2018 outlook: The last charge of the bulls

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 (upgrade)

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

The outlook for 2018

It`s that time of year, when investment strategists look ahead to the following year. I favor the analytical framework of New Deal democrat, who views the economy through the prism of coincident, short leading, and long leading indicators. I agree with NDD`s latest assessment that the short term outlook is very strong. While NDD scores the long term outlook as neutral, long leading indicators have been gradually deteriorating. A continuation of the Fed tightening cycle could see downward pressure to equities from either valuation or recessionary warnings by mid-year.

Enjoy the party for now. The global economy is undergoing a reflationary surge, and the outlook for Q1, and possibly Q2, is bright. Consequently, equity bulls are responding with one last charge.
 

 

Be warned, however, that the early part of 2018 could be as good as it gets for this cycle. Chris Puplava observed that consumer confidence is nearing the 90th percentile level going back to 1967.
 

 

Such readings have seen stock prices perform poorly over a 1-2 year time horizon. The latter half of 2018 could therefore be very bumpy.
 

 

Short leading indicators all green

Looking over the next few months, it`s hard to argument with the combination of positive fundamental and price momentum. The US Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, is surging (orange line). While high than expected growth is likely to put upward pressure on interest rates and bond yields, that`s a worry for later.
 

 

Now that Q3 earnings season is mostly done, it was a quarter of strong results. Urban Carmel, writing at The Fat Pitch, pointed out that stock market gains were mainly driven by earnings growth. About two-thirds of the rise in the market was the result of profit increase, and about one-third from multiple expansion, based on the expectations of further growth ahead.
 

 

EPS gains were not illusory, either. Virtually all (89%) of the growth in EPS was organic profit growth, and only 11% attributable to buybacks.
 

 

The latest update from John Butters of FactSet tells the story of Wall Street optimism. Forward 12-month EPS estimates are rising, indicating positive fundamental momentum.
 

 

Forget about the sensational warnings about the combination of a Hindenburg Omen and Titanic Syndrome, the stock market is unlikely to crash during Q1 2018. New Deal democrat`s weekly assessment of high frequency economic indicators found that “all short leading indicators…remain positive”. Equity investors can’t ask for much more than that.

Watching for inflation in 2018

Looking further into 2018, however, some dark clouds are gathering on the horizon. The biggest macro risk for the US economic outlook in 2018 is the re-emergence of inflation.

Rising inflationary pressure is especially insidious as some Fed officials have been reluctant to normalize rates due to the absence of inflation. Should inflation begin to rise again, those objections are likely to be stilled, and market expectations of a December rate hike, followed by two more quarter-point hikes in 2018 may prove to be overly dovish.

Last week’s October CPI report may be the indication of an inflationary revival. Core CPI came in slightly ahead of expectations (blue line), while Median CPI, which has been significantly more elevated than Core, is also rising.
 

 

Inflation internals are also signaling an acceleration. The blue line below shows the difference between PPI and CPI, while the red line is Core CPI. When the PPI-CPI spread rises sharply during a late cycle expansion, which is what the economy is experiencing now, it is often a signal of an inflationary blow-off to which the Fed would undoubtedly respond.
 

 

Since the Fed’s operates mainly from a Phillips Curve framework, measures of labor market slack are important metrics to the determination of monetary policy. Labor market slack, as measured by slack as a fraction of the labor force (blue line), or the spread between the U6 and U3 unemployment rates (red line), are at levels seen at the lows in the previous economic cycle. While acceleration in wage growth has not made an appearance yet, these statistics are likely to make Fed policy makers sit up and take notice.
 

 

Fed watcher Tim Duy believes these low unemployment rates leave the Fed no choice but to hike rates. The experience of the late 1960’s, when unemployment fell below 4% and inflation accelerated from 1.5% to 4.8%, showed that the slope of the Phillips Curve steepened dramatically. Rate hike delays would run the risk of the Fed finding itself significantly behind the inflation fighting curve.
 

 

The market effects of higher rates

The conditions that I just described are likely to be equity negative and push the economy into recession. Past tightening cycles has seen real money supply growth go negative, which has been a signal of recession. In the past, it has been M1 growth (blue line) that has fallen below inflation (black line). The current cycle is seeing an unusual condition where M2 growth (red line) decelerating to about 3%, which is a cautionary signal. Continued normalization of monetary policy should see real money supply growth decelerate further and becoming negative in the near future.
 

 

Another factor that is likely to spook the markets is the gap between the market and the Fed’s expectations of monetary policy. While a December rate hike is a near certainty, the market believes that the Fed will only raise rates only twice next year, while the dot plot calls for three hikes. Should signs of inflation start to appear, the probability of three hikes will begin to rise and even four hikes would become a real possibility.
 

 

Another concern is the effects of rising rates on financial stability. New York Fed President Bill Dudley has been in favor of further rate normalization because financial conditions have been loosening even as the Fed raised rates.
 

 

While that interpretation is correct, the Chicago Fed’s Financial Condition Index has shown a near 1 for 1 correlation with the VIX Index. As the Fed tightens, it will eventually tighten financial conditions, and market volatility is sure to follow.
 

 

Equity investors caught between Scylla and Charybdis

Should the Fed embark on an aggressive rate hike cycle, it would put equity investors in a difficult place as they try to navigate between the metaphorical Scylla and Charybdis of monetary policy.

On one hand, should we see a parallel upside shift in the yield curve in response to monetary tightening, it could cause dislocation in equity valuation. The 10-year Treasury yield is forming a potential inverse head and shoulder pattern. Should the pattern complete with an upside break in the neckline, the measured upside target is in the 2.8-2.9% region, which would enough to cause a significant degree of P/E compression.
 

 

On the other hand, the 10-2 year spread has already flattened to 62bp, which is a cycle low. Should the yield curve flatten in response to rising rates, it would only take two or three rate hikes to invert the yield curve, which is a warning of a bull market killing recession.
 

 

Party’s not over yet

That said, all of these negative factors are unlikely to be important until Q2 2018 at the earliest. Relax, and enjoy the momentum party. Momentum remains a dominant factor in today’s market. As this smart beta analysis from Lazard Asset Management shows, returns to momentum are tied to risk appetite and the market just saw the start of a momentum cycle that probably has further to go (grey line).
 

 

Momentum stocks (MTUM) are in a solid relative uptrend against the market.
 

 

Callum Thomas pointed out that upside potential is considerable, especially if the market is undergoing a blow-off.
 

 

The week ahead

The near-term market outlook is a bit more uncertain. Subscribers got a trading alert on Friday when the trading model flipped from bearish to bullish. The market had gotten oversold when the VIX Index rose above its upper Bollinger Band and mean reverted below.
 

 

A historical study of such signals has seen mainly bullish outcomes. However, 35% of past signals have resolved themselves with W-shaped recoveries, where the market rallied, stalled and fell to test the previous low. The lack of fear and capitulation selling in the last pullback, which was extremely shallow, raises the probability above 35% in the current case.
 

 

I also wrote last week that I was waiting for the Fear and Greed Index to fall to a minimum of 40 before I can declare it to be oversold. The index did fall below 40 on Wednesday, but recovered on Thursday to 55 and closed Friday at 44. Past episodes where this index bottomed at 40 saw the stock market chop around for several weeks afterwards. This is also consistent with my belief that the market is likely to experience greater volatility for the next few weeks.
 

 

Next week is the week of American Thanksgiving. Jeff Hirsch at Trader’s Alamanac found while performance on Monday tended to be mixed, there was a bullish bias for the other days of the week. My inner trader is leaning bullish after the VIX buy signal, and breadth indicator showed signs of technical healing.
 

 

Nevertheless, there are a number of potential sources of downside volatility next week from the GOP tax bill and NAFTA negotiations. While I don’t expect much breaking news from the NAFTA talks, the Republican Senate bill faces a few major hurdles:

  • The bill funds the tax cuts by repealing the ACA individual mandate, which is politically risky in light of the last healthcare bill fiasco.
  • One hidden “feature” of the bill that has not been widely publicized is the CBO assessment that it would trigger about $100B in entitlement cuts, including $25B from Medicare, because of the PAYGO law. Such cuts are politically toxic, especially in a midterm election year.
  • The Republicans look increasingly likely to lose the Alabama special election, where the latest polls show that Democratic challenger Doug Jones trending ahead of the scandal ridden Republican Roy Moore.

