominated by frequent eurozone summits, where participants were planning to have a plan to solve the Greek Crisis. At the same time, stock prices were volatile but stopped reacting to bad news, Equities were range-bound while flashing frequent oversold readings, as measured by my Trifecta Bottom Spotting Model, and Zweig Breadth Thrust oversold conditions. The market eventually broke up out of the range when the European Central Bank stepped in with their LTRO cheap loan scheme to re-liquify the banking system.
 

 

We are seeing a similar level of washed out sentiment today. The normalized equity-only put/call ratio is showing a constructive mean reversion from a crowded short reading. If history is any guide, such episodes have indicated favorable risk/reward ratio, with low downside risk.
 

 

Technical analyst Pat Hennessy also observed a similar case of bearish exhaustion. The VIX Index is underperforming even when stock prices fall, indicating that implied volatility is also not responding to bad news.
 

 

The SPX appears to have found its footing at its 200 dma. The bears have been unable to push prices below the 200 dma support level despite the bad news on the trade front. The SPX staged an upside breakout through a downtrend last week, and Friday’s weakness saw the index retreat back to test the downtrend line. Initial upside resistance can be found at the 50 dma level, which also coincides with the gap located at about the 2700 level.
 

 

Insider activity also added another intermediate term bullish signal to stock prices. Open Insider data flashed a buy signal in late March as insider selling (red line) dried up and briefly fell below the level of insider buying (blue line).
 

 

The signals from this group of “smart investors” are not infallible, but if history is any guide, downside risk is limited at current levels.
 

 

My inner investor remains constructive on the equity outlook for the next few months. My inner trader is also bullishly positioned, and he believes that the risk/reward ratio favors the bulls over the bears.
 

Disclosure: Long SPXL
 

The post-FANG market beaters hiding in plain sight

Posted by Cam Hui -

Mid-week market update: It is encouraging that the stock market held up well in the face of bad news on global trade. Global markets adopted a risk-off tone on the news of Chinese trade retaliation, but the SPX managed to hold a key support level and rally through a downtrend line.
 

 

Looking over the past few weeks, equity market weakness really started rolling when technology stocks rolled over in March. The carnage was not just confined to Facebook, or Amazon, but to the entire technology sector and globally. The relative performance of European technology stocks (green line) paralleled the relative performance of US technology.
 

 

One encouraging sign for the broader market can be found in my risk appetite metrics. High yield bonds (top panel) are not confirming the weakness in stock prices, though momentum (middle panel), and high beta (bottom) panel are struggling.
 

 

Notwithstanding the weakness in the technology sector, where can investors find opportunity (or places to hide) in light of the constructive view on the broader equity market?
 

Quality and Value the emerging leadership

We can get some clues with the use of RRG charts. 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. Instead of applying RRG analysis to sectors, I decided to think laterally and apply rotation analysis to factors, or styles.
 

 

A number of observations stand out from this RRG analysis:

  • Momentum and growth, which are in the top right leading quadrant, are in the process of rolling over;
  • Emerging leadership does not just consistent of defensive styles, such as low volatility, but…
  • Quality, and Value.

We can see how leadership is changing. I have already shown how price momentum, and high beta vs. low volatility are struggling. One interesting standout from the RRG chart is the emerging leadership of high quality stocks.
 

 

One attractive feature of the superior performance of the high quality factor is that it was largely achieved without making big sector bets. The accompanying chart from Morningstar shows the variance in sector weights between QUAL and the Russell 1000 benchmark. The biggest sector differences were only 2-3%, seen in an overweight position in Financials and underweight in Technology.
 

 

Other factors of note are large and small cap value. The superior relative performance of small cap value over large cap value is not a surprise in light of the recent revival of small cap stocks, which may also be worthwhile to consider (bottom panel).
 

 

One factor that I would think twice about despite its position in the top right improving relative strength quadrant is low volatility. The recent outperformance of low volatility stocks appear to be a low beta effect. Low vol began beating the market when stock prices turned down.
 

 

The sector exposure of SPLV can be seen in dramatic fashion from this Morningstar chart. The ETF has significant overweight positions compared to its Russell 1000 benchmark in Industrial and Utility stocks, and underweight positions in Energy, Healthcare, Communication Services, and Financials.
 

 

Think about what you are betting on. If you want to maintain some equity market exposure, but in a defensive fashion, low volatility is certainly a good candidate. However, don’t expect this factor to outperform should stock prices take off.
 

