Can the melt-up continue?

Posted by Cam Hui -

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

 

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

 

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

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

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

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

Is this the end of the momentum rally?

Making sense of the China announcement

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

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

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

 

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

 

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

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

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

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

Momentum lives!

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

 

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

Disclosure: Long SPXL

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

Posted by Cam Hui -

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

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

I reiterate my belief that this is not the top of the market, but investors should be aware of the risks where sentiment is getting increasingly frothy. Jeremy Grantham of GMO recently penned an essay calling for a market melt-up. Investors should also remember Bob Farrell’s Rule #4: “When markets go parabolic, they rise further than you think, but they don’t correct by going sideways.”

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

 

Retail bullish stampede

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

 

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

 

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

 

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

 

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

Retail bullishness + Leverage = ???

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

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

 

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

 

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

 

Hedge funds pile in

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

 

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

 

Feed the ducks…

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

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

 

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

Don’t get too bearish just yet

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

 

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

Could a Trump trade war spark a bear market?

Posted by Cam Hui -

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

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

 

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

The latest signals of each model are as follows:

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

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

Staying ahead of the curve

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

What’s next?

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

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

  • Those advisers recognize that the day of reckoning will come in 2018, regardless of whether economic adviser Gary Cohn and Secretary of State Rex Tillerson — who advocated restraint — stay or go.
  • Cohn and Treasury Secretary Steve Mnuchin successfully persuaded Trump not to do anything rash while tax reform was being negotiated.
  • Trump also saw the advantage of trying to use that as leverage with China to get help on North Korea. He said yesterday in an interview with the N.Y Times: “China’s hurting us very badly on trade, but I have been soft on China because the only thing more important to me than trade is war. O.K.?”
  • And he tweeted yesterday, in response to Chinese ships secretly delivering oil to North Korea: “Caught RED HANDED – very disappointed that China is allowing oil to go into North Korea. There will never be a friendly solution to the North Korea problem if this continues to happen!”

 

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

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

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

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

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

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

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

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

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

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

Modeling a trade war

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

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

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

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

 

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

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

 

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

Trade war second order effects

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

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

 

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

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

 

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

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

 

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

 

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

 

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

What to watch for

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

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

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

 

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

 

The weeks ahead: Momentum, momentum!

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

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

 

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

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

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

A frothy rally, but…

Posted by Cam Hui -

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

 

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

 

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

 

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

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

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

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

Frothy sentiment

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

 

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

 

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

 

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

 

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

 

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

Negative divergences

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

 

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

 

…and the small cap Russell 2000.
 

 

Pay attention to risk management

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

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

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

 

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

 

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

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

Disclosure: Long SPXL

My 2017 report card

Posted by Cam Hui -

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

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

 

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

The latest signals of each model are as follows:

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

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

Marking my 2017 calls to market

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

 

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

 

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

My inner investor: Never bearish

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

 

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

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

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

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

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

 

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

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

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

My inner trader: Who needs market timing?

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

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

 

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

  1. When and what do you buy and sell?
  2. How much do you buy and sell?
  3. How do you time the trade?

 

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

The return calculations shown are based on the following assumptions:

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

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

 

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

 

The history of the trading signals are as follows:

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

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

 

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

 

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

 

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

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

The weeks ahead: As good as it gets?

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

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

 

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

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

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

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

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

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

Disclosure: Long SPXL

What you should and shouldn’t worry about in 2018

Posted by Cam Hui -

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

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

 

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

 

Fed balance sheet effects on housing

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

 

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

 

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

Worry about a more hawkish Fed

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

 

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

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

 

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

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

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

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

Translation: It could mean even higher interest rates.

The effects of higher rates

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

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

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

 

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

 

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

 

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

 

A possible false sell signal from junk bonds

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

 

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

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

 

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

A sector review reveals animal spirits at work

Posted by Cam Hui -

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

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

 

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

The latest signals of each model are as follows:

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

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

Here comes the animal spirits

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

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

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

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

 

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

 

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

A sector review

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

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

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

 

Technology: The momentum play

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

 

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

Financials: Breaking out, but…

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

 

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

Industrials: A capex revival?

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

 

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

Materials: Emerging leadership

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

 

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

 

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

 

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

Energy: An inflation hedge laggard

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

 

Consumer Discretionary: Tame wage growth a drag?

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

 

Defensive sectors: Needs more time

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

 

 

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

Interest sensitive sectors: Avoid

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

 

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

 

A likely melt-up ahead

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

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

 

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

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

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

The week ahead

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL, TNA

An update on gold (but not frankincense or myrrh)

Posted by Cam Hui -

Mid-week market update: There is not much that can be said about the stock market that I have not already said. The small cap seasonal Santa Claus rally that I wrote about appears to be proceeding as expected, though the tape is thin and most professionals have shut down their books for the year.
 

 

Next week is Christmas. It is said that the three kings visited the infant Christ with gifts of gold, frankincense and myrrh. While there is no active and liquid market for the latter two gifts, gold is still traded and an update on the outlook for gold would be timely.

Gold is getting intriguing. Analysis from Nautilus Research indicates that we are entering a period of positive seasonality for gold.
 

 

At the same time, gold stocks are testing a key relative downtrend line. Should it rally further, it would be a signal of possible further future strength.
 

 

Final flush ahead?

However, sentiment models suggest that it may be a little too early to wholeheartedly commit to the long side in this sector. The top panel in the chart below depicts the long-term performance of gold (dark red line) and gold stocks (black, GDX). Both have violated an uptrend line, indicating that they may need time to rest and consolidate before a bull phase can be sustainable. The bottom two panels show that breadth indicators are nearly washout levels, but not just yet.
 

 

The silver/gold ratio measures the performance of high beta precious metal silver to gold. Historically, readings of 0.0125 or less have signaled investor capitulation on gold. Similarly, the % bullish indicator has also been good signals of buyable bottoms when it falls to 15% of less. We are not there yet. In fact, when we zoom into a shorter time frame of the above chart, we can see that the silver/gold ratio rising, which may be an indication that a final sell-off is needed before contrarians can buy at the “panic bottom”.
 

 

Indeed, the latest update of the Commitment of Traders report from Hedgopia confirms that large speculators (read: hedge funds) are selling gold en mass, but readings are not consistent with washout bottoms (annotations are mine).
 

 

Cross-asset market implications

As gold is inversely correlated to the US Dollar, analysis from Hedgopia also indicates a crowded short in the USD, which should provide a bullish underpinning for a Dollar rally.
 

 

This analysis suggests that the USD has room to rally in the short-term. The USD Index is testing a key support level here, if it holds, then watch for to possibly test resistance at the 95 level in the weeks ahead.
 

 

However, USD bulls shouldn’t overstay their long trade. The trend of synchronized global upturn is providing a powerful tailwind for the reflation trade. The copper/gold ratio (red line), which is a global cyclical indicator, is rising, and it is correlated with the stock/bond ratio, which is a risk appetite indicator.
 

 

In conclusion, gold bulls may want to take a partial long position, but don`t go all in just yet. Stay tuned.

Five steps, where’s the stumble?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

What happened to 3 steps and a stumble?

As expected, the Federal Reserve raised rates by a quarter point last week and re-affirmed its dot-plot projection of three more quarter-point hikes next year. What happened to “three steps and a stumble”?

The old Wall Street trader’s adage of “three steps and a stumble” refers to the stock market’s reaction to Fed rate hike cycles. At first, stock prices don’t react to the Fed raising rates, but eventually the market succumbs to the economic cooling effects of monetary policy, and a bear market usually begins after three rate hikes. Hence, “three and a stumble”. The chart below from Ned Davis Research shows the effects of this rule on the Dow. Historically, the DJIA has declined a median of -17.9% from sell signals to NDR market bottoms.
 

 

Historically, the sell signals have been fairly prescient, though sometime early. This expansion cycle has been unusual in that the Fed began raising rates two years ago. We have seen five consecutive quarter-point rate hikes, so where’s the stumble?

When is the next recession?

Another way of framing the question of timing the next market stumble is, “When is the next recession?” Historically, recessions have been bull market killers, and they are caused by Fed tightening.
 

 

Fed watcher Tim Duy observed that there is recession embedded in the Fed’s latest forecast:

There is a recession in the Federal Reserve’s forecast. You won’t see it in the growth projection, but it’s staring you in the face in the unemployment forecast. And it’s a doozy.

The Fed’s Summary of Economic Projections, or SEP, released at the end of this week’s Federal Open Market Committee meeting, projects an unemployment rate of 3.9 percent at the end of 2018. This is well below the Fed’s current estimate of the longer-run rate of unemployment, equivalent to NAIRU, or the non-accelerating inflation rate of unemployment, which remained at 4.6 percent.

Sustained unemployment rates below NAIRU would, in the Fed’s framework, eventually trigger above-target inflation. To counter these pressures, the Fed anticipates tighter policy to guide the unemployment rate back to 4.6 percent. This is evident in the SEP. Central bankers now project a benchmark federal funds rate of 3.1 percent by the end of 2020, compared with a neutral (or longer-run) rate of 2.8 percent. Monetary policy thus will turn from accommodative to slightly restrictive in the next couple of years.

The somewhat restrictive policy tempers economic activity sufficiently to nudge the unemployment rate back up to 4.6 percent. But therein lies the problem in this forecast. There is no evidence that the Fed can nudge the unemployment rate up 0.7 percentage points (from the projected low of 3.9 percent to 4.6 percent) without more aggressive rate increases that would trigger a recession.

In other words, the Fed is projecting that its own actions would cause a recession some time in the future. Historically, it has not been able to raise the unemployment rate by 0.7% without inducing an economic slowdown.

Timing the slowdown

When will the slowdown take place? A review of current monetary conditions show that financial conditions are still easy, so there is nothing to worry about for the immediate future.
 

 

Despite the general lack of financial stress, the Fed`s program of policy normalization is slowing down money supply growth. Real money supply growth, whether M1 or M2, has turned negative ahead of past recessions. In this cycle, real M2 growth is decelerating quickly, and could turn negative in Q1. That would be the first sign that the Fed’s actions are having a substantial effect.
 