 

 

  • The latest Joint Committee on Taxation assessment of the GOP tax plan on who gets a tax cut and tax increase could be problematical for the Republicans as the midterm elections approach.

 

 

  • The Republican margin in the Senator is extremely narrow. Ron Johnson of Wisconsin has already announced his opposition to the bill, which means that Majority Leader Mitch McConnell can only lose one more vote. Should Roy Moore lose the Alabama special election on December 12, or other potential GOP mavericks like Collins, McCain, Corker, Flake, or Paul move into the “no” column, tax reform will go down in flames.

On the other hand, stock prices could catch a bid if we get confirmation that the White House nominates Mohamed El-Arian to the post of Federal Reserve vice chairman (via CNBC). El-Arian would be welcome by the markets as a triumph of the pragmatists within the Trump administration over the rules-based ideologues in the Republican Party.

My inner investor remains neutrally positioned at the weights specified by his investment policy asset mix. My inner trader went long on Friday, but he believes that this is a market where traders should opportunistically buy the dips on weakness, and sell the rips on strength.

Disclosure: Long SPXL

An orderly retreat, but getting oversold

Posted by Cam Hui -

Mid-week market update: After several weeks of waiting, evidence of near-term weakness and consolidation is finally appearing. The SPX violated an uptrend this week and it is undergoing a retreat or a period of sideways consolidation.
 

 

Until today, this orderly retreat in stock prices was enough to depress stock prices, but not enough to flash oversold readings. Today`s decline, however, is beginning to spark oversold readings, indicating that a tradeable bottom may occur in the next few days.

Breadth deterioration continues

The weakness has been evident for weeks. The deteriorating in breadth and risk appetite that I recently identified are showing few signs of reversal. Credit markets are still performing badly. The negative performance of high yield (HY) against their duration equivalent Treasuries (blue line), EM bonds vs. UST (green line), and investment grade bonds vs. USTs (red line) are still headed downwards.
 

 

Small and mid cap stocks continue to underperform, indicating poor breadth participation. Leadership is restricted to just a few megacaps and large cap NASDAQ stocks.
 

 

The rise in risk aversion is spreading to Europe. Both the Euro STOXX 50 and FTSE 100 recently fell below their 50 dma, indicating a loss of momentum.
 

 

The poor performance of eurozone equities is particularly surprising in light of their recent positive macro surprises.
 

 

Tiho Brkan confirmed my observation about non-US market breadth by pointing out that global breadth is deteriorating.
 

 

Commodity prices are also falling, based on signs that Chinese economic growth may be coming off the boil. In particular, the cyclically sensitive industrial metals has fallen below both its uptrend line and its 50 dma.
 

 

Getting oversold

Some of the short-term lines that I outlined on the weekend where I would cover my short position have been crossed. RSI-14 has fallen to 50 or less. The VIX Index has risen above its upper Bollinger Band, indicating an oversold condition.
 

 

At the time of this writing, the Fear and Greed Index has not been updated since Monday night, and it is unclear whether it has fallen to the minimum target reading of 40. (In response to a reader comment, these are all minimum readings indicating that the market has fallen sufficiently to cover a short, and they are not necessarily buy signals, as oversold markets can get more oversold).

Interestingly, the Zweig Breadth Thrust Indicator is nearing an oversold setup, which could be indication of a brewing buy signal. Readers who want to follow this indicator in real-time can use this link.
 

 

As a way of estimating near-term downside risk, I went back in time for eight years and looked for past occurrences of negative HY negative performance to see how far down equities fell after such episodes. The early instances of poor HY relative returns saw the SPX experience drawdowns of 5-15%. The 2014-16 period can be discounted because HY was affected by the specific underperformance of energy related companies. Since then, HY underperformance has been relatively shallow, and SPX drawdowns were in the order of 2%. If the market were to see a 2% peak-to-trough decline, then that would put the SPX downside risk at around 2540.
 

 

Don`t get too bearish

Despite my short-term bearish bias, my intermediate term outlook remains bullish. I have already outlined the many signs of bullish intermediate term momentum last weekend (see The tax reform jitters correction?) so I would repeat them.

I would point out, however, that the release of the latest BAML Fund Manager Survey contained a number of surprises. Upon first glance, fund manager positioning indicating a stampede into risky assets may prompt a reflex interpretation of these readings as a contrarian sell signal. Upon closer examination, however, the historical evidence suggests that these bullish excesses are the first indications of a FOMO (Fear of Missing Out) melt-up. (I have annotated less extreme buy signals in grey, which are also consistent with market advances, not tops).
 

 

As well, the historical record shows that excessive valuation and risk appetite can take some time to resolve itself in a bearish manner. Similar levels of perceived excessive valuation and falling cash levels began to appear in 1998, which was well before the NASDAQ peak in early 2000.
 

 

What about the back up in yield spreads touted by Gundlach and others? Here is some context of the “blow out” in spreads. Bottom line: it’s a trading call warning and not a sign of the Apocalypse.
 

 

Don’t stay bearish too long. The melt-up may be just around the corner.

Disclosure: Long SPXU

Nervous about FANGS? Here is a washed-out high beta opportunity

Posted by Cam Hui -

Are you getting nervous about the FANG stocks? The debut of the FANG+ futures contract may mark a top for this group, as it presents an easy vehicle for hedgers to short these high beta stocks. But don’t despair, consider this chart of the relative performance of a high beta group that is washed-out, and may present an opportunity for investors and traders who missed out on the FANG move.
 

 

Would you buy this?

Thought about Biotechs lately?

The mystery chart is the relative performance of Biotech stocks (IBB) against the market. As the chart shows, the group is testing a key relative support zone when compared to the market. Unless the outlook deteriorates significantly, relative downside risk appears to be limited.

There are a couple of reasons to consider the Biotech stocks. First, the group is experiencing a bullish breadth divergence. IBB is a cap weighted ETF, which means that the largest capitalization stocks dominate the performance of that security. By contrast, the equal weight XBI Biotech ETF is performing much better.
 

 

There is also fundamental support for this group. The Morningstar fair value estimate shows that Biotech stocks are about 9% undervalued.
 

 

In conclusion, here is a high-beta group that is undervalued and washed-out. What more could anyone ask for?

The tax reform jitters correction?

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.

Tax reform jitters

This was the week that jitters over the Republican tax bill finally caught up with stock prices. Now that both the House Republicans and Senate Republicans have different versions of a tax bill, the market is waking up to the challenges ahead.

  • Both Houses of Congress have to reconcile their bills, which may not be easy. Further bargaining lies ahead, which has the potential to dilute the bullish effects of any corporate tax cuts.
  • Any bill will have to overcome the twin Byrd Rule hurdle of $1.5 trillion in incremental deficit in the next 10 years, and no further deficits after 10 years. Any violation of the Byrd Rule would require 60 votes in the Senate, which would be challenging as the GOP only has a 52-48 seat majority.
  • The Roy Moore scandal is creating additional uncertainty, as a Moore loss in the December special election in could cut the Republican majority to a single vote in the Senate.

Even before stock prices got spooked, the market showed signs it was ready to go down. There were cautionary signals from risk appetite indicators, which signaled rising skepticism over the passage of any tax bill. The top panel depicts the relative performance of high beta vs. low volatility stocks as a metric of risk appetite. Risk appetite perked up in September as the odds of a tax cut became more likely, then flattened out into a range. This pair broke down through a relative support on Friday. The other pairs show the relative performance of “champagne” stocks Sotheby’s (BID) and Tiffany’s (TIF) against the market. The “champagne” stocks have been underperforming the market for the last few months, which is another sign of market skepticism that much was going to be accomplished on the tax bill.
 

 

As well, the latest update from John Butters of FactSet shows that the market reaction to earnings reports may be showing signs of bullish exhaustion. EPS beats were barely being rewarded, while misses were severely punished (annotations are mine).
 

 

Tax cut headwinds

Bloomberg published a good summary of the challenges that the GOP faces in reconciling the House and Senate versions of the tax bill. Both chambers have boxed themselves by generating $1.5 trillion in deficits over 10 years, but different tax breaks and revenues sources in both bills. The reconciliation process will have to make the difficult choice of deciding which provision to keep (and add) in order to add up to a final $1.5 trillion deficit.

Jonathan Traub, who oversees tax policy for Deloitte Tax LLP, said the biggest sticking points will emerge as the Senate Finance panel begins rehabbing its bill to comply with Senate rules.

“That’s a hole that Hatch and the other Senate Republicans are going to have to fill,” Traub said. “And how they fill it may not be very attractive to House Republicans. It’s an unenviable challenge they face.”

On the House side, last-minute changes to the bill before it cleared the Ways and Means Committee on Thursday pulled its price tag under the $1.5 trillion allowed in the first decade under the budget resolution.

“Today, the first and oldest Committee in Congress passed transformational tax reform legislation that charts a new course for the country,” Ways and Means Chairman Kevin Brady said after his panel approved his tax bill.

To get there, the panel appears to have employed a touch of fiscal finesse: The single biggest source of new revenue in Brady’s changes stems from a revision that wouldn’t take effect until 2023 — raising questions about whether Republicans in Congress would ever really let it happen.

Then they have to appease the deficit hawks in the Senate as they navigate their fragile two seat majority:

Three senators have already raised concerns about tax cuts that increase the deficit, including Senator Bob Corker of Tennessee, Senator James Lankford of Oklahoma and Senator Jeff Flake of Arizona. “I remain concerned over how the current tax reform proposals will grow the already staggering national debt,” Flake said Thursday, calling for a “fiscally responsible” bill.

The Republicans may also be driven by an increasing sense of panic. Cristina Marcos of The Hill reported that one House Republican admitted that donations are likely to dry up should the tax reform bill fail. Falling political contributions would reduce their chances of retaining control in the midterm elections next year.
 

 

Moreover, the special Senate election in Alabama on December 12 to choose Jeff Session’s successor may represent a key deadline. Republican candidate Roy Moore has been accused of sexual improprieties with minors, and the news has split the Party. While there has been an outpouring of support for Moore, Politico reported that the National Republican Senatorial Committee has withdrawn its financial support for Moore’s campaign. Three GOP senators, Bill Cassidy of Louisiana, Steve Daines of Montana, and Mike Lee of Utah, have rescinded their endorsement of Moore. More importantly, Donald Trump put out a press statement distancing himself from Moore:

Like most Americans, the President believes that we cannot allow a mere allegation — in this case, one from many years ago — to destroy a person’s life. However, the President also believes that if these allegations are true, Judge Moore will do the right thing and step aside.

As the news of the scandal broke, the latest poll showed that his Democrat opponent Doug Jones had pulled even with Moore in support, which is highly unusual in a state that has leaned deeply red like Alabama. Should Moore lose the special election, it would erode the Republican majority in the Senate to a single vote, even as the leadership tries to manage the opposition of maverick senators such as Corker, Flake, Lankford, McCain, and Collins.

Warnings from technical deterioration

Even before last week’s market weakness, the stock market’s technical internals were looking rather unhealthy, as market breadth has shown signs of deterioration even as the index rose.
 

 

It could be said that market breadth is an imperfect timing tool. Negative divergence can exist for months before the major averages drop. The credit markets is another matter. Jeff Gundlach issued a series of warnings based on the action of the junk bond market.
 

 

While Gundlach highlighted the negative price action of junk bond, or high yield (HY), ETFs, I prefer to focus on the relative price action of HY bonds to equivalent duration Treasury paper, which neutralizes the interest rate effect to analyzes the credit spread effect (see The market`s report card on the GOP tax bill).. As the chart below shows, credit spreads were not only rising in the HY market, but investment grade corporates and EM bonds too. Even though HY and EM bonds recovered a bit on Friday, IG relative performance continued to deteriorate, indicating that further stress is likely ahead.
 

 

Indeed, the approach of using HY to measure risk appetite can be useful as a confirmation signal. The chart below shows the history of equities and the relative performance of HY to UST. With the exception of a brief episode in late 2014 when energy related HY dragged down the performance of the sector, the two series have been highly correlated in the last 10 years.
 

 

Don’t panic, it’s only a correction

Even if the tax bill were to fall apart and stock prices sell off, I would be inclined to buy the dip, as the intermediate term outlook is still bright. Fundamental momentum remains positive, which is bullish. FactSet reports that, with Earnings Season nearly over, EPS and sales beat rates are well above historical averages, and forward EPS is rising robustly, indicating Street optimism about the earnings outlook for 2018, even without tax cuts.
 

 

From a top-down perspective, the nowcast of the economy is upbeat. Initial jobless claims has shown a remarkable inverse relationship with stock prices in this expansion, and claims continue to fall.
 

 

The Citigroup Economic Surprise Index is rising, indicating that high frequency economic releases are handily beating expectations.
 

 

The upturn is global, and not just isolated to the US.
 

 

My inner investor would therefore regard any significant weakness in stock prices as a buying opportunity.

Correction not over

If we were to assume this is the start of a long awaited correction, then most indications suggest that it is not over. Short term indicators have not reached oversold and fear levels consistent with bottoms. After the SPX breached its uptrend line late last week, I am now watching both the RSI-14 to see if it can reach a minimum target of 50, and the VIX Index to see if it can breach the upper Bollinger Band (BB), which would flash an oversold condition.
 

 

Short term breadth indicators from Index Indicators are nowhere near an oversold reading.
 

 

Intermediate term indicators like the NYSE Common Stock McClellan Summation Index is also not oversold.
 

 

The Fear and Greed Index stands at 54, and the market has historically not bottomed until it has fallen to 40 or less.
 

 

My inner investor remains neutrally positioned, with his stock and bond weights at roughly their investment policy weights. My inner trader is short the market, and waiting for oversold conditions to materialize before he covers his position.

Disclosure: Long SPXU

The market’s report card on the GOP tax bill

Posted by Cam Hui -

Mid-week market update: The price action of stocks in the last few weeks makes it evident that US equities are awaiting the resolution of the Republican tax bill. This week will be critical for the progress of the bill through the House, as it is scheduled to be marked up in the Ways and Means committee. So far, the market verdict is not hopeful.

As the top panel of the chart below shows that high beta stocks rallied against low volatility stocks in September, followed by a range-bound market, indicating a lack of conviction. The bottom panel shows that this market has been mainly driven by momentum stocks.
 

 

Other market internals are also flashing warning messages for the bulls. From a political perspective, the tax bill is also running into trouble. These are all signs of likely corrective action ahead.

Poor technical internals

From a technical perspective, the market does not look healthy. The recent advance is characterized by extremely narrow leadership of megacap and large cap NASDAQ stocks. Both mid and small cap stocks are underperforming, and the equal-weighted NASDAQ 100 (NDX) is tanking against the cap weighted NDX.
 

 

It could be argued that negative breadth divergence could last a long time with few ill effects on the major averages. A more immediate concern is the negative divergence in risk appetite shown by the credit market, where high yield and emerging market bonds are underperforming equivalent duration Treasuries, but stock prices continue to rise.
 

 

In addition, there are signs of complacency showing up in the option market. While the low level of the VIX Index is a concern, the term structure of the VIX has steepened to historical extremes, indicating excessive bullishness.
 

 

Tax bill resistance

If the market is focused on the prospect of tax cuts, then the Republican tax bill is increasingly running into trouble on Capitol Hill. While the Democrats and other opponents may denounce the bill as a giveaway to the rich, CNBC reported that Fitch, which is a more credible third-party source, concluded that the proposed cuts “may lead to a short-lived boost to output”, but they “will not pay for themselves or lead to a permanently higher growth rate”. Moreover, “Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact”.

The longer the bill gets discussed, the more likely it will fail, as the delay allows third parties to study the bill and raise objections. The opposition by the National Association of Realtors and National Home Builders Associations over the mortgage interest deduction is well known. Other bombshells have emerged, which could create widespread opposition, such as:

  • The discovery that individuals would lose the state and local tax writeoff, but pass-through entities would not (via David Kamin)
  • A 20% excise tax on companies shifting profits to foreign subsidiaries in low tax jurisdictions. This would be a variation of the Border Adjustment Tax that was originally proposed by later abandoned by lawmakers (via Bloomberg, Business Insider)

I pointed out before (see Peak small cap tax cut euphoria) that the effective corporate tax rate is substantially below the stated statutory rate. Depending on how the tax loopholes are closed, and the eventual statutory rate, companies may in some instances end up with a tax increase, rather than a tax cut.
 

 

The latest WSJ report from Tuesday night showed that GOP lawmakers had retreated and the House tax bill is at least $74 billion over the $1.5 trillion limit specified by the Byrd Rule. Even if the excess gets resolved, the tax proposals face another fight in the Senate, where the Republicans hold a slim two vote majority.

1st and 10 on own 35

In short, the GOP tax bill faces many hurdles. Despite all of the progress so far, a football analogy would put them at first and 10 on their own 35 yard line. At this rate, even the prospect of a field goal is in doubt.

My base case scenario calls for a short-term correction, based on the combination of technical deterioration, and the likely perception of a tax bill failure. The intermediate term outlook is still bullish, as the growth outlook remains upbeat.

Disclosure: Long SPXU

Bull or bear? It depends on your time horizon

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.

Tops are processes

It is said that while market bottoms are events, which are sparked by emotional panic selling, tops are processes, which are the result of a series of connected episodes that depress prices. In the past few months, I have adopted the belief that the market is undergoing a topping process. Consequently, I become increasingly cautious about the stock market, though I do not believe that the ultimate top has been seen yet.

Here is what we know about the market on an intermediate term time frame:

  • Positive momentum: The market has been supported by strong price, fundamental, and macro-economic momentum. Most macro models show that the risk of recession is low or nonexistent.
  • Valuation: Valuation is stretched.
  • Sentiment: Sentiment has been frothy, which is contrarian bearish.
  • Technical: The pre-conditions for an intermediate or long-term top are not yet in place.
  • Short-term outlook: Much depends on the fate of the GOP tax bill and the market’s evaluation of other sources of risk, such as the Middle East.

Under these conditions, an investor could be either bullish or bearish and be correctly positioned. It just depends on the investment time horizon.

Powerful momentum

Global equity markets are enjoying a macro-economic sweet spot. The world is seeing signs of synchronized global growth. Torsten Slok at Deutsche Bank pointed out that the number of countries in recession, or forecasted recession, is at a historical low.
 

 

The G10 Economic Surprise Index, which measures whether macro indicators are beating or missing expectations, is surging.
 

 

In the US, the latest update from Factset shows that the results from Q3 Earnings Season remain upbeat. Both the EPS and sales beat rates are well above historical averages, and forward 12-month EPS continues to rise. The Q4 negative guidance rate came in at 66%, which is below the 5-year average of 75%.
 

 

Despite the upbeat growth outlook, the bond market is flashing a warning. The 2s10s yield curve is flattening and readings are at a cycle low of 0.72%, though it is nowhere near an inversion. While the yield curve has been an uncanny recession warning signal in the past, it may not invert this time because of the effects that the Fed’s QE programs had on the bond market.
 

 

Stretched valuation

On the other hand, equity valuations are stretched using a variety of metrics. Morningstar estimates that the market is about 4% overvalued, which is roughly the degree of overvaluation seen at the 2007 top.
 

 

The Shiller P/E now stands at 31x, which is above of the 28x multiple seen at the last market peak in May 2007, and it is even ahead the levels reached before the Crash of 1929.
 

 

Ed Yardeni’s Rule of 20, which states that the market is overvalued when the sum of forward P/E (18.0, via FactSet) and headline CPI (2.1) is 20 or more, indicates that stock prices are stretched.
 

 

That said, valuation is not very effective as a short-term market timing indicator. The Morningstar analysis showed that the market went through stretches of overvaluation without entering into a bear market. As well, analysis from EconoPic found that high levels of CAPE was not an impediment to stock prices, as long as it was accompanied by positive price momentum.
 

 

Frothy sentiment

There is also little doubt that sentiment is getting overly frothy. I have been detailing how investor sentiment has gotten out of hand with my series, “Things you don’t see at market bottoms”:

Here is the latest example from Tracy Alloway.
 

 

While excessively bullish sentiment can provide a warning sign for investors, it is also not a very good short-term market timing indicator. As an example, there was some buzz last week about the bullish excesses seen in the level of Investors Intelligence bulls and bears. This chart from Yardeni Research shows current bull/bear ratio at such an extreme that it was only exceeded by readings before the Crash of 1987.
 

 

Further examination of this indicator reveals that stock prices can rise further even after the bull/bear ratio has reached crowded long levels.
 

 

By contrast, excessive fear has shown itself to be a much better signal of limited downside in stock prices, though the model failed in the bear market of 2008-09.
 

 

This is another example of the adage, “bottoms are events, while tops are processes”.

Nearing technical target, but no signs of a top

In a recent post (see Nearing upside target, now what?), I had outlined a range of S&P 500 upside target using daily, weekly, and monthly prices and a variety of assumptions (outliers shown in red). The consensus final target came to 2560-2580, which the market has exceeded.
 

 

On the other hand, the pre-conditions for a cyclical market top are not in place. The global reflationary rebound has lifted stock prices all around the world. As the chart below of the DJ Global Index shows, past peaks (N=3) have been marked by an initial top, a retreat, and a second rally that was characterized by a negative RSI divergence. We have not even seen the first pullback yet.
 

 

One clue for the timing of an ultimate market top came from Variant Perception, which found that the real Fed Funds rate leads the high yield (HY) credit spreads by 18-24 months. If this relationship continues into the future, then HY spreads, which is a proxy for risk appetite, would begin to widen in early to mid 2018.
 

 

Market vulnerable, but buy the dip

To summarize, the question of whether to be bullish or bearish depends on your investment time horizon. I believe that the market is in the process of making a long-term cyclical top. Valuations are stretched, and sentiment is frothy. New Deal democrat’s latest update of high frequency economic indicators reveals that coincident and short leading indicators are positive, while long leading indicators are neutral.

However, the nowcast of the economy is as close to perfection as any investor could ask. As an example, there is a close inverse correlation between initial jobless claims (blue line, inverted scale) and stock prices (red line). These readings suggest that the market is likely to grind higher over the next few months.
 

 

The longer term outlook is not as rosy. Long leading indicators are in neutral territory and readings are deteriorating. The risk of a Fed policy error that tightens the economy into a recession is high. In particular, the combination of a new Fed chair, a shift of votes from dovish to hawkish voting regional presidents in 2018, and likely newly appointed hawkish Fed governors will set monetary policy on a more aggressive course than current market expectations (see Is the Fed tightening into a stalling economy?).
 

 

In the short run, the market is tactically overbought and vulnerable to a pullback. I detailed the short-term negative divergences in my last post (see A market volatility update), and I will not repeat all of them here.
 

 

Tax bill uncertainty

Much of the near term equity outlook depends on the success of the Republican tax proposals. I am monitoring the reaction of major lobby groups and the degree to which they can mobilize effective and widespread political opposition. There has not been sufficient detail for all interest groups to fully study the implications of the proposals. Major business groups such as the Chamber of Commerce have issued non-committal statements indicating support with “a lot of works remains to be done” qualifiers. Rather than dwell on the Republicans apparent united front, here are a number of potential pitfalls for the proposal.

There were scattered complaints from groups who stand to lose from the bill. Not unexpected were the objections from the National Association of Home Builders and National Association of Realtors over the limited loss of mortgage interest deductibility. I am also watching whether the powerful AARP reacts to the elimination of medical expense deductions, which would hit nursing home residents very hard (via CNBC). The bill has also attracted opposition from the National Farmers’ Union.

A major potential sticking point is the opposition from the National Federation of Independent Business, which is composed of small-c conservative business owners, to the pass-through provisions in the bill. The House GOP proposal calls for the taxation of pass-through entities at a 25% rate, with a set of complicated rules to prevent abuse. Kansas governor Sam Brownback had eliminated all state taxes on pass-through entities, but those provisions had created an enormous hole in the state budget as Kansas residents converted themselves from employees to LLCs in order to take advantage of the loophole (see NY Times account). Congressional lawmakers learned from that experience and created “guardrails”, which consist of a number of arcane rules to reduce the abuse of the pass-through provision. The NFIB objected on the grounds that “the bill leaves too many small business behind”. Even though the details of these provisions are highly technical, the bill was drafted without any IRS input because of budget secrecy. This approach is highly likely to create problems, either in the immediate future during debate, or later during the implementation phase should the bill pass.

The elimination of the state and local tax deduction is another potential sticking point in the passage of the bill. This will hurt the residents of high state tax jurisdictions, and it is unclear whether Republicans in those districts could be relied upon to support the bill.

Bloomberg also reported that the House bill, as written, would run afoul of the Byrd Rule in the Senate and a sunset provision would therefore have to be inserted to the proposals:

In order to fast-track the tax legislation through the Senate without having to rely on support from Democrats, Republicans are using a budget process known as reconciliation. That means rather than needing 60 votes to keep the bill moving, Republicans — holding only 52 seats — can proceed with a simple majority of 51 votes to pass the legislation.

To qualify for the Senate’s reconciliation process, the bill must meet the terms of an adopted budget resolution and adhere to rules developed by and named for the late Robert Byrd, the West Virginia Democrat who served as majority leader from 1987 to 1989.

The House plan passes the first test. The fiscal 2018 budget resolution does not allow a tax bill to add more than a total of $1.5 trillion to deficits over 10 years, and the Joint Committee on Taxation’s initial assessment of the measure puts the bill’s cumulative shortfall at $1.41 trillion over a decade.

The red flag is raised after 2027. The nonpartisan joint committee’s analysis shows the plan adding $156 billion to the budget shortfall in that year, a sure sign that it will add to the deficit in 2028. That would trigger the Byrd rule, giving Democrats an opening to raise an objection to the bill on the Senate floor that would require 60 votes to overcome.

The Democrats have so far presented a united front in opposition. Assuming that the Byrd Rule problem is overcome, the Republicans can only afford to lose 22 House votes and 2 Senate votes. Bloomberg reported that Senator John McCain has called for “regular order and support for both parties” for tax reform. Bloomberg also separately reported that Republican senator James Lankford also opposes the bill because of excessive debt. The Republican margin in the Senate is now razor thin. The fate of the tax bill now hangs by thin thread and depends on the support of GOP mavericks like Bob Corker and Susan Collins.

Stay tuned for the full reaction. None of the obstacles presented are necessarily fatal to the bill. It just means that there will be a lot of bargaining and modifications ahead. However, if the market believes that the tax package is becoming a repeat of the healthcare fiasco, it would be the spark for a correction of unknown magnitude.

Correction, then a year-end rally

Putting it all together, my base case scenario calls for a shallow pullback in the next few weeks, followed by a rally into year-end. Evidence of robust growth and emerging inflationary pressures will prompt the Fed and other major central banks to adopt a tightening policy, which will result in an economic slowdown in late 2018 or early 2019. Already, we are seeing evidence that inflation trends are bottoming and starting to turn up around the world.
 

 

My inner investor is constructive on stocks, and he is neutrally positioned at the asset mix specified by his investment policy. Should equity prices sell off, he is prepared to add to his positions.

My inner trader is tactically short the market in anticipation of a pullback.

Disclosure: Long SPXU

A market volatility update

Posted by Cam Hui -

Mid-week market update: In my weekend post (see Good news, bad news from Earnings Season), I had identified several sources of potential market volatility this week:

  • Mueller indictments
  • GOP tax plan
  • FOMC decision
  • Fed chair nomination
  • Key macro-economic reports

It’s time for an update, and it spells caution for the bulls.

Mueller indictments

I don’t consider my job to judge whether the Mueller indictments are right or wrong, whether it is a legitimate act of government inquiry or simply a political witch hunt. My job is to consider their effects on the market.

It is unclear how much of an effect the Mueller indictments had on presidential approval. Gallup shows Trump’s approval rating fell to to a low of 33% before recovering to 35% on Tuesday.
 

 

NDR Research has found that stocks don’t perform well when presidential approval falls to 35% (annotations are mine).
 

 

Here is a more recent chart from Bespoke showing stock market performance and presidential approval that show a similar effect (annotations are mine).
 

 

GOP tax plan

The markets got spooked on Monday when news leaked that the GOP was considering a phase-in of a corporate tax cut to 20%, indicating that stock prices are being held up by the expectations of a tax cut. The latest news indicates that the House tax plan unveiling is delayed until tomorrow (Thursday). Politico reported yesterday that the House Republicans are still having trouble figuring out how to pay for their tax cut wish list without a firestorm of special interest opposition:

But not 24 hours before the bill’s big reveal, lawmakers had yet to settle on one of the most sensitive questions of all: How to pay for their proposed $5.5 trillion in tax cuts, since any major revenue-generator is certain to antagonize some powerful lobby or group of lawmakers who could defeat it.

I have no idea of how much of the potential effects of any tax cuts has been discounted. However, there are a couple of ways of measuring the market reaction to a tax plan. The top panel of the chart below shows the relative performance of the high beta ETF against the low volatility ETF. Based on the experience with the healthcare bill fiasco, high beta underperformed from late 2016 because the market believed no tax cuts were getting done. It only began to rally again in late August on the hopes of a tax package getting through Congress.
 

 

Another sure winner of any tax cut package would be gold prices, as the increases in fiscal deficits would be judged to be inflationary. The bottom two panels show the price of gold and the relative performance of gold stocks to the market. Both have been range-bound and shown little leadership characteristics. For some context, consider these comments from former IMF chief economist Simon Johnson:

Name the country. Its leader rails against foreigners, erects various import barriers, and pushes for low interest rates and lots of cheap credit for favored sectors. Government debt is already high, but the would-be strongman in power decides to pile on even more by increasing the budget deficit, arguing that this will boost prosperity to previously unattainable levels. While the government claims to represent the common people, state contracts are awarded to friends of friends.

Surprise! The answer is Argentina:

The answer, of course, is Argentina under Juan Perón, who was in power from 1946 to 1955 (and again briefly in 1973 and 1974), and many of his successors. One of the richest countries in the world around 1900 was laid low by decades of unsustainable economic policies that made people feel good in the short run but eventually ended in disaster, such as runaway inflation, financial crisis, and periodic debt defaults.

For now, the jury is still out on the GOP tax plan. But watch equity risk appetite and gold prices for the instant market verdict. Should the tax plan fail to materialize, or if it becomes apparent that it will not pass because it turns into ACA Repeal 2.0, then don`t be too surprised to see presidential approval fall further (see above analysis for the market consequences of ultra-low approval ratings).

The future direction of Fed policy

As expected, the FOMC decision turned out to be a yawn. The Fed has hiked three times in the past 12 months, but financial conditions implies that they cut rates. They therefore remain on track to raise rates at its December meeting.
 

 

More importantly, the question of the future leadership of the Fed is unknown. Trump is expected to name the Fed chair tomorrow (Thursday). I have already written about what a Taylor Fed would look like, but there are a number of nuances that are unappreciated by the market.

The latest news indicates that Trump is likely to name Jay Powell as the new Fed chair. If true, then the initial market reaction would be euphoric, as Powell would largely represent the continuity of the Yellen Fed’s monetary policies. That said, there are a number of key differences between how a Powell Fed might operate compared to the Yellen Fed.

First, Powell differs from Yellen on regulation. FT Alphaville highlighted a recent Powell speech on Fannie Mae and Freddie Mac, where Powell blamed the mortgage melt-down on these GSEs, while FT Alphaville made the case that it was the private label mortgage insurers that was the main problem. Powell’s solution called for greater privatization of mortgage finance, and a shift of government guarantees from institutions such as Fannie and Freddie to mortgage securities. If Congress were to undertake such an initiative today, then we can expect greater downside volatility in the next crisis.

Business Insider also featured a revealing commentary about Powell, as he is a lawyer and investment banker, and not an economist, by training:

“He has been in line with the leadership on monetary policy in recent years,” Julia Coronado, a former Fed board economist who worked on Wall Street before founding the research firm MacroPolicy Perspectives, told Business Insider. “His comfort zone and leadership has been in getting his hands dirty on regulatory and financial sector plumbing issues. He is smart and collegial and knows how to lean on the staff’s expertise.”

She added he would probably be a different kind of Fed chair than Yellen “in that he will be forging a consensus more than driving it on monetary policy.” She continued: “His depth on financial infrastructure could come in handy if and when the FOMC needs to confront decisions on balance sheet policy again.”

Powell is likely to be a consensus builder on monetary policy. While he is not an economist, the combination of his experience in finance and his years as a Fed Governor will likely make him to initially adopt a stay the course policy of the Yellen Fed. Such a management style, however, indicates a subtle shift of more power to the other members of the FOMC. The market should therefore pay greater attention to the composition of the FOMC and the Federal Reserve Board of Governors. The voting rotation of the regional Fed presidents, from the dovish Evans and Kashkari to the more hawkish Meester and Williams, already guarantee a more hawkish FOMC in 2018.

Then there is the issue of the Fed Board. If Janet Yellen does not serve out the remainder of her term as a Fed governor, then there are five out of a possible seven open seats on the Board. It would be a golden opportunity for Trump to shape future Fed policy. Assuming that Trump focuses on Republican candidates, then there are very few candidates who are likely to steer the Fed in a direction that is more dovish that the current Yellen Fed (see A Fed preview: What happens in 2018?). Moreover, most Republican candidates are likely to favor a rules-based approach to monetary policy, which would push the Fed Funds target much higher than it is today.

Currently, the market is discounting a quarter-point rate hike in December, and roughly two quarter-point hikes in 2018. By contrast, the Fed’s dot-plot calls for three rate hikes in 2018. In light of the likely more hawkish tilt of the FOMC in 2018, expect the three rate hike to be a floor and not a ceiling for the evolution of monetary policy next year.

Macro data = Fragile economy

I had written before that my greatest fear is that the Fed is tightening into a slowdown (see Is the Fed tightening into a stalling economy?). The latest set of macro data releases confirms that view.

On Monday and Tuesday, we got the latest on Personal Consumption, Savings Rate, and Employment Cost Index. As the chart below shows, increases in wages are not keeping up with personal consumption. As a result, households are running down their savings in order to finance their spending.
 

 

One alternative is to send more people in the household into the labor force. We will see an update of this in the Jobs Report on Friday, but with the labor market already tight, I have my doubts as to how much the Labor Force Participation Rate could improve.

Market breadth

In the meantime, the major averages are within a hair of their all-time highs, but the internals are signaling caution. Risk appetite, as measured by high-yield bonds, is flashing a minor negative divergence.
 

 

As well, the equity advance has been extremely narrow. Leadership is concentrated in the megacap stocks, and large cap NASDAQ issues, while mid and small caps lag.
 

 

Similarly, RSI-5, RSI-14, net 52-week highs-low, and 10 dma of advance-declines are also flashing negative divergences, indicating a loss of momentum and a possible change in market direction.
 

 

While I remain constructive on stocks for the remainder of the year, the market is vulnerable to a short term pullback. My inner investor is neutrally positioned at his investor policy weight of stocks and bonds, while my inner trader is short equities in anticipation of a 2-5% correction.

Disclosure: Long SPXU

Things you don’t see at market bottoms: Halloween edition

Posted by Cam Hui -

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

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

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

$1,000 gold bagel

The Westin New York will start selling a bagel with white truffle cream cheese and sprinkled with gold flakes for $1,000. This item was last offered on the menu in *ahem* 2007.
 

 

The timing of this menu offering speaks for itself.

Euphoriameter at a cycle high

Callum Thomas of Topdown Charts has constructed a “Euphoriameter”, which is a combination of forward P/E, VIX and bullish sentiment. Readings are at a cycle high and it is near the peak seen in the last market cycle.
 

 

Cash is trash

We are seeing numerous signs that retail investors are all in on equities. Consider this comment from Morgan Stanley CEO James Gorman on the company’s earnings call:

“We saw more cash go into the markets, particularly the equity markets as those markets rose around the world. And we’ve seen cash in our clients’ accounts at its lowest level.” –Morgan Stanley CEO James Gorman

These readings have been confirmed by the AAII asset allocation survey, which shows cash at lows not seen since the top of the NASDAQ Bubble.
 

 

A similar level of investor enthusiasm can be found in mutual fund cash data.
 

 

The latest University of Michigan investor confidence survey shows that respondents have 100% confidence that the stock market will not decline in the next year.
 

 

ICOs are the new black

Finally, Bloomberg reported that Initial Coin Offerings (ICOs) have raked in $1 billion in two months, and their total market capitalization now exceeds $3 billion.
 

 

For a primer on ICOs, please see Appcoins are the new snake oil, by Daniel Krawisz, published at the Nakamoto Institute.

With that in mind, Humble Student of the Markets would like to announce an ICO offering…

Good news, bad news from Earnings Season

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 (downgrade)

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

Good news and bad news

We are about halfway through Q3 earnings season, and the market saw its share of ups and downs last week.
 

 

The market rallied to fresh highs on Friday, and leadership was provided by large cap FAANG stocks. Beneath the surface, there was a mixture of both good news and bad news for investors.

The good news

Let’s start with the good news. John Butters FactSet pointed out that, with 55% of the SPX having reported results, both the earnings and sales beat rates are well above historical average. As well, forward 12-month EPS continues to rise, which is reflective of positive fundamental momentum (all annotations are mine).
 

 

Q3 GDP grew at +3.0%, which beat expectations. This was a continuing series of positive macro-economic surprises that has lifted the Citigroup Economic Surprise Index to new recovery highs.
 

 

In addition, the latest update from Barron`s of insider trading activity is constructive and could be supportive of higher stock prices.
 

 

The bad news

Unfortunately, there is lot of bad news. Despite the positive headlines from FactSet`s analysis, the sales beat rate deteriorated from 72% last week to 67% this week, though the EPS beat rate remained steady at 76%. As well, forward 12-month EPS was up an anemic +0.01% in the week, which is hardly anything to get excited about.

Another disappointment can be found in the market reaction to earnings results. FactSet observed that the market is barely rewarding earnings beats, but punishing misses.
 

 

Another worrisome macro and fundamental headwind can be found in the strength of the USD. FactSet found that companies with greater foreign exposure tended to see better sales and earnings growth.
 

 

However, much of those Q3 EPS gains can be attributable to USD weakness. As the USD strengthens, large cap multi-national companies are likely to see a reversal of the currency effect. In other words, don’t expect the same pace of sales and earnings growth in Q4 as Q3.
 

 

Another ominous theme from earnings calls is rising inflation. Higher input costs, such as wages and materials, are squeezing operating margins as companies have been reluctant to raise prices (via Avondale Investment Management).

“There is some commodity inflation, but the biggest drag that we’re facing right now is related to the labor investments that are being made.” —McDonald’s (Restaurants)

“The labor market in the U.S. is extremely tight, hard to find people.” —Manpower (Temp Staffing)

“we’re now estimating about a $300 million profit hit from higher commodity costs.” —Procter and Gamble (CPG)

“scrap price has moved up and we were unable to move plate prices up with scrap prices. So we started to see a margin compression and that’s where we live now. We’re living in a margin-compressed world today.” —Nucor (Steel)

“we continue to have a positive view on domestic steel consumption…This will be a solid foundation for a strong pricing environment as the macro market drivers continue to be persuasive…These dynamics could create a tight market and lead to significant price appreciation as we saw at the end of last year…I just see it setting up a very, very positive pricing environment for the first quarter of 2018 and all the way through 2018.” —Steel Dynamics (Steel)

“we are seeing a little bit of resistance at the higher price points because of affordability and I think that’s a broader concern that affects the entire business.” —Pulte Home (Homebuilder)

There is widespread anecdotal evidence of tightening labor markets. We will get a more complete picture when the October Jobs Report is released this coming Friday.
 

 

The bottom-up signs of rising inflationary pressures are supportive of the Fed’s decision to continue with its rate normalization policy. Expect more a hawkish tilt from the Fed, regardless of who is nominated as the chair.

Dark clouds in GDP report

There were also a number of negatives in the upbeat Q3 GDP report that beat Street expectations. New Deal democrat pointed out that the two components of his leading indicators from the GDP report are showing signs of weakness.

Proprietors’ Income, which is a data item that gets released before NIPA corporate profits, failed to achieve a cycle high for a second quarter in a row. Both proprietors` income and corporate profits appear to be rolling over, which is a negative sign for the economy.
 

 

Real private residential investment is also showing signs of peaking.
 

 

These reports are consistent with NDD’s weekly analysis of high frequency economic indicators that “the present and near future economy looks strong than at any time during this expansion. The picture among long leading indicators deteriorated further this week…confirms a neutral outlook one year out.” Combined with the prospect of a hawkish Fed, the outlook for equities is becoming increasingly cloudy.

Negative divergences everywhere

From a technical perspective, the equity outlook is equally fragile. Last week’s advance was accomplished with evidence of narrow breadth. Leadership was only provided by the megacap stocks. The mid caps, small caps, and even NASDAQ 100 stocks were either range bound or declining relative to the SPX.
 

 

An analysis of the relative performance of high beta groups tells a similar story. The relative performance of the High beta ETF (SPHB) vs. the Low volatility ETF (SPLV) appears to be rolling over. Except for the Social Media stocks, which is dominated by FB, the relative performance of all other groups, namely Biotech, NASDAQ Internet, and NASDAQ 100, are either rolling over or range bound.
 

 

There are also signs of negative divergences everywhere. Even though the SPX staged a breakout to new all-time highs, the RSI-5, RSI-14, and net new highs-lows are not confirming the new highs.
 

 

To be sure, the weekly chart of the SPX remains above its upper Bollinger Band, and the weekly RSI Indicator has not flashed a sell signal yet. That is a positive sign for the bulls.
 

 

Brace for volatility

Do all-time highs normally look like this? Sentiment Trader observed that the market is in uncharted territory. Despite all of the warning signs, the market is undergoing a slow melt-up phase and anything can happen.
 

 

Next week, there are numerous sources of event driven volatility.

  • The first charges from the Robert Mueller probe may be unsealed on Monday.
  • The GOP is expected to unveil its tax plan Wednesday.
  • The FOMC will conclude its meeting on Wednesday.
  • Trump is expected to announce the nomination of a Fed chair some time next week.
  • There will also be numerous key macro reports next week, including Core PCE (Monday), Personal Income (Monday), Employment Cost Index (Tuesday), ISM (Wednesday), and the Jobs Report (Friday).

My inner investors remains neutrally positioned, with his asset allocation at his investment policy target weight mandates. My inner trader initiated a small short position last week, and may add to it should the market rise further.

Disclosure: Long SPXU

Minor turbulence ahead

Posted by Cam Hui -

Mid-week market update: The SPX has been on an upper Bollinger Band (BB) ride on the weekly chart, and I have been waiting for a downside break on the weekly RSI-14 indicator as the signal that a correction is starting. Current readings show that the weekly RSI has not broken down below 70 tet.
 

 

However, a downside break could also be seen on the daily chart. RSI-5 has broken down below 70, which is a short-term sell signal. RSI-14 has also followed suit, which is another bearish sign. The index also experienced a bearish engulfing pattern on Monday, which is potentially ominous.
 



 

The bear case

Urban Carmel pointed out last weekend that the market is now in the seventh week of consecutive weekly gains, which historically has not ended well.
 

 

Equally disturbing are signs of diminishing breadth during the period where the RSI Indicator was exhibiting a “good overbought” condition (shaded region). At this point, only the megacap stocks are exhibiting any signs of market leadership.
 

 

A shallow correction?

The cautionary signs exhibited by a potential downside break from the weekly RSI signal has historically led to 2-5% downdrafts. However, I would expect that any correction to be fairly shallow. Jeff Hirsch of Almanac Trader found that the end of long winning streaks tend to resolve themselves with a short pullback, followed by a period of sideways consolidation.
 

 

In addition, one of outcomes of the recent period of low volatility has had the perverse effect of the VIX flashing an oversold buy signal for stocks on the shallow pullback this week. As shown by the chart below, the VIX Index has climbed above its upper BB, which is an oversold signal for the stock market. Past episodes, which are marked by vertical lines, have been buy signals for the market. Moreover, the BB width is not particular low by historical standards, and therefore the lack of recent volatility is not an excuse to ignore this signal.
 

 

As well, one little known indicator from the option market is showing a high degree of anxiety. The SKEW Index, which measures the price of tail-risk protection, is spiking. In the past, SKEW spikes when the market has pulled back (red arrows) have been reasonably good contrarian buy signals, but SKEW spikes when the market was rising (black arrows) have resolved themselves in relatively benign ways.
 

 

The Fed chair wildcard

One potential source of volatility is the announcement of the nomination of the Fed chair, which is expected to occur before the start of November. Bloomberg reported that Yellen is finding support in Trump himself, who stated in a Fox Business News interview, “I like her a lot”. However, Bloomberg also reported that Trump informally polled Republican senators yesterday as to their preferences for a Fed chair.

The president, in a lunch meeting with Senate Republicans on Tuesday, asked for a show of hands in support of Yellen and other contenders for the job — Stanford University economist John Taylor and Fed governor Jerome Powell. He didn’t announce a winner and most of the senators didn’t raise their hands. But of those who did, “I think Taylor won,” said Senator Tim Scott of South Carolina.

The market is already starting to price in the possibility of a more hawkish should the Fed take a more drastic change in direction. A Yellen renomination or a Powell nomination would be regarded as equity bullish because they represent the status quo. A Taylor nomination would be viewed as bearish, as he is believed to be considerably more hawkish (see What would a Taylor Fed look like?).

However, there are other scenarios where the market reaction would be difficult to predict. The bigger question is whether John Taylor is on the Fed board in some capacity. Imagine Yellen as chair, and Taylor as vice chair. Assuming that John Taylor would accept a position as vice chair, I believe that such an outcome would tilt policy in a slightly more hawkish direction. Market expectations would then move quickly towards the dot plot, which calls for one more rate hike in 2017, and three quarter-point hikes in 2018. Such a pace of rate hikes is well beyond current market expectations, and the presence of Taylor on the Fed board would likely be viewed as equity bearish.

The road forward

My base case scenario calls for a short and shallow sell-off in the next week. The historical evidence suggests that any weakness should be viewed as an opportunity to buy the dip.

For the time being, the “arrow” on the Trend Model is changing from a buy signal, or up arrow, to a down arrow, or a sell signal. My inner trader has sold his long SPX position and flipped to a small short position.

Disclosure: Long SPXU

Peak FANG?

Posted by Cam Hui -

I had been meaning to write about this topic, but Barron’s beat me to it with a terrific article called “Breaking up Tech” which detailed the anti-trust vulnerability of Big Tech companies. The Barron’s article stands in direct contrast to a recent Josh Brown post which postulated that investors are rushing into the technology sector as a hedge against the obsolescence of their own skill sets:

A 45 year old married father of two with a mortgage and a pair of college educations to fund. The remote yet persistent threat of a nuclear war is not what keeps him up at night. In fact, he might almost see it as a relief should it come. He is a bundle of raw nerves, and each day brings even more dread and foreboding than the day before. What’s frying his nerves and impinging on his amygdala all day long is something far scarier, after all. He, like everyone else, is afraid that he doesn’t have a future.

He is petrified by the idea that the skills he’s managed to build throughout the course of his life are already obsolete…

We could be in the midst of the first fear-based investment bubble in American history, with the masses buying in not out of avarice, but from a mentality of abject terror. Robots, software and automation, owned by Capital, are notching new victories over Labor at an ever accelerating rate. It’s gone parabolic in recent years – every industry, every region of the country, and all over the world. It’s thrilling to be a part of if you’re an owner of the robots, the software and the automation. If you’re a part of the capital side of that equation.

If you’re on the other side, however – the losing side – it’s a horror movie in slow motion.

The only way out? Invest in your own destruction. In this context, the FANG stocks are not a gimmick or a fad, they’re a f***ing life raft. Market commentators rhetorically ask aloud what multiple should investors pay to own the technology giants. That’s the wrong question when people feel like they’re drowning.

What multiple would you pay to survive? Grab a raft.

Who is right?

A Big Data world

Here is some more flavor on this issue. Consider the fascinating article penned by Feng Gu and Baruch Lev for the Financial Analysts Journal entitled Time to Change Your Investment Model. Gu and Lev found that, even in hypothetical cases where an investor had perfect knowledge of reported earnings, the gains are shrinking very quickly.
 

 

Instead, they found that returns to this “earnings surprise” factor was a function of the intensity of intangible assets on the balance sheet. The higher the level of intangibles, the better earnings surprise models performed (assuming perfect foresight).
 

 

Here is an example:

Consider a pharmaceutical or biotech company that beats the consensus estimate and/or reports sales growth but has a thin “product pipeline” (drugs or medical devices under development), with no drugs in advanced development, clearly indicating that the good earnings/sales news will be short-lived.

In other words, it’s intellectual property that matters a lot more today than physical property, plant, and equipment. GAAP earnings doesn’t matter as much anymore in a winner-take-all world where intellectual property matters. Think the Big Data companies, or FANG, as prime examples.

Big Data eats the world

It is said that data is eating the world. The one who has the data, wins. Indeed, the dominance of Big Data companies is astonishing. As an example, web advertising is effectively a duopoly, and the dominant companies are reaping monopolistic-like profits.
 

Web Advertising Market Share

 

Remember all of the hand wringing over elevated profit margins? Much of that can be attributable to the current winner-take-all environment. Goldman Sachs found that profit margins are positively correlated to industry concentration.
 

 

An academic study by Mordecai Kurz at Stanford tells a similar story. IT companies are enjoying monopolistic profits. Here is the abstract:

We show modern information technology (in short IT) is the cause of rising income and wealth inequality since the 1970’s and has contributed to slow growth of wages and decline in the natural rate.

We first study all US firms whose securities trade on public exchanges. Surplus wealth of a firm is the difference between wealth created (equity and debt) and its capital. We show (i) aggregate surplus wealth rose from -$0.59 Trillion in 1974 to $24 Trillion which is 79% of total market value in 2015 and reflects rising monopoly power. The added wealth was created mostly in sectors transformed by IT. Declining or slow growing firms with broadly distributed ownership have been replaced by IT based firms with highly concentrated ownership. Rising fraction of capital has been financed by debt, reaching 78% in 2015.

We explain why IT innovations enable and accelerate the erection of barriers to entry and once erected, IT facilitates maintenance of restraints on competition. These innovations also explain rising size of firms.

We next develop a model where firms have monopoly power. Monopoly surplus is unobservable and we deduce it with three methods, based on surplus wealth, share of labor or share of profits. Share of monopoly surplus rose from zero in early 1980’s to 23% in 2015. This last result is, remarkably, deduced by all three methods. Share of monopoly surplus was also positive during the first, hardware, phase of the IT revolution. It was zero in 1950-1962, reaching 7.3% in 1965 before falling back to zero in 1970. Standard TFP computation is shown to be biased when firms have monopoly power.

It is therefore no mystery as to why FANG stocks have surged. The winners of a winner-take-all competitive environment are reaping the profits of growth and high margins. The secret to Apple’s success isn’t just selling you a phone, or tablet, but to entice you inside their walled garden where they can sell you other products and services. Similarly, Amazon’s strategy is to learn as much as it can about its customers, and sell them more products and services through multiple channels.

These business models show the supremacy of scale in an era of Big Data and AI. Somewhere along the way to market dominance, these companies forgot Google’s original guiding principle: “Don’t be evil.”

The blowback is likely to be fierce. As the latest BAML Fund Manager Survey shows biggest manager overweight is in the technology sector, the blowback will also be painful.
 

 

Big Data = Big Brother

John Lanchester, writing in the London Review of Books, worried about the ubiquitous power of Big Data companies and the invasion of privacy. The narrative is quickly turning from “Facebook and Google are innovative” to “Facebook and Google are in the surveillance business”.

What this means is that even more than it is in the advertising business, Facebook is in the surveillance business. Facebook, in fact, is the biggest surveillance-based enterprise in the history of mankind. It knows far, far more about you than the most intrusive government has ever known about its citizens. It’s amazing that people haven’t really understood this about the company. I’ve spent time thinking about Facebook, and the thing I keep coming back to is that its users don’t realise what it is the company does. What Facebook does is watch you, and then use what it knows about you and your behaviour to sell ads. I’m not sure there has ever been a more complete disconnect between what a company says it does – ‘connect’, ‘build communities’ – and the commercial reality. Note that the company’s knowledge about its users isn’t used merely to target ads but to shape the flow of news to them. Since there is so much content posted on the site, the algorithms used to filter and direct that content are the thing that determines what you see: people think their news feed is largely to do with their friends and interests, and it sort of is, with the crucial proviso that it is their friends and interests as mediated by the commercial interests of Facebook. Your eyes are directed towards the place where they are most valuable for Facebook.

The recent ProPublica article about how users could use Facebook to target “Jew haters” was a wake up call for the public. Not only that, the stories about Russian interference in the US election using a Facebook platform doesn’t help matters. I would add that Google has similar targeting capabilities. Bloomberg reported that both Facebook and Google personnel were actively involved in an American led effort to convince voters that France and Germany was being overrun by Sharia law.

In the final weeks of the 2016 election campaign, voters in swing states including Nevada and North Carolina saw ads appear in their Facebook feeds and on Google websites touting a pair of controversial faux-tourism videos, showing France and Germany overrun by Sharia law. French schoolchildren were being trained to fight for the caliphate, jihadi fighters were celebrated at the Arc de Triomphe, and the “Mona Lisa” was covered in a burka…

Unlike Russian efforts to secretly influence the 2016 election via social media, this American-led campaign was aided by direct collaboration with employees of Facebook and Google. They helped target the ads to more efficiently reach the intended audiences, according to internal reports from the ad agency that ran the campaign, as well as five people involved with the efforts.

Facebook advertising salespeople, creative advisers and technical experts competed with sales staff from Alphabet Inc.’s Google for millions in ad dollars from Secure America Now, the conservative, nonprofit advocacy group whose campaign included a mix of anti-Hillary Clinton and anti-Islam messages, the people said.

We are quickly moving toward a Big Brother world where details about anyone is potentially for sale. Consider this CBC report about data vendors in China. The most amazing part of this story is data gathering is not done by the government, but by private companies – and that data is available to anyone at a small price:

There is an entire network — the internet inside China’s Great Firewall — designed to gather the information. And there’s an industry of private and state-owned high-tech enterprises serving it.

“You could go so far as to make the argument that social media and digital technology are actually supporting the regime,” says Ronald Deibert, the director of The Citizen Lab, a group of researchers at the University of Toronto’s Munk School of Global Affairs. They study how information technology affects human and personal rights around the world.

The lab has taken apart popular apps like WeChat, a messaging app that also does financial transactions designed specifically for the Chinese market by private software giant Tencent. It’s used by more than 800 million people here every month — virtually every Chinese person who is online.

Deibert’s team found it contains various hidden means of censorship and surveillance. Among other things, the restrictions follow Chinese students who study abroad.

Chinese authorities “have a wealth of data at their disposal about what individuals are doing at a micro level in ways that they never had before,” Deibert says.

“What the government has managed to do, I think quite successfully, is download the controls to the private sector, to make it incumbent upon them to police their own networks,” he says.

And now it seems, the data these firms collect is for sale.

An investigation by a leading Chinese newspaper, the Guangzhou Southern Metropolis Daily, found that just a little cash could buy incredible amounts of information about almost anyone. Friend or fiancé, business competitor or enemy … no questions asked.

Using just the personal ID number of a colleague, reporters bought detailed data about hotels stayed at, flights and trains taken, border entry and exit records, real estate transactions and bank records. All of them with dates, times and scans of documents (for an extra fee, the seller could provide the names of who the colleague stayed with at hotels and rented apartments).

All confirmed by the colleague. And all for the low price of 700 yuan, or about $140 Cdn.

Stories like this one about how Google’s smart speaker inadvertently recorded every sound that was in the room, even when it was supposedly turned off, raises enormous privacy concerns. The actions of Big Data companies are reminiscent of Lily Tomlin’s Ernestine the operator character from a bygone era (click this link if the video is not visible).
 

 

I would add that Amazon isn’t innocent either. Alexa forms part of its Big Data and Big Brother efforts and its smart speakers are the Trojan Horse for consumer AI. As well, Amazon’s patent to prevent shoppers from online price comparison in its own bricks and mortar stores, starting with Whole Foods, is an anti-competitive step to market dominance.

The scapegoats in the next recession

Don’t be surprised when the pitchforks gather at the gates of the Big Data companies in the next recession. Economic pain demands scapegoats. Big Data companies are the perfect candidates. They are not large employers in the United States and therefore they have no natural political constituencies that can stand up on their behalf.

The backlash is already starting. Ben Smith at Buzzfeed wrote that There is Blood in the Water in Silicon Valley:

The tech industry has also benefited for years from its enemies, who it cast — often accurately — as Luddites who genuinely didn’t understand the series of tubes they were ranting about, or protectionist industries that didn’t want the best for consumers. That, too, is over. Opportunists and ideologues have assembled the beginnings of a real coalition against these companies, with a policy core consisting of refugees from Google boss Eric