A plain vanilla market rotation

In conclusion, the market seems to be undergoing a plain vanilla rotation. The underlying internals appear to be constructive. Watch for high quality and value stocks to take the leadership baton from the faltering growth names.
 

Disclosure: Long SPXL
 

What’s the real test? The 200 dma or you?

Posted by Cam Hui -

As the SPX sold off today and tested the 200 day moving average (dma) while exhibiting positive RSI divergences, a Zen-like thought occurred to me. Is the market testing the 200 dma, or is it testing you?
 

 

Oversold, but…

The stock market is obviously very oversold. My Trifecta Bottom Spotting Model flashed another exacta buy signal today. While this model has not worked well in the recent past, the appearance of either an exacta or trifecta signal is an indication of an oversold market, with the caveat that oversold markets can get more oversold.
 

 

The TRIN indicator, which can indicate panic selling when it rises above 2, is more revealing on the 30-minute chart. During “normal” periods of panic liquidation, TRIN spikes at the end of the day in conjunction with price declines because of margin clerk and risk manager induced selling. Today, we saw TRIN hold up and rise, even as the market staged a minor late day rebound.
 

 

Now that’s real panic selling!
 

Unbridled panic

I recently pointed out that the Fear and Greed Index is now in single digits. Even if you are bearish, be warned that major market down legs don’t begin with sentiment at these levels.
 

 

As for the test of the 200 dma, I refer readers to Helene Meisler’s recent Real Money column, where she stated that the time to worry about a breach of this key support level is when the 200 dma begins to fall:

The general rule is the longer the S&P (or any index or stock) spends in a trading range and then breaks down from there, the more negative it is because that has given the long-term moving average line a chance to roll over — and rolling-over moving average lines are resistance on any rally.

 

The 2011 template

I suggested last week (see Technicians nervous, fundamentalists shrug) that a template for today’s market might be 2011, when the market chopped around for about two months before resolving itself in a bullish fashion. During this period, which is marked by the shaded area, the market generated a series of exacta and trifecta buy signals, as well as Zweig Breadth Thrust oversold readings.
 

 

Even if you are bearish, wait for the rally (and there will be one) to see if the market makes a lower high before going short.
 

Disclosure: Long SPXL
 

Is this what a regime change looks like?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Tech rollover = Regime change?

Is the stock market undergoing a regime change? The Average Direction Index (ADX) is a trend indicator developed by J. Wells Wilder to measure the strength of a price trend. The higher the ADX level, the strong the trend. The chart below shows the relative performance of technology stocks compared to the market. Even though this sector remains in a relative uptrend, the ADX of the relative performance ratio began to roll over in late 2017. The weakness in trend culminated in the recent carnage of FANG and semiconductor stocks.

 

The enthusiasm for technology stocks may be overdone, as the sector has exceeded its weight in the SPX index, which last peaked during the NASDAQ Bubble.

 

There is a fundamental reason for the weakness in this sector. I had written about this possibility last October (see Peak FANG), where I suggested that the regulators would come for the Big Data companies in the next recession. Facebook and Google were the prime targets because they were in the surveillance business, largely because of the creepiness effect of their practices. Of the other FANG names, Amazon is also vulnerable because of their strategy to entice users into their walled garden by learning everything about them in order to sell them goods and services. The latest Facebook episode mane mean that the competitive moats of these companies may be already breached. A prolonged period of market performance may be in store, much in the manner of Microsoft after its anti-trust battle with the Justice Department.

In connection with the failure of FANG and technology leaders, the stock market is also showing signs of weakening. The SPX recently breached an uptrend line, and its ADX has also rolled over.

 

These developments raise two key questions for investors. If technology leadership is indeed failing, can any other sectors step up to take its place? As well, does the weakness in these high octane and high beta groups the sign of a top for the overall stock market?

The bull case

Let’s the bull and bear cases, starting with the bull case. A review of leadership by market cap shows that even though NASDAQ leadership wanes, mid and small cap stocks are poised to take over the leadership mantle. The smaller size effect is evident even within the NASDAQ 100 index, as the equal weighted NASDAQ 100, which gives bigger weights to the smaller cap stocks within the index, is outperforming its cap weighted counterpart (bottom panel).

 

Looking ahead to Q1 earnings season, the short-term outlook appears to be bullish. FactSet reports that forward 12-month EPS estimates are rising, which is indicative of positive fundamental momentum. Moreover, Q1 corporate guidance is on pace to be the best on record since quarter on record since FactSet started keeping records in 2006.

 

The positive momentum is not just confined to earnings, which is arguably affect by the newly passed tax cuts. Ed Yardeni found that are also being revised upwards as well, which is indicative of fundamental momentum at the operating level.

 

At a sector level, I have a couple of candidates that could become the new market leaders. Morgan Stanley recently reported that their capex tracker is surging. Rising capital expenditures would be supportive of earnings gains in the capital goods Industrial sector.

 

I analyzed the relative market performance of equal weighted industrial stocks, as heavyweight GE, which has been a significant laggard, is dragging down the cap weighted sector (bottom panel). The equal weighted relative performance of the industrial and capital goods sector (top panel) shows that the sector has been trading in relative range in 2018. Further positive earnings surprise could see this sector stage a relative upside breakout in the near future.

 

The other candidate for market leadership are financial stocks. Both the equal and cap weighted sector are in relative uptrends, though the equal weighted stocks are slightly better behaved (top panel) when compared to the cap weighted sector (bottom panel).

 

In short, the stock market bull remains intact. Earnings growth expectations are supportive of higher prices, with an anticipated shift in leadership from technology (25% weight) to industrial (10% weight) and financial stocks (15% weight).

 

The bear case

One of the key legs of the bear case rests on the amazing work of former Value Line research director Sam Eisenstadt. Six months ago, Mark Hulbert wrote that Eisenstadt had forecasted an SPX target of between 2620 and 2640 at the end of March. The index closed at 2641. Hulbert had been highlighting Eisenstadt’s forecasting track record for years, and stated that the r-squared of Eisenstadt’s six month forecast is 0.31, which is statistically significant at the 95% confidence level. The chart below shows Eisenstadt’s out of sample six month SPX forecasts since 2013, as documented by Hulbert.

 

Here is what concerns me. In the last forecast as of September 2017, Hulbert wrote that “two of the more important inputs are low interest-rates and market momentum…[which] are mildly positive right now”. Both interest rates and momentum have deteriorated since then.

I have already pointed out how the ADX indicator is signaling a trend change and a possible loss of price momentum. Monetary conditions are also tightening and interest rates are rising. Both the 2-10 and 10-30 yield curves are flattening to a cycle low. Even though neither yield curve is inverted, two more quarter point rate hikes would do it. This would create the pre-conditions for a recession in late 2018, and an equity bear market to begin soon afterwards.

 

The loss of momentum is setting up for an RSI negative divergence sell signal. If history is any guide, the past three bear markets have been preceded by negative divergences in the 14-month RSI. While I am not in the habit of jumping the gun on model signals, should the latest correction end at these levels and rally to either test or make marginal new highs in the next couple of months, a negative RSI divergence is likely to appear at that point.

 

A different kind of regime change

Speaking of regime changes, another regime change risk is rapidly rising because of Donald Trump’s appointment of John Bolton as National Security Adviser. In a recent op-ed, conservative commentator George Will described Bolton as the “second most dangerous American”:

Because John Bolton is five things President Trump is not — intelligent, educated, principled, articulate and experienced — and because of Bolton’s West Wing proximity to a president responsive to the most recent thought he has heard emanating from cable television or an employee, Bolton will soon be the second-most dangerous American. On April 9, he will be the first national security adviser who, upon taking up residence down the hall from the Oval Office, will be suggesting that the United States should seriously consider embarking on war crimes.

As a reminder, Bolton was a strong advocate of the war on Iraq. He is also a strong advocate of attacking Iran and North Korea.

For the first time since the Second World War, when the mobilization of U.S. industrial might propelled this nation to the top rank among world powers, the American president is no longer the world’s most powerful person. The president of China is, partly because of the U.S. president’s abandonment of the Trans-Pacific Partnership without an alternative trade policy. Power is the ability to achieve intended effects. Randomly smashing crockery does not count. The current president resembles Winston Churchill’s description of Secretary of State John Foster Dulles — “the only bull I know who carries his china closet with him.”

Like the Obama administration, whose Iran policy he robustly ridicules, Bolton seems to believe that America has the power to determine who can and cannot acquire nuclear weapons. Pakistan, which had a per capita income of $470 when it acquired nuclear weapons 20 years ago (China’s per capita income was $85.50 when it acquired them in 1964), demonstrated that almost any nation determined to become a nuclear power can do so.

Bolton’s belief in the U.S. power to make the world behave and eat its broccoli reflects what has been called “narcissistic policy disorder” — the belief that whatever happens in the world happens because of something the United States did or did not do. This is a recipe for diplomatic delusions and military overreaching.

As recently as February 2018, Bolton penned a WSJ editorial entitled “The legal case for striking North Korea first”. Moreover, he has shown a history of strong arming the intelligence community to his views. In one case, when the intelligence officer refused to change his assessment, Bolton tried to get him fired (via Lobe Log).

The most egregious recent instances of arm twisting arose in George W. Bush’s administration but did not involve Iraq. The twister was Undersecretary of State for Arms Control and International Security John Bolton, who pressured intelligence officers to endorse his views of other rogue states, especially Syria and Cuba. Bolton wrote his own public statements on the issues and then tried to get intelligence officers to endorse them. According to what later came to light when Bolton was nominated to become ambassador to the United Nations, the biggest altercation involved Bolton’s statements about Cuba’s allegedly pursuing a biological weapons program. When the relevant analyst in the State Department’s Bureau of Intelligence and Research (INR) refused to agree with Bolton’s language, the undersecretary summoned the analyst and scolded him in a red-faced, finger-waving rage. The director of INR at the time, Carl Ford, told the congressional committee considering Bolton’s nomination that he had never before seen such abuse of a subordinate—and this comment came from someone who described himself as a conservative Republican who supported the Bush administration’s policies—an orientation I can verify, having testified alongside him in later appearances on Capitol Hill.

When Bolton’s angry tirade failed to get the INR analyst to cave, the undersecretary demanded that the analyst be removed. Ford refused. Bolton attempted similar pressure on the national intelligence officer for Latin America, who also inconveniently did not endorse Bolton’s views on Cuba. Bolton came across the river one day to our National Intelligence Council offices and demanded to the council’s acting chairman that my Latin America colleague be removed. Again, the demand was refused—a further example of how such ham-fisted attempts at pressure seldom succeed. There was even more to the intimidation than has yet been made public, but I leave it to those directly targeted to tell the fuller story when they are free to do so.

The NY Times reported that Secretary of Defense Mattis has told colleagues he is unsure if he can work with John Bolton.

I had suggested in early January that 2018 would be the year of “full Trump”, after he had achieved the primary objective of the tax cuts (see Could a Trump trade war spark a bear market?). The Bolton appointment is just part of an emerging pattern of the “full Trump”, where he has acted on his instincts.

Bolton will undoubtedly steer foreign policy toward tearing up the deal with Iran, which is likely to destabilize the region. Bloomberg reported that Energy Secretary Rick Perry is discussing the sale of nuclear power stations to Saudi Arabia in support of American supplier Westinghouse, which is in Chapter 11 reorganization. The sale would give the rights to the Saudis to enrich uranium, which is the first step to the acquisition of nuclear weapons.

The geopolitical threat is not restricted to just North Korea and Iran. The more dangerous red line is China, where Trump is playing the Taiwan card. A recent editorial in the state controlled China Daily warned against the passage of the Taiwan Travel Act, which permits high level discussions between Washington and Taipei officials:

Unlike trade, though, Taiwan is a matter of sovereignty. For Beijing, it is a clearly defined core interest that is not negotiable.

This latest move is reflective of what George Will characterized as using “U.S. power to make the world behave and eat its broccoli” that is risky and could lead to war, whether with North Korea, Iran, or China. As Bolton settles into his position, geopolitical risks is likely to rise, starting in 2H 2018. A rising geopolitical risk premium will unsettle global markets. In that case, the defense and aerospace sector is likely to outperform, and could become a safe harbor for equity investors should investors get rattled. The industry group is already in a relative market uptrend. The history of the group shows that it performed well and acted as a counter cyclical manner during the post 9/11 bear market.

 

Resolving the bull and bear cases

In summary, the bull case for equities is based on continued underlying fundamental and economic momentum. The near-term earnings outlook appears bright, and even if technology leadership were to falter, industrial and financial stocks are poised to take up the baton.

The bear case consists of rising monetary and price momentum headwinds. Price momentum is weakening, bond yields are rising, and the yield curve is flattening, which is a sign that the bond market is discounting slowing economic growth. In addition, the Trump’s appointment of John Bolton as National Security Adviser is likely to raise the geopolitical risk premium later this year.

Who is right? How about both? The near-term direction for equities is bullish, and stock prices are likely to test the old highs or make further marginal highs. However, this is part of a topping pattern where stock prices make a cyclical high this summer, and bearish factors begin to dominate later in the year.

The week ahead

The week ahead may see further market volatility as last week. I believe that intermediate term downside risk is limited. The Fear and Greed Index is in single digits and oversold. Major bear legs simply do not start with readings this low.

 

Market breadth indicators are supportive of a market bottom. Both the NYSE A-D Line and the NYSE Net highs-lows have exhibited positive divergences.

 

SentimenTrader also pointed out that the put/call ratio is favors market gains over the next two months.

 

That said, the rally Friday left the market overbought on a short-term (1-2 day time horizon) basis. Expect some pullback or consolidation early next week.

 

On a longer term (3-5 day) time horizon, readings are only neutral, and exhibit positive momentum. Expect further gains later in the week.

 

The big event next week will be Friday’s Jobs Report, followed by a speech by Fed chair Jay Powell on the economic outlook later in the day.

My inner investor remains constructive on equities. My inner trader is long the market. He believes that the risk/reward ratio favors the bulls over the bears.

Disclosure: Long SPXL

Technicians nervous, fundamentalists shrug

Posted by Cam Hui -

Mid-week market update: Both my social media feed and the my questions this week have a jittery tone. Will the 200 day moving average (dma) hold as the SPX tests this important support level? What sectors or groups could step up to become the next market leaders if technology stocks falter?

Callum Thomas of Topdown Charts highlighted an important bifurcation in sentiment between the technicians and the fundamental analysts. He has been conducting an (unscientific) Twitter poll on a weekly basis since July 2016, and the latest results show a record level of bearishness among technicians, while fundamental analysts have largely shrugged off the recent round of market weakness.

 

Who is right?

Fundamentally bullish

Let’s start with the fundamental outlook. As we approach quarter end, all eyes start to turn towards Q1 earnings season for some signs on stock market direction. One of the early clues to earnings season is corporate guidance. John Butters of FactSet reported last weekend that guidance is at an off the charts bullish reading:

At this point in time, 104 companies in the index have issued EPS guidance for Q1 2018. Of these 104 companies, 52 have issued negative EPS guidance and 52 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 50% (52 out of 104), which is well below the 5-year average of 74%.

If 52 is the final number of companies issuing positive EPS guidance for the first quarter, it will mark the highest number of S&P 500 companies issuing positive EPS guidance for a quarter since FactSet began tracking EPS guidance in Q2 2006.

I have documented in the past that bottom-up EPS estimates surged because of the tax cut effect. As the chart below shows, the rise in estimates from lower tax rates have petered out, and we are now seeing the organic growth element of EPS growth in Q1 estimates.

 

Looking ahead into April, the earnings outlook is positive. Trade war fears are fading. What do you have to worry about?

A crowded short

There is also evidence of capitulation. Inverse ETF volume is spiking indicating a crowded short. The last time this happened, the market was unwinding its crowded short volatility trade.

 

Notwithstanding the longer term problems that confront Facebook, the latest magazine covers could be interpreted as a contrarian buy indicator for the stock.

 

Technical buy signals everywhere, but…

From a short-term technical and sentiment perspective, I am seeing buy signals everywhere, though the market does not be responding as expected to these models, which is causing some concern.

Rob Hanna of Quantifiable Edges maintains a Capitulative Breadth Indicator (CBI). While his normal buy signal occurs when CBI reaches 10, a study of its reading of 9 still shows a bullish edge.

 

Recession Alert’s Selling Pressure indicator shows that current conditions as extremely stretched on the downside, though a buy signal has not been generated yet until mean reversion occurs.

 

Similarly, I had highlighted a VIX buy signal when it rose above its upper Bollinger Band and mean reverted, though the market hasn’t responded as expected with a rally.

 

A past historical study has also shown a bullish edge.

 

Why the choppiness?

More volatility ahead?

Ed Clissold of Ned Davis Research resolved the edginess felt by many technicians this way with some good news and bad news. The good news is selling pressure is abating, implying that any 200 dma test will not be resolved in a bearish fashion.

 

The bad news is that the bearish breadth thrusts that the market has experienced tend to be followed by further choppiness.

 

The best analogy of current market conditions may be the summer of 2011, when the market chopped around for about two months in a range for about two months before rallying. That period was marked by several false starts, as marked by exacta and trifecta buy signals from my Trifecta Bottom Spotting Model, and oversold readings from the Zweig Breadth Thrust indicator. If 2011 is the template, then expect the near-term SPX range to swing between 2600-2800, with an initial upside target of filling the gap at around 2700.

 

My inner trader remains bullishly positioned, as he believes that downside risk is limited at current levels. The Fear and Greed Index stands at 6. While I cannot predict what the market might do in the short-term, major bear legs simply do not start with readings at such low levels.

 

Disclosure: Long SPXL

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

Posted by Cam Hui -

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

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

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

 

Rising default risk

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

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

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

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

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

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

 

Companies tied to local projects are facing similar difficulties:

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

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

Speaking of debt…

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

 

The new Fragile Five

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

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

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

 

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

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

Trade war, Schmade war!

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A market triple whammy

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

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

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

 

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

A dovish hike?

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

 

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

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

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

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

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

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

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

Trade war fears: Bark or bite?

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

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

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

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

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

 

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

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

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

Market nowcast still bullish

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

 

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

 

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

 

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

How oversold is the market?

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

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

 

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

 

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

 

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

 

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

 

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

 

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

The preconditions of a bear market

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

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

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

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

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

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

 

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

 

A Monday flush?

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXL
 

Is the NASDAQ trend still your friend?

Posted by Cam Hui -

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

 

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

 

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

 

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

Don`t panic

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

 

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

 

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

 

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

 

One last flush?

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

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

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

 

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

 

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

 

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

Disclosure: Long SPXL

 

FOMC preview: Rising stress edition

Posted by Cam Hui -

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

 

Rising Libor-OIS spread

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

 

As a primer:

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

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

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

 

Flattening yield curve

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

 

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

 

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

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

When the story changes…

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

A change in seasons

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

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

He concluded:

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

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

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

 

 

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

 

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

A recession watch review

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

  • Consumer and household sector
  • Monetary conditions
  • Corporate sector

 

Rising household and consumer stress

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

 

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

 

A tightening Fed

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

 

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

 

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

Corporate sector still the bright spot

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

 

Be prepared!

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

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

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

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

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

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

 

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

 

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

The week ahead

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

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

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

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

 

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

 

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

 

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

 

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

 

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

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

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

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

Disclosure: Long SPXL
 

A test of bullish resolve

Posted by Cam Hui -

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

 

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

Buy the dip!

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

 

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

 

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

 

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

 

 

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

Disclosure: Long SPXL

The new Fragile Five to avoid

Posted by Cam Hui -

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

 

Call them the new Fragile Five.
 

The pro-cyclical Fragile Five

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

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

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

 

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

 

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

 

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

 

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

 

Will diversified portfolios be doomed in the next recession?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

Will Treasuries continue to be diversifiers?

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

 

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

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

 

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

 

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

 

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

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

Dire projections

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

 

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

What are the alternatives?

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

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

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

 

Stress points in the next recession

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

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

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

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

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

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

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

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

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

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

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

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

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

Eurozone: Lingering problems from the last crisis

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

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

 

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

 

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

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

China: Hard landing risk

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

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

 

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

 

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

Japan: Safe haven?

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

 

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

Good news, bad news

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

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

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

 

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

 

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

The week ahead

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Disclosure: Long SPXL

The rise of populism and the policy challenge for global elites

Posted by Cam Hui -

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

 

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

Italian populism explained

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

 

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

 

 

The Grand Plan teeters

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

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

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

WSJ: Bad austerity?

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

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

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

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

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

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

WSJ: Job for life…

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

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

 

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

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

Populism in America

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

 

The policy challenge

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

 

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

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

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

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

The long awaited W-shaped recovery?

Posted by Cam Hui -

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

 

Is that all the bears can do?

Signs of washout

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXL

Beyond the headlines of the February Jobs Report

Posted by Cam Hui -

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

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

 

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

Leading employment indicators

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

 

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

 

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

Stay tuned.

Tariff Tantrum, or Trade War Apocalypse?

Posted by Cam Hui -

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

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

 

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

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

The latest signals of each model are as follows:

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

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

 

Trade chaos, or buying opportunity?

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

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

 

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

 

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

 

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

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

A trade policy analytical framework

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

  • Fiscal policy
  • Trade policy
  • Monetary policy

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

Policy pushback

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

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

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

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

 

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

 

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

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

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

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

 

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

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

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

Not enough panic

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXL

The animal spirits are back, but which ones?

Posted by Cam Hui -

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

 

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

Cautiously bullish

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

 

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

 

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

 

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

 

Animal spirits = Rising volatility

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

 

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

Disclosure: Long SPXL