 

The yield curve, as measured by the spread between 2 and 10 year Treasury paper, stands at 51bp. Even though the yield curve is flattening, it is not inverted. Therefore there is no need to panic yet. In the past, the stock market has boomed just as the yield curve flattens. The yield on the 10-year Treasury note has been range bound for all of 2017, and in an even narrower range between 2.1% and 2.4% since April.
 

 

If the Fed keeps its commitment to raise three more times in 2018 and 10-year yield remains range bound, the yield curve could invert by mid-year or in Q3. Historically, stock prices have performed well in the period leading up to yield curve inversions.
 

 

Here is a table of the same analysis. The highest level of excess returns seem to occur 9-12 months before a yield curve inversion.
 

 

 

Assuming that it inverts in late Q2 or Q3, it means that we are in a sweet spot for stock market returns. If history is any guide, expect an SPX target of 2860 to 2970 in 6-9 months.

Global momentum

Another bullish tailwind is the synchronized global upturn, as evidenced by the rising regional Citigroup Economic Surprise Indices, which measures whether economic data is beating or missing expectations.
 

 

Further indications of a cyclical upturn comes from the copper/gold ratio, which distills the economically sensitive element of the copper price from its commodity and hard asset component. Historically, a rising copper/gold ratio (red line) has been correlated with a positive risk appetite, as measured by the stock/bond ratio (grey bars).
 

 

The latest update from John Butters of FactSet shows that Street earnings estimates are rising, which is a bullish indication of fundamental momentum. Q4 earnings season also looks bright.
 

 

The Q4 earnings season looks bright. Butters also reported that consensus Q4 2017 EPS estimates have fallen by -0.6% since September 30, which is substantially better than the five-year average of -3.3% and 10-year average of -4.3%. As well, we may see further price upside as Q4 earnings season gets underway in January, as Street analysts raise their estimates based on corporate guidance on the effects of the tax bill. Stay tuned!

Ned Davis Research recently pointed out that EPS growth acceleration is already as good as it gets. The market is in the sweet spot of earnings growth, where stock prices achieve the best level of gains (via Callum Thomas).
 

 

Enjoy the party while it lasts.

When the yield curve inverts

Looking ahead, what happens if the yield curve inverts next year? A number of analysts have trotted out studies that indicate stock prices continue to rise once the yield curve inverts. Rather than rely on historical studies, here is what I am watching for.

What happens to inflation, and inflationary expectations? So far, some Fed officials have been reluctant to be overly aggressive in raising rates as inflation has not appeared. Greg Ip of the WSJ observed that the Fed did not react by projecting further monetary tightening in light of the fiscal stimulus from the GOP tax cuts. They are watching to see if the tax cuts will spur productivity growth through greater capital spending:

The reasons are twofold. One is that inflation is still too low, and that completely changes the equation: It suggests overheating is to be welcomed, not resisted. The other is that officials are open to the possibility that the tax cut will raise the economy’s potential growth rate, which means faster growth wouldn’t necessarily lead to more inflation.

That isn’t their base case, which may irritate President Donald Trump. But more important for Mr. Trump is that Ms. Yellen and her likely successor, Fed governor Jerome Powell, aren’t yet the party poopers many supply-side tax cut advocates feared.

At the same time, underlying measures of inflation, such as the New York Fed’s Underlying Inflation Gauge, is running a little hot.
 

 

Some components of the Atlanta Fed’s inflation dashboard are also starting to heat up, namely labor costs, retail prices, and wholesale prices.
 

 

Another key question revolves around the evolution of the voting membership of the FOMC next year. Dovish regional presidents such as Charles Evans and  Neel Kashkari will be gone, to be replaced by John Williams, who is more centrist, and uber-hawk Loretta Mester.

As well, there are several open seats on the Fed’s Board of Governors. The Trump administration has already nominated monetarist hawk Marvin Goodfriend to one of the positions. Who will be the new vice chair, and who will fill the other board seats? The FOMC could conceivably take a dramatic hawkish turn should Trump appoint rules-based Republican economists to the board. Four, or even five rate hikes are not inconceivable under such a scenario.

Should the market start to falter, one of the technical warnings would be a negative divergence on the 14-month RSI of global stocks. Historically, major tops have been characterized by an initial top, a pullback, and a rally to either a second high, or a test of the old high with a negative RSI divergence. So far, the first pullback has not occurred yet.
 

 

Barring any surprises, such as a trade war, a market melt-up is ahead for the next few months.

Key risks

There are a couple of key risks to my bullish outlook. The main one is, in fact, a trade war. The Trump administration is scheduled to unveil its National Security Strategy (NSS), which is an important document that outlines its foreign policy initiatives, on Monday. A Financial Times article gave a preview of the document. It appears that Trump is turning his sights to China, and not in a market friendly fashion:

Donald Trump will accuse China of engaging in “economic aggression” when he unveils his national security strategy on Monday, in a strong sign that he has become frustrated at his inability to use his bond with China’s President Xi Jinping to convince Beijing to address his trade concerns.

Several people familiar with the national security strategy — a formal document produced by every US president since Ronald Reagan — said Mr Trump would propose a much tougher stance on China than previous administrations.

The market has learned to discount Trump’s tweets, as they tend to be spur-of-the-moment thoughts, but the NSS is a policy paper produced by staff:

“The national security strategy is likely to define China as a competitor in every realm. Not just a competitor but a threat, and therefore, in the view of many in this administration, an adversary,” said one person. “This is not something that they just cooked up. Mar-a-Lago interrupted the campaign rhetoric, and Xi Jinping took a little gamble and came here and embraced Trump. Trump said ‘fine, do something on North Korea and on trade’, but that didn’t work out so well.”

The NSS could contain highly protectionist language that could spook the markets:

Some people familiar with the strategy said it would be the most aggressive economic response to China’s rise since 2001 when the US backed its entry into the World Trade Organization. It points to the waning influence of Gary Cohn, the White House National Economic Council head who many people believe will leave the administration next year, and the growing power of Robert Lighthizer, the US trade representative, and other China hawks in the administration.

“It’s like a Peter Navarro PowerPoint presentation,” said one person, referring to the provocative economist and author of “Death by China” who is now a White House official…

Mr Lighthizer, an unapologetic economic nationalist, has long advocated a more muscular trade policy toward China. Critics worry that if the US pushes too hard, it may provoke a trade war that could have devastating consequences for US business and the global economy. Former officials said accusing China of economic aggression and labelling it a strategic rival was likely to lead to carefully calibrated retaliation by Beijing, with US companies bearing the brunt of any response.

Another key market risk is Trump’s faltering political support. Gallup’s tracking poll of presidential approval has fallen to 35%. Ned Davis Research has found that stock prices tend to be sloppy when presidential approval ratings fall to 35% or less, but this is a purely tactical call as recent low approval ratings have only led to shallow price corrections.
 

 

The week ahead

In my last post (see Do you believe in Santa Claus?), I suggested that a small cap seasonal rally is about to get underway. Subscribers received a trading alert that my trading account had bought a long position in small cap stocks on Thursday. An update of the relative return of small cap stocks in 2017 shows that they appear to be bottoming right on schedule.
 

 

Breadth indicators from Index Indicators show that small caps bounced off an oversold reading, indicating further near term upside.
 

 

The SPX is in a similar position as it rallied off an oversold position and displaying positive momentum.
 

 

Similarly, the Fear and Greed Index is rallying, but it is nowhere near a crowded long reading.
 

 

However, the NASDAQ rally may be nearing an inflection point, as readings have become overbought. It may be time for these stocks to pause after staging an oversold rally.
 

 

The year-end seasonal rally is underway. My inner investor remains constructive on the market. My inner trader is long equities up to his neck, though he may take some profits on his NASDAQ 100 long position early next week.

Disclosure: Long TQQQ, TNA

Do you believe in Santa Claus?

Posted by Cam Hui -

Mid-week market update: You can tell a lot about market psychology by the way it reacts to events. News overnight of the victory by Democrat Doug Jones over the troubled Republican candidate Roy Moore in the Alabama senate race was judged to be market unfriendly, as it meant that the GOP would have its Senate majority shrink by one vote to 51-49. ES fell immediately, but eventually recovered to roughly even the next morning at 8:30 before the release of CPI.

The near term message from the market is “stock prices don’t want to go down”.

Rob Hanna of Quantifiable Edges observed that this week, which is December OpEx, is one of the most bullish weeks of the year. Moreover, positive seasonality extends past this Friday for another two weeks.
 

 

Do you believe in Santa Claus?

The small cap Santa rally

Even though traders have observed an upward bias stock prices at year end, the so-called “Santa Claus rally” is especially prominent among small cap issues at the end of the year. I went back to 1991 and calculated the average relative return of small vs. large cap stocks in December and January.

As the chart below shows, the relative performance of small cap stocks tend to bottom out about the end of this week. Historically, they run up until the start of the New Year, dip for about a week, and end January with a bang. The relative performance of small caps so far this year shows that they are hugging the lower one standard deviation band below the average, which makes their upside potential that much higher if they could even just get back to an average level.
 

 

There is every reason to expect small caps to perform well. The latest reading of NFIB small business confidence stands at its second highest level in history, and momentum is strong.
 

 

From a technical perspective, the Russell 2000 small cap index successfully tested a key support level last week, and staged an upside breakout through a downtrend today. In all likelihood, the index is headed for a test of the old highs. With the aid of the seasonal tailwinds, we will probably see fresh highs in the Russell 2000 in early January.
 

 

My inner trader is already long the NASDAQ 100. He is watching and he expects to opportunistically buy a long position in the Russell 2000 in the next few days. Yes, he believes in Santa Claus.

Disclosure: Long TQQQ, expected purchase of TNA in the next 2 days

China: A 19th Party Congress postscript

Posted by Cam Hui -

A decent interval has passed since China’s 19th Party Congress (see Beware the expiry of the 19th Party Congress put option), and it’s time to check in again on China to see how things are progressing. For the China bears, the overhang in debt looms large.
 

 

The worries are especially acute in light of International Monetary Fund’s publication of the results of its financial stability assessment of China. In connection with that review, the IMF issued the following warning about three sources of vulnerability:

  • Excessive debt: In particular, concerns were raised over the rapid buildup of debt to keep non-viable zombie companies alive.
  • Growth of shadow banking: The growth of the shadow banking system makes it more difficult to monitor and control the risks in the financial system.
  • Moral hazard: The IMF also raised concerns over “moral hazard and excessive risk taking” because of the belief that the government will bail out troubled state-owned enterprises (SOEs) and local government financing vehicles (LGFV).

The concerns raised by the IMF echoes the writings of Winston Yung at McKinsey, who penned an article called “This is what keeps Chief Risk Officers in Chinese Banks awake at night“.

  • Economic downturn leads to the emergence of credit risk
  • Risk management cannot keep up with constantly changing business models: 
  • Asset liability mismatch
  • Significant risk from off balance sheet activities

It’s all about real estate!

Simply put, the problems of credit growth have fueled a real estate boom in China. The following chart tells the story of a Chinese cultural affinity towards property investment. The latest figures show that 43% of household wealth was in real estate.
 

 

That’s just the household sector. Reuters analyzed the debt burden of the corporate sector and found that it had been growing steadily, despite government attempts at deleveraging.
 

 

When broken down by sector, the biggest five-year debt growth rate came from (surprise!) real estate, though industrial companies have the largest proportion of debt outstanding. Despite these classifications, virtually all companies appear to be exposed to the real estate sector in some form, from either straight ownership, to property development, to financing.
 

 

For another perspective, this series of (lightly edited) tweets from No Sunk Costs document the immense scale of the Chinese property sector.
 

 

Lenders gone wild

A recent Reuters article documents the shenanigans that have gone on in plain sight in property lending. When a property is sold, three bills of sale are prepared, with the open acquiescence of lenders:

When Zhu Chenxia bought a flat early last year from Lei Yarong in the up-market Nanshan district of China’s southern metropolis of Shenzhen, the two women drew up three purchase agreements to cover the deal.

Only one was genuine.

In the legitimate contract, Zhu agreed to pay Lei 6.49 million yuan (about $980,000) for the 96-square-meter apartment near the city’s border with Hong Kong, according to records filed in a Shenzhen court. With the help of her property agent, Zhu cooked up a second contract with Lei that overstated the value of the flat at 7 million yuan. This one was for the bank…

Mortgage fraud like the pair’s flouting of rules designed to protect banks is rampant in China’s roaring property market, according to interviews with buyers, sellers and dozens of property market insiders including real estate agents, lawyers, bankers, valuers and loan middlemen from three of China’s major cities and four smaller cities. Many of these people declined to be identified because they were familiar with or involved in “re-packaged” loan applications, the industry euphemism for these frauds…

Under the third contract she drew up with Lei, the Shenzhen flat was valued at only 2.8 million yuan, less than half its true value, the court records show. That contract was for showing to the taxman. At that value, Zhu would have saved more than 50,000 yuan in taxes, according to Shenzhen regulations.

Imagine the non-performing loan problem. For now, lenders are more interested in loan growth and therefore turn a blind eye to mortgage fraud, which appears to be quite common, and they appear to have adopted a “don’t ask, don’t tell” mortgage origination policy:

Reuters interviewed 12 property agents selling new and existing homes who said they had helped clients dodge lending rules. Another veteran salesperson in Shanghai who works at real estate company E-House China said around 50 percent of his clients engage in some kind of mortgage fraud. The person declined to be identified, and the company didn’t respond to questions.

Property agents often recommend buyers use so-called loan agents to help them secure funds from lenders. These loan agents have created an industry satisfying the demand for funds from borrowers unable to meet lending standards.

Bankers anxious to hit lending targets also introduce borrowers to these agents, according to property insiders. The use of loan agents allows the bankers to keep fraud at arm’s length.

Besides household debt for property purchase, analysis from Reuters showed that SOEs are not immune from excessive debt burden. Debt burden at 75 of the CSI Central SOE 100 Index, which excludes financials, came in roughly 25% of revenue. That means operating margins have to be at least 25% for these companies to be profitable.
 

 

The government’s response

Just because a part of the economy is precariously positioned, in this case property and finance, doesn’t mean it will crash. In the wake of the 19th Party Congress, the authorities are taking steps to gently deflate the bubble, and pivot to a path of more sustainable growth. The good news is that Beijing has abandoned the “growth at any cost” model. The bad news is a shift toward an SOE driven growth strategy (via Tom Orlik at Bloomberg):

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

If that’s an indication of where policy makers’ priorities now lie, then it’s a troubling one. Deng’s clearest lesson for Xi is that market reforms — not state planners — are the path to China’s national renewal.

Last week, Caixin reported that the Politburo is taking additional steps to cool the property market:

The Politburo of the Communist Party of China, the country’s top decision-making body, said in a meeting on Friday that reforming the housing system and building a long-term policy for the real estate market are top priorities for 2018, according to the official Xinhua News Agency.

The bull and bear cases

Does this mean that Beijing tank the real estate market, which could then take down the Chinese economy? Let’s consider the bull and bear cases.

The bear case is relatively easy to make. China’s economy is sitting on a mountain of debt. The sugar high of the artificial stimulus leading up to the 19th Party Congress is starting to wear off. Fathom Consulting’s indicators of industrial activity are weakening.
 

 

Real-time indicators, such as industrial metal prices, are rolling over.
 

 

Combined with Beijing’s stated intention to slow down the real estate market, the risk of a financial accident rises very quickly.

The bull case

I would remind readers that this site is not Zero Hedge. If you are looking for permanent bearishness, you should look elsewhere.

There is a case to be made that China is unlikely to crash. The PBOC still has plenty of bullets left if disaster were to strike. At a minimum, the PBOC has plenty of room to lower the RRR in order to inject liquidity into the financial system and the economy.
 

 

As an example, just as bond yields spiked in November, Tom Orlik pointed out that the PBOC injected significant levels of liquidity into the banking system. There were several consecutive days where the PBOC injected over USD 3 billion. To put those figures into some context, the Fed’s quantitative tightening program placed an initial limit of USD 6 billion of Treasury securities to roll off the Fed’s balance sheet per month – and the PBOC injected roughly half that amount into the banking system in a single day. This shows that, when push comes to shove, the PBOC is ready to act to ensure financial stability.
 

 

Chen Zhao, chief strategist at Alpine Macro, recently made the case that China is not at risk of a Minsky Moment in an FT article for the following reasons:

  • Debt-to-GDP is an invalid metric for measuring risk: Debt is a stock concept. GDP is flow.
  • China has plenty of room to service debt: The domestic savings rate is 48%.
  • Credit risk is sovereign risk: Since the government and SOEs are so intimately involved in the economy, credit risk is sovereign risk. And most of the debt is denominated in RMB, which is a currency that the government controls.

The long Yuan trade

In addition, Kevin Muir at The Macro Tourist outlined an offbeat bull case for CNYUSD. His analysis began with an interview with hedge fund manager Felix Zulauf, who believed that Xi Jingping needs to slow the Chinese economy next year in order to have a strong rebound by 2021, when Xi is up for re-election:

China I believe is in an interesting position right now. You heard President Xi’s speech last week, and in 2021 there is the 100th anniversary of the Chinese Communist party and it’s very clear that they want to have a strong economy at that time. If you want to have a strong economy in 2021, you stimulate in 2020. And they are central planners. So that’s means they have to take their foot off the pedal in 2018, 2019. I think in ‘18 and ‘19, they will address the imbalances in the financial sector and that will slow down the Chinese economy in ‘18 and ‘19, which will also slow down the rest of the world.

So we are entering a period where sometime in ‘18, I would say the peak of the market will be in the first half, the peak in the economy is probably from mid-2018 on, and then we slow down into 2020.

And 2022 is the next Chinese Congress, and President Xi is probably the first leader who tries to run for a third time. So he wants to have a very good economy in 2021 and 2022. That means he has to first slow things down, restructure some of the imbalances in the system because if he tries to carry through, it could backfire on him. It could be the worst of all worlds. Namely a completely overheated situation, with high inflation rates, etc…

That’s why I think the leader of this cycle, China, is going to slow down next year.

Muir went on to explain that China is running an extremely loose fiscal policy through its “one belt-one road” initiative, but starting to run a tight monetary policy to cool the property market in 2018-19:

We have a Chinese President who wants to be re-elected shortly after his party’s 100th anniversary celebration in 2021. Therefore, it will be important that the Chinese economy is humming along at full speed at that time. To do that, he needs to stimulate in 2020, but the problem is, if he doesn’t tap the brakes now, he might risk overheating before then. President Xi will therefore take the hit, and get the pain over with in 2018 and 2019. Yet the story is further complicated by the fact that China’s long run infrastructure program is causing a hot fiscal policy. All of these factors add up to a much tighter PBOC for the next couple of years.

Call me an idiot, but I am tempted to take the long Yuan trade. I know that seems insane – all those really smart hedge fund managers are all forecasting a China collapse. But buying Yuan is probably better than betting on stocks going down because of the tight Chinese monetary policy. Not convinced it’s the best trade, and not even sure if I am going to do it in any real size, but I have often found the hardest trades, are often the best trades.

This scenario is based on the assumption that China can contain any fallout from a slowing real estate market.

Endogenous vs. exogenous shocks

I believe that resolving the bull and bear debate depends on whether the Chinese economy is subject to an endogenous shock driven by government policy, or an exogenous shock from abroad, which the central authorities cannot control. The bulls are largely correct in that most of the debt is denominated in RMB, and any so-called debt crisis will not be the typical EM crisis experienced in the past. Beijing can engineer soft landings, as long as they control both the regulatory and credit levers. If reform efforts threaten financial stability, the authorities can always back off. Indeed, we have seen the same start-stop pattern of deleveraging in the past few years.

However, what happens if China is hit by an external shock? Global central banks are entering a tightening cycle. What would happen to China if American demand slows as the Fed normalizes monetary policy? Already, we are seeing signs of a global rebound in inflationary surprise, which will embolden monetary authorities to raise rates and discontinue their emergency QE rescue measures.
 

 

As the PBOE tightens monetary policy, this will drive Chinese corporations to seek cheaper financing offshore. Bloomberg found that borrowers are flocking to the Hong Kong branches of Chinese banks to borrow, and exposure is nearly USD 1 trillion. This level of exposure of loans in a non-RMB currency creates an additional level of risk for the Chinese financial system.
 

 

Imagine a scenario in which the PBOC tightens monetary policy, and CNYUSD appreciates as outlined in Kevin Muir’s thesis, then the US economy slows into a mild recession as the Fed tightens policy. Demand slows, Chinese corporate defaults rise, and starts to cascade. Under normal circumstances, Beijing could ease policy, but it may not be enough to offset falling demand through the trade channel. Even though China has a closed capital account, capital starts to flee and CNYUSD plummets.

Watch the Hong Kong market as the canary in the coalmine. Watch the CNY exchange rate. Watch Australian and Canadian real estate. Watch commodity prices.

Here comes the blow-off

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Party on!

Friday’s November Jobs Report highlighted a number of important bullish data points for the stock market in the weeks ahead. The headline non-farm payroll release came in ahead of expectations, while average hourly earnings missed. At the margin, tame wage pressure which will restrain the Fed from becoming overly aggressive in raising rates.

As well, Thursday’s release of initial jobless claims also underlined the remarkable inverse correlation between initial claims (inverted scale) and stock prices. So far, the continuing improvement in initial claims is supportive of higher equity prices.
 

 

In his latest update of high frequency economic data, New Deal democrat painted a bright picture for the near term, and an improving long term outlook:

The nowcast and the near term forecast remain very positive, with only relatively strong oil prices juxtaposed with relatively weak commodity prices as flies in the ointment. The longer term forecast, which I briefly downgraded to neutral, is weakly positive again.

Throw in the anticipated corporate tax cuts, it is difficult to contain our short-term enthusiasm. This week, I review my Recession Watch indicators and find that the current snapshot of recession risk is receding, though there are still some key risks on the horizon (also see Things you don’t see at market bottoms: Rational exuberance edition).

A leading indicator review

As a reminder, my Recession Watch indicators is a set of seven leading indicators designed to spot a recession a year in advance. They are split into three broad categories, the consumer and household sector, the corporate sector, and financial and monetary conditions.

Starting with the household sector, the outlook looks bright. Real retails sales are rising with no signs of a top in sight.
 

 

The housing sector is a highly cyclical measure of consumer durables. Peaks in housing start have historically been recessionary warnings. The latest figures show that housing starts are recovering after a weak patch, though some of the surge may be related to hurricane rebuilding. That said, this sector is likely to face artificial headwinds next year as higher Canadian lumber prices and the partial loss of mortgage interest destructibility raise housing prices and dampen demand.
 

 

On the other hand, real private residential investments have not recovered as strongly. However, this is a quarterly data series, compared to the more timely monthly frequency of housing starts.
 

 

On the surface, the consumer and household sector is in good shape. However, the lack of wage growth suggests that households are spending in anticipation of better times ahead. To cope, they are either digging into their savings, or borrowing to keep up with consumption.
 

 

This is not anything to panic over, but these conditions represent a cautionary flag longer term.

Corporate sector: Mildly positive

Conditions in the corporate sector can be best described as mildly positive. Historically, corporate bond yields have bottomed out well before the onset of a recession. Current readings show that corporate bond yields are falling, but the last low occurred in August 2016. This indicator tends to be very early, so it is nothing to worry about yet.
 

 

NIPA corporate profits are recovering after oil prices cratered in 2015. Corporate profits to unit labor costs (blue line) have made a new high for the cycle, though real corporate profits (red line) just missed the new high.
 

 

Corporate profits tend to be released with a lag, and proprietors’ income is a more timely data series. Real proprietors’ income has not made a new high for the cycle yet. Call the corporate profits/proprietors’ income indicators a mixed positive. Throw in the prospect of corporate tax cuts, they get even better.
 

 

Financial and monetary conditions: Watch out for the Fed

The third leg of my leading indicators is financial and monetary conditions. It is no secret that the Federal Reserve is embarking on a monetary policy normalization cycle of unknown length and magnitude. As the Fed tightens, money supply growth has tended to slow. In the past, either real M1 or M2 growth has fallen negative ahead of recessions. The latest readings show that real M2 growth stands at 2.3% and it is decelerating quickly. At this rate, it could easily go negative in Q1.
 

 

As well, the market has shown great concerns about the shape of the yield curve, which is flattening but nowhere near an inversion yet. However, should the Fed continue on its course to raise rates at its December meeting and proceed with three quarter-point hikes in 2018, the yield curve could easily be inverted by Q2 or Q3.
 

 

Despite the signs of tame inflation, there are plenty of indicators that show nascent inflationary pressures. The New York Fed’s Underlying Inflation Gauge estimates underlying trend CPI to be 2.25% to 3.00%, which is well above the Fed’s 2% target.
 

 

Moreover, measures of global inflation show that inflation surprise is turning up around the world.
 

 

Bottom line: Don’t expect the Fed to slow down in its course of rate hikes.

Investment implications

Putting it all together, the near term implications for US equities is bullish. The latest update from FactSet shows that earnings estimates continue to rise, indicating positive fundamental momentum.
 

 

From a technical perspective, risk appetite indicators are behaving well. There are few signs of stress from the credit markets after the hiccup in November.
 

 

NASDAQ and momentum stocks have also begun to recover after suffering a recent scare. The technical uptrend for both the NASDAQ 100 and the relative uptrend for price momentum remain intact.
 

 

Next week is option expiry week. Rob Hanna at Quantifiable Edges found that December OpEx has been one of the better OpEx weeks in the year.
 

 

In conclusion, the near term outlook looks unabashedly bullish. Barring an unexpected event, such as a trade war, or a shooting war on the Korean peninsula, positive momentum should carry equity prices to further highs – until the Fed steps in and hits the monetary brakes.

My inner investor remains constructive on equities. My inner trader covered his shorts on Thursday and went long the NASDAQ 100 on Friday.

Disclosure: Long TQQQ

Duel of the market studies

Posted by Cam Hui -

Mid-week market update: Swing and day traders are often fond of studies that show an edge under certain market conditions. But what happens when two different studies disagree?

On one hand, Rob Hanna at Quantifiable Edges published a study yesterday that signaled a likely bullish outcome for stock prices. Yesterday (Tuesday) would have day 1 of that study.
 

 

On the other hand, I had identified a hanging man candle on Friday. While hanging man formations are thought of as bearish reversals, further studies showed that they don’t necessarily resolve themselves in a bearish fashion unless there is a bearish follow-through the next day.
 

 

When the market opened up strongly on Monday, I had given up on Friday’s hanging man, but the market astonishingly closed in the red to flash a bearish confirmation. My own historical study indicates that these episodes tend to be short-term bearish, and bottom out between day 3 and 4, which translates to either this Thursday or Friday.
 

 

How can we resolve this apparent contradiction in market studies?

Market getting oversold

As a quant, I am always cautious about studies that torture the data until it talks. One way of resolving conflicting conclusions is to analyze the market conditions outside the scope of the study.

The short term (1-2 day time horizon) charts from Index Indicators show that, as of the close Tuesday, the market was getting oversold.
 

 

The long term (1-2 week time horizon) chart also showed that long term trading breadth indicators had fallen dramatically below neutral and closing in on a near oversold reading.
 

 

As of the time of publication, Index Indicators has not updated their charts yet. Even though the SPX closed flat on the day, the negative market breadth today suggests that these readings are likely to get worse, which indicates that the bearish impulse may be close to getting played out.

How far will the Tech weakness go?

One of the features of the recent market weakness is the selloff in Tech stocks, and semiconductor stocks in particular. One of the other features of the current episode is the rotation of funds into other sectors, such as Financials. Business Insider recently highlighted analysis from Credit Suisse which indicated that sector correlation is at a historical low. These circumstances, where losses in one sector are offset in gains in another, serve to mitigate the losses in the major market indices.
 

 

That said, how bad is the Tech and semiconductor selloff and what are the likely outcome when it ends? An analysis of the relative performance of semiconductor stocks shows that they are oversold, and the selling pressure is likely to end soon.
 

 

An analysis of the Tech sector shows a similar result.
 

 

In connection with the current rotation, Bloomberg highlighted analysis from Andrew Lapthorne of Societe Generale, who believed that the violent reaction in Tech was not just simple sector rotation, but quant factor rotation from momentum into value. As the chart below shows, the relative performance of the price momentum ETF (MTUM) remains intact.
 

 

If Lapthorne is correct, and institutional and hedge fund quants are rotating factor exposures, then there is no telling how much further the Tech weakness has to go. I will be monitoring the relative performance of MTUM in the near future. Even though these stocks may see a near term bounce in the days ahead, an analysis of the weekly relative performance of the semiconductor stocks shows that they are not anywhere near an extreme oversold reading on the weekly chart. In the past, whenever the relative RSI has become overbought and mean reverted, the relative underperformance of this group does not end until RSI becomes oversold.

Should Tech start to turn around here, especially with the market mildly oversold, we could see a short-term market bottom in the next few days. This suggests that both studies are correct. The hanging man candle will see a market bottom this week, and the bullish resolution from Rob Hanna’s study will see a temporary market top next week. This is also consistent with the consolidative seasonal pattern identified by Callum Thomas in the early part of December.

My inner trader is short the market, but he is getting ready to pull the trigger and cover his position in the next few days. Stay tuned.

Disclosure: Long SPXU

Should you be worried about an elevated Shiller P/E?

Posted by Cam Hui -

In my discussions with investors, the Cyclically Adjusted P/E (CAPE), or Shiller P/E, has come up numerous times as a risk for the U.S. stock market. The current reading of 32x is only exceeded by the peak during the NASDAQ Bubble, and it is higher than the levels seen before the Crash of 1929. Does this mean that the risk of a substantial stock market drawdown in the near future is rising?
 

 

I studied the question in the context of some of the criticisms of the Shiller P/E and made a number of adjustments to the calculation. I found that the answer is the same. The U.S. equity market is expensive, but Shiller P/E does not work well as a short-term market timing technique. However, I have found that the combination of valuation and price momentum can provide clear warning signs that the market is about to enter a bear market.

Adjusting Shiller P/E for the Great Financial Crisis

The Shiller P/E uses the average 10-year real earnings as one of its inputs. One of the points made in our investor discussions is the effects of the Great Financial Crisis of 2008–2009 (GFC) will be fading soon from the calculations. Once those depressed earnings drop off the 10-year trailing window, the ratio should decline, which makes valuation much cheaper.

The adjustment for the GFC depends on the timing of recessions during Robert Shiller’s study period, and current conditions today. The chart below shows that the current equity bull market, which began in March 2009, is well above average. Past profit and economic cycles were shorter, and therefore Shiller P/E calculations would have tended to include at least one recession during its 10-year lookback period.
 

 

For another perspective, following chart shows history of NIPA corporate profits, which historically have been correlated with equity market profits (see BEA study), and the Wiltshire 5000 as a frame of reference for equity returns. As the chart shows, the frequency of recessions was early in the post-WW II period and past Shiller P/E calculations would have tended to include recessionary periods where earnings contracted in its 10-year lookback periods.

Should the current economic cycle continue into 2019 without a recession, then arguably the effect of dropping off the recessionary earnings of the GFC actually artificially elevates Shiller P/E, rather than act to make the market less expensive.
 

 

Another way of addressing the 10-year GFC recession problem is to extend the lookback period. DQYDJ has such a facility. Extending the lookback period to 20 years shows that valuations are similarly elevated.
 

 

Adjusting Shiller P/E for macroeconomic conditions

A researcher at the San Francisco Fed recently proposed a novel way of adjusting the Shiller P/E for the effects of changes in r* and other macroeconomic inputs (see link to paper). To explain, r-star (r*) is what economists use to describe the long-term expectation for the real rate. Even though it is not observable, a useful proxy is long-term forecasts for Fed funds, adjusted for the Fed’s inflation target, found in the Fed’s dot-plot.

In the latest dot-plot, the median Fed forecast now stands at 2.75%. Assuming it reaches its inflation target (2%) that would put the real rate at 0.75%.

Kevin Lansing of the San Francisco Fed found that changes in CAPE was highly correlated to changes in r-star:

Figure 3 shows that shorter-run movements in r-star generally go in the same direction as the CAPE ratio. The correlation between the two series is strongly positive. This pattern is consistent with the idea that upward movements in r-star tend to be observed during booms or recoveries, which are periods of lower macroeconomic uncertainty (Lansing 2017). Lower uncertainty stimulates investors’ demand for risky assets like stocks, contributing to a rise in the CAPE ratio. Likewise, downward movements in r-star tend to be observed during recessions or crises, which are periods of higher uncertainty. Higher uncertainty stimulates investors’ demand for safe assets like U.S. Treasury securities while stock prices tend to fall, contributing to a decline in the CAPE ratio. Using the projected path for r-star from Figure 1, the projected path for the 20-quarter change in r-star shows a continued increase for a time, followed by a reversal as r-star levels off at 1%.

 

These results may initially appear to be counterintuitive. Why should the Shiller P/E rise as r* rises? This effect can be explained by changes in expectations. During the late phase of an expansion, stock prices can rise even as the Fed raises interest rates. That’s because positive effects of expected higher earnings growth overwhelms the negative effects of higher interest rates, which results in P/E expansion. The same effect is observable when Shiller P/E and r* rise together.

Lansing went on to fit a projected CAPE ratio into the future using a series of macroeconomic variables, namely the Laubach-Williams (LW) two-sided estimate of r-star, the CBO four-quarter growth rate of potential GDP, the 20-quarter change in the LW r-star estimate and the four-quarter core PCE inflation rate.
 

 

He concluded:

Over the long history of the stock market, extreme run-ups in the CAPE ratio have signaled that stocks may be overvalued. A simple regression model that employs a parsimonious set of macroeconomic explanatory variables can account for most of the run-up in the CAPE ratio since 2009, offering some justification for its current elevated level. The same model predicts a 13% decline in the CAPE ratio over the next 10 years. This prediction, if realized, would imply lower returns on stocks relative to those enjoyed in recent years when the CAPE ratio was rising.

In effect, investors can expect no help on expected equity returns after macroeconomic adjustments.

High Shiller P/E = Low LT returns

Having established that the Shiller P/E is elevated, what does that mean for investors? The experience of the last 10–20 years has shown that a high Shiller P/E is not necessarily a danger signal for equity prices. Stocks have continued to rise even in the face of above-average CAPE. Simply put, CAPE is ineffective as an intermediate-term market timing model, though it can be a useful tool to forecast long-term returns.

Michael Lebowitz at 720Global projected 10-year U.S. equity returns under a variety of scenarios using the combination of earnings growth, starting and ending Shiller P/E and 10-year Treasury yields. His base-case scenario called for Shiller P/E to fall from the current elevated levels to one standard deviation above its long-term average in 10 years. Expected U.S. equity returns came in at 2.7%, which is barely above the yield of the 10-year Treasury note.
 

 

In other words, U.S. equities will be nothing to write home about.

A better way to market time with Shiller P/E

CAPE is not known for being a market timing tool, as high Shiller P/E ratios have not historically been followed by bearish markets. There may be a better way, which I wrote about before.

The blogger Econompic found that adding price momentum to CAPE valuation can be an effective way to time the market. He found that equity prices are at the greatest risk of a major decline when CAPE is above 30 (32x today), and CAPE is falling.
 

 

This study makes market timing with Shiller P/E simple. As long as CAPE is rising, as evidenced by rising prices that raise the ratio, bear market risk is low, but get out of the way when the market starts to decline.

Investors should bear this rule in mind in the current environment where Shiller P/E stands at an elevated reading of 32x.

Brace for a more volatile 2018

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Volatility ahead

Equity market volatility, as measured by the VIX Index, has been extraordinarily low by historical standards.
 

 

Last week’s events is setting the stage for greater market volatility in 2018, which stems from the following three sources:

  • Political uncertainty
  • Fiscal policy
  • Monetary policy

Let’s examine each, one at a time.

The tale of l’affaire Russe

Last Friday, the stock market was hit by the report that former Trump administration National Security Adviser Mike Flynn had pleaded guilty to a minor charge, and he was fully cooperating with the Mueller investigation by testifying against the Trump campaign in return for leniency. It was further reported that Flynn claimed that Trump had directed him to contact the Russians during the election (later corrected to the transition period). The SPX nosedived over 1% on the news, though it recovered later in the day to close -0.2%. The difference between the timing of any Russian contact is legally important. If candidate Trump had contacted the Russians during the campaign, it could be interpreted as a violation of the Logan Act which prohibits ordinary citizens from negotiating with unfriendly governments. Contacting foreign governments during the transition period to conduct foreign policy could be viewed as it constitutes the normal business of a new team.

Nevertheless, it is hard to see how Flynn got off so lightly if the only revelation was the Trump transition team had contacted the Russian government. There was no mention of the planned Gulen rendition to Turkey in return for a $15 million fee in the indictment, and Mueller declined to indict his son. The Lawfare blog’s quick and dirty analysis concluded that we should expected further bombshells in the near future:

The narrowness [of the charge against Michael Flynn] gives a superficial plausibility to the White House’s reaction to the plea. Ty Cobb, the president’s ever-confident attorney, said in a statement: “The false statements involved mirror the false statements [by Flynn] to White House officials which resulted in his resignation in February of this year. Nothing about the guilty plea or the charge implicates anyone other than Mr. Flynn.” Cobb reads Friday’s events as an indication that Mueller is “moving with all deliberate speed and clears the way for a prompt and reasonable conclusion” of the investigation.

This is very likely not an accurate assessment of the situation. If Mueller were prepared to settle the Flynn matter on the basis of single-count plea to a violation of 18 U.S.C. § 1001, he was almost certainly prepared to charge a great deal more. Moreover, we can infer from the fact that Flynn accepted the plea deal that he and his counsel were concerned about the degree of jeopardy, both for Flynn and for his son, related to other charges. The deal, in other words, reflects the strength of Mueller’s hand against Flynn.

It reflects something else too: that Flynn is prepared to give Mueller substantial assistance in his investigation and that Mueller wants the assistance Flynn can provide. We are not going to speculate about what that assistance might be. But prosecutors do not give generous deals in major public integrity cases to big-fish defendants without good reason—and in normal circumstances, the national security adviser to the president is a very big fish for a prosecutor. The good reason in this case necessarily involves the testimony Flynn has proffered to the special counsel’s staff. The information in that proffer is not in any of the documents released Friday, and it may not even be related to the information in those documents. Prosecutors tend to trade up. That is, for Mueller to give Flynn a deal of this sort, the prosecutor must believe he is building a case against a bigger fish still.

Notwithstanding any dispute over whether anyone violated the Logan Act, the Trump team`s troubles with the Mueller probe are not over. Trump’s weekend tweet was problematical, as he admitted that he knew Flynn had lied to the FBI, and then asked Comey to back off on the Flynn investigation. Many legal analysts have interpreted these actions as obstruction of justice, which was the charge that forced Nixon`s resignation.
 

 

The latest Gallup presidential job approval, which was taken before the Flynn news, shows that Trump’s approval at 34%. Historically, the stock market has not performed well when the approval rate falls to 35% or lower.
 

 

That’s bearish, right? Well…should sufficient evidence surface to force either the resignation or impeachment of Donald Trump, the knee-jerk market reaction would be bearish. However, Wall Street would undoubtedly sleep better at night if President Pence were to be in the White House, which would be a bullish outcome.

Hence the potential volatility. How this plays out, or how the market is likely to react to any single piece of news, I have no idea. But watch for rising political uncertainty in the year ahead.

Upside volatility from a cyclical surge

Notwithstanding any possible noise from l’affaire Russe, the market will continue to focus on the combination of the earnings and interest rate outlook. Even without any tax cut effects, the earnings outlook looks bright, which will likely be a source of upside equity price volatility.

As experienced investors are aware, Street analysts tend to publish earnings estimates that are too high and then gradually revise them downward. The latest update from FactSet indicates that Q4 EPS estimates are seeing the least amount of downward revisions since Q2 2011.
 

 

In addition, the latest FactSet summary of EPS estimates show that normalized forward 12-month EPS continues to rise steadily. This is another sign of bullish fundamental momentum that is supportive of higher stock prices.
 

 

In addition, Callum Thomas pointed out that the market is enjoying a period of macro tailwinds, as economic surprises and investor sentiment, otherwise known as FOMO, tend to surge into January.
 

 

Tax cuts: Upside or downside volatility?

What about the effects of the corporate tax cuts? The aggregate benefits of a corporate tax cut may be marginal. The next step for the tax bill is the reconciliation between the Senate and House versions of the bill before it can become law. One of the key differences is the Senate version of the bill cuts the corporate tax rate to 20% in 2019, while the House version immediately lowers the corporate tax rate to 20% in 2018.

Assuming the optimistic case that the corporate rate is 20% in 2018, a Reuters report indicated that the consensus 2018 EPS estimate would be about $150. Based on the current FactSet FY2018 estimate of $146.05, that amounts to a 2.7% increase in EPS. To be sure, other strategists put the increase higher, in the 5-8% range,
 

 

A mid single digit percentage increase in earnings, which translates to a similar level of stock market price appreciation, assuming no further multiple expansion? Is that all?

Ed Yardeni came to a similar conclusion using top down data. Yardeni, who declared that he was “all for tax cuts”, but he was “having a problem with the data”. He analyzed the effective corporate tax rate using two separate and distinct sources, the GDP data, and IRS data. The effective corporate tax rate was somewhere between 13.0% and 20.7%. If the effective rate is already that low, what’s the benefit of cutting the statutory rate to 20%?
 

 

Yardeni concluded:

Congress may be about to cut a tax that doesn’t need cutting. Or else, the congressional plan is actually reform aiming to stop US companies from using overseas tax dodges by giving them a lower statutory rate at home.

It is unclear how much of the stock price rally in the last few months is attributable to the cyclical effects of better earnings growth, and how much is discounting the effects of a tax bill. Given the relatively meager tax cut estimated boost to 2018 EPS growth. The tax bill may already been discounted by the market. In that case, we may be setting up for the downside volatility effect of “buy the rumor, sell the news” scenario when the bill is actually passed.

And we haven’t even discussed the possibility of a government shutdown in early December…

How will the Fed react?

Assuming that the GOP tax cut package does pass, another downside wildcard is the Fed’s reaction. Will the Fed be more inclined to tighten monetary policy faster in the face of fiscal stimulus?

Consider where we are today. The market is fully discounting a December quarter-point rate hike, and about two quarter-point rate hikes in 2018. By contrast, the Fed’s dot plot calls for a December hike, followed by three more raises next year.
 

 

While there has been some discussion from Fed officials about the uncertainty surrounding possible rate hikes in light of the absence of inflation, the inflation internal indicators are edging up. In all likelihood, we will start to see rising inflationary pressures in the very near future. As an example, the New York Fed’s Underlying Inflation Gauge (UIG) has been gradually rising. The latest readings in October shows the full data set measure at 3.0%, while the price-only measure at 2.3%. Both of these metrics are above the targeted inflation rate of 2.0%.
 

 

In the past, real YoY money supply growth has gone negative ahead of recessions. Real M2 growth is falling and could go negative by Q1 or Q2 at the current pace of deceleration.
 

 

In addition, the nomination of Marvin Goodfriend as Federal Reserve Governor will tilt the FOMC in a more hawkish direction. I wrote about Goodfriend last June (see A Fed preview: What happens in 2018?). At that time, I had highlighted the Gavyn Davies endorsement of Goodfriend for the Fed by characterizing him as an orthodox rules-based monetarist:

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

Goodfriend has also shown himself to be a highly dogmatic advocate of demonstrating central bank credibility in its price stability mandate. As an example, he wanted to raise rates in 2011, even as the eurozone underwent its crisis and Washington underwent a debt ceiling crisis. As a way of demonstrating its credibility, Goodfriend believed that the Fed should abandon a gradualist monetary policy and adopt a rapid-fire decisive approach to interest rate changes (via FT Alphaville):

Goodfriend was also sceptical of the Fed’s decision to begin raising interest rates in 2015, when inflation was weak — even excluding commodities — and nothing indicated it would quickly return to 2 per cent. According to this former student, Goodfriend believed the Fed should make its moves over relatively short periods of time. Thus the 1994-5 tightening was close to ideal because it quickly recalibrated the level of short-term interest rates from 3 per cent to 5.25 per cent. (With an overshoot to 6 per cent in the middle, but still…)

The former student recalls Goodfriend saying that if the Fed were to raise interest rates in 2015 it would probably have to wait a long time before any additional rate increases, which would damage the Fed’s credibility and potentially worsen the downtrend in inflation expectations. That’s more or less exactly what happened. According to this student’s account, Goodfriend would have preferred the Fed waited until it could commit to a relatively short and uninterrupted campaign of “normalisation”.

You want policy volatility? You’ll get it with Marvin Goodfriend. Despite his monetarist beliefs, Marvin Goodfriend may be more tolerant of rising inflationary pressures, at least initially, and then respond with a series of staccato rate hikes to cool off the economy.

Left unsaid during the news of the Goodfriend nomination is the identity of the Fed vice chair. The latest speculation of the two top contenders are John Taylor, who is just as dogmatic as Goodfriend and equally hawkish, and the more moderate Mohamed El-Erian.

Even though El-Erian may be viewed as the moderate and pragmatic choice by Wall Street, he may turn out to have far more hawkish views should he assume the position as vice chair. In early 2016, El-Erian had penned a Project Syndicate essay, entitled “The End of the New Normal?”. In that essay, he worried that the Fed would run out of bullets in the next downturn, and it was time for fiscal policy to engage in some of the heavy lifting currently performed by monetary policy. More recently, he wrote a Bloomberg article that was supportive of the tax bill and infrastructure plan, which is likely to endear him to Trump:

That brings us back to the importance of policy implementation in sustaining and buttressing the historic rally in stocks.

To maintain the uptick in growth, Europe and the U.S. need to implement measures that reverse persistent downward pressures on potential — that is, the ability of advanced economies to grow not just today but also in the future, and to do so in a more inclusive manner.

In the U.S., this requires progress on Capitol Hill on the tax plan, as well as congressional support for the administration’s infrastructure initiative and steps to enhance labor productivity and improve the benefit-to-cost ratio of technological innovation.

That said, the passage of a tax cut would take some of the pressure off the Fed to be overly accommodative and embark on a faster pace of  monetary policy normalization. While Mohamed El-Erian as vice chair would largely be supportive of the Republican tax bill, he would also push for faster pace of rate hikes.

The market is only expecting about two quarter-point rate hikes next year. Would four or five hikes increase market volatility?

The week ahead

Looking to the week ahead, the market may be ready for a brief pause in its advance. I sent out an alert to subscribers on Thursday that my trading account was taking a short position in the market. A number of signs of bullish exhaustion were starting to appear.

First, risk appetite was starting to roll over. Momentum stocks, which had been performing well, had begun to weaken relative to the market. As well, small cap stocks, which tend to be more domestically exposed and more sensitive to tax cuts, underperformed even as the tax bill made its way through the Senate.
 

 

Sentiment is getting a little frothy. The 10 day moving average of the CBOE put/call ratio (CPC) has reached a crowded long reading. In the past, the market has tended to stall out at these levels of complacency.
 

 

In addition, Tommy Thornton identified a monthly $SPX DeMark upside exhaustion signal on Friday.
 

 

The track record of these signals have been remarkable, though the sample size is small (N=7).
 

 

My inner trader is short the market, and he is waiting for either signs of oversold conditions on short-term indicators to cover, or a renewed upside surge to fresh highs as a way of defining his downside risk. The market ended Friday with a hanging man candle, which is a potential sign of a bearish reversal.
 

 

History has shown that if we get any downside follow-through on Monday, the short-term outlook is bearish for stock prices over a 3-4 day time horizon.
 

 

My inner investor remains constructive on stocks, and his asset allocation is at roughly the level specified by his investment policy statement. If history is any guide, the market is likely to pause briefly before resuming its seasonal rally into year-end (via Topdown Charts).
 

 

Disclosure: Long SPXU

What’s next for the tax cut bull?

Posted by Cam Hui -

Mid-week market update: It was clear from yesterday’s market action that the equity bull depends entirely on the success of the Republican tax cut bill. The market rallied on the news that the tax cut bill had made it out of Senate Budget Committee. It manage to shrug off the news of a possible government shutdown, and a North Korean ICBM test, which was later determined to have a range to reach the entire Continental United States.

The combination of the market enthusiasm yesterday and the strength in the Goldman Sachs high tax basket indicates that the market is discounting the passage of the bill.
 

 

Roadblock ahead

The Senate’s version of the bill now goes to the floor of the Senate. Here is where it is likely to run into trouble. Under the Byrd Rule, which states that Senate legislation on budget and spending can be passed with a simple majority without filibuster and then undergo the reconciliation process with House legislation, it needs to pass two tests. First, it cannot increase the deficit by more by $1.5 trillion over 10 years. As well, it cannot raise the deficit any more after the 10 year period. The determination of whether a bill passes those tests is done by the non-partisan Joint Committee on Taxation (JCT). Any budget legislation that is not Byrd Rule compliant is subject to filibuster and needs a 60 vote majority to pass the Senate.

The Republican Senate leadership is trying to bring the bill to a vote on the Senate floor this week, before the JCT has scored the bill. Notwithstanding all the bargaining that is going on right now to get the bill passed, the Washington Post reported that the JCT is rushing to produce a score, whose “optimistic estimate for completion of this analysis is late Wednesday”.

While we don’t have the JCT report yet, we have the results of other models. The analysis of the Penn-Wharton model, which is run by a former Bush administration official, found that “the Senate Tax Cuts and Jobs Act reduces federal tax revenue in both the short- and long-run relative to current policy”, or increase deficits after 10 years, even with dynamic scoring. That doesn’t sound Byrd Rule compliant to me. It’s hard to see how the JCT analysis would come to a significantly different conclusion.

What about the effects of Bob Corker’s proposed “trigger tax”, where tax rates rise if growth does not hit projected targets and the deficit rises? Would that solve the Byrd Rule problem?

Here is what former Reagan budget director David Stockman had to say about writing and implementing a “trigger tax” provision:

The problem is, what is the baseline for measuring any revenue shortfall, and what happens if the short-fall is due to a recession or some other un-programmed economic development? Or even a multi-quarter growth hiatus that may or may not be the on-set of an officially designated “recession” by the authorities at the NBER.

You editor speaks with some authority on this point—having helped devise such a “trigger tax” back in 1983 when Ronald Reagan was looking for a way to raise taxes to stem the exploding deficit caused by the 1981 cut without admitting he was back-tracking. The long and short of it was Reagan’s “trigger tax” never got off the ground because even the threat of a trigger release causes it own set of adverse but impossible to quantify economic feedbacks.

In addition, CNBC reported that other Republican senators opposed the “trigger tax” provision.

Bottom line, the Senate version of the tax bill is hanging on by a very thin thread. If the JCT does manage to publish an analysis, the bill will not be Byrd Rule compliant and will need 60 votes to pass the Senate. Good luck with that.

Equity bulls need to be prepared for a rude awakening should the JCT manages to publish its analysis before the Senate vote.

Technical market condition

Notwithstanding the hurdles surrounding the passage of the Senate tax bill, Urban Carmel highlighted some short-term risks to the market after the strong market action on Tuesday:

US indices closed at new all time highs on Tuesday. The gain was so strong that SPX closed 25% above its Bollinger Band width. This is rare. There have been only 5 similar instances since 2009. None marked an exact short-term top in the market, but all preceded a fairly significant drawdown in the week(s) ahead. Risk-reward over this period was very poor.

While the sample size is low (N=5), he found that the market tended to rise for a few days, and suffer a substantial correction in the weeks ahead:

What is noteworthy is that none marked an exact short-term top in the market – price was usually higher the next day or two – but all preceded a fairly significant drawdown in the week(s) ahead. Risk-reward over this period was very poor.

Subsequent analysis going back to 1986 found that the risk-reward to be unfavorable as well:

The pattern described in this post was more common prior to 2003. Below are additional 18 instances since 1986. Roughly 75% fit the bearish pattern described above; in 5 instances (mostly in 1995-96), SPX continued to rise largely unabated.

For another perspective, the breadth metrics from Index Indicators found that the market was overbought on short (1-2 day), medium (3-5 days), and long (1-2 week) time horizons.
 

 

These readings do not necessarily mean that the market has to correct significantly. However, some consolidation or minor weakness may be in order in the near future.

Things you don’t see at market bottoms: Rational Exuberance edition

Posted by Cam Hui -

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

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”.

Rational exuberance

This is roughly the time for investment strategists to write their outlook for next year. I called for a possible blow-off high in stocks early in the year, followed by a rocky second half (see 2018 Outlook: The Bulls’ Last Charge). By contrast, Street strategists had turned unabashed bullish for 2018. Two separate strategy teams separately and independently rationalized their bullishness as “rational exuberance”.
 

 

In addition, Bloomberg reported that “the average estimate of all the major brokerage firms predicts that stocks are expected to rise 10 percent next year”. Birinyi Associates found that the S&P 500 performs poorly when the average year ahead forecast calls for gains of over 10%:

Stock market research firm Birinyi Associates has tracked the predictions of Wall Street strategists back to 2001. The general conclusion, according to Birinyi’s director of research Jeff Rubin, is not to put too much faith in them. The stock market has plunged in years when analysts predicted it would go up a lot, and jumped in years when Wall Street strategists said it would go up only a little. (Strategists as a group rarely predict down years and haven’t since 2001.) But there is one pattern to look out for: Years in which Wall Street is looking for a double-digit return for the first time in a while.

 

These results are consistent with the research conclusions of the BAML Buy Side Indicator, which is “based on the average recommended equity allocation of Wall Street strategists as of the last business day of each month”. When Street strategists become overly bullish, defined as the Sell Side Indicator rising to at least one standard deviation above its 4-year moving average, equity performance has tended to struggle. (Annotations are mine because the data has been updated since the original chart was produced.)
 

 

Please note that current Sell Side Indicator readings are roughly two-standard deviations above the average, which suggests even weaker equity returns ahead.

BBB Borrower Issues 3-Year Bond at Negative Yield

Would you pay a BBB borrower to take your money? Evidently, that has happened. What’s more, Business Wire reported that the deal was over four times oversubscribed.

Veolia (Paris:VIE) has issued a 500 million 3-year EUR bond (maturity November 2020) with a negative yield of -0.026 %, which is a first for a BBB issuer.

The transaction was very positively welcomed by the investors, which led to an oversubscription ratio over 4. Thanks to this strong demand, Veolia managed to issue the bond with a spread against swap rate of 5 basis points, which is the tightest spread ever achieved for a 3-year fixed-rate EUR Corporate bond.

Thank you, European Central Bank for your QE programs.

Short Selling Managers Are Disappearing

Sometimes I find the most fascinating tidbits. David Swensen, the Chief Investment Officer of Yale University, stated in an interview that he found that short sales represent an important area of opportunity from a contrarian viewpoint. One sign occurred when Yale had to change its short-selling performance benchmark because the number of short selling managers was disappearing:

One of the obvious areas of opportunity in an environment of extended valuations is short something. Recently we had to change an index that we use to measure the returns of short sellers, because the index stopped being published because there weren’t enough managers to populate the—populate the index. So it’s incredibly out of favors. Short sellers have suffered enormously. And I think that’s an area of opportunity.

Monster Art Sale

The art world was recently rocked by the auction sale of Leonardo da Vinci’s portrait of Christ, known as Salvator Mundi, for a record US$450 million. The chart below from SentimenTrader shows that, while these astounding prices don’t always pinpoint the exact market tops, the timing and the amount involved certainly raise eyebrows.
 

 

Crypto and Other Madness

Market lore tells the story of how Joe Kennedy got out of the stock market before the Crash of 1929 when a shoeshine boy started talking to him about stocks. Minneapolis Fed President Neel Kashkari’s tweet may be the modern equivalent for crypto-currencies.
 

 

This astonishing anecdote was followed by the Bloomberg story that survivalists, who had a propensity to hoard food, water and weapons to prepare for the Apocalypse, were turning from holding gold to Bitcoin as a store of wealth:

Across the North American countryside, preppers like McElroy are storing more and more of their wealth in invisible wallets in cyberspace instead of stockpiling gold bars and coins in their bunkers and basement safes.

They won’t be able to access their virtual cash the moment a catastrophe knocks out the power grid or the web, but that hasn’t dissuaded them. Even staunch survivalists are convinced bitcoin will endure economic collapse, global pandemic, climate change catastrophes and nuclear war.

“I consider bitcoin to be a currency on the same level as gold,” McElroy, who lives on the farm with her husband, said by email. “It allows individuals to become self-bankers. When I fully understood the concepts and their significance, bitcoin became a fascination.”

I could ask what these people are smoking, but I found this on Twitter.
 

 

Ummm, never mind…

Embrace the Blow-off (but with a stop-loss discipline)

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Yield Curve freakout

I received a considerable amounts of feedback to my post last week (see 2018 outlook: Last charge of the bulls) over my comments about the risks posed by a flattening yield curve. Interest in the term “flattening yield curve” has spiked, but consistent with levels last seen when the yield curve flattened to this level.
 

 

My readers highlighted some recently published articles indicating that a flattening yield curve doesn’t matter.

  • Scott Grannis wrote a thoughtful piece about the contrary indicators that point to a slowdown.
  • Cullen Roche at Pragmatic Capitalism concluded that a flattening yield curve isn’t a concern until it inverts, and that analysis from the Cleveland Fed indicated that the current yield curve implies a 12% chance of a recession.
  • Tim Duy observed that a flattening yield curve is a typical market reaction in a tightening cycle, though it suggests that “the economy remain mired in a low rate environment for the foreseeable future” and the Fed probably didn’t expect it to flatten this much.
  • Philadelphia Fed President Patrick Harder voiced concerns about inverting the yield curve in a Bloomberg interview.
  • The San Francisco Fed released a paper entitled, “A new conundrum in the bond market?”, that was reminiscent of Greenspan’s hand wringing over the flattening yield curve even as the Fed raised rates in 2005.

I agree 100%. The more the authorities pay attention to a metric, the less the metric matters. In some instances, the metric can be gamed, just like China’s regional GDP growth statistics.
 

 

Even though an inverted yield curve has been an uncanny leading indicator of recession, it may not work this time because of the effects of the Fed’s quantitative easing (and now quantitative tightening) program on the bond market. Indeed, the Fed’s own estimates showed that its QE programs had pushed the 10-year yield down by 100 bp, which had the effect of manipulating the shape of the yield curve.
 

 

There are sufficient contrary indicators that the economy is booming, and the near-term odds of a recession is low. Those conditions are consistent with my belief that the stock market is undergoing a terminal blow-off phase, but Scott Grannis’ work also hint at how investors might look for signs of a market top.

Investors can embrace the blow-off, but I can also offer you some risk control techniques that can act as a kind of stop-loss discipline.

The yield curve is not a red flag

Scott Grannis recently outlined a well reasoned thesis of why investors should not be overly concerned about the flattening yield curve. Cutting to the chase, here is his conclusion:

Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.

In his post, Grannis pointed out that financial conditions are loose.
 

 

Even though the yield curve is flattening, past recessionary episodes have been preceded by a positive and rapidly rising real Fed Funds rate.
 

 

In summary, Grannis is arguing that monetary conditions are far from tight. In the past, it has been tight monetary policy that has cooled growth and plunged the economy into recession. Today, the economy is booming, liquidity is plentiful, inflation is tame, and inflationary expectations are muted. We live in a not-too-hot and not-too-cold Goldilocks period. Therefore equity investors should not get overly bearish.

I agree, to a certain extent. Here is where we differ. My scenario calls for rising inflationary pressures to appear soon, which would cause the Fed to become far more hawkish than market expectations (see 2018 outlook: Last charge of the bulls). Nevertheless, Grannis’ analysis reveals some clues of what to look for in as a top develops.

How to watch for the Top

Here is what I am watching. These signals can be divided into two categories. The first would indicate that tighter monetary conditions are starting to have a significant negative effect on either the economy or the markets.

Are financial conditions tightening? Financial condition indices are currently signaling loose conditions. Equities are unlikely to get overly stress until financial and liquidity conditions tighten as the Fed raises rates.
 

 

As financial conditions are historically correlated with the VIX Index, one real-time indicator of tightening liquidity might be the VIX.
 

 

The lack of volatility is not just restricted to the VIX Index, which measures equity volatility. Callum Thomas at Topdown Charts pointed out that low bond volatility is also a characteristic of a late cycle expansion. A rise in the MOVE Index could also be a signal that the market could be topping (annotations in red are mine).
 

 

As the Fed normalizes monetary policy, money supply growth has tended to decline in response to tighter conditions. Watch for real money growth to go negative. The latest readings show that YoY real M2 growth at 2.7% and decelerating.
 

 

Grannis pointed out that past yield curve inversions have been accompanied by a positive and rising real Fed Funds rate. We are not there yet.
 

 

Momentum and risk-on stampede

From a technical perspective, I am watching for signs of faltering momentum as a warning of a market top. The current macro environment is showing strong fundamental and price momentum. The latest update from John Butters of FactSet indicates that forward 12-month EPS continues to rise strongly, which is an indication of fundamental momentum.
 

 

The market has been dominated by a risk-on bias. The Relative Rotation Graph (RRG) chart by style shows that leadership has been shown by high beta stocks, such as small caps, growth, and momentum stocks.
 

 

The relative performance of different flavors of price momentum factors is also strong, as measured by MTUM and PDP.
 

 

From a sector perspective, leadership is dominated by technology, as inflation hedge groups such as mining and golds starting to falter.
 

 

The technology driven momentum has the fundamental potential to continue for a few more months. Brian Gilmartin, writing at Seeking Alpha, observed that much of the sector is driven by the iPhone cycle, which has the potential to be positive in Q1.

The tech sector could see a “binary” year, with strong growth in the first half of 2018 and slower growth in the 2nd, with the variable being how “super” the iPhone SuperCycle turns out to be.

Another way of showing this for readers is to show Apple’s fiscal ’18 and ’19 EPS estimates and expected growth:

 

Note that estimated YoY growth in Q4 is still strong. Q4 earnings are reported during Q1, which has the potential to create a tailwind for technology stocks during that period.

BAML quantitative strategist Savita Subramanian found that this kind of growth and momentum driven leadership is typical of the behavior in a late stage bull market.
 

 

However, some caution may be warranted in making too large a bet on price momentum. Topdown Charts recently pointed out that price momentum is highly extended on a global basis.
 

 

On the other hand, just because a market is overbought does not mean that it can`t become even more overbought. BAML`s Subramanian observed that the terminal stage of a market bull usually shows the best performance.
 

 

Her analysis suggests that this bull may have some upside left before it gets exhausted.
 

 

Embrace the Dark Side, buy growth and momentum.

The week ahead

Looking to the week ahead, the outlook appears to be mixed. Subscribers received an email alert that my trading account had taken profits on all of its long positions and moved to 100% cash because of the event risk posed by the upcoming vote next Thursday on the GOP tax bill. The market was not overbought, but the lack of bullish follow through was disturbing for the bulls, and these readings could be indicative of a short-term top.
 

 

Schaeffer’s Research also found that the week after Thanksgiving has historically shown a minor bearish bias, at least until Friday.
 

 

However, should the market rise next week, the odds are much better for stock prices in the next three months.
 

 

My inner investor remains constructive on stocks. He is neutrally positioned with his asset allocation at his investment policy target weight. My inner trader took profits on Friday, but he is still intermediate term bullish. He is hoping for a pullback next week so that he can buy in at lower prices. His positioning is consistent with the observation from Callum Thomas of the market seasonal pattern of a brief period of consolidation in late November and early December, followed by a rally into the year end.
 

Round number-itis at SPX 2600?

Posted by Cam Hui -

Mid-week market update: The mid-week market update is being published a day early because of the shortened trading week due to American Thanksgiving on Thursday.

You can tell a lot about market psychology by the way it reacts to news. Early Monday morning (Europe time) and before the market open, a grim Angela Merkel announced that coalition talks had collapsed, and she was unable to form a government. DAX futures instantly took a tumble, and so did US equity futures. Over the course of the European trading day, equity prices recovered and the DAX actually closed in the green. US stocks followed suit and closed with a slight gain. This was a signal that the market has a bullish short-term bias.

I issued a tactical “buy the dip” trading call for subscribers last Friday. Now that the SPX has risen to test resistance at 2600, which represents an all-time high, is it time to sell the rip?
 

 

Negative divergences galore

There are plenty of reasons to be cautions. Credit markets, as measured by the relative price performance of high yield (HY), investment grade corporate bonds (IG) and emerging market (EM) bond prices against their duration-equivalent Treasury benchmarks, have recovered smartly from the risk-off episode last week, but they are still showing a negative divergence as equities test all-time highs.
 

 

Similarly, the market is also showing a negative divergence on RSI-5 and RSI-14.
 

 

Looming government shutdown

As Americans recover from their Thanksgiving long weekend next week, one market risk that could appear is the looming December 9 deadline for a Continuing Resolution (CR) to fund the federal government. That’s because the Republican leadership has been spending so much effort on their tax bill that little attention has been given to the CR that funds the government. Writing in Forbes, here is how Steve Collendder (@thebudgetguy) sees the situation:

Congressional staff, lobbyists and reporters all cheered when the current continuing resolution — the law that’s keeping the government’s lights on while Congress figures out what to do about the fiscal 2018 spending bills — was drafted so it would expire on December 9. They all figured the early-in-December deadline meant they could make relatively secure plans to be out-of-town for the holidays.

I sure hope they didn’t get nonrefundable tickets.

The GOP’s efforts to enact a tax bill by President Trump’s arbitrary and nonsensical Christmas 2017 deadline has made it almost certain that Congress will be in session until close to the end of December. That, in turn, virtually guarantees that the (hopefully) final funding decisions for the year also won’t be made until the end of the month.

That will wreak havoc with holiday schedules. It could also mean there could be a federal government shutdown by January 1.

In addition, Politico reported that Congress speeds towards a shutdown over Dreamers, with the CR as the leverage that the Democrats holds over the Republicans.

Will the market get spooked over the a government shutdown and possible Treasury default in January?

Positive seasonality, strong momentum

On the other hand, stock prices are enjoying a period of positive seasonality and strong momentum.  The Wednesday before and Friday after Thanksgiving have historically leaned bullish, while Cyber Monday leaned bearish.
 

 

Jeff Hirsch at Almanac Trader observed that high beta small cap stocks are entering a period of positive seasonality.
 

 

My former Merrill Lynch colleague Walter Murphy highlighted the strong breadth performance today (Tuesday).
 

 

Current conditions show that high beta, tech stock driven high beta, high octane, and momentum stocks have dominated the market, and there is no end in sight. These reading suggest that, notwithstanding any short-term weakness, stock prices are likely to continue to rally into year-end.
 

 

How should traders interpret this environment of strong momentum with negative divergences? I believe that a buy the dip/sell the rip is still the best short-term approach. However, short-term indicators, such as the % above the 10 dma from Index Indicators, are nowhere near overbought yet.
 

 

My inner trader is long the market, but waiting for short-term overbought readings to appear to take profits. With any luck, that opportunity may appear on Black Friday.

Disclosure: Long SPXL

Relax! NAFTA isn’t going to collapse

Posted by Cam Hui -

As American, Canadian and Mexican negotiators meet for a fifth round of NAFTA discussions in Mexico City, CNBC reported that a number of analysts are projecting significantly high odds that the trade pact would fall apart:

Jens Nordvig, Exante Data CEO, sent out a warning note Monday that his firm now sees a 30 to 40 percent chance of NAFTA “blowing up” by March.

While Ian Bremmer, president of Eurasia Group said in a note Monday that he has long thought there was 50/50 chance NAFTA would fall apart, but he is also becoming increasingly concerned.

“The big risk is that trade tension in NAFTA spreads to a more global stage, for example if the EU sides with Mexico in WTO disputes. This is where the global risk grows very large,” Nordvig said in an email.

Canada’s McLean’s magazine proclaimed in an article that, “If NAFTA dies, ‘all hell will break loose’“. As a consequence of these trade jitters, both Canadian and Mexican equities have underperformed American ones.
 

 

Relax, even if the Trump administration didn’t get its way in its negotiations, the path to walking away from NAFTA will be long and difficult.

Obstacles to leaving NAFTA

Bloomberg recently published an excellent primer on how Trump could kill NAFTA (it’s not as easy as you think).

Technically, any country could leave on six month’s notice, but the process of leaving the trade pact will be as complicated as the Brexit process. The NAFTA treaty was implemented as an Act of Congress, H.R. 3450, the North American Free Trade Agreement Implementation Act, and it will be up to Congress to repeal all of the laws that set up the NAFTA relationship in order to unwind the treaty.

That’s where the political obstacles come in. Here is a chart of each state’s biggest export trading partner. Umm…see the problem?
 

 

The Petersen Institute analyzed the effects of a cold turkey NAFTA withdrawal and concluded that it would have a direct cost of 187,000 export jobs, mostly in the American heartland (click link to see the interactive impact by state).
 

 

Notice a pattern here? The worst hit states tend to be deep red Republican leaning areas that voted for Trump. Assuming that the GOP fails to pass a tax bill by year-end, and Trump wanted to deliver a political victory by withdrawing from NAFTA, he will find a fight in Congress with Republicans.

Relax. Despite the tough rhetoric, it’s difficult to see how the Trump administration could realistically tear up the NAFTA treaty.