A secular bottom for inflation?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Rising inflation = Secular commodity bull

This chart has been floating around since July and was featured in a Marketwatch article. While it is interesting from the viewpoint of a chartist, the stretched relationship between stocks and commodities is difficult to reconcile when seen through macro and fundamental lenses. Rising commodity prices require a sustained recovery in inflation, or a collapse in the value of financial assets. How is that possible in this era of inflation undershoot and pedal-to-the-metal central bank QE?
 

 

I think I found the answer, and it may be a signal of an inflection point in inflation, interest rates, and asset return patterns.

Demographics is destiny

The Bank for International Settlement, or BIS, recently published an important working paper by Charles Goodhart and Manoj Pradhan that explained how inflation is about to return because of global population demographics. Here is the abstract:

Between the 1980s and the 2000s, the largest ever positive labour supply shock occurred, resulting from demographic trends and from the inclusion of China and eastern Europe into the World Trade Organization. This led to a shift in manufacturing to Asia, especially China; a stagnation in real wages; a collapse in the power of private sector trade unions; increasing inequality within countries, but less inequality between countries; deflationary pressures; and falling interest rates. This shock is now reversing. As the world ages, real interest rates will rise, inflation and wage growth will pick up and inequality will fall. What is the biggest challenge to our thesis? The hardest prior trend to reverse will be that of low interest rates, which have resulted in a huge and persistent debt overhang, apart from some deleveraging in advanced economy banks. Future problems may now intensify as the demographic structure worsens, growth slows, and there is little stomach for major inflation. Are we in a trap where the debt overhang enforces continuing low interest rates, and those low interest rates encourage yet more debt finance? There is no silver bullet, but we recommend policy measures to switch from debt to equity finance.

The approach taken by Goodhart and Pradhan is philosophically similar to the approach used by Branko Milanovic in his study of global vs. local inequality in formulating his well-known elephant graph. While local (within country) income inequality has risen between 1998 and 2008, global inequality has fallen because of the effects of globalization.
 

 

The authors of the BIS paper have taken the same approach to global demographics:

We approach the critical role of demographics differently from previous studies in three specific ways. First, we attach a great deal of importance to the role of China, both in the past and future. Second, we argue that the political economy of the social safety net in AEs will play a critical role in driving our results. Third, in an extension of our first point, we take what we think is a truly global approach to the discussion of demographics, looking collectively at the global labour supply and the global prices of labour and capital. By contrast, much of the literature that looks at demographics in an international context examines local demographic dynamics of two (or more) economies and then discusses spillovers to and from neighbouring economies.

Here is their key argument, and somewhat controversial conclusion:

We argue that ageing will lower both desired savings and desired investment, but desired savings will fall by more. The resulting imbalance will require the real interest rate to rise for the market to clear. Just as the real interest rate has fallen since the 1980s thanks to a decline in desired investment borne out of the demographic sweet spot we described above, real interest rates will reverse course along with demographic trends and the resulting changes in savings and investment dynamics.

This is clearly our most controversial proposition, and much of the pushback we receive is based on the argument that demographics will lower potential output growth, and hence real interest rates. We agree wholeheartedly with the first argument regarding output growth. But we disagree that it will also lower real interest rates. Indeed, there is much less reason to believe the two are connected than many believe. We discuss first the path to determining the equilibrium real interest rate and then delve into some of the dynamics that will drive savings lower but keep investment from falling by as much or more.

As the world ages, both the savings and investment rate will fall, but Goodhart and Pradhan believe that the investment rate will fall more slowly, which raises the cost of capital and therefore drive up real interest rates:

Our view is that the corporate sector is likely to respond by raising the capital/labour ratio, ie by adding capital to compensate for labour, which is the factor of production that is getting scarcer and more expensive.

There will be a rising cost of labour and a falling cost of capital. We cannot think of any other time in history when the prices of the two main factors of production were moving as clearly in opposite directions. Even before demographics start pushing wage growth up, the price of capital goods has already collapsed. As wages begin to rise, compensating for more expensive labour will be easier thanks to a lower cost of capital goods. The resulting increase in productivity will somewhat temper the increase in wages and inflation. The savings and investment lens gives us another way to view this response. Given significantly cheaper capital goods, the cost of accumulating a given stock of capital uses up a smaller amount of the economy’s stock of savings. To some extent, this can counter the savings deficit created by ageing demographics and somewhat temper the rise in both the interest rate and wages.

They acknowledge that there are three key risks to their thesis:

  1. Withdrawal of the social safety net in advanced economies: A more fragile social safety net will raise the savings rate, which would the savings and investment relationship towards a lower cost of capital.
  2. Higher participation rates and the rise of India and Africa: Much of the favorable demographic patterns in the last two or three decades is attributable to the enormous rise in labor supply from China. Now that China is aging, that demographic sweet spot is turning sour. However, should Africa and India step up and take up the role that China did in the last few decades, or if the participation rate rises substantially in advanced economies, the capital/labor ratio equilibrium changes, which puts downward pressure on inflation.
  3. High debt levels delay the inevitable: If US real interest rates rise or threaten to rise quickly, debt servicing will become more difficult, in turn putting downward pressure on spending and real interest rates.

Notwithstanding the risks, this BIS working paper represents a solid argument for the secular revival of inflationary pressures over the next decade.

Intermediate inflation and interest rate outlook

However important the inflation thesis of the BIS paper, nothing in it tells us anything about the outlook for inflation for the next month, next quarter, or even next year. Inflation has been surprising to the downside all around the world, though it may be stabilizing in the eurozone and emerging market economies.
 

 

In the US, the markets were surprised last week by the stronger than expected CPI readings. However, much of the strength was attributable to a surge in Owners’ Equivalent Rent. Nevertheless, core CPI momentum has been picking up in the last few months.
 

 

Leading indicators of inflation are picking up. Capital Economics pointed out that the NFIB quality of labor index leads average hourly earnings by about 15 months. Wage inflation is likely to pick up.
 

 

The combination of these forward indicators, along with New York Fed President Bill Dudley’s contention that financial conditions are still easing while Fed Funds are rising, mean that the Fed is likely to stay the course on normalizing monetary policy.
 

 

I pointed out recently that one wildcard of Fed policy is the composition of the Federal Reserve’s Board of Governors, as there will be four vacant seats after Stanley Fischer’s departure, out of a total of seven (see The Fed’s perfect storm of 2018). As well, there is the question of whether the Trump administration will replace Janet Yellen as Fed chair when her term expires in February. Bloomberg reported that virtually all of the potential candidates for Fed chair are Republicans who favor rules-based approaches to monetary policy. As most rules-based approaches will see Fed Funds targets that are higher than they are today, this will put upward pressure on interest rates.

Interest rate expectations are also rising globally. The chart below depicts the 12-month G7 forward rates, which has reached the highest since 2011.
 

 

I would be not be surprised by a hawkish FOMC statement from their upcoming meeting on Wednesday. My base case is a Fed decision to begin normalizing its balance sheet at its September meeting, followed by a December rate hike.

Market implications

When analyzing the market implications of rising inflation on asset prices, we have to distinguish between cyclical effects and the secular trend. While a case can be made for a secular bottom of inflation, the cyclical trend is trickier. The US economy is in the late phase of an expansion. Past episodes have historically seen a cyclical inflation surge, followed by the Fed raising rates to cool the economy, and pushes the economy into recession.

From a long term perspective, the following chart from Fathom Consulting is a useful guide showing the bubble z-scores of different asset classes over time. While there seems to be asset bubbles everywhere today, the most extended asset class is government bonds, followed closely by NASDAQ stocks. Should interest rates start to rise, first cyclically because of tighter bank policy, and later from a secular basis because of the demographic pressures outlined in the BIS paper, bond investors are likely to suffer substantial losses.
 

 

Under such a scenario, the scramble for yield by extending duration are going to come back and haunt investors. As another example of the yield madness today, Austria recently floated a 100-year old bond at 2.1%, which is less than what 10-year Treasuries are paying.
 

 

Stocks should outperform bonds in an era of rising inflation and inflationary expectations. Nominal company sales and profits are more linked to inflation than bond coupons, which are fixed. That said, sector leadership will gradually shift to hard asset linked inflation hedge sectors. Indeed, these sectors are currently bottoming out on a market relative basis.
 

 

I would warn, however, that any leadership exhibited by these late cycle sectors are cyclical in character. Tighter Fed policy to choke off inflation is likely to tank the performance of these sectors. For now, they should only be viewed as trading vehicles.

Still, equity investors are not out of the woods from a long term perspective. Ned Davis Research also observed that, from a cyclical viewpoint, an extended “wealth effect” as measured by the ratio of Household Financial Assets to GDP has led to poor performance by stocks and corporate profits (annotations in red are mine).
 

 

The week ahead

When I shorten the stock market’s time horizon to a trader’s perspective, not much has changed since my mid-week update (see A “good overbought” advance, or an imminent pullback). While I am maintaining an open mind, I am still tilting towards the bearish scenario that the market is at the top of a trading range.

Seasonality does not favor the bulls next week, Jeff Hirsch of Almanac Trader observed that the SPX has been down 22 of the last 27 weeks after September option expiration (OpEx), which was last Friday. The average SPX loss in the September post-OpEx week since 1982 was -0.64%, and -1.00% since 1990. Rob Hanna at Quantifiable Edges found a similar effect.
 

 

Tom DeMark also warned of a market top (click link if the video is not visible).
 

 

The Fear and Greed Index has turned from fear to greed in very quickly as it has surged to 77 from 17 three weeks ago. While readings could get more bullish, they are getting extended, indicating that upside potential in stock prices may be limited.
 

 

As well, breadth indicators from Index Indicators show the market retreating from an overbought reading, with negative momentum dominant in multiple time frames. Here is the % of stocks above their 5 dma:
 

 

Here is the % of stocks above their 10 dma:
 

 

That said, the music is still playing, which is a signal that the intermediate term remains bullish. The latest update from FactSet indicates that forward 12-month EPS continues to trend upwards.
 

 

Moreover, New Deal democrat’s weekly assessment of high frequency economic indicators was bullish: “Despite the hurricane impacts, the economy appears in very good shape over the near term, and retains a positive tone, if more mutedly so, in the longer term.”

My inner investor remains neutrally weighted in accordance with his target asset mix weights. My inner trader missed the bottom of the rally and was caught short as the SPX rallied up to 2500. The technical picture suggests a period of either sideways consolidation or shallow correction next 1-2 weeks, when that will the opportunity to buy the dip. The SPX may catch a case of round number-itis, where it stalls or pulls back at a major round number. As well, past episodes where the market has become overbought on RSI-5 and MACD has begun to roll over has often seen some short-term weakness.
 

 

Disclosure: Long SPXU

Things you don’t see at market bottoms, Paris Hilton 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.

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “things you don’t see at market bottoms”. Past editions of this series include:

As a result, I am publishing another edition of “things you don’t see at market bottoms”.

Cryptocurrency Mania

No doubt many investors have heard about the parabolic rise in the value of many cryptocurrencies. Now there is a gold rush to cash in on Initial Coin Offerings, otherwise known as ICOs.

Now Paris Hilton, the woman who is known for…being famous, has gotten into the act.
 

 

What exactly is the Lydian Coin? FT Alphaville explains:

Lydian Coin is from a company called Gravity4, whose chairman and chief executive, Gurbaksh Chahal, pleaded guilty in 2014 to misdemeanour battery charges of domestic violence.

The digital advertising business claims to be “the world’s first A.I. big data marketing cloud” and is raising $100m (!!!) through the sale of Lydian “tokens” to finance the development of… well, nothing really:

100% of the proceeds raised by the sale of Lydian tokens will be held by LydianCoin Pte. (in fiat currency or cryptocurrency, as financial, security, and other considerations may demand) as reserves against the cost of services to be performed for Lydian token holders upon negotiation of the token back to Lydian.

If the whitepaper is to be believed, the whole idea here is that people will pay for Lydian tokens and use them to buy advertising campaigns from LydianCoin, which in turn licences its technology, products and services from Gravity4. The money won’t be used for anything. It will just sit there, covering the enormous balance sheet liability this ICO will create for LydianCoin.

In other words, the Lydian Coin is nothing more than a gift card for services that you could have bought with ordinary money:

We’ve often talked about how ICOs are like buying funfair tickets for a funfair that hasn’t been built yet. This is like buying tokens for rides at a funfair when you could just use your money to pay for the rides directly. All that’s really happening here is people are paying for services in advance of receiving them, like purchasing a giftcard.

Not to be outdone, hedge fund manager, author and venture capitalist, James Altucher, has now moved to the Dark Side, and he is now flogging cryto-currencies.
 

 

I can’t wait for the [shudder] leaked Altcher sex tape.

Retail investor mania

An update of the TD-Ameritrade Investors Movement Index, which measures Ameritrade client bullishness, shows that readings have reached another all-time high.
 

 

The Wells Fargo/Gallup investor optimism poll provides a longer term perspective. This poll shows investor confidence at a 17-year high.
 

 

Former Target manager starts volatility hedge fund

This story from the New York Times speaks for itself:

Each morning, at the market’s open, Seth M. Golden, a former logistics manager at a Target store, fires up the computer in his home office in northern Florida and does what he has done for years: Put on bets that Wall Street’s index of volatility, the VIX, will keep falling.

It has been a lucrative strategy as the so-called fear gauge has been, outside of the occasional spike, largely fearless — confounding experts by sloping persistently downward and in the process making Mr. Golden a multimillionaire.

Seth Golden’s trading strategy has been…well…golden:

Mr. Golden, who is 40, lives in a suburb of Ocala, Fla. Since he has been shorting VIX, he says his net worth has gone to $12 million from $500,000 in about five years.

The vol shorting strategy has been so successful that he is starting a hedge fund:

Now, he is starting a hedge fund dedicated to wagering against the VIX. Investors, he says, have been pounding on his door to get in early, offering him $100 million for starters.

David Merkel, former actuary turned portfolio manager, had these sensible but sobering words of caution for volatility traders:

It is like the credit cycle in many ways. There are two ways to get killed playing credit. One is to speculate that defaults are going to happen and overdo going short credit during the bull phase. The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts. Then there are those that are short volatility because it pays off when volatility is low. When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit. Doesn’t matter much if you are a professional or amateur. That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility. It has been a winning strategy so far. Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. Do you have enough wherewithal to survive a longer bull phase?

It’s like picking up pennies in front of a steamroller. Use some leverage, and you start to make substantial money.

Merrill Lynch credit analysts down to only one idea

You know that a market is extended when sell-side analysts run out of ideas. After a relentless search for yield, BAML credit analysts have become exhausted. Bloomberg reported that they are down to one idea for fixed income investors:

Years of record-breaking new issuance combined with risk premiums that continue to narrow amid a seemingly insatiable appetite for credit, have resulted in what can only be described as a case of “sell-side block” for investment strategists at Bank of America Merrill Lynch.

In a note published on Wednesday, the team said it was “down to one” strategy in global credit: “just long U.S. investment grade.” The bank closed out a recommendation to buy exposure to junk-rated European company debt while shorting the region’s investment-grade bonds through two of the credit indexes in the Markit iTraxx family.

 

In a related comment about the search for yield, CNBC reported that Goldman Sachs CEO Lloyd Blankenfein expressed his unease about the general state of risk appetite in an interview at a European banking conference:

When yields on corporate bonds are lower than dividends on stocks that unnerves me. The biggest problem, the anxiety that people have, is non-specific to what asset we are pointing to but the general feeling that things have been going up for too long.

 

Not the top, but…

For now, the frothy excess that I cited in this and past posts represents a “this will not end well” narrative without an obvious bearish trigger. However, sentiment doesn’t function well as precise market timing tools.

I reiterate my belief that this is not the top of the equity market (see Correction is over, wait for the blow-off top). Nevertheless, investors should be aware of the risks of an environment in which sentiment has become increasingly frothy.

A “good overbought” advance, or an imminent pullback?

Posted by Cam Hui -

Mid-week market update: A number of major averages hit fresh all-time highs this week. For traders and investors, the question is whether the market is likely to continue to grind upwards while flashing a series of “good overbought” signals, or will it pull back?
 

 

Here are the bull and bear cases.

Fresh highs are not bearish

The most convincing bull case is “fresh highs are not bearish”. Major market indices hitting new highs include the SPX, DJIA, NASDAQ Composite, and DJ Global Index.
 

 

Moreover, the all-time highs in the SPX has been confirmed by the action of the NYSE Advance-Decline Line.
 

 

Bearish non-confirmation

On the other hand, other indicators of breadth and risk appetite have not confirmed the fresh highs. While the large cap SPX has made new highs, the mid and small cap indices are lagging, which is a cautionary message about the generals leading but the troops not following the charge.
 

 

There are also negative divergences in credit market risk appetite, as measured by the relative performance of junk bonds, as well as net NYSE highs-lows, % bullish and % above 200 dma indicators.
 

 

These breadth indicators from Index Indicators also show that the market was overbought on multiple time frames and begun to pull back. Here is % above 5 dma (1-2 day time frame).
 

 

The % above 10 dma indicator (2-5 day time frame) is telling a similar story.
 

 

So is the net 20 day highs – lows.
 

 

These readings suggest to me that the market’s assault on the new highs is likely to fail in the short term. The market action in the last few weeks is that of a defined uptrend changing into a trading range. This is evidence of a period of consolidation. The next key test will occur in the likely pullback. Will it make a lower high, or will it weaken to test the August lows?

Wait for Mr. Market to give us an answer.

Disclosure: Long SPXU

The Fed’s perfect storm of 2018

Posted by Cam Hui -

I see that the world is catching up to me. The resignation of Federal Reserve vice chairman Stanley Fischer has sharpened the focus of analysts on the future composition of the Fed Board in determining the direction of monetary policy. This is a topic that I have been writing about since June (see A Fed preview: What happens in 2018?).

As well, in light of leaks indicating that Gary Cohn is no longer the front runner to be the next Fed chair, there has been widespread speculation as to the identity of the next Fed chair in determining interest rate policy. A number of commentators, such as Pedro da Costa, have speculated that Trump’s demand for personal loyalty is likely to usher in an era of a highly politicized Federal Reserve and destabilize the Fed’s credibility. This factor is particularly acute as there will be four vacant seats on the Fed’s Board of Governors after Fischer’s departure – and that does not include the possible replacement for Janet Yellen.

In other words, we have potential chaos at the Fed in 2018.

Shifting FOMC dynamics

Tim Duy described the dynamics of the FOMC as voting power shifting from Board governors to regional Fed presidents, which lends to more volatility in policy direction:

So now we are down to three governors and five regional presidents on the FOMC. At least in theory, this means the regional presidents can roll the governors on policy votes. Which means I have to start taking the presidents a little more seriously. Because in all honestly when the Board is fully staffed, that is where the power resides. And there is only so much time in the day to read speeches. The presidents talk a lot (but will the come speak at my events in Portland, a little hop from San Francisco – noooo), the governors too little.

Moreover, the Board generally offers a certain consistency of thought across years, whereas the regional presidents on the FOMC rotate. So next year, for example, the torch will pass from the dovish Minneapolis and Chicago Presidents Neal Kashkari and Charles Evans to the more hawkish San Francisco and Cleveland Presidents John Williams and Loretta Mester. Also added will be the still-to-be-announced Richmond Federal Reserve President, a hawkish spot in recent years.

From a tactical perspective, the December FOMC meeting on interest rates could be volatile, as the FOMC is split down the middle between the hawks and the doves:

It is easy to tell a story where Chair Yellen, Powell, Philadelphia President Patrick Harker, and New York President William Dudley all support a December rate hike while Brainard, Kashkari, Evans, and Dallas President Robert Kaplan oppose. What fun would that meeting be?

New faces at the Fed

And then there are the potential changes to the Fed Board:

Of course, Randy Quarles is waiting in the wings for Senate confirmation, so perhaps he would tip the balance to the hawkish side. Marvin Goodfriend is rumored for another open position, but has yet to be nominated (I can see both hawk and dove in his record, but I am thinking he will lean hawkish). So it may be that by the beginning of the year the voting power will tip back to the Board, backed by a fairly hawkish rotation of presidents. So if the doves want to take a longer pause before hiking rates again, they need to ensure Yellen is on their side going into the end of the year.

A Bloomberg article indicated that the race for the new Fed chair is not just a two horse race between Yellen and Cohn, but the White House is considering at least six names, such as Kevin Warsh, Glenn Hubbard, John Taylor, and others.

While the Fed chair has a strong voice in determining the future of monetary policy, I believe that a singular focus on the identity of the next chair is the wrong way to forecast the direction of interest rates in 2018 and beyond. There are several other openings on the Board, and the tilt of the new governors will play an equally important role in the Fed’s policy direction.

I recognize the framework of Trump’s predilection for personal loyalty is important, but if he wants a dovish Fed, he will need to not just appoint a loyal and dovish Fed chair, but stack the Board with other doves. Janet Yellen has historically been a dovish central banker, starting with her stint as the president of the San Francisco Fed. Can Trump actually find that many doves?

Consider the alternatives. Randy Quarles, who has been nominated for a post as Fed governor, is a Republican and a hawk. Marvin Goodfriend, who is said to be up for nomination, is a monetarist who favors a rules-based approach to monetary policy and therefore a hawk.

The other leading candidates for the position of Fed chair are also in the Republican rules-based monetary policy mold. Bloomberg reported that John Taylor, Glenn Hubbard, and Kevin Warsh criticized the Fed early this year for being behind the curve on monetary policy:

Speaking at the annual American Economic Association meeting that ended Sunday, Glenn Hubbard of Columbia University, along with Stanford University’s John Taylor and Kevin Warsh, criticized the central bank for trying to do too much to help an economy struggling with problems that monetary policy can’t solve.

Kevin Warsh, in particular, is thought to be a leading candidate for Fed chair, now that Gary Cohn is in Trump’s doghouse. Warsh would be an unusual choice, as he is not an economist, but a securities lawyer by training. As a reminder, the last non-economist who held the Fed chair was William Miller, who turned out to be a disaster. Also see this brutal takedown of Warsh in Medium. Reuters reported that Warsh was involved in a debate at the Council on Foreign Relations on the value of monetary policy as improv. Warsh came out against the idea:

[T]o continue to improvise policy strikes me as quite counterproductive. The crisis response is one thing and requires some degree of improvisation. A recession response or a response to weaker economic conditions, I think, to me, suggests that you go back to a view of rules, a view of understanding between markets and central bankers so they’re not surprised, so they are not finding themselves waiting breathlessly on what central bankers announce on Sunday nights to get markets to move up on Monday morning, with press releases in hand.

In an environment where fiscal, trade, and regulatory policy have room to provide further jolts of stimulus, Warsh thinks the Fed will face higher risks and more uncertain rewards if it chooses to expand its balance sheet or engage in more unconventional measures of the variety that Posen suggested. Moreover, Warsh would not like to see the Fed get into the habit of absolving elected officials of their responsibilities to promote economic growth, saying central banks are “terrible repair shops for broken fiscal policy.”

Most rules-based approaches to monetary policy would see the Fed Funds rate target substantially higher than it is today. Is that what Trump wants? Where will he find the doves?

A better framework for forecasting Fed policy

Rather than try and guess who will or will not be appointed to the Fed Board of Governors, the identity of the next Fed chair, and the tilts of the various regional presidents, I suggest using a Taylor Rule framework for thinking about Fed policy. It is evident that most of the new Fed governors will have a bias towards a rules-based approach to monetary policy.

Both the Atlanta Fed and Cleveland Fed have tools for determining Fed Funds targets using the Taylor Rule under differing assumptions. Here is the table from the Atlanta Fed for the Fed Funds target as of Q3 2017.
 

 

Here is the table from the Cleveland Fed, which helpfully provides projections for next two years.
 

 

As the Trump appointees assume their position at the Fed, the likely debate will shift to the assumptions and inputs into a Taylor Rule model. As a base case, the current Q3 median Fed Funds target is 1.25%, according to the Cleveland Fed model, and 1.33%, according to the Atlanta Fed model. Both median projections are slightly higher than what the actual target is today.

As the debate revolves around the assumptions and inputs, a dovish tilt will see the policy Fed Funds target shift downwards from the median, while a hawkish tilt will mean a target higher than the median.

Here is the punch line for investors. Should rules-based adherents take control of the FOMC, the table from the Cleveland Fed is a useful guide to how interest rates are likely to rise over the next few years. Current projections call for a Fed Funds target of 1.25% in Q3, a 1% rise in the next year, and a more moderate rise in the following year to 2.43%. By contrast, current market based expectations are barely discounting a 0.25% raise by the August 2018 meeting.

A Fed policy error setup

Be prepared for a far more hawkish FOMC in early 2018. Regardless of who is the Fed chair, the combination of voting regional Fed presidents with more hawkish views, and the likely nomination of more rules-based Republican economists are likely to set interest rate on a far steeper path than current market expectations.

I recently wrote about the possibility of a Fed policy error, where a hawkish Fed tightens into a weakening economy (See Is the Fed tightening into a stalling economy?). The likely evolution of the FOMC in 2018 significantly raises those risks.

Correction is over, wait for the blow-off top

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

The bull and bear cases

In my last post (see A step-wise market advance), I indicated that some of the concerns that overhang the stock market have been alleviated. Falling risk levels should act to put a floor on stock prices. Does that mean that stock prices are ready to rocket to new highs?

This week, I analyze both the near-term bull and bear cases for stocks. The bull case is based mainly on broad based fundamental momentum, such as continued improvements in ISM.
 

 

The bear case, on the other hand, is based on a case of bad breadth.
 

 

The bull case

The bull case for equities rests on a combination of positive fundamental momentum, and technical signs indicating that the worst of the decline is over.

Viewed through a fundamental and macro lens, it is difficult to be overly bearish on stocks in the face of improving macro momentum. The Citigroup US Economic Surprise Index, which measures whether macro indicators are beating or missing expectations, is rising.
 

 

Better macro momentum can also be observed outside the US. Global PMI is strong, indicating robust global economic growth ahead.
 

 

From a bottom-up perspective, FactSet reported that forward 12-month EPS continues to rise, indicating Street optimism about earnings growth.
 

 

FactSet also observed that Q3 EPS estimates are falling at a far slowing pace than the historical average, which is bullish for positive surprises as we head into Q3 earnings season.
 

 

From a technical perspective, there are constructive signs that point to a market bottom. A number of indicators have reached oversold readings and begun to mean revert upwards. These conditions have historically marked decent buy signals.

As an example, the NYSE common-stock only McClellan Summation Index recently got oversold and turned up. The dotted vertical lines indicate similar conditions in the past five years, and they have all been either bullish or shown little downside risk after the signal.
 

 

NAAIM sentiment reached a near buy signal two weeks ago and turned up last week. A buy signal is flashed when NAAIM sentiment falls below its lower Bollinger Band. In reality, the indicator did not actually breach its lower BB two weeks ago, but call it close enough for government work. Similarly, the vertical lines indicate past buy signals in the past, which have also been quite good.
 

 

Does that mean that the market is ready to go up, up and away? Not quite. Here is what’s bothering me.

The bear case

The main headwind for stocks rests on a case of bad breadth. I don’t mean just bad breadth in the form of narrowing leadership, though there are plenty examples of that.
 

 

The bull case for stocks rests on positive fundamental and macro momentum. A tour around the world, however, shows that non-US stocks are actually performing quite poorly in light of the bullish fundamental backdrop. Consider, for example, the eurozone. Can someone explain to me why The Euro STOXX 50 is in a minor downtrend and has difficulty regaining its 50 day moving average (dma) when the macro backdrop indicates a sustained expansion?
 

 

Across the English Channel, the FTSE 100 is also trading below its 50 dma. To be sure, the weakness in UK equities could be attributable to investor concerns over Brexit.
 

 

The view from Asia tells a different story. I tend to discount the Shanghai Composite because the Chinese stock market is just a casino and it is not indicative of economic reality. However, the stock markets of China’s major trading partners is a mixed picture. Hong Kong and Taiwan are performing well and have rallied to new recovery highs. The South Korean KOSPI is understandably lagging due to geopolitical jitters over North Korea. But why has Singapore fallen below its 50 dma? As well, the Australian market is surprisingly flat despite the stellar performance of industrial metals, which is shown in the next chart.
 

 

As the chart below shows, industrial metals have been soaring. This may be due to speculative demand from Chinese traders, as reports indicate that the price of many metals in China are trading above prices in the west. The industrial metal rally may therefore be a false positive signal of rising global growth.
 

 

This is confirmed by the far more pedestrian performance of the CRB Index, which represents a broader index of commodities. While the CRB has recovered from the lows made in the summer, it has not strengthened sufficiently to breach its 200 dma.
 

 

This does not look like the underpinnings of a broad based and sustainable rally for risk assets.

Watch for the blow-off top

Longer term, the perennially bullish Scott Grannis outlined a possible blow-off top scenario in his post (see Something to worry about). In that post, Scott Grannis fretted about what might happen once confidence returns, as it seems to be happening now. He is worried about a reversal in what he calls “money demand”, which is the inverse of M2 velocity.
 

 

The above chart is arguably the most powerful illustration of how strong money demand has been in the past 8-9 years: the ratio of M2 to nominal GDP. Nominal GDP is a proxy for national income, and M2 is arguably the best measure of readily-spendable money. Think of this chart as measure of how much money the average person wants to hold relative to his annual income. It’s risen from 50% prior to the Great Recession to 70% today. That’s huge, and one of the defining characteristics of the current business cycle expansion—a massive increase in the demand for money…

We now may be on the cusp of a reversal in the huge increase in money demand. With increased confidence, the public is becoming less desirous of accumulating money balances. The growth of bank savings deposits has slowed significantly, and it is now less than the growth of incomes. People may now be desirous of decreasing their holdings of cash relative to incomes. But since cash can’t disappear, the public can only accomplish a reduction in their relative holdings of money by bidding up the prices of other things. Less demand for money means a lower price for money and a higher yield on money, plus higher prices for things and eventually higher nominal incomes. That’s another way of saying that a decline in money demand is likely to result in an increase in inflation—unless the Fed takes offsetting measures.

 

Once confidence returns, monetary velocity will rise, and all of those pent-up savings that is a major component of M2 will have to go somewhere. Some of it will go into spending, which raises growth; and some will go into investments, which raises asset prices. The result is rising prices and inflation.
 

 

There is technical support for the Grannis rising inflation thesis. Sector rotation analysis using Relative Return Graphs (RRG) reveal a theme of emerging late cycle leadership consisting of inflation hedge sectors.
 

 

From a different perspective, here are the market relative charts of gold, energy, and mining stocks in the US and Europe. They all show constructive patterns of relative bottoms and different degrees of emerging market leadership.
 

 

That said, the short-term outlook for inflation hedge vehicles is fraught with risk. Commitment of Traders analysis from Hedgopia indicate that large speculators are in a crowded long in gold. Tom McClellan also pointed out that the public is chasing gold, as GLD asset levels have surged.
 

 

As well, there is a crowded short in the US Dollar, which is inversely correlated to commodity prices.
 

 

My base case scenario calls for several weeks of sideways stock market consolidation, followed by an upside breakout to new highs led by late cycle inflation hedge vehicles. Despite all of the recent hand wringing by Fed speakers about tame inflationary pressures, Variant Perception pointed out that inflation is just around the corner.
 

 

The week ahead

Current market conditions, however, show a market in need of a period of consolidation, as directional moves have been lacking in conviction.

The behavior of market psychology has been puzzling. On Friday, stock prices ended the day with a slight loss, in the face of a major hurricane about to hit Florida on the weekend, as well as a rumored North Korean missile test on September 9. The bears’ inability to push the market down in anticipation of bad news is bullish and indicates that most of bad news is already in the market. On the other hand, futures dropped after the close on Wednesday when the WSJ reported that Gary Cohn was a long shot to be the next Fed chair because of his post-Charlottesville criticism of Donald Trump. In fact, he was said to be more likely to get the electric chair than the Fed chair.

Bottom line: the market is directionless and reacts to the headline of the day.

Breadth indicators from Index Indicators provide few clues to market direction. Short-term breadth (1-2 day horizon) are in neutral territory, with a slight negative momentum bias.
 

 

Longer term models (1-2 week horizon) are showing similar neutral readings, but with a positive momentum bias.
 

 

My inner investor is neutrally positioned at his investment policy equity weight. My inner trader is slightly short the market. He is inclined to tactically buy should prices weaken to the bottom of the range, and sell or raise his short positions should the market strength to the top of the range.
 

 

Disclosure: Long SPXU

A stepwise market advance

Posted by Cam Hui -

Mid-week market update: In my post written last Sunday (see September uncertainties), I outlined three disparate sources of uncertainty that faced investors in September.

  • Legislative uncertainty over the debt ceiling and tax reform;
  • Geopolitical uncertainty over North Korea; and
  • Uncertainty over Fed action.

While some of those problems have been temporarily resolved, developments since the weekend have raised further questions about others. This suggests that the market will follow the recent pattern of a stepwise advance, but remain range-bound pattern until many of these uncertainties are resolved.
 

 

The debt ceiling logjam breaks, sort of…

Let’s start with the good news. The Washington Post reported that the House had passed $7.85 billion Hurricane Harvey aid package, along with Continuing Resolution to fund the government until December 15, based on a deal that Trump made with the Democrats:

President Trump wants Congress to fund the government for three months and raise the debt ceiling for the same amount of time, defying leaders from his own party and potentially giving Democrats leverage in debates over immigration, health care and federal spending.

Trump made his position clear at a White House meeting with congressional leaders on Wednesday, overruling top Republicans.

“In the meeting, the President and Congressional leadership agreed to pass aid for Harvey, an extension of the debt limit, and a continuing resolution both to December 15, all together,” Senate Minority Leader Charles E. Schumer (D-N.Y.) and House Minority Leader Nancy Pelosi (D-Calif.) said in a joint statement. “Both sides have every intention of avoiding default in December and look forward to working together on the many issues before us.”

This development is unsurprising, especially as Hurricane Irma bears down on Florida. After the devastation from Harvey, Irma victims will also need aid. No politician would want to be seen so heartless as to deny the hurricane victims the help they need.

That said, this deal just kicks the can of uncertainty down the road to December. October T-Bill yields fell as immediate tail-risk dwindled, but December T-Bill yields rose in response.
 

 

Apocalypse averted, but the problems of the debt ceiling and tax reform remain unresolved.

North Korean tensions rise

On the other hand, tensions over North Korea`s nuclear and missile capabilities are rising internationally. Bloomberg reported that both Russia and China, both permanent members of UN Security Council with veto power, have resisted the call for more sanctions:

Russian President Vladimir Putin again rejected U.S. calls for new sanctions against North Korea after its sixth and most powerful nuclear test, echoing China’s resistance to more punitive measures to pressure Pyongyang into abandoning its atomic and missile programs.

The Russian leader criticized sanctions as “useless and ineffective,” instead urging the international community to offer security guarantees to North Korea.

“They’ll eat grass, but they won’t abandon their program unless they feel secure,” he told reporters Tuesday at an emerging markets summit in Xiamen, China, which was hosted by his Chinese counterpart Xi Jinping.

Bottom line: The White House is not going to get anywhere with additional UN sanctions on North Korea.

However, the US has a very effective weapon in its arsenal to unilaterally “go nuclear” on the sanctions front. As Ian Bremmer of Eurasia Group pointed out in 2015, the US could deny countries, or specific entities access to the financial markets. As an example, instead of cutting off trade with any country that trades with North Korea, which was Trump’s initial reaction, the US could impose an embargo on any entity or country that trades with North Korea. (Looking at you, China.) Between China and Hong Kong, those two entities have roughly $2 trillion in external debt, whose financing, and rollover could come to a screeching halt. It would, indeed, be a nuclear option as it would collapse the financial markets in Asia.

Hopefully, it won’t come to such a drastic step, because China has an equally potent “nuclear trade weapon” of its own, rare earths. When Japan arrested the captain of a Chinese fishing boat in 2010 over a territorial dispute in the South China Sea, China responded by imposing a rare earths embargo on Japan. The Orlando Sentinel described what’s at stake today:

China controls the world’s production and distribution of rare earths. It produces more than 92 percent of them and holds the world in its hand when it comes to the future of almost anything in high technology.

Rare earths are great multipliers and the heaviest are the most valuable. They make the things we take for granted, from the small motors in automobiles to the wind turbines that are revolutionizing the production of electricity, many times more efficient. For example, rare earths increase a conventional magnet’s power by at least fivefold. They are the new oil.

Rare earths are also at work in cellphones and computers. Fighter jets and smart weapons, like cruise missiles, rely on them. In national defense, there is no substitute and no other supply source available.

To be sure, the West has adapted since 2010 and new sources of supply have appeared. Nevertheless, Chinese supply remains dominant in that market. The combination of a financial embargo on China, which would tip Asia into a slowdown, and a rare earths embargo, which is the modern equivalent of the Arab Oil Embargo in the wake of American support for Israel in the 1973 Yom Kippur War, is an Apocalyptic scenario that will tank the global economy into a deep and synchronized recession.

And we haven’t even discussed the possibility of military action.

More uncertainty at the Fed

Meanwhile, there is more uncertainty over the direction of Fed policy. Fed governor Lael Brainard gave a remarkable dovish speech on Tuesday. In a speech she gave last May, Brainard had been on the fence on the direction of monetary policy, but decided to give the consensus view the benefit of the doubt:

In recent quarters, the balance of risks has become more favorable, the global outlook has brightened, and financial conditions have eased on net. With the labor market continuing to strengthen, and GDP growth expected to rebound in the second quarter, it likely will be appropriate soon to adjust the federal funds rate. And if the economy evolves in line with the SEP median path, the federal funds rate will likely approach the point at which normalization can be considered well under way before too long, when it will be appropriate to adjust balance sheet policy. I support an approach that retains the federal funds rate as the primary tool for adjusting monetary policy, sets the balance sheet to shrink in a gradual and predictable way for both Treasury securities and MBS, and avoids spikes in redemptions.

While that remains my baseline expectation, I will be watching carefully for any signs that progress toward our inflation objective is slowing. With a low neutral real rate, achieving our symmetric inflation target is more important than ever in order to preserve some room for conventional policy to buffer adverse developments in the economy. If the soft inflation data persist, that would be concerning and, ultimately, could lead me to reassess the appropriate path of policy.

Her speech this week signaled that she has changed her tune, as Brainard has become increasingly concerned about persistently low inflation and low inflationary expectations:

To conclude, much depends on the evolution of inflation. If, as many forecasters assume, the current shortfall of inflation from our 2 percent objective indeed proves transitory, further gradual increases in the federal funds rate would be warranted, perhaps along the lines of the median projection from the most recent SEP. But, as I noted earlier, I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation, which would imply a more persistent shortfall in inflation from our objective. In that case, it would be prudent to raise the federal funds rate more gradually. We should have substantially more data in hand in the coming months that will help us make that assessment.

Tim Duy has interpreted Brainard’s speech as a dovish tilt on Fed policy:

Brainard is making a push to slow the pace of rate hikes. I am not sure she will be as successful as her last effort to change the course of policy. But she still has two important takeaways for investors. First, if you think interest rates will rise sharply, think again. The neutral rate of interest is too low to expect much more tightening – we need much faster growth to justify a higher estimate of the neutral rate. Second, assuming she is right and the Fed doesn’t take her advice, her colleagues are positioning themselves for a substantial policy error that would both bring the expansion to an end sooner than later and further entrench disinflationary expectations. And that would only make the Fed’s job harder in the future.

Before getting overly excited about Brainard’s dovish turn, I would wait for New York Fed’s Bill Dudley speech, which is scheduled for after the market close on Thursday. Dudley is known to taken a far more hawkish view of monetary policy. That said, Duy’s comment was written before the surprising news of the resignation of vice chair Stanley Fischer. For readers who are unfamiliar with Fischer’s record, in addition to being the head of the Bank of Israel, he was the Ph.D. thesis committee of both Ben Bernanke and Mario Draghi.

Fischer’s departure, which is scheduled for October, throws a wrench into the future of Federal Reserve monetary policy. On one hand, Fischer is a close confidant of Janet Yellen, and he is regarded as a hawk on interest rate policy. With only three active governors on the Federal Reserve Board, it tilts the center of gravity towards the doves, at least in the short term.

The wild card is the reaction of the Trump Administration. There are now four open seats on the board and Donald Trump can fashion the Fed in the manner of his own choosing. What kind of appointee will he nominate and pack the board with? Will they be pragmatic (and likely dove), such as a Gary Cohn, or economists hewing to Republican orthodoxy like John Taylor, whose approach to monetary policy would be far more hawkish than the Yellen Fed?

Moreover, the decision to rescind the Obama DACA initiative also raises a high degree of uncertainty for future Fed policy. Most estimates indicate that up to 800,000 people are subject to deportation if Congress does not pass a bill in the next six months. What happens if 800,000 people disappear from the labor force in a year, and what are the implications for labor market dynamics, wage inflation, and, most importantly, the conduct of monetary policy?
 

 

Noah Smith at Bloomberg highlighted this problem of labor force dynamics:

Jobs don’t just appear out of the sky. People give each other jobs. When new people arrive, either by being born or by immigrating, businesses expand — to take advantage of the new labor, and to sell things to the newcomers. Also, new businesses get started. Often, newcomers start the businesses themselves — immigrants and young people are both overrepresented among the ranks of entrepreneurs.

Now, it’s possible that immigration or population growth could temporarily put some people out of work. Economists have found that with some changes, like trade and automation, there are long-term gains but short-term pain as the economy rearranges itself. It takes time to start new businesses, and for existing businesses to expand, so it’s theoretically possible that a big surge of immigrants or a baby boom could temporarily raise unemployment.

I have no answers, but undoubtedly Federal Reserve staff economists are hard at work on this question.

Bottom line: Much of the Fed related uncertainty has also been kicked down the road until late this year, when nominations for Fed governors, as well as the fate of Janet Yellen, is known.

Expect further choppiness

The market went risk-off on Tuesday as investors returned to the desk after the Labor Day long weekend over North Korean jitters. It recovered on Wednesday when further North Korean related stress failed to appear, and on the news of the temporary debt ceiling deal.

Short-term breadth indicators from Index Indicators have retreated from overbought levels and they are now in neutral territory.
 

 

My base case scenario calls for a range-bound market for the next several weeks, until much of this uncertainty gets resolved. In the meantime, my inner trader is inclined to buy when the market reaches the bottom of the range and sell at the top of the range.

Disclosure: Long SPXU

The bullish implications of the North Korean Bomb

Posted by Cam Hui -

In the wake of the news of the latest North Korean news, Donald Trump responded with his usual tweetstorm.
 

 

The markets have learned that Trump doesn’t necessarily follow up presidential tweets with action. Official statements, on the other hand, are another matter. In the aftermath of the North Korean missile test which overflew Japan, the statement that “all options are on the table” was far more serious and chilling.

After the North Korean H-bomb test, Trump met with his senior advisors and Secretary of Defense released the following statement to the press:

Good afternoon, ladies and gentlemen. We had a small group, a national security meeting today with the president and the vice president, about the latest provocation on the Korean Peninsula. We have many military options. The president wanted to be briefed on each one of them.

We made clear that we have the ability to defend ourselves and our allies, South Korea and Japan, from any attack. And our commitments among the allies are ironclad: Any threat to the United States or its territories, including Guam, or our allies, will be met with a massive military response. A response both effective and overwhelming.

Kim Jong-Un should take heed of the United Nations Security Council’s unified voice. All members unanimously agreed on the threat North Korea poses, and they remain unanimous in their commitment to the denuclearization of the Korean Peninsula. Because we are not looking to the total annihilation of a country, namely North Korea. But as I said, we have many options to do so. Thank you very much, ladies and gentlemen.

It was a measured response that made the following points:

  • The United States is not looking to preemptively annihilate North Korea, but
  • Any threat to the US or its allies will be met with “a massive military response”.

How should investors react in the face of escalating tensions? Is the world on the brink of nuclear war, or another Korean war?

The likely policy response

First, investors need to take a deep breath and step back, which can lead to panic. The Mattis statement was a measured response that was a climb down from the usual Trump “fire and fury” rhetoric. War is not imminent. The US will not go to war unless explicitly threatened.

It is unclear where the red lines are. The North Korean threat to fire missiles at Guam was very specific. It would fire four missiles at targets surrounding Guam (and not at Guam itself). Would the White House consider that to be a threat and a casus belli, or just an act of provocation?

Longer term, the world needs to determine a policy to deal with the emergence of North Korea as a nuclear power. Can the genie be put back in the bottle?

In 1942, the science fiction writer and libertarian Robert Heinlein wrote that “an armed society is a polite society”. That line that became a favorite of the Second Amendment crowd and NRA supporters. Today, you can find t-shirts with that slogan at gun shows.
 

 

Barring some miscalculation by either side, my base case scenario is the world eventually adopts the same approach to dealing with North Korea. Kim Jong-Un will be told, “Welcome to the club, but you bear a heavy responsibility”, much in the manner that Barack Obama wrote a letter to Donald Trump (via CNBC), and other presidents have written their successors.

The “well armed society is a polite society” model has served the nuclear club well since the first use of nukes in 1945, and global geopolitics has been in an uneasy, but stable equilibrium. India and Pakistan, both of which acquired nukes at about the same time, have remained at peace. Similarly, both sides in the recent China-India border have taken steps to use measured military force. Even Israel, which is the sole nuclear power in the region, has not threatened to nuke any of its neighbors (see this Times of Israel account of how PM Golda Meir stepped back from the nuclear brink even in the dark days of the 1973 Yom Kippur War, when the existence of Israel was at stake).

That said, the entry of North Korea into the nuclear club will likely spark an arms race in the North Pacific. Abe’s Japan has already shown its desire to re-militarize. The latest development may cause Japan to seek its own nuclear weapons. South Korea may try to follow suit, though it is far more certain to raise its military budget in the near future.

These developments are bullish for the Aerospace and Defense stocks. These stocks have staged relative breakouts against the market, and North Korean actions are likely to highly bullish for this industry.
 

 

Trading the rearmament theme

As I write these words, the markets are unsettled by the North Korean bomb test. Moreover, South Korea has revealed that it has detected North Korean preparations to test another missile, possibly an ICBM. The timing of the test is unknown, but a likely date is September 9, which commemorates the founding of the DPRK.

The South Korean KOSPI has not reacted well to the bomb test. Monday’s market opened down in Seoul and the close was weak. This market reaction was in stark contrast to the missile test that overflew Japan, when the KOSPI opened down over -1%, but recovered to close with a small loss.
 

 

My inner investor is considering a plan to take a partial position in Aerospace and Defense now, with a view to add to his position once short-term geopolitical tensions start to clear.

September uncertainties

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

September headwinds and tailwinds

Welcome to September. Looking forward, this month is known to be seasonally bearish. Jeff Hirsch of Trader`s Almanac found that September was the worst month of the year, based on seasonal factors.
 

 

Ryan Detrick of LPL Financial Research further dissected past September seasonality. While while returns have been negative, he found a silver lining. When the SPX is trading above its 200 dma, which it is today, the market has seen positive average returns, though the percentage positive is still below 50% at 47.9%.
 

 

That said, investors face a sea of uncertainty as we head into September. I have never known the market to perform well under conditions of high uncertainty, but consider the hurdles ahead:

  • Legislative uncertainty over the debt ceiling and tax reform
  • Geopolitical uncertainty over North Korea
  • Uncertainty over Fed actions

Can stock prices climb the proverbial wall of worry in September, or will it retreat and test its correction lows seen in August?

Debt ceiling brinkmanship

One immediate problem that the US Congress faces as it returns from recess is the passage of a bill that raises the debt ceiling. That legislation is complicated by the damage caused by Hurricane Harvey. Longer term, the market has to be concerned about the viability of Trump’s tax reform initiatives.

Even though the Republicans control the White House, and both chambers of Congress, Steve Collender explained the problem of legislative chaos as seven GOPs at war with each other.

This year there are seven GOPs rather than just one Republican Party and they are all fighting each other far more than they’re confronting Democrats.

And eventually they’re going to have to deal with the Democrats too.

The first two groups of Republicans are in the House, where the ultra conservatives in the Freedom Caucus and the relative moderates in the Tuesday Group support vastly different policies and have enough votes to stop the other..and the whole House of Representatives…from doing anything.

The second two are in the Senate, where there’s also a huge divide between ultra conservatives and moderates. But the two Senate groups have to be considered different from their House counterparts because they have institutional concerns that often equal or exceed their ideological preferences. As a result, the policies, strategies and tactics that House Republicans use or demand frequently are unacceptable to GOP senators.

The next two are the Republican leaders — House Speaker Paul Ryan (R-WI) and Senate Majority Leader Mitch McConnell (R-KY) — who have management responsibilities that often conflict with their party’s political preferences. Ryan and McConnell have also become such personal targets for the other GOP groups that they have to spend a great deal of time, energy and political capital protecting themselves and their positions on most issues.

Finally, there’s Donald Trump.

Trump’s political needs and goals are different from almost every congressional Republican. Not only is he not up for reelection in 2018, his base of supporters is very different from that of most GOP representatives and senators. As the Affordable Care Act debacle amply demonstrated, what’s politically correct for Trump sometimes isn’t even close to what’s right for many others in his party…and continued funding for the federal government and the debt ceiling are two of those times.

Trump also continues to refuse to accept that Congress is not a wholly-owned subsidiary of his presidency. His ongoing attacks on individual Senate Republicans for not doing what he wants on health care, the wall, the debt ceiling, the Russia sanctions law and the collusion-with-Russia investigation undeniably shows that he considers the House and Senate to be subservient divisions of Trump Administration, Inc. rather than the equal partners created by the U.S. Constitution.

The existence of these seven Republican groups all point directly to legislative and political chaos and perhaps an explosion in September on the shutdown and debt ceiling.

That article was written before Hurricane Harvey devastated South Texas. Before the hurricane, Trump stated in a speech that he was prepared to shut down the government if a debt ceiling bill did not include sufficient funds to fund his Wall. In the wake of the hurricane, most analysts believe that Harvey has changed the legislative calculus of a debt ceiling increase, as no legislator wants to be seen to be so cold-hearted as to hold up a bill for hurricane victim relief.

Not so fast! Collender, in a separate Forbes article, detailed the political maneuvers behind hurricane relief and each GOP faction’s political motives:

In theory, providing funds for Hurricane Harvey relief should be quite easy. Fiscal 2018 begins on October 1 and some type of funding — either individual appropriations or a continuing resolution (CR) — will have to be enacted by then to avoid a government shutdown. In other words, there’s an almost must-pass-and-must-sign legislative vehicle already in the works that can be used for Hurricane Harvey and adding those funds should make the CR even easier to enact.

Except that’s not the case.

President Trump’s vow that he’ll veto the CR and shut down the government if money for his wall between the U.S. and Mexico isn’t included is still in effect. In fact, it’s noteworthy that he hasn’t yet withdrawn or modified that threat in the face of the Harvey-caused destruction.

Trump may be thinking that adding the funds for his wall to a bill with Harvey relief will make it easier for him to get the dollars he wants. After all, would congressional Democrats, who so far have indicated they’re adamantly against the wall, dare oppose a bill if funding for the wall and Harvey relief aid were combined?

But House and Senate Democrats almost certainly see this coming and are likely to announce very soon — perhaps even this week — that they insist that the hurricane relief funds be in a standalone bill rather than the CR and that this bill not include anything other than aid for Harvey victims. As a sweetener, they could ask that a Harvey relief bill be considered now rather than by the end of the month so that the aid can start flowing immediately.

That would put the White House in a political bind. If the president signed the standalone relief bill, he might be giving up what he considers to be the best chance at getting the funds for his wall. If he vetoed it, he would be delaying aid to Texas, Louisiana and everywhere else that will be affected by the storm and causing a great deal of voter and congressional GOP angst.

The political theater is already starting to play out. The Washington Post reported that the House Freedom Caucus leader Mark Meadows has urged Congress not to attach a hurricane relief to a debt ceiling increase bill. Politico reported that GOP lawmakers plan on doling out Hurricane Harvey relief in increments, rather than one big bill as was the case with Hurricane Sandy. Such an approach could mitigate the political costs of attaching a debt ceiling increase provision to any single relief legislation. Late Friday, the Trump Administration sent Congress a request seeking $7.85 billion for Harvey aid, and “suggested” that Congress link the bill to a debt ceiling increase. The request was consistent with a Bloomberg report that House leaders planned to omit a debt ceiling provision to a hurricane relief bill.

What about money for the Wall? Will Donald Trump blink, or will he make a stand on that issue and veto any debt ceiling increase that doesn’t contain Wall funding? Trump could take some comfort that his base remains committed to a Wall. A Morning Consult poll indicated that 51% of Republican voters were willing to shut down the government if Wall funding is not forthcoming (see rightmost column).
 

 

In the meantime, Business Insider highlighted analysis from Beth Ann Bovino of Standard & Poor’s, who warned that a Treasury default (which is different from a government shutdown) would be “more catastrophic to the economy than the 2008 failure of Lehman Brothers”. Moreover, every week of a government shutdown would shave an annualized 0.2% from Q4 GDP growth. No pressure at all – there are only 12 working days in September to raise the debt ceiling.

Get your popcorn. The show has only just begun – and, incidentally, the same “seven GOPs” problem applies to the tax reform efforts too.

The North Korea wildcard

In light of the recent news that North Korea’s H-bomb test and its claim that it had perfected the technology to mount an H-bomb warhead on an ICBM, I suggest that everyone take a deep breath and calm down. I wrote in a recent post (see “Fire and Fury” is hard) that there were two “speed bumps” to an American attack on North Korea. First, Washington had to secure the cooperation of the South Koreans, who is at risk of suffering Hiroshima and Nagasaki sized civilian losses in an attack.

As these tweets from NoonInKorea shows, the South Koreans are getting on board with the idea of a strike on the North with the agreement of the highest levels in the military.
 

 

As well, ROK aircraft has been practicing executing decapitation strikes on the North Korean leadership.
 

 

That said, Chinese objections to war remain in place. The Diplomat reported that China has refused to condemn North Korea’s missile launch over Japan and instead has called for all sides to exercise restraint.

On August 29, questions about North Korea’s latest missile launch dominated the regular press conference of the Chinese foreign ministry. Yet the Chinese foreign ministry spokesperson Hua Chunying refused to put out any harsh word on North Korea.

When asked if North Korea deserves special condemnation for launching missile flew over populated areas of Japan, Hua said:

The Security Council resolutions have explicit stipulations concerning the DPRK’s launch activities using ballistic missile technology, and the Chinese side is opposed to the DPRK’s launching activities in violation of the resolutions.

Then, she used hundreds of words to explain why the Korean Peninsula nuclear crisis is a complicated issue and implied that sanctions toward North Korea are useless:

[T]he Security Council has passed several resolutions, and sanctions never stop, but do they really have any actual effects? Everyone notices that sanctions and missile launches are happening side by side…The current development of the situation has just proved once again the fact that sanction and military pressure alone will never be the final way out.

Further, the semi-official Communist Party organ Global Times was restrained in its reaction to the H-bomb test, and advised that “China needs a sober mind and must minimize the risks Chinese society has to bear”. Moreover, it stated that China “should avoid resorting to rash and extreme means by imposing a full embargo on North Korea” by “[cutting] off the supply of oil to North Korea or even [closing] the China-North Korea border”. As for the criticism that China is not putting enough pressure on North Korea, Beijing can point to the fact that North Korean exports to China has collapsed since March (chart via Bloomberg).
 

 

The greater risk of the North Korean situation is a war of a different sort, namely a trade war with China. Axios has reported that President Trump has fumed that his aides have been bringing him inadequate solutions in response to trade with China: “I want tariffs! Bring me some tariffs!”

Notwithstanding the American trade frictions with China, The Washington Post reported that Trump is preparing to withdraw from a free trade agreement with South Korea. If Trump is willing to throw his South Korean allies under the bus on trade, what would the outcome be if he is less than satisfied with the Chinese position on North Korea?

Any move to impose tariffs on Chinese exports would bring on an inevitable round of retaliation. Therefore the risk of a trade war that collapses global trade is high.

A hawkish or dovish Fed?

Finally, the FOMC is scheduled to meet September 19-20, where it is expected to begin its Quantitative Tightening (QT) program of shrinking its balance sheet, subject to an adequate agreement on a debt ceiling increase. The latest market expectations shows that market expects the next rate hike to occur at its June 2018 meeting, and a less than 40% odds of a December rate hike.
 

 

What if the market is wrong? Current market positioning (via Hedgopia) shows a crowded long by large speculators, or hedge funds, in the 10-year note and long Treasury bond.
 

 

…a crowded short in USD futures, even as the index tests a key support level…
 

 

…a crowded long in the euro, which is a major component of the USD Index.
 

 

…a crowded long in gold, which is inversely correlated to the USD.
 

 

In other words, hedge funds have all rushed to one side of the ship in the futures market. Market internals, however, are not supportive of the crowded position. As an example, Andrew Thrasher pointed out that the recent upside breakout in gold was unconfirmed by action in the Japanese Yen, which makes the recent strength in bullion suspect.
 

 

A picture is worth a thousand words. The following picture dramatically illustrates the Fed`s policy dilemma, as it balances its financial stability responsibilities with current data showing weak inflation and wage growth. Current Fedspeak has focused on the need for financial stability, which indicates that it is likely to remain on its policy normalization path.
 

 

Should the Fed become more hawkish than expected, it would spark a USD rally. The risk of a disorderly unwind in these crowded positions could become chaotic. Volatility would spike and a market tantrum could be the result. Watch for clues from speeches from Fed governor Lael Brainard on Tuesday, and New York Fed President Bill Dudley on Thursday.

In addition, there is the risk of a change in Fed leadership before year-end. Should Trump decide not to re-appoint Janet Yellen as Fed chair when her term expires in February, the alternatives are likely to set a more hawkish path for monetary policy. PredictIt shows the leading contenders to be the next Fed chair as: Janet Yellen, Gary Cohn, Kevin Warsh, Glenn Hubbard, John Taylor, and Thomas Hoenig. Gary Cohn had been the frontrunner to succeed Yellen, but his chances have fallen in the wake of his criticism of Donald Trump’s comments after the Charlottesville affair. The remaining candidates are Republicans with rules-based approaches to the conduct of monetary policy, which yield Fed Funds targets that are significantly higher than what they are today.

That’s another level of uncertainty that is not widely discussed in the financial press.

My inner investor`s outlook

While near-term uncertainty is likely to create some volatility in stock prices, the long-term investor`s outlook of stocks is not so dire. Barron`s feature article this week warned about the end of the bull market. The bottom line: equities don`t perform well in recessions.
 

 

However, current recession risk is relatively low. As I pointed out last week (see Is the Fed tightening into a weakening economy?), there are some signs of weakness in the economy. Taken by themselves, they are just the signs of a late cycle expansion and do not constitute a recession warning. In the current environment, however, the risk of a Fed policy mistake that over-tightens the economy into a recession is high.

My inner investor is still constructive on stock prices. Don’t get overly bearish unless there is evidence of overly aggressive Fed action. There is still some valuation support for equity prices. Bloomberg pointed out that the forward dividend yield on stocks is now higher than the 10-year Treasury note.
 

 

In the absence of an aggressive Fed, TINA (There Is No Alternative) still rules.

The technical condition of the market

Looking to the week ahead, the technical condition of the stock market appears to be challenging for the bulls in the short term. Even as the SPX tests its all-time highs, breadth indicators are tracing out negative divergence patterns of lower lows and lower highs.
 

 

Other short-term breadth indicators from Index Indicators are flashing overbought signals.
 

 

On a very short-term basis, the hourly chart of SPX shows RSI-5 surging above 90, which are levels that are rarely sustainable for a very long time.
 

 

The term structure of the VIX shows that sentiment is now signaling complacency. Past episodes of complacency, which are marked by vertical lines, has seen the market struggle to advance. At a minimum, expect a neat-term flat to down bias in prices.
 

 

These readings suggest that the market is due for either a period of consolidation or some weakness ahead. The bearish potential that it will revisit and re-test the August lows in the weeks ahead.

My inner investor is neutrally positioned at his investment policy equity weight. My inner trader got caught offside as short last week, but he is not abandoning his position as he believes that near-term weakness lies ahead. His risk control discipline will require him to cover his short should the market decisively rally to new highs.

Disclosure: Long SPXU

The surprising conclusion from top-down vs. bottom-up EPS analysis

Posted by Cam Hui -

Mid-week market update: Business Insider recently highlighted an earnings warning from Strategas Research Partners about possible earnings disappointment for the remainder of 2017 and early 2018. Expect a deceleration in EPS growth because of base effects:

A big part of Strategas’ argument stems from the fact that the period against which current earnings are compared — the first half of 2016 — was notably weak. And that, in turn, pushed year-over-year growth to unsustainable levels.

As the chart below shows, Wall Street is not bracing for the decline. Its estimates are represented by the blue columns, which show continued profit expansion over the next two quarters. Strategas has other ideas. Adjusting for historical factors, the firm sees earnings growth declining over the period before being cut almost in half by the first quarter of 2018, as indicated by the red columns.

 

 

In addition, Strategas believes that sales growth appears “toppy”.
 

 

On the other hand, Ed Yardeni has the completely opposite bullish view:

(1) S&P 500 forward revenues per share, which tends to be a weekly coincident indicator of actual earnings, continued its linear ascent into record-high territory through the week of August 10.

(2) S&P 500 forward operating earnings per share, which works well as a 52-week leading indicator of four-quarter-trailing operating earnings, has gone vertical since March 2016. It works great during economic expansions, but terribly during recessions. If there is no recession in sight, then the prediction of this indicator is that four-quarter-trailing earnings per share is heading from $126 currently (through Q2) to $140 over the next four quarters.

Yardeni’s believes that there is little risk to stock prices, as long as forward 12-month EPS and revenues are rising.
 

 

What`s going on? How do investors reconcile the two contradictory conclusions of analysis of the same data set?

Top-down vs. bottom-up analysis

The Strategas case for caution rests on lower than expected YoY EPS growth rates for the remainder of 2017 and into early 2018. The Strategas view is not unique. Callum Thomas is warning of a similar dropoff in EPS growth based on a deceleration in the weekly ECRI indicator.
 

 

The key question in resolving the Yardeni bull and Strategas/Thomas bear debate appears to be a top-down vs. bottom-up debate. The Strategas analysis indicates that the market is likely to see disappointing growth rates in Q3 and Q4. Reading between the lines, Strategas seems to be estimating earnings and sales growth rates, rather than aggregating bottom-up derived earnings estimates and then calculating the growth rates afterwards. Some clues that it is employing a top-down analytical framework is the inconsistency of its conclusion with the relatively low levels of negative guidance shown by companies, and continued upward revisions of forward 12-month EPS and sales observed by Yardeni.

Solving the puzzle

Which is right, the top-down or bottom-up analysis?

An important piece of this puzzle comes from Yardeni Research. While forward 12-month EPS is rising for the large cap S+P 500, it is falling in mid and small cap stocks. As the chart below shows, the rate of negative estimate revisions is higher as we go down the market cap band.
 

 

A case of bad breadth

Technical analysts often use price breadth as an analytical tool. An often posed question is, “If the underlying theory is, if the generals (large caps) are leading the charge, are the troops (small and mid caps) following?”

In this case, we are seeing a negative divergence in fundamental breadth. While large cap forward EPS revisions remain healthy, negative estimate revisions in mid and small cap stocks reveal a lack of broader participation in fundamental improvement.

From a technical perspective, we are seeing a similar breadth deterioration as we go down the market cap band. The chart below depicts the net 52-week highs-lows for large, mid, and small cap stocks. As the chart shows, mid and small cap breadth is significantly weaker compared their large cap counterparts.
 

 

In conclusion, both the fundamental and technical frameworks lead to the conclusion that the generals are leading, but the troops are not following. These conditions indicate a high risk environment going into Q3 Earnings Season.

Disclosure: Long SPXU

Hurricane Harvey as a mini-stress test

Posted by Cam Hui -

Q: What’s George W. Bush position on Roe vs. Wade?
A: He doesn’t care how people get out of New Orleans after Katrina.

 – Joke that circulated in the aftermath of Hurricane Kartina

There are many stories coming out in the wake of Hurricane Harvey that hit Texas. I was most struck by this BBC account of the woman who was too poor to evacuate from her mobile home:
 

 

Judie stayed, she tells me, because she had no means to leave and no place to go.

“I had some problems getting out of town, a little broke and stuff, so I had to come home and, you know, tough it out,” she says. “We’re all the working class people.

“We’re the ones who go to the restaurants and wait on you and pick up your trash and do all that work. We don’t have a lot of money.”

“Fighting for the American dream,” she adds, with a rueful laugh.

Hurricane Harvey may prove to be a significant stress test for both the American economy and the Federal Reserve. A recent Bankrate survey indicated that only roughly 4 in 10 Americans have sufficient savings to cope in an emergency, which is indicative of the low margin of financial error that the household sector operates under.
 

 

The financial first responders

Bloomberg reported that initial estimates of the devastation caused by Harvey at $24 billion. Moreover, fewer than 1 in 6 of homes in Harris county, where Houston is located, are covered by flood insurance. The damage to household balance sheets in the area will be substantial.

Harvey’s cost could mount to $24 billion when including the impact of relentless flooding on the labor force, power grid, transportation and other elements that support the region’s energy sector, Chuck Watson, a disaster modeler with Enki Research, said by phone on Sunday. That would place it among the top eight hurricanes to ever strike the U.S.

“A historic event is currently unfolding in Texas,” Aon Plc wrote in an alert to clients. “It will take weeks until the full scope and magnitude of the damage is realized,” and already it’s clear that “an abnormally high portion of economic damage caused by flooding will not be covered,” the insurance broker said…

Most people with flood insurance buy policies backed by the federal government’s National Flood Insurance Program. As of April, less than one-sixth of homes in Houston’s Harris County had federal coverage, according to Aon. That would leave more than 1 million homes unprotected in the county. Coverage rates are similar in neighboring areas. Many cars also will be totaled.

“A lot of these people are going to be in very serious financial situations,” said Loretta Worters, a spokeswoman for the Insurance Information Institute. “Most people who are living in these areas do not have flood insurance. They may be able to collect some grants from the government, but there are not a lot, usually they’re very limited. There are no-interest to low-interest loans, but you have to pay them back.”

The question for is investors is the extent of losses, how they are distributed, and the secondary effects of the hurricane on the economy and banking system. In the past, the Fed has acted to supply liquidity to the system during periods of high financial stress. In this case, the financial stress is highly localized. The most likely Fed response will be to monitor conditions, but to rely on programs that are already in place. As a reminder, the Fed continued its campaign of rate hikes at its September 2005 meeting after Hurricane Katrina hit the Gulf Coast in late August.

The WSJ indicates that hurricane losses are unlikely to cause much damage to insurance company balance sheets. Score one for financial stability.

Harvey’s timing is good for insurers and insurance customers from one perspective: Personal and commercial insurers have record levels of capital, the money they have on hand that isn’t required to back obligations. With insurers’ overall strong capital position, Harvey is unlikely to cause extensive damage to the industry’s financial strength, though it could hurt quarterly earnings for those carriers with blocks of business in hard-hit areas.

So far, there has been no word from the Dallas Fed about local conditions, other than an announcement that its Houston branch has moved to modified operations. As of the close on Monday, credit markets have only shown minor signs of deterioration. Investment grade (IG, green line) bond spreads have weakened, and high yield (HY, blue line) performance has barely budged relative to duration equivalent Treasury prices.
 

 

The Fed only has so much power. It cannot make people who suffered hurricane losses whole. Only under extraordinary circumstances will central bankers take steps to ensure the stability of the financial system. A hurricane, regardless of how devastating, is not a likely candidate for such measures.

I will be watching how the economy, markets, and the Fed react to any fallout from Hurricane Harvey. This will be the first stress test of the economy to a mini-crisis under the Trump Administration.

Is the Fed tightening into a stalling economy?

Posted by Cam Hui -

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

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

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

 


The latest signals of each model are as follows:

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

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

Risk of a policy error is rising

Tim Duy, writing at Bloomberg View, recently observed that the stock market has been behaving roughly as expected during past Fed rate hike cycles. As long as growth is holding up, stock prices should continue to rise, regardless of any perceived valuation excesses:

The general rule is that if the economy continues to grow, then it is more likely than not that stock prices rise, even if the Fed tightens monetary policy. Many analysts, however, continue to resist this historical lesson, largely on the basis of traditional valuation metrics. These metrics, such as PE ratios, have been long elevated, leading to the difficulty explaining market behavior that my Bloomberg View colleague Barry Ritholtz has observed.

But if not market valuations what should be the focus on investors? My view is that they should be watching for signs that, at a minimum, earnings growth will falter or, probably more importantly, that the economy is set to tip into recession. I tend to think it is more likely that the economy takes the equity market down with it than the opposite.

 


Duy thinks that risks are low and we are not near the tipping point yet:

To be sure, it is impossible to know that the future holds. The chaotic environment in Washington, for example, could erupt into a crisis than threatens the economy. A more likely scenario is that the time will come — as it always has — when the Fed tightens policy too much and reverses itself too slowly. That is the most likely event that brings down the economy and equity markets. We just aren’t near that point yet.

I beg to differ. There are early signs that the American economy is starting to stall. These indications, if viewed from a standalone basis, are not cause for concern. But combined with the Fed`s resolve to normalize monetary policy, current conditions could become the basis for a monetary policy error that tips the economy into recession.

Weakness in housing

The most worrisome sign comes from the highly cyclical consumer durable industry, housing. I have been writing for several months that the housing sector appears to be rolling over. Simply put, the housing canary in the cyclical coalmine is struggling, and investors should pay attention to its message.

Housing starts and permits appear to have peaked and they are starting to roll over. This is one of my long leading indicators that are designed to spot recessions a year in advance in my Recession Watch list.
 

 


NAR reported July new home sales last week, which missed Street expectations and confirmed the signs of weakness shown by housing starts.
 

 


While no indicator is perfect, real private fixed residential investment has also tended to peak and exhibit negative YoY growth before recessions. Current readings are suggestive of a peak, much like the housing starts and new home sales data. However, YoY growth has not fallen below zero yet, though it is decelerating quickly.
 

 


Real time market based indicators are flashing cautionary signals, though they are not in the recessionary levels yet. The market relative performance of homebuilders (top panel) is declining and it has violated an initial relative support line. There is a further relative support zone below which, if broken, would be a red flag for the housing sector. As well, the lumber to gold ratio (bottom panel), which was identified as a useful inter-market cyclical indicator by Bilello and Gayed in their paper, Lumber: Worth its weight in Gold, is showing signs of relative weakness. The ratio remains in a longer term relative uptrend. A violation of the uptrend would be another sign of trouble for the housing industry.
 

 

Other signs of economic weakness

In addition to housing, there are other preliminary signs of economic weakness. Calculated Risk reported that the Chemical Activity Barometer (CAB) is showing some softness. CAB has historically led industrial production, which is a key component of economic growth.
 

 


As well, Calculated Risk reported that the Philly Fed’s Coincident State Activity is weak, which confirms the signs of growth deceleration from other indicators.
 

 


Bloomberg also highlighted analysis from Wall Street analysts warning of a downturn:

Oxford Economics Ltd. macro strategist Gaurav Saroliya points to another red flag for U.S. equity bulls. The gross value-added of non-financial companies after inflation — a measure of the value of goods after adjusting for the costs of production — is now negative on a year-on-year basis.

“The cycle of real corporate profits has turned enough to be a potential source of concern in the next four quarters,” he said in an interview. “That, along with the most expensive equity valuations among major markets, should worry investors in U.S. stocks.”

 

The thinking goes that a classic late-cycle expansion — an economy with full employment and slowing momentum — tends to see a decline in corporate profit margins. The U.S. is in the mature stage of the cycle — 80 percent of completion since the last trough — based on margin patterns going back to the 1950s, according to Societe Generale SA.

 


The growth slowdown is not restricted to the US, but it is global in scope. Callum Thomas of Topdown Charts pointed out that global diffusion index of growth are starting to roll over as well.
 

 


None of these indicators, by themselves, represent a cause for concern or the basis of a recession call. These are just the typical signs of a late cycle expansion. However, should the Fed make the typical policy mistake of tightening into a late cycle expansion, a recession is more or less a sure bet.

A determined Federal Reserve

From the Fed’s perspective, this is the perfect time to take the foot off the accelerator and begin tapping the brakes of monetary policy. As Bill Dudley of the New York Fed has repeatedly pointed out, financial conditions have eased since the Fed began to raise rates. Therefore there are ample reasons to continue on the normalization path.
 

 


As for the question of the below target inflation rate, the Fed continues to operate in a Phillips Curve framework. While there may be some research from the Philly Fed indicating that the Phillips Curve is dead, there is also supportive evidence from the San Francisco Fed which concluded that the lack of wage growth is attributable to demographics. Janet Yellen was trained as a labor economist and she shows few signs of abandoning the Phillips Curve as a policy guidance tool without overwhelming evidence. Tim Duy concluded that the Fed has good reason to expect wage growth in the near future.

Current market expectations show that the odds of a December hike at below 50%. Expect the Fed to surprise the market with a more hawkish stance, which will eventually prove to be bearish for most asset classes.
 

 

Who will be the next Fed chair?

Left unsaid in all the discussion at Jackson Hole is who will be the Fed chair after Yellen’s term expires in February. Will Trump re-appoint Janet Yellen to another term, or will he replace her with someone else?

Bloomberg reported that Gary Cohn appears to be the front runner to be the next Fed chair. Other reports indicate that Cohn has the job, if he wants it. However, there are a few of reasons why a Cohn nomination to head the Fed could spook the markets.

First, it is unclear whether he wants the job, as Bloomberg reported that the pragmatic Cohn may chafe at the academic style at the Federal Reserve. Moreover, it is unclear what his views on monetary policy, and he may be out of his depth. As a reminder, the last Fed chair who was not a trained economist was William Miller, who was appointed to his position by Jimmy Carter for the period from March 1978 to August 1979. Miller was overly dovish during that era of high inflation, and his performance during his brief tenure as Fed chair was less than impressive.

More importantly, investors can kiss any hope of tax reform goodbye should Cohn move to the Fed. Axios reported that Cohn believes that tax reform is dead if it doesn’t get done this year, which is an ambitious target date in light of the myriad of competing interests that need to be resolved:

Cohn has told associates that if tax reform doesn’t get done this year, it’s probably never going to happen. Sources who know Cohn speculate that he’ll leave the White House the instant he concludes tax reform is dead.

While the Axios report is dated July 2, a more recent report indicates that the year-end deadline for tax reform is still live. In an FT interview, Cohn indicated that he is pushing hard for the passage of a tax reform bill by December with the following wishlist:

  • Simplify the tax code by preserving only three individual deductions: mortgage interest, charitable giving, and retirement contributions;
  • Repeal the estate tax;
  • Minimizing the corporate tax rate to “as low as possible”; and
  • Create a one-time offshore cash repatriation incentive.

Should Cohn become the new Fed chair, another worry for the markets is the politicization of the Federal Reserve because of Trump`s demands for personal loyalty (via Business Insider):

The problem is the widely reported premium Trump places on loyalty and the potential repercussions this has for the appointment of a close confidant to a position that is ostensibly meant to be independent.

Should the market adopt such an interpretation of a Cohn appointment, expect long rates to climb as the inflation risk premium widens. Higher long rates will serve to depress the already fragile housing sector and could tank the economy. Ironically, a Cohn nomination could have the effect of raising inflation expectations without the Fed having to raise a finger.

On the other hand, Cohn’s decision to publicly rebuke Trump in his FT interview may raise questions about his personal loyalty to Trump. It could doom his current position as NEC director and put the Fed chair out of reach. Politico reported that Cohn drafted multiple resignation letters in the aftermath of Trump’s Charlottesville comments about blaming both sides. The markets would not react well should Trump fire Cohn.

Should Gary Cohn falter in his quest to succeed Janet Yellen as Fed chair, the alternative scenarios are either market negative or neutral. Trump could opt to re-appoint Yellen for another term, which would be a neutral outcome as her views are well known. Otherwise, the most likely replacements are Republican economists with rules-based approaches to monetary policy, such as John Taylor, or Marvin Goodfriend (see A Fed preview: What happens in 2018?). Virtually all rules-based approaches to monetary policy would see a Fed Funds target significantly higher than it is today, which implies a steeper path of interest rate normalization that creates significant headwinds for economic growth.

The weeks ahead: A shallow or deep correction?

Looking to the weeks ahead, the question for traders and investors is whether the current stock market weakness represents a shallow or deep correction. By some metrics, the pullback has reached points where declines have halted in the past.

The Fear and Greed Index is 27, but it recovered from readings that are well within the zone where intermediate term bottoms have occurred in the past.
 

 


Short-term breadth from Index Indicators have reached oversold levels where the market has seen relief rallies begin.
 

 


AAII bull-bear sentiment spreads have also reached a minor oversold level where the market have bounced in the past.
 

 

The bear case

The caveat to the foregoing analysis is oversold markets can get more oversold. The question then becomes whether the market is sufficiently oversold to begin advancing again. The bear can contend that the market remains in a downtrend and displays a pattern of lower lows and lower highs.
 

 


NAAIM sentiment is nearing a bearish extreme, but this indicator has not yet flashed a buy signal, which is triggered when it touches the lower Bollinger Band (blue vertical lines).
 

 


The percentage of NYSE stocks above their 200 dma had fallen to 50%. Such readings are usually signals of deeper corrections that end at the SPX 200 dma, which implies downside risk of about 2350 points from current levels.
 

 


As well, the debt ceiling impasse has been complicated by Trump’s threat to shut down the government if there is insufficient funding for his Wall. Default risk on Treasury paper has perked up, and premiums on Treasury paper around the debt ceiling date are also spiking. It is difficult to believe that this drama can go away overnight.
 

 


Trump’s popularity is also becoming a headwind for the equity market. Gallup’s measure of presidential approval fell to a low of 34%. Analysis from NDR indicates that stock prices tend to be sloppy when the approval rating is 35% and below. FiveThirtyEight analyzed Trump’s pardon of former sheriff Joe Arpaio and concluded that the effect would be neutral to slightly negative for presidential approval, but Trump’s popularity likely depends more on how the government handles the aftermath of Hurricane Harvey.
 

 


Another development that is not on most investors’ radar are the wide ranging effects of American sanctions on North Korea. Bloomberg reported that, so far, the US has only sanctioned the “small fry”, or companies that do business with North Korea. However, those sanctions could be expanded to major Chinese SOEs, such as oil companies and banks:

So far, the U.S. is seeking to punish relatively minor companies such as Dandong Chengtai Trading Ltd., which is accused of laundering money for North Korea. But there’s reason for Chinese officials to worry that the America may go after major state-owned enterprises and banks, such as China National Petroleum Corp. and Bank of China.

“We have the ability to say, ‘Any Chinese SOE that we consider relevant is fair game,”’ said Derek Scissors, resident scholar at the conservative-leaning American Enterprise Institute in Washington. “We haven’t even gotten close to the economic coercion we’re capable of.”

Sanctioning large Chinese SOEs could spark a major trade war, as Beijing will respond to additional sanctions by pointing out that it is doing all it can by fully supporting UN Security Council resolution 2371 that placed additional sanctions on North Korea.

Yet that coercion might unleash a trade war between the two biggest economies that would affect everything from soybeans to smartphones. China is the U.S.’s largest trading partner, with $578.6 billion in two-way trade last year, according to the Office of the U.S. Trade Representative.

We have yet to see these risks develop in the market. Given the Trump administration’s antipathy towards both China and North Korea, the probability of additional sanctions are non-trivial, and the market would not react well to such a development.

The overhang of these tail-risks makes me think that a deeper correction is the more likely scenario. These threats are not likely to go away overnight and a sustainable rally is unlikely until these risks recede. From a seasonal perspective, Jeff Hirsch of Almanac Trader found that the last four days of August has shown a bearish bias.
 

 


My inner investor is neutrally positioned at his policy weight in stocks and bonds. My inner trader remains short the market, and he is bracing for further volatility and drama in the days and weeks ahead.

Disclosure: Long SPXU

Trumponomics meets Mr. Market

Posted by Cam Hui -

Mid-week market update: As the stock market staged a bounce yesterday, it was still exhibiting a pattern of lower highs and lower lows. After the close, the market ran into a dose of Trumponomics that spooked the market and pushed the index below its 50 day moving average.
 

 

Notwithstanding Trump’s fiery rhetoric about Charlottesville and immigration policy, which are beyond the scope of this publication, two details of his speech served to tank the market. First, his threat to shut down the government by holding up debt ceiling negotiations if his Wall was not funded did not do the bulls any favors. As well, his comment of “I don’t think we can make a deal”, when referring to NAFTA raised the specter of tariff walls.

Debt ceiling jitters

Trump’s brinkmanship tactics over Wall funding by using the debt ceiling as a bargaining chip is a serious threat to market stability. Already, gold, as an alternative currency, is testing a key resistance level, while gold stocks have rallied through a relative downtrend line.
 

 

I will be monitoring this chart as a way of measuring the level of market anxiety.

NAFTA jitters

The concerns over NAFTA should be less of a problem for investors. As this BNN article points out, the President cannot unilaterally rip up NAFTA without Congressional approval:

Without the support of Congress, a president might withdraw the U.S. from the international agreement, but he could not singlehandedly wave away the law on the U.S. books that implemented NAFTA.

An international economic law professor and former State Department lawyer said he believes it would ultimately end up in court. And he said U.S. courts would ultimately conclude that the president can’t rip up NAFTA without congressional support.

That’s because the president can’t just erase the 1994 NAFTA Implementation Act passed by Congress. Only Congress can pass laws. In addition, the U.S. Constitution makes clear that Congress has power over international commerce.

The markets have shown some skepticism over any negative impacts on trade from the NAFTA negotiations. As the chart below shows, Canadian and Mexican equities have outperformed the MSCI All-Country Index (ACWI) recently, while US equities have underperformed.
 

 

Presidential approval

Another factor that could affect stock prices is presidential approval. As I pointed out in my last post (see Imagining the next bear market), NDR showed that stock prices have shown a historical tendency to be sloppy when presidential approval, as measured by Gallup, falls to 35% or below. The latest Gallup readings show Trump`s approval at 35%.
 

 

I interpret these conditions as indicative of a corrective market. My inner trading remains slightly short.

Disclosure: Long SPXU

Imagining the next bear market

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

What will the next bear market look like?

Recently, Lawrence Hamtil of Fortune Financial wrote an article entitled “Imagining the next bear market (with examples from the last two)“. He analyzed the effects of sector performance, large and small cap returns, asset correlations, and other characteristics of the last two two equity bears.

While that kind of analysis represents a good starting point, we know that history doesn’t repeat, but rhymes. With that in mind, here is an examination of the stress points of the next bear market, based on the assumption that it is sparked by a recession.

My main focus estimating equity downside risk. What will the next bear market look like (chart bars =annual returns, dots=annual drawdowns)? Will the recession be mild (1990), or long and protracted (1980-82, 2000-02)? Will the market crash? If so, will it be accompanied by a recession (2008) or not (1987)?
 

 

Recessions are periods when the excesses of the past expansions are unwound. Arguably, there have been few excesses in the current expansion except for the proliferation of Silicon Valley unicorns. That argues for a shallow bear market with a drawdown in the order of 20%, such as 1990. On the other hand, the excesses have occurred outside the US (see Looking for froth in the wrong places), which makes the case for higher losses if the economic downturn is global.

The answer can be found by analyzing the fault lines of the economy today for clues of how the next recession might develop.

Political fault lines

David Leonhart of the New York Times recently featured a chart that characterized how income inequality has developed in the US. In the years ending in 1980, income inequality had been falling (grey line). Since then, inequality has widened dramatically (red line) with the top 1% getting the lion’s share of the gains while the bottom half losing ground.
 

 

I show this chart not to start a debate, but to show how changes in income inequality have created fault lines within the American political landscape which culminated in the election of Donald Trump in 2016. Even today, 10-years into a recovery after the Great Financial Crisis, US households are still stressed.

A recent Bankrate survey indicates that only 41% of Americans have sufficient savings to rely on in an emergency, such as an unexpected car, appliance or home repair, illness, and so on. Zillow also warned about the problems of rental affordability for low-income renters (and this is occurring in a strong economy):

Rent affordability, or really unaffordability, has become a serious issue in recent years, with renters nationally spending a median 29.1 percent of their incomes on rent, up from 25.8 percent historically. Conversely, the share of income spent on mortgages remains relatively low at 15.9 percent, down from 21 percent in pre-bubble years.

While 30 percent has long been considered a reasonable amount of money to spend on housing, a median of 29.1 percent means that a lot of renters are spending more than that – and a lot of them have low incomes.

In the 25 largest metro areas in the country, people with low incomes pay far more than 30 percent for rent. The best case scenario is St. Louis, where the bottom third of renters spend 38.5 percent on the bottom third of rentals. In all the other markets, low-income renters spend more than 45 percent of their incomes on rent.

In notoriously pricey New York, Los Angeles, and San Francisco, the median low-income wage will not even cover a low-end apartment: Median bottom-tier rents in those markets require 111.8 percent, 107.8 percent, and 99.9 percent of the median low-income wage, respectively.

For another perspective, this chart shows that the cash flow service capacity of households have not recovered from the GFC.
 

 

In addition, corporate leverage is high. It is unclear how much stress levels will rise if interest rates rise and sales fall in a recession.
 

 

Another open question is how small business confidence is likely to evolve in a downturn. The latest NFIB confidence survey statistics remains elevated, but internals tell a different story.
 

 

Growth in small business employment (businesses with 1-19 employees, red line) is lagging Non-Farm Payroll growth (black line).
 

 

As well, some analysts have used Paychex (PAYX) as a real-time proxy for the health of small business employment. This indicator is not telling a positive story of small business America.
 

 

When the economy goes into the next recession, one of the biggest questions is how the political fault lines change. Will the bifurcation of the American electorate widen even further? While proposing workable solutions is well beyond my pay scale, the increase in political risk is not in most analysts spreadsheets in a recessionary scenario.

Equity political risk

Ned Davis Research featured analysis from a political risk analytical perspective. NDR found that stocks decline at an annualized rate of -18.8% when Gallup presidential approval falls to 35% and below. To be sure, it wasn’t just the performance of the White House occupant, most of the examples involve some form of economic malaise that plagued the economy.
 

 

Gallup’s latest figures shows that Trump’s approval is 38%, and approval fell to a low of 34% last week. Like it or not, presidential approval tends to decline when economic growth falters. So what happens to equity returns as the economy slides into recession?
 

 

Donald Trump will find out that taking credit for a rising stock market and economy is a two-edged sword.
 

 

If the economy slows, and small business confidence tanks, his support will erode. Then watch out below!

Earnings (currency) risk

Should the world sink into a synchronized global recession, the safe haven of choice will be USD denominated assets. This will put upward pressure on the USD.

Here is why the level of the USD is important. Q2 Earnings Season has seen one of the best results in some time. Much of the gains has been related to USD weakness. As this analysis from FactSet shows, companies with the most non-US exposure has seen the best sales and earnings gains. USD strength will create headwinds for earnings, particularly for large cap multi-nationals.
 

 

The currency effect can also be seen in earnings guidance. Credit Suisse recently pointed out that large caps, which tend to have greater international exposure, has seen more positive earnings guidance than small caps.
 

 

A rising USD will therefore be a headwind for US equity earnings on a cap-weighted basis.

Fixed income market risks

Looking ahead into 2018, the fixed income market may not be a good place to hide. Both the Fed and ECB are expected to engage in some form of quantitative tightening (QT), either by shrinking the size of its balance sheet (Federal Reserve) or tapering its QE program (ECB). At the same time, global bond market issuance is expected to materially increase next year. At the margin, this will put upward pressure on bond prices as supply increases.
 

 

In the wake of the Volcker Rule reforms, bond market liquidity has dried up as banks have withdrawn capital from market making. Tiho Brkan observed that credit spreads are tight. While they are not as tight as the top in 2007-08, they are as tight as they were at the NASDAQ Bubble top. So what happens if the credit suffers a shock as in a liquidity starved market?
 

 

Risk is even more elevated in the eurozone credit market. Bloomberg reported that the average yields of eurozone junk bonds are at historical lows.
 

 

Issuers have stampeded to sell high yield paper.
 

 

BAML pointed out that eurozone junk bonds are trading at yields roughly equivalent to US Treasury paper (top left chart), and fully 60% of eurozone BB HY trades at or below maturity equivalent US Treasuries (top right chart).
 

 

Carmen Reinhart recently penned a Project Syndicate article, “Recovery is not resolution”. Despite hopeful signs of economic recovery, the eurozone banking system is not fixed. This Bloomberg chart dramatically shows the unresolved problems with Europe’s banking system. Ten years after the GFC, European banks still trade at a discount to book value, compared to a premium multiple for US banks. In effect, the market is discounting significant non-performing loans on European banking books.
 

 

Pro-cyclical credit risk

At the same time, a Bloomberg story raised the point that the Fed’s QT program of reducing its mortgage backed securities (MBS), in additional to its Treasury paper holdings, is likely to widen the spreads on MBS paper.
 

 

Higher mortgage rates will put even greater pressure on the cyclically sensitive housing sector, which is already showing signs of rolling over.
 

 

The combination of higher bond yields from greater issuance, and Fed’s QT program will have a pro-cyclical effect of depressing the fragile housing market even as the sector already appears wobbly. Easy come, easy go.

Equity valuation risk

As well, there has been much recent hand wringing over stock market valuation. Analysis from Goldman Sachs indicates that the stock market is at historical nosebleed levels for virtually all metrics, except one, free cash flow yield.
 

 

Notwithstanding the problems with Shiller CAPE, the ratio recently edged above 30, which has only been exceeded by readings seen at the height of the NASDAQ bubble and beats levels seen just before the Market Crash of 1929.
 

 

Joroen Blokland pointed out that elevated levels of CAPE have seen poor real long-term returns.
 

 

Should investors be worried about current levels of equity valuations? Yes and no. These problems have a way of not mattering until they matter.

The music is still playing

I am reminded of former Citigroup CEO Chuck Prince’s comment in the period leading up to the Subprime Crisis, “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Reuters reported that he later qualified that remark and stated that he wasn’t referring to subprime lending, but the leveraged lending business. Nevertheless, his “the music is still playing” comment has dogged Prince’s legacy.

To be sure, analysis from EconoPic found a “music is playing”, or momentum, effect in the face of high equity valuations. High CAPE ratios have not historically been bearish for monthly returns when the CAPE ratio is rising (positive price momentum), but investors should get out of the way when valuations are high and momentum turns south.
 

 

Here is the same analysis in table form.
 

 

So should you stay long stocks, as long as the music is playing? That depends on your time horizon.

Long-term balanced fund investors should take profits on their equity portfolios and re-balance their portfolios back to their policy weights defined in their Investment Policy Statement (IPS). [You do have an IPS, don’t you? If you don’t, how do you know which way to go if you don’t know where you are going?]

Investors and traders with shorter time horizons can stay long the equity bull as long as the music is playing. The evidence shows that the band is still on stage, despite my tactical call for a correction (see Correction ahead). Any setback should be relatively mild, as I do not believe that the final top has not been reached yet.

Despite the risk-off tone taken by the markets last, week, here are some examples of how the music is still playing. The latest update from FactSet shows that forward EPS is still rising, indicating positive fundamental momentum.
 

 

The nowcast of the jobs market remains healthy. There is a strong inverse correlation between initial jobless claims and equity prices, and the initial claims data is not flashing any signals of weakness yet.
 

 

BAML strategist Savita Subramanian recently made the case for staying at the party. She pointed out that missing the terminal phase of a bull market can be painful.
 

 

The week ahead: A correction begins

Looking to the week ahead, the market seems to be tracking the seasonal pattern identified by Callum Thomas at Topdown Charts.
 

 

The political turmoil in Washington is likely raising market anxiety over the passage of a debt-ceiling bill in September. Zero Hedge (bless their Apocalyptic hearts) pointed out that the CDS market expects that the US is twice as likely to default than Germany.
 

 

The stock market may be following a similar script as the 2013 debt ceiling experience (chart via Bloomberg). In that case, expect a decline, followed by a rally, and a fall into a final low before the political anxiety ends.
 

 

From a technical perspective, the behavior of the Zweig Breadth Thrust Indicator in 2013 and 2014 may be instructive from a historical viewpoint. The ZBT Indicator recently fell to an oversold reading last week but failed badly in its rally attempt. Should the indicator decline again back to oversold territory, we may see a similar market pattern as 2013 and 2014. During those episodes, the stock market weakened to an initial low [check], saw a failed rally [check], and then sold off again to a much lower panic low [not yet, and ZBT is not oversold yet either].
 

 

Another disturbing sign is the lack of fear that is indicative of capitulation selling. The chart below shows the term structure of the VIX as measured by the ratio of VIX vs. 3-month VIX (VXV). Ratios above 1 indicate an inverted term structure and periods of high market anxiety. Even with the recent sell-off, fear levels have not spike to washout panic levels yet.
 

 

Other breadth metrics are flashing ominous signals. The relative performance of the small cap Russell 2000 (RUT) has broke its Fibonacci retracement support. As well, RUT fell through its 200 day moving average. I interpret these conditions as indications of poor market breadth, which is a signal of further weakness ahead. As well, expect higher than expected choppiness and daily volatility as the market reacts to the headline du jour.
 

 

This chart from Nautilus Capital paints a even more dire picture of downside potential of the small cap Russell 2000.
 

 

If a major correction, such as the 2013 debt ceiling sell-off, is the template to follow, then breadth indicators from Index Indicators are not sufficiently oversold. In that case, expect further near term volatility, along with a series of “bad oversold” readings that culminate in a washout low. We are not there yet.
 

 

My inner investor is neutrally positioned at his investment policy asset mix. My inner trader initiated a small SPX position late last week. He believes that rallies should be sold, or shorted, into in anticipation of further weakness ahead.

Disclosure: Long SPXU

A summer reading list

Posted by Cam Hui -

I will be off for a few days in Oregon, where I will (hopefully) observe the Great American Eclipse of 2017. The regular weekend commentary will continue to be published, but posting will be lighter than usual as internet access is expected to be spotty.

Before I leave, I leave you with a summer reading list. I have been asked in the past to suggest books on how to invest and trade. My answers are a bit more offbeat than the usual recommendations to read Market Wizards, The New Market Wizards, or Fidelity Low-Price Stock PM Joel Tillinghast’s book, Big Money Thinks Small (see Barron’s interview).

The purpose of this site is to teach readers how to fish. No book is going to make you the next Warren Buffett or Paul Tudor Jones. I am going to make you work and expend some effort to catch your fish in your reading.

The basics

Let`s start with the basics. Even before thinking about investing, consider the basics of financial literacy and why you need a financial plan. Here are some blog posts of value, including some old posts of my own.

Freakonomics: Everything you wanted to know about money (but were afraid to ask). Can you correctly answer three basic financial literacy questions? If not, you should start with the 10 things you need to know about investing that fit on an index card.

Humble Student of the Markets: The ABCs of financial planning. Do you have an Investment Policy Statement? If not, how will you know where you are going if you don’t have an objective? Put simply, if the term investment plan sounds overly intimidating, think of it as a savings plan.

Humble Student of the Markets: Investment policy: Not just for pension funds. Once you have figured out where you are going, here is an example from CALPERS on how to create an investment road map.

A Wealth of Common Sense: Thinking through a change in asset allocation. Once you have an investment plan, Ben Carlson goes through on how to create a process on thinking through changes.

A Wealth of Common Sense: Reframing the concept of risk. Risk is everywhere. Carlson puts it very simply, “Don’t over-react to events.”

Corporate strategy and fundamental analysis

For a primer on corporate strategy, there is no better place to start than with Michael Porter. Porter is known as the guru of corporate strategy. His books Competitive Advantage and Competitive Strategy are must-reads and taught in virtually all B-School programs. However, Porter acknowledged that his list of competitive advantages, however, are static advantages and shifts can occur. He evolved by detailing how the shifts occur at a macro level in The Competitive Advantage of Nations.

For investors interested in how disruptions happens, Blue Ocean Strategy represents a newer line of thinking in corporate strategy. Authors W. Chan Kim and Renée Mauborgne argue that companies can succeed by creating “blue oceans” of uncontested market space, as opposed to “red oceans” where competitors fight for dominance, the analogy being that an ocean full of vicious competition turns red with blood. They assert that these strategic moves create a leap in value for the company, its buyers, and its employees while unlocking new demand and making the competition irrelevant. The book presents analytical frameworks and tools to foster an organization’s ability to systematically create and capture blue oceans (via Wikipedia).

Do you want to find undervalued companies and takeover candidates? Try this useful handbook of how companies work financially: Best-Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value. The book is an eye opener and details how companies add shareholder value. More importantly, the Economic Value-Added (EVA) framework details where the cash flow goes in a company. In turn, it lends to an understanding of corporate restructuring process by private equity investors. In the process, investors can discover hidden gems and takeover candidates where private market value exceeds publicly listed value.

Top down analysis

Regular readers know that I have a global big picture macro focus. Here are some important books that have formed my views of how societies develop. Unless you understand the development process, you won’t be able to construct an analytical framework and react properly when shocks like the Great Financial Crisis, or the Asian Crisis occur.

The Competitive Advantage of Nations. Michael Porter lays out how countries go through the stages of development, and the kinds of policies that work at each stage of growth.

The Economy of Cities and Cities and the Wealth of Nations: Principles of Economic Life. Jane Jacobs was a leading researcher in how cities develop. Jacobs’ views on development are very similar to Porter’s, except that her unit of development is the city-state, instead of country, which is Porter’s framework.

Personal journeys in technical analysis

Finally, we get to the good stuff (for traders)! I am going to disappoint many readers here. There is no magic black box to trading. Everyone has to develop their own style. Books like Market Wizards will not instantly make anyone a better trader. Instead, I have suggested to readers that they enroll in the Charter Market Technician program. Start by learning the basic body of knowledge, then develop your own style.

That said, here are some examples of books written by a couple of readers that undertaken their own journey of market analysis.

Mind, Money and Markets: A guide for every investor, trader, and business
Authors Dave Harder, portfolio manager, and Janice Dorn, a psychologist, have put together a book that combines human psychology with market analysis. The book has received positive reviews from the likes of James P. O’Shaughnessy, money manager and author of What Works on Wall Street, Predicting the Markets of Tomorrow, How to Retire Rich, and Invest Like the Best; Robert McTamaney, Former Partner and Head of Trading, Goldman Sachs Asia; Robert Sluymer, Technical Analyst, RBC Capital Markets; and John Gray, Editor, Investors Intelligence.

The Pathway
Author and portfolio manager Ken MacNeal uses a unique technique that uses price momentum for his clients. While I don’t always agree with his conclusions, I respect his approach and insights. Ken describes his book this way:

‘The Pathway – Your money … in a changing world’ tells why Momentum-style investing is the best strategy to navigate the new factors, with unknowable outcomes, affecting financial markets today: the digital revolution, globalization, new Central Bank policies like negative interest rates, Middle East politics, Donald Trump, to name a few. Momentum points you mathematically to the winning sectors and companies while as importantly, avoiding the casualties. You are also given the tools to invest; customized momentum charts of over 500 industry ETFs and the largest companies in them. These are dynamically linked to the internet and update automatically when viewed.

These are just some samples of journeys that others have taken. The CMT program as a good way of learning the basics, and then you can find your own path.
 

 

Regular programming will resume next week. Please keep everything together while I step out (and, please, don’t shoot any Archdukes while I am gone).

Bought for a good time, not a long time

Posted by Cam Hui -

Mid-week market update: Last Friday, subscribers received an email alert indicating that the trading model had flipped from short to long. In my weekend commentary (see “Fire and Fury” is hard) that my inner trader expected “the time horizon of that trade to be not much more than a week.”

I am reminded of the Trooper song, “We’re here for a good time, not a long time” when referring to this trade. On one hand, the relief rally has been impressive. Both my VIX model and Zweig Breadth Thrust Indicator had flashed deeply oversold conditions (see Three bottom spotting techniques for traders). If history is any guide, the duration of the rally should last, at a minimum, until Friday or Monday.

On the other hand, breadth indicators are not showing the bulls any love. The chart below shows negative divergences in credit market risk appetite, % bullish, % above 50 and 200 dma, In particular, the latter three indicators are exhibiting bearish patterns of lower lows and lower highs.
 

 

Looking into September, the stock market faces a number of macro headwinds that could serve to further depress prices.

Debt ceiling default?

Donald Trump’s unusual performance press conference (see CNBC transcript) yesterday is raising the odds of a schism within the Republican Party at precisely the wrong time for the markets.
 

 

The emerging split in the party is threatening Trump`s economic agenda. National Economic Council director Gary Cohn, who is Jewish, is said to be upset.
 

 

Congress has only 12 working days to reach an agreement to raise the debt ceiling when it returns from recess in September. Based on the experience with ACA repeal, it was already going to be difficult enough to reconcile the different wings of the GOP to come to an agreement to raise the debt ceiling. Now Republican Congressional leaders may have to heal a ruptured party, and probably reach out to Democrats to raise the debt ceiling and avoid a Treasury default of its financial obligations.

Watch for political fireworks, brinkmanship, and risk premiums to rise.

A determined Fed

At the same time, despite the bifurcated opinions evident in the FOMC minutes, a recent speech from a member of the Fed triumvirate of Yellen, Fischer, and Dudley has signaled a determination to stay the course on policy normalization. In an AP interview, New York Fed President Bill Dudley stated, “If [the economy] evolves in line with my expectations … I would be in favor of doing another rate hike later this year.”

What about the lack of wage growth and inflation? There are answers for that, too.

A San Francisco Fed study explained the lack of acceleration in wage growth as new entrants to the workforce dragging down overall growth statistics. Wage growth among the fully employed (blue dotted line) is behaving as expected. On the other hand, new entrants (red dotted line) tend to make below average wages.
 

 

In addition, the demographic effects of the retirement of Baby Boomers and young people entering the workforce is also depressing average wages. Overall, the internals of the labor market looks fine.

As for inflation undershoot, Matt Busigin recently highlighted analysis from BLS which concluded that the lack of inflationary acceleration is attributable to a currency effect. Non-tradable inflation has been behaving as expected, but inflation in tradable goods and services has been a drag on headline CPI.
 

 

This chart of the Trade Weighted Dollar (red line, inverted scale), import prices of capital goods (blue line), and CPI (black line) tells the same story. Headline CPI is highly correlated to import prices and inversely correlated to the TWD.
 

 

In short, inflation is on the way. Regardless of whether you believe these two analytical reports or not, the important thing is the Fed believes it. And the Fed is set on a stubborn path of monetary policy normalization. Rates are going to rise at a faster rate than the market consensus. Balance sheet normalization will possibly push up bond yields. As well, expect mortgage rate spreads to see some additional upward pressure as the Fed implements its quantitative tightening program.

Turbulence ahead

Neither of the debt ceiling fight, nor a more aggressive Fed, are fully discounted by the market. The weeks ahead are likely to see risk premiums risk, and the markets take on a risk-off tone.

My inner trader sold out of his long position today and went to 100% cash, as he is about to leave on a week-long vacation. In addition, short-term breadth indicators had moved from an oversold to overbought reading, though overbought markets can get more overbought. The trading model remains at a “buy” ranking, though that could change at any time.
 

 

He only bought for a good time, and not a long time.

“Fire and Fury” is hard

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

War is hard

President Donald Trump has achieved few major legislative victories in his six month presidency, despite the Republican majority in both the Senate and House. One disappointment was the failure of the Republicans to repeal Obamacare because of disagreements between different wings of the GOP. Trump has learned that “healthcare is hard”. Similarly, “tax reform is hard”.

By design, American government was built on a system of checks and balances. While Trump’s legislative initiatives may be held up by Congressional dissension, the President has far fewer constraints in the conduct of trade policy, foreign policy, and military affairs. In particular, he can do more or less what he wants without Congressional oversight when it comes to his role as Commander-in-Chief of the American military.

As the markets are gone risk-off in light of Trump’s “fire and fury” comment about North Korea, I am going to depart from the usual economic and market analysis this week and focus on the question of the constraints on President Trump in a conflict with North Korea. To be sure, the markets are showing a high degree of fear that war could break out on the Korean peninsula. Past scares has seen little reaction from the Korean Won (KRW) or Korean equities. This time, South Korean stocks are tanking, both on an absolute basis and relative to global stocks.
 

 

Investors should relax. As Donald Trump is about to find out, “War is hard too”.

North Korean capabilities

Let’s begin with an assessment of North Korea’s nuclear and missile capabilities. Consider this interview with Siegfried Hecker, former director of Los Alamos National Laboratory. Hecker was the last American scientist to visit North Korea and he has toured their nuclear facilities seven times. Here are his views on the state of DPRK missile technology:

The missile tests on July 4th and 28th were the first that had intercontinental ballistic missile (ICBM) capabilities. They were intentionally launched at lofted angles, most likely so they wouldn’t overfly Japan. According to the Korean Central News Agency, North Korea’s state news outlet, the most recent Hwasong-14 missile reached an altitude of 3,725 kilometers (2,315 miles) and flew a distance of 998 kilometers (620 miles) for 47 minutes before landing in the water off the Korean peninsula’s east coast, close to Japan. If launched on a maximum-range trajectory the missile could travel more than 10,000 kilometers (6,200 miles), giving it the ability to reach much of the US mainland…

I think not yet, but these two tests demonstrate substantial progress and most likely mean they will be able to master the technology in the next year or two. The North Koreans have very cleverly combined various missile stages and rocket engines to get this far, but a reliable, accurate ICBM will require more testing. In addition, it is not clear whether they have sufficiently mastered reentry vehicles, which are needed to house the nuclear warhead on an ICBM. Advanced reentry vehicles and mechanisms to defeat missile defense systems may still be five or so years away. However, make no mistake, North Korea is working in all of these directions.

Even if Kim has perfected the ICBM, another hurdle is to make a nuclear warhead that will not burn up on re-entry and detonate as expected:

I think the warhead is still the least developed part of North Korea’s plans for nuclear ICBMs. It must survive such extreme conditions, and it must detonate above the target by design. It can’t accidentally detonate on launch or burn up during reentry. North Korea likely made some of the key measurements required to define those extreme conditions during the two July tests, but I can’t imagine it has learned enough to confidently make a warhead that is small and light enough and sufficiently robust to survive.

Achieving these goals is very demanding and takes time, particularly because warheads contain materials such as plutonium, highly enriched uranium, high explosives, and the like. These are not your ordinary industrial materials.

His assessment of Kim Jong-un:

I do not think that North Korean leader Kim Jong-un is a madman. We can’t even call him unpredictable any more—he says he will launch missiles, then he does. The madman rhetoric only flames the panic we see in this country because it makes Kim Jong-un appear undeterrable, and I don’t believe that to be the case. He is not suicidal. Nevertheless, it is possible that in his drive to reach the US mainland to achieve a greater balance with the United States, Kim could miscalculate where the line actually is and trigger a response from Washington that could lead to war. The problem is that we know nothing about Kim Jong-un and the military leaders that control his arsenal. It’s time to talk and find out.

In short, the North Koreans don`t have a fully functional ICBM with an operative warhead yet. The Kim regime is a rational actor and therefore can be bargained with.

The speed bumps to war

Bloomberg published an article summarizing the steps that the US takes to launch of her nuclear arsenal, from how POTUS consults with staff and orders the strike, down to what happens with submarine commanders and land-based missile crews. While it is true that no one within the military or civilian establishment can countermand a presidential order to launch, there are nevertheless a number of speed bumps on the way to war.

Here is the first speed bump to war. The city of Seoul is right on the border with North Korea, and its population is roughly 10 million people. North Korea has numerous artillery batteries aimed at the South Korean capital, ready to strike the second hostilities begin. Estimates of civilian loss are in the 100,000 to 200,000 range, which represents a casualty rate that is the same order of magnitude as the Hiroshima or Nagasaki bombs – and that’s done with conventional weaponry.

Newly elected South Korean President Moon Jae-in is known to take a softer line with the North and favor greater dialogue with the Kim regime. Moon is not likely to look kindly on an American plan to strike the North and risk Hiroshima sized civilian casualty counts. For some perspective, that figure represents a multiple of the number of names of American military deaths etched on the Vietnam Memorial after over a decade of war.

Air and missile strikes require South Korean assent, cooperation, and coordination at many levels. If Trump were to move unilaterally, which may or may not be possible in practice, what would that do the American relations with other allies? Would would NATO allies, especially in the Baltic States of Latvia, Estonia, and Lithuania view Trump’s willingness to sacrifice civilians as cannon fodder? How much trust would, say, the Israelis have in American intentions after such a decision? What would the consequences be in the cooperation on anti-terrorist intelligence activities after such an act?

That’s the first speed bump to war. Fire and fury is hard.

Comrade Xi’s veto

In addition, the logistics of a strike is formidable. Since North Korean nuclear sites are well hidden, fortified and dispersed, an American strike would have to hit them all to eliminate the threat of retaliation. In addition, the Pentagon would also target radar, communications, command and control facilities, as well as the numerous artillery batteries in order to suppress the effects of a counter-strike. All of this would have to occur at the same time.

One way to hit all these sites remotely is through the use of nuclear tipped ICBMs or submarine launched nuclear missiles. Herein lies the problem, if you look at the map, Beijing is awfully close to North Korea.

China would have to be informed of a strike well in advance. I have no idea what the state of Chinese satellite technology is, but imagine that you are a Chinese military officer who detected American ICBM launches headed towards North Korea. You may only have a minute or so to decide whether those missiles are headed for Pyongyang or Beijing. In the a latter case, a counter-strike is in order. Does Trump really want to risk a nuclear confrontation with a nuclear superpower with real ICBMs aimed at American cities?
 

 

Imagine that Russia wanted to nuke Canada, and its first target is Toronto, and the Kremlin informed the Americans of their intention. An American officer would similarly have only a minute or two to decide whether the missiles are headed to Toronto, New York City, Buffalo, or Detroit, and act accordingly. I have no idea the state of satellite technology and the trajectory algos, but a estimate error of a degree or two in trajectory could lead to a very different conclusion. Even if the Russians were to invite American observers into their Situation Room(!) to observe the attack, the observers have no way of knowing if they are seeing an actual attack, or a realistic simulation.

Bottom line, the Chinese would have to be informed of a pre-emptive nuclear attack, and not at the last minute. Such an early warning effectively gives Xi Jingping a veto over an American attack. Supposing that the Chinese opposed the attack, and announced that North Korea is under their nuclear umbrella. Does Trump want to risk a nuclear confrontation with the Chinese?

If the strike uses conventional (non-nuclear) weapons, then the US would have to assemble a massive armada of air assets, along with several carrier task forces, and cruise missiles launched from ship and submarine based platforms. The concentration of a fleet of that size in the North Pacific will undoubtedly be noticed by Beijing.

Similarly, this would also give the Chinese a veto over a conventional strike. Indeed, Global Times, which is a semi-official organ of the Chinese Communist Party, stated that China would stay neutral if Kim were to attack first, but would come to the aid of North Korea should the US execute a first strike:

China should also make clear that if North Korea launches missiles that threaten US soil first and the US retaliates, China will stay neutral. If the US and South Korea carry out strikes and try to overthrow the North Korean regime and change the political pattern of the Korean Peninsula, China will prevent them from doing so.

Speed bump number two. Fire and fury can be really hard.

Reading past the rhetoric

Bottom line: Investors need to take a deep breath and read past the rhetoric. Consider Donald Trump’s statement, “North Korea best not make any more threats to the United States. They will be met with fire and fury like the world has never seen.” Investors should be alarmed if that was delivered if that was part of a planned speech and read off a teleprompter. Instead, it was an impromptu remark when he was supposed to be speaking about opioids. Business Insider reported that the Administration sought to walk back the bellicose tone of Trump’s comment on the next day:

“The words were his own,” Sanders said. “The tone and strength of the message were discussed beforehand. They [Gen. Kelly and others] were clear the president was going to respond to North Korea’s threats following the sanctions with a strong message in no uncertain terms.”

Trump’s statement represented a marked escalation in tensions between the two countries, and North Korea retaliated by threatening to strike a US air base in Guam.

Since Tuesday’s events, Trump’s advisers have reportedly sought to diffuse the heated situation, and Tillerson said Americans “should sleep at night” without worrying about the threat of a nuclear war.

In other words, treat the “fire and fury” comment as seriously as Trump’s numerous tweets. As the LA Times pointed out, there have been no active preparations for war:

Despite Trump’s blustery warning of “fire and fury,” which he amplified further in comments to reporters on Thursday, warships are not known to be moving toward the Korean peninsula, a tactic deliberately publicized during previous tense times to signal U.S. resolve. The U.S. has not reinforced troop levels in South Korea, as President Clinton was about to do in 1994 when the two countries did come to the brink of war. U.S. dependents have not been ordered out, nor have U.S. nuclear weapons been sent back in to South Korea.

Instead, Secretary of State Rex Tillerson said Americans should “sleep well at night” and has pressed for talks, albeit with preconditions that the North Koreans so far have not been willing to meet.

As for the North Korean threat to target Guam with missiles, analysis from Stratfor shows that the North Koreans threats are conditional, and there are lots of off ramps in their rhetoric:

North Korea has released specific details of its plan to strike the U.S. territory of Guam. According to comments attributed to Gen. Kim Rak Gyom, commander of the Strategic Force of the Korean People’s Army, the military is drawing up plans for a four-missile salvo of Hwasong-12 intermediate-range ballistic missiles to fly over Japan and land about 17 minutes later 30-40 kilometers (18-25 miles) from the island of Guam. Once prepared, the plan will be presented to North Korean leader Kim Jong Un by mid-August, after which Pyongyang will “keep closely watching the speech and behavior of the US”…

A few things are important to note about the series of North Korean comments. First is that many countries draw up operational plans — it is a standard and necessary practice for militaries, and these are frequently reviewed and updated during times of heightened tensions. Second is that the current comments are clearly conditional threats — something emphasized by Pyongyang’s assertion that the United States “should immediately stop its reckless military provocation against (North Korea) so that the latter would not be forced to make an unavoidable military choice.” Finally, while Pyongyang is very specific in its numbers (“They will fly 3 356.7 km for 1,065 seconds and hit the waters 30 to 40 km away from Guam”), the Hwasong-12 has had only a single successful launch after a series of back-to-back tests earlier this year. It is not clear that this missile is reliable enough for such a demonstration, even if the North felt it was necessary.

“Fire and fury” is hard. Just like healthcare reform, there are too many speed bumps along the way. The likelihood of another Korean war is roughly on par with the Republicans controlled Congress passing a tax reform bill before the end of this year. Risk premiums should be receding very soon and Trump tweets like this that spook the market should be viewed as a buying opportunity.
 

 

Military solutions are NOT fully in place. The US has not evacuated dependents, nor has it reinforced ground forces in South Korea. South Korean forces are not even in a heightened state of alert. Moreover, Stratfor’s assessment of the location of US naval forces do not show any strike forces in the region (CVN=carrier task force, LHA, LHD=marine assault groups).
 

 

The week ahead

The market seems to have sped up my timetable from my last post (see Correction ahead). Short term technical readings have reached sufficiently oversold levels for stock prices to temporarily bottom at these levels. Subscribers received an email alert indicating that the trading model had flipped from short to long for several reasons.

Firstly, I wrote that the Fear and Greed Index had to reach a minimum of 40 for the market to bottom. The current level of 28 is past that level, though the market has bottomed when this index has been much lower.
 

 

Breadth indicators from Index Indicators show that the market is oversold on a short-term (1-2 day) basis.
 

 

Intermediate term (1-2 week time horizon) indicators are also oversold.
 

 

Two of my trading models (see Three bottom spotting techniques for traders) have flashed oversold signals too. The VIX Index is trading above its upper Bollinger Band, indicating an oversold condition as the SPX tests its 50 day moving average. Friday’s doji candle could indicate market indecision at a critical junction, which could indicate a short-term turning point.
 

 

A mean reversion below the upper BB, which has not occurred yet, has historically been a good buy signal.
 

 

As well, the Zweig Breadth Thrust Indicator has reached an oversold condition, which shows that short-term selling pressure is a bit overdone. The last time the ZBT Indicator became oversold, the market staged a one-week rally of about 1%, and proceeded to weaken to new lows. I interpret these conditions to indicate that, at a minimum, a short-term bounce is ahead.
 

 

Incomplete correction

That said, the bigger test for the stock market will occur after an oversold rally. Will it recover and test old highs, or will it make a lower high and weaken?

CNBC reported that JPM derivative analyst Marko Kolanovic, who correctly called the latest volatility spike, is forecasting more weakness in September:

On CNBC’s “Fast Money” on Thursday, Kolanovic said people should expect volatility to rise in September. The historic level is 19, and people should expect VIX to be in the high-teens, low-20s, he said. Right now it is at 16.04.

Congress returns next month and will have to take up the matter of the debt ceiling, the legislative cap on government debt, and a spending bill to avert a government shutdown. Tax reform, the promise of which had lifted markets, seems further off, he said.

Indeed, Business Insider pointed out that Congress has a mere 12 working days to raise the debt ceiling when it returns to work in September and avoid disaster:

Despite potentially dire consequences, there is confidence but no guarantee that factions in Congress, with a variety of competing interests, will be able to come together on a deal to raise the limit.

Currently, the two sides do not appear to be close on a deal.

“There are no talks going on right now,” one senior Democratic congressional aide told Business Insider.

Despite this, there is hope that the two sides will be able to avoid the worst case scenario.

“I think we will avoid a default,” one Republican aide told Business Insider. “I think we might have one attempt that fails and then we have to come back and do something else.”

A similar sentiment was expressed by outside analysts and economists.

“We think most policymakers are aware of the severe political and economic consequences of a failure to raise the debt limit. But September could be an anxious month for market participants,” Nancy Vanden Houten, a senior economist at Oxford Economics, wrote in a note to clients this week. “There are just 12 full days on the legislative calendar, and there is no clear legislative path as of yet for a debt limit hike.”

The NYSE Common stock only McClellan Summation Index is just starting to roll over. This is an intermediate term indicator with a time horizon of 2-4 months. From this technical perspective, it would be difficult to believe that a pullback could be complete in such a short time.
 

 

As well, my Trifecta Bottom Spotting Model (see Three bottom spotting techniques for traders) is not showing the bulls any contrarian love. The term structure of the VIX hasn’t inverted, indicating rampant fear, nor has TRIN surged above 2, indicating capitulation.
 

 

Lastly, this analysis from FactSet shows that, despite the positive sales and EPS surprises, Q2 2017 has seen the worst price reaction to positive earnings surprises in six years. This is a signal that much of the good news is already priced into the market.
 

 

These conditions are suggestive of an oversold rally over the next few days within the context of a longer term corrective impulse that is still incomplete. The market has reached its first critical test, namely a uptrend line on SPX, and breadth support on % bullish and % above the 200 dma. The most likely scenario is to see a bounce into the 2460-2470 region, which sets a lower high, followed by additional weakness in the manner of the sell-off in the summer of 2015.
 

 

Longer term, my base case scenario calls for a correction, followed by a rally to new highs but whose strength is unconfirmed on RSI-14 (top panel). This negative divergence would mark the top of the current market cycle. As the chart below is the DJ Global Index, weakness would be worldwide in scope and signal a synchronized global economic downturn.
 

 

My inner investor is overweight stocks, but he expects to lighten up some positions and re-balance to his investment policy weight in equities on market strength. My inner trader reversed from short to a small speculative long position on Friday. He expects the time horizon of that trade to be not much more than a week.

Disclosure: Long SPXL

Correction ahead

Posted by Cam Hui -

Mid-week market update: Narrow trading ranges are often technical signs of sideways consolidation, followed by further upside. In this case, bulls are likely to be disappointed, as market internals point to a correction ahead.
 

 

I am reiterating my tactically cautious view that has been in place for the last two weeks (see Curb your (bullish) enthusiasm) for the following reasons:

  • All sectors are overbought, indicating an extended condition
  • Negative seasonality
  • Overbought breadth
  • Negative momentum

Overbought sectors

Trade Followers had pointed out over two weeks ago that the market was overbought based on the assessment of Twitter breadth by sector. Such conditions usually resolve themselves with market weakness. The latest observation shows that Twitter breadth continues to be overbought in all sectors.
 

 

Three consecutive weeks of overbought sectors indicate an over-extended market ripe for a pullback. At a minimum, traders should not be pressing their long positions.

Negative seasonality

Another warning of near-term weakness comes from Ned Davis Research. If the history of aggregate seasonality is any guide, then the stock market may see a short-term top very soon.
 

 

Breadth overbought and rolling over

The NYSE Common Stock only McClellan Summation Index is overbought, and it is rolling over. As any chartist knows, the combination of weakness after an overbought condition is generally interpreted as a sell signal.
 

 

Negative momentum in Fear and Greed

Similarly, the Fear and Greed Index reached an overbought level (81) and it has been falling ever since. In the past, negative momentum has not been arrested until this index reaches a minimum level of 40.
 

 

Waiting for the bearish trigger

In short, a number of disparate intermediate term technical indicators a signaling a period of equity price weakness. Chris Dieterich, writing in the WSJ, observed that while the VIX Index remains depressed, internals are signaling rising volatility. As the chart below shows, average single stock realized volatility is rising even as VIX remains flat.
 

 

The failure of VIX to track rising realized individual stock volatility can be explained this way. The upward pressure higher individual stock vol can be offset by a diversification effect. If stocks, industries, and sectors do not move together, then lower correlation between stocks can serve to depress overall index volatility even as individual stock vol rises. In other words, the market has become a market of stocks, where individual issues move in response to their idiosyncratic fundamentals, instead of what happens to the sector or market.

However, should the market of stocks become a stock market, where all stocks move together, then investors should watch for heightened downside risk. Current technical conditions that indicate the market’s technical vulnerability to a correction is a setup for a triggering event that spikes fear, such as nascent fears about a war on the Korean peninsula. Such events tend to see asset correlations rise. At the extreme, correlation all goes to 1 and there is nowhere to hide.

In short, the market is technically vulnerable to an unknown bearish catalyst that will see fear rise and the market of stocks become a stock market. The trigger might even be trivial or totally nonsensical (see The Ebola correction? Oh PUH-LEEZ!). Nevertheless, traders should be aware of the asymmetric risk and reward that lie ahead.

Disclosure: Long SPXU

Can China save the world again?

Posted by Cam Hui -

Japan saved the world in the aftermath of the Crash of 1987. When the panic selling of stocks cascaded around the world, the Nikkei Index bent, but did not break (via the FT):

The Nikkei tumbled 15 per cent on its “Black Tuesday” in the wake of Wall Street’s violent collapse and lost a further 5 per cent before global markets regained their feet in mid-November.

Yet, even though the crash knocked $500bn off corporate Japan’s market value, Tokyo’s fall was mild compared with those in the US, Europe and elsewhere in Asia – where some bourses plunged as much as 40 per cent. By the spring of 1988 the Nikkei was back up to a 15-year high, from which it would continue soaring for another 20 months.

“I don’t remember anybody in the office panicking,” Soichiro Monji says of the turbulent weeks that followed the October crash. Mr Monji, then a dealer at Daiwa Securities, Japan’s second-biggest brokerage house, now plans equity strategy at the group’s asset management arm.

“The economy was in good shape and the stock market had momentum. We thought, ‘There must be days like this sometimes’.”

Daiwa and Japan’s other big brokers were in any case sitting tight, having been ordered by their regulators in the Finance Ministry not to sell into the panic – an act of intervention that “would be inconceivable today”, notes Mr Monji.

Kiichi Miyazawa, the finance minister and later prime minister, who died earlier this year, told all who would listen that calm would soon return.

The government’s tactics helped stem the Nikkei’s fall, although a rosy growth outlook, low interest rates and a rising yen probably played a bigger role. The market’s structure helped: two-thirds of all company shares were held not by profit-seeking investors but by allied companies seeking to cement business ties.

In many ways, the panic was arrested in Japan and saved the world, but it paid a price later in that decade when the Japanese market collapsed and began the Lost Decades.

Fast forward to the Great Financial Crisis of 2008. The Chinese authorities ordered the banks to lend, and local authorities to spend. In many ways, China saved the world. As the American economy starts to show evidence of late cycle behavior, a recession is sure to follow some time in the future. Can China save the world again?

Vulnerable China

China today is vastly different from the China of 2008. This chart from Kevin Smith of Crestat shows how much more leverage there is in the Chinese financial system today compared to 2008.
 

 

The debt bubble is not only isolated just in China, but it has migrated to other countries.
 

 

Daniel Moss, writing at Bloomberg Views, recently asked the chilling question, “Global growth depends on China’s debt. Can it muddle through? The world should hope so.”

There are others ways that China is more vulnerable to a shock than it was in 2008. A SCMP article indicated that, despite the multi-decade boom and export miracle, Chinese firms operate on extremely thin margins, which makes them vulnerable to external shocks such as the global effects of rising US interest rates:

Chinese business owners say their profit margins have been “squeezed to the extreme” by rising rent and labour costs – and 80 per cent want taxes and levies cut to ease their burden.

That’s according to the results of a nationwide survey of 14,709 companies released on Tuesday, relating to the three years from 2014, by the Chinese Academy of Fiscal Sciences, a think tank affiliated with the Ministry of Finance.

Their sentiments reflect limited progress in the push to “cut costs for business” – one of the biggest economic goals under President Xi Jinping, along with reducing excess capacity and cutting debt levels.

Mitigating factors

Despite these concerns, there are a number of mitigating factors. First, most of the debt is held domestically, and therefore any crisis can be largely contained within Chinese borders. If there is a crisis, it won’t be your father’s emerging market debt crisis.
 

 

The latest update of Chinese GDP shows no signs of slowing growth. As well, Fathom Consulting’s projections of Q3 GDP shows a growth acceleration to levels well above the market consensus.
 

 

Moreover, China has been successfully rebalancing its economy, from credit driven infrastructure to a more sustainable domestic household driven growth.
 

 

As good as it gets?

That’s the good news. Here is the bad news. Business Insider reported that China analyst Charlene Chu is calling for a slowdown that begins late this year:

In her latest note to clients, she warns that the “Chinese medicine” that seems to be stabilizing the country’s financial sector for now — a “prescription of less excessive behaviour and a rebalancing of energy” — isn’t going to work forever

In fact she sees its usefulness fading fast. That’s because as this medicine takes effect, China’s monster credit machine must slow, and that will start to show in the economy as early as 2018.

“Our Autono credit impulse points to GDP growth peaking in 3Q17 at 10-10.5% (rolling 4-quarter yoy),” she wrote in her note.”This is a high figure, and there is room for deceleration before it starts to feel painful. We expect growth in 2018 will be under pressure, as a negative credit impulse by year-end begins to pass through to economic activity. Although new credit based on the official TSF has been strong this year, we are anticipating 12% less new credit in 2017 versus 2016 based on our Autono-adjusted TSF [total social financing].”

Expect that slow down to be felt the world over. China led the rebound in global banking activity in early 2017, according to recent data from the Bank of International Settlements, and without its demand global GDP will undoubtedly take a hit.

Instead of become a global savior, China is likely to be a drag on global growth in 2018. Analysis independent of Chu from Macrobond agrees with that assessment. Chinese credit growth is slowing, and it’s a leading indicator of GDP growth.
 

 

What deleveraging?

In the latest series of reforms, Beijing has made a lot of noise about creating sustainable growth through deleveraging. But Christopher Balding pointed out that while a lot of debt has been reshuffled around, there has been no actual deleveraging:

In reality, though, there’s been no deleveraging to speak of. New total social financing grew by 14.5 percent in the first half of 2017, up from 10.8 percent in the same period last year and rising roughly 3 percent faster than nominal gross domestic product. It’s true that measures such as credit intensity and the stock of total social financing to GDP have flattened or declined somewhat. But this was due to a temporary surge in commodity prices, now receding quickly.

China isn’t so much deleveraging as changing who borrows. Loans to non-financial corporations, for instance, have in fact been scaled back: They’re up a relatively modest 8 percent. But total loans to households are up 24 percent. “Portfolio investment” — code for bank holdings of wealth-management products — is up 18 percent. Combined, household debt and portfolio investment are now 13 percent larger than non-financial corporate debt, and growing by 20 percent on an annual basis. These aren’t small numbers.

Just as worrisome is where this debt is flowing. Wealth-management firms are routinely encouraged to push up commodity prices to drive growth. Total capital inflows from WMPs into commodities rose by 772 percent between January 2015 and June of this year. By tonnage, iron-ore futures trading on July 31 exceeded China’s entire iron-ore output for all of 2016. Given this flood of capital, it’s not surprising that iron-ore future prices are up 87 percent since December 2015. The government is trying to solve its overcapacity problem by having investors and banks prop up prices — even if output and consumption are stable or declining. Relying on triple-digit gains in commodities isn’t a good way to promote stability or sustainable growth.

Another concern is that the mythically prudent Chinese household is no longer quite so prudent. Total household debt now exceeds 100 percent of income. Most of this debt is flowing into real estate. Although gains in so-called tier-one cities have subsided — from year-over-year increases of 30 percent in late 2016 to 10 percent now — prices in tier-three cities are stirring, up more than 8 percent from a year ago and still rising.

In other words, China is spreading the debt burden from corporations to households. Although this might forestall a domino effect should one of China’s big companies start teetering, it’s far from a long-term solution.

Balding’s concerns about rising household debt could be one way that China is kicking the can down the road. Andrew Brown of Shorevest Investment Partners, writing in SCMP, recently asked if the Chinese consumer market might become the next debt bubble:

The only segment left that is not over-leveraged is the Chinese consumer market. In fact, household leverage is extremely low. Household debt-to-GDP ratio is only 40 per cent, among the lowest in the world. For comparison, the US is at 79 per cent while Australia is at 124 per cent.

The consumer market has the capacity to service higher debt. Household debt-to-disposable income is 56 per cent, which is also among the lowest in the world. For context, the US peaked at 123 per cent, and Australia is now at a worrying 168 per cent.

China could double its household debt ratios and still be “average” in a global context. Admittedly, this is a multi-year process, but with an US$11 trillion economy, this implies an additional US$4 trillion in purchasing power in today’s terms.

This is a staggering number and has powerful global implications. For context, the fourth-largest economy in the world is Germany with a GDP of US$3.5 trillion.
We expect the initial mode of consumer finance to be point-of-sale vendor financing, rather than a rapid increase in residential mortgages, given the concerning rise in residential property prices.

As such, the biggest near-term beneficiaries from a leveraged consumption boom are likely the providers of this credit in the form of consumer credit companies, and the providers of “white goods” such as household appliances and consumer electronics, as well as the entire global supply chain to manufacture these products.

Other areas will include education, travel and leisure, cosmetics, etc. The providers of consumer data analytics will be in high demand to develop infrastructure.

Over the medium term, this should be good for the stock market, as same-store sales growth begins to accelerate at consumption-related companies, and then financial intermediaries such as brokers and asset managers will benefit as the positive wealth effect kicks in.

Could this be how China saves the world in the next global downturn? The Chinese consumer steps into the breach?

What rebalancing?

While that scenario is within the realm of possibility, implementation of such an initiative is far more difficult than the shock and awe stimulus in the wake of the Great Financial Crisis. In a command economy, Beijing could order government owned banks to lend, and local authorities to spend. It’s far more difficult to command individual consumers to spend. How do you enforce or incentivize such a edict to buy appliances, to travel, or to buy things?

Moreover, there are signs that much of the so-called rebalancing may be a mirage. Tom Orlik recently pointed out that Chinese infrastructure spending has rebounded to a post-crisis high. Is this what rebalancing looks like?
 

 

Tactically, a couple of pairs trades give us a real-time market based indication of how well the Chinese economy is rebalancing, and the verdict is decidedly mixed. The black line in the chart below shows a pair consisting a long position in the Golden Dragon China (PGJ), which is a tech heavy ETF with tilted towards the consumer such as Baidu and JD.com, and a short position in iShares China (FXI), which is heavily weighted in finance. The green line shows a pair with a long position in GlobalX China Consumer ETF (CHIQ) against a short position in GlobalX China Finance ETF (CHIX).
 

 

While these two pairs tend to move in lockstep, they have diverged recently. they have diverged recently. While these divergences have occurred in the past, I interpret these conditions as an uncertain verdict on how well the Chinese economy is rebalancing.

In short, China’s capacity to cushion the global effects of the next economic downturn has been greatly compromised by its debt expansion. While it is theoretically possible that the Chinese consumer could step up and “save the world” in the next recession, the chances of such a scenario is slim at best.

Will overheating spoil the market rally?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Risk-on
  • Trading model: Bearish

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

A late cycle market

Bloomberg recently published an article, Why a little economic overheating won’t spoil the market rally, that featured the views of Nomura strategist Kevin Gaynor:

The “Goldilocks” rally still has juice.

That perfect environment to sustain broad market gains — when global growth is fast enough to lift corporate profits, but tame enough to keep inflation muted — should be in effect for at least another 12 months, according to Kevin Gaynor, the head of international economics at Nomura Holdings Inc.

As the business cycle reaches its climax, European stocks, high-yield bonds and emerging-market credit have the potential to catch up with valuations notched in the halcyon days before the 2008 financial crisis, he said.

“We could get a more extended market rally,” Gaynor said in an interview. “When labor markets are tight and economic growth operates above trend, you see corporate profitability dropping, and that’s one reason to get bearish. For now, we aren’t seeing that type of margin pressure.”

I agree 100%. The nowcast shows that initial jobless claims, which has shown a remarkable inverse correlation with stock prices, is pointing to a robust economy.
 

 

For investors and traders, the trick is to spot the turning point. Here are the bull and bear cases for stock prices.

The bull case

Arguably, the stock market is in a sweet spot. Rates are low, and rising very slowly at a controlled pace. Growth is positive and non-inflationary. Core PCE, which is the Fed’s preferred inflation metric, remains tame.
 

 

The deceleration in inflation rates is not just confined to the US, but it’s a global phenomena.
 

 

The latest update from FactSet shows that Q3 Earnings Season is showing blowout results, and forward 12-month EPS continues to get revised upwards, indicating Street optimism.
 

 

In short, the stock market is enjoying Goldilocks environment (not too hot, not too cold) growth, low rates, and low inflation, which is likely to restrain central bankers from being overly aggressive in raising rates. What more could an equity investor ask for?

Inflation pressure on the horizon

The bad news is the series of negative inflation surprises may be temporary. There are signs of nascent inflationary pressures from both the manufacturing and services sectors, which will force the Fed to raise rates in order to cool the overheating economy.

IHS Markit found that delivery times are getting rising (falling global manufacturing PMI delivery times = longer deliveries), and these supply chain pressures are indicative of capacity constraints that push up input prices.
 

 

As well, the labor market is showing signs of tightness. The Conference Board spread between “jobs plentiful” and “jobs hard to get” is rising, which is a signal of rising labor supply capacity constraints. This measure has historically led the Atlanta Fed’s wage growth measure by several months.
 

 

In addition the headline Non-Farm Payroll figure in the Employment Report, one closely watched number is Average Hourly Earnings (AHE) as a sign of wage inflation, which impacts Fed policy. While AHE remained stable at 2.5%, another way of measuring compensation is to calculate total pay using AHE X Hours Worked. As the chart below shows, Manufacturing Total Pay (blue line) is a more volatile data series compared to AHE (red line), but YoY change in Total Pay has begun to accelerate upwards.
 

 

Even before any of these nascent inflation pressures appear, Tim Duy’s interpretation indicates that the Fed is set on its normalization path because the risks of falling behind the curve are too high:

The path laid out by the Federal Reserve at the beginning of the year for three interest-rate increases plus the start of reducing its $4.5 trillion balance sheet looks shaky due to the slowdown in inflation. There’s no question that the Fed is nervous about the persistent inflation shortfall. Chair Janet Yellen made note of the issue during her congressional testimony earlier this month.

That said, the Fed will balance the inflation data against the broader economic backdrop of ongoing job growth and easier financial conditions. If the latter two trends continue, policy makers will be hard-pressed to rein in existing rate hike plans even if inflation continues to fall short of their forecasts. The traditionalists at the Fed, including Yellen, retain their fundamental Phillips curve framework. They think it is only a matter of time before the Phillips curve is proved true and sends inflation higher, especially if monthly job growth remains well above the 100,000 level. They do not want to find themselves well below their estimate of the neutral interest rate should inflation accelerate.

Moreover, they have reason to retain faith in their fundamental forecast that inflation will return to target given that financial conditions have eased, not tightened, in response to the Fed’s four rate hikes in this cycle.

The CME‘s implied market expectations of a December rate hike stands at just under 50%, which sounds low to me. An upward adjustment of rate hike probability would likely spook stock and bond prices.
 

 

A possible policy mistake

That said, the Fed’s normalization path is raising the risk of a policy mistake. Current market expectations call for the Fed to begin reducing the size of its balance sheet in September, followed by a possible December rate hike. CNBC highlighted analysis by Michael Darda of MKM Partners of the historical risks of balance sheet reduction. Five of the past six episodes have ended in recession:

Over the past several months, the Fed has prepared markets for the upcoming effort to reduce the $4.5 trillion it currently holds of mostly Treasurys and mortgage-backed securities. The balance sheet ballooned as the Fed sought to stimulate the economy out of its financial crisis morass.

The Fed has embarked on six such reduction efforts in the past — in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000.

Of those episodes, five ended in recession, according to research from Michael Darda, chief economist and market strategist at MKM Partners. The balance sheet trend mirrors what has happened much of the time when the Fed has tried to raise rates over a prolonged period of time, with 10 of the last 13 tightening cycles ending in recession.

Central bankers are in uncharted waters. In the past, real money supply growth has turned negative ahead of previous recessions, However, past episodes of negative money growth have also coincided with rising M1 velocity (Velocity= GDP/M1). The current expansion cycle has been characterized by relentless falling M1 velocity, which is an indication of a liquidity trap. The Fed can push money into the economy by raising M1 and M2, but the liquidity injections are not showing the same effects as they have in past cycles.
 

 

Central bankers are about to embark on a grand monetary experiment. What happens when they normalize monetary policy even as velocity falls?

A weakening consumer?

Even as the Fed continues on its normalization path, there are signs that the economy is weakening. New Deal democrat recently fretted about softness in consumer durable, namely autos and housing. Auto sales seems to have peaked for this cycle, though arguably some of the decline could be attributable to the “sharing economy” and the rise of services like Uber.
 

 

Housing, which represents a significant consumer durable good and a highly cyclical part of the economy, appeared to have peaked as well.
 

 

At the same time, FT Alphaville raised some questions about the resilience of consumer spending. To be sure, real retail sales remain on a growth path today and it has not peaked yet, which can be an early warning of recessionary downturns.
 

 

The internals, however, are not as positive. Incomes are not keeping up with consumption, which indicates that consumers are borrowing to maintain their spending.
 

 

This interpretation is confirmed by the falling savings rate.
 

 

Is it any wonder why the risks of a policy mistake are rising?

Spotting the inflection point

The big question for investors is, “Where is the inflection point? When should investors start to get cautious about stocks?” An analysis from EconoPic Data is highly instructive. Shiller CAPE is current trading at above 30, which is historically high, and therefore the market faces valuation headwinds as it tries to advance.
 

 

Further analysis shows that, as long as CAPE is rising, which indicates multiple expansion, returns have held up well. But investors should get out of the way when CAPE reverses course, which is reflective of multiple contraction, or negative price momentum.
 

 

For now, the nowcast of the economy and stock market remains strong. The latest Employment Report shows that temporary jobs, which has led Non-Farm Payroll in the last two cycles, shows no signs of peaking.
 

 

The Citigroup Economic Surprise Index is recovering from a very low extreme, indicating that macro data is starting to improve.
 

 

As long as these indicators, along with initial jobless claims, real retail sales, and forward EPS revisions are positive, the risk of a major stock market downturn is low. While the market may appear to be tactically over-extended, any corrective action should be seen as a buying opportunity.

The week ahead

Looking to the week ahead, the SPX remains in a narrow range but I stand by my mid-week remarks (see Bullish exhaustion). The latest analysis from FactSet confirms the analysis by BAML in my Bullish exhaustion post. The market is not rewarding earnings beats but punishing misses:

Companies that have reported upside earnings surprises for Q2 2017 have seen an average price decrease of -0.1% two days before the earnings release through two days after the earnings. This percentage decrease is well below the 5-year average price increase of +1.4% during this same window for companies reporting upside earnings surprises.

Companies that have reported downside earnings surprises for Q2 2017 have seen an average price decrease of -2.6% two days before the earnings release through two days after the earnings. This percentage decrease is slightly higher than the 5-year average price decrease of -2.4% during this same window for companies reporting downside earnings surprises.

The inability of stock prices to rally on good news is a signal that the path of least resistance for stock prices is down. We just need a negative catalyst to trigger a correction.

Jeff Hirsch of Almanac Trader also highlighted an ominous Dow Theory Sell Signal that the market flashed on July 26:

Lack of confirmation or synergy between the two oldest U.S. market benchmarks triggered a Dow Theory Sell Signal July 26. When the backbone of our economy that transports goods across the nation does not perform well it is an indication that there is underlying economic woe. It is not always right and like everything else it is subject to interpretation, but it does have a solid track record and is worth heeding here as our other indicators are pointing to a summer selloff around the corner…

These Dow Theory Sell signals take some time to pan out, but the recent history suggests that usual selloff and low following a Dow Theory sell signal may be on its way shortly. After experiencing a typically strong post-election July VIX is still low but turning higher. Sentiment is high and stocks are higher, so the time seems nigh for the August-September slide.

 

Negative breadth divergences are also flashing warning signals. Both the % bullish and % above the 200 dma are falling, while the market has been flat. The last two times this happened, the market resolved itself in corrections.
 

 

My inner investor remains constructive on stock prices. Recession odds remain low, and therefore so is downside risk from a major bear market. My inner trader is positioned for a corrective episode of unknown magnitude. He is just waiting for the bearish catalyst to surface.

Disclosure: Long SPXU

The things you don’t see at market bottoms: No fear 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.

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of “thing you don’t see at market bottoms”. Past editions of this series include:

Numerous readings indicate that any semblance of investor fear has gone out the window. An update of the Euphoriameter.from Callum Thomas shows that it has reached a new recovery high for this market cycle.
 

 

There are plenty of other examples of fearlessness.

The new money market

Let’s begin with a self-explanatory tweet from Charlie Bilello.
 

 

[Shudder]

There is also this *ahem* enticing ad that came across my desk.
 

 

[Double shudder]

A kid’s market

Mark Hulbert recently wrote that we are now in a “kid’s market”, where the “kids” with no fear are making all the money:

The concept of a “kids market” was introduced by Adam Smith, the pseudonymous author, in his classic book from the late 1960s entitled “The Money Game.” He used that phrase to refer to an investment environment in which the advisers and traders making the most money are those too young to remember the last bear market.

That would certainly appear to be the case today. The 2007-2009 financial crisis and bear market is now more than eight years in the past. Anyone younger than in their mid-30s probably wasn’t even out of college or graduate school during that bear market, and therefore has little or no direct investment experience of a severe bear market. Their attitudes toward downside risk are entirely different from those of us who lived through that crisis, the bursting of the internet bubble, or other bloodbaths of investment history…

Consider the investment newsletters I monitor with the best risk-adjusted returns over the trailing 30 years (Investment Quality Trends, edited by Kelley Wright) and trailing 20 years (The Buyback Letter, edited by David Fried). Both of these ranking periods are long enough to encompass not just one but at least two severe bear markets. And neither of these top performers is currently recommending Amazon, Facebook or Netflix.

To be sure, kids markets can remain that way for some time. Eventually, however, the kids will encounter a bear market and, in the process, become older and wiser like the rest of us.

As another example of the “kids’ market”, Marketwatch reported on a survey indicating that millennials are far more bullish on equities than their elders:

According to a quarterly investment survey from E*Trade Financial, nearly a third of millennial investors—defined as ones between the ages of 25 and 34—are planning to move out of cash and into new positions over the coming six months. By comparison, only 19% of Generation X investors (aged 35-54) are planning such a change to their portfolio, while 9% of investors above the age of 55 are planning to buy in.

In addition, AAII’s asset allocation survey, which reports on what AAII members are actually doing in their portfolio rather than the volatile weekly sentiment survey, shows that cash allocations have reached a 17 1/2 year low, or the NASDAQ top (chart via Dana Lyons). To be sure, the survey also reported that equity allocations edged down from a 12-year high, but readings are still ahead of levels seen at the start of the Great Financial Crisis.
 

 

Booming retail “client engagement”

The rise in retail investor appetite is exemplified by the comments that accompanied the financial results from Schwab, indicating that account openings is the strongest in 17 years, or since the NASDAQ market top:

Strong client engagement and demand for our contemporary approach to wealth management have led to business momentum that ranks among the most powerful in Schwab’s history. Equity markets touched all-time highs during the second quarter, volatility remained largely contained, short-term interest rates rose further, and clients benefited from the full extent of the strategic pricing moves we announced in February. Against this backdrop, clients opened more than 350,000 new brokerage accounts during the second quarter, bringing year-to-date new accounts to 719,000—up 34% from a year ago and our strongest first half total in seventeen years.

These comments are consistent with my previous report about the comments from T-D Ameritrade CEO Tim Hockey about “investor engagement” and “asset gathering”:

Investor engagement has been resilient. High trading volumes despite ongoing volatility. We’re seeing very, very healthy trends and new funded account growth, and asset inflows from both new and existing accounts. Asset gathering itself is a quarterly record, and we’ve already met our previous fiscal year record for net new assets with nearly a quarter yet to go.

The T-D Ameritrade Investor Movement Index is at an all-time high since its inception in 2010.
 

 

Surging Street employment

As a result of the retail boom, securities industry employment has risen to a new high (via Sentiment Trader), despite the puzzlement voiced by Josh Brown about downsizing on Wall Street.
 

 

No fear in credit markets

Bloomberg recently pointed out that yield spreads in credit markets have become so tight that the rule of thumb of a bond coupon falling below a company`s leverage is being violated:

Bond buyers have a rule of thumb that says be wary when the coupon on a new debt sale slips below the issuer’s leverage. It’s an indicator that investors aren’t being paid enough for the risk they’re taking on.

This adage is being tested anew amid a bubble-like market, as issuers wear down buyers with deals that they’d spurn in almost any other era. One recent example is July’s $500 million sale from HD Supply Waterworks. The water and wastewater company priced the debt beneath its 6.3 level of leverage, which measures debt as a multiple of earnings.

Not only did the sale go through, but demand allowed HD Supply to boost it from $475 million and pay even less interest than initially asked, finishing at 6.125 percent.

In a recent interview, Howard Marks cited the Argentina 100-year bond issue (see my previous comment, Things you don’t see at market bottoms, 23-Jun-2017), as well as the Netflix 10-year bond with a 3.625% coupon as signs of market froth (click this link if the video is not visible). Marks expressed concern about the maximum upside of 3.625% for a growthy company like Netflix,
 

 

As a frame of reference, the latest statistics from Morningstar shows the NFLX interest coverage to be 2.8, and a debt to equity ratio of 5.3 – well above the 3.625% coupon.
 

 

That’s enough. I am exhausted and don’t have time to talk to you anymore, I am heading back into the party and to trade the new 5x leverage ETPs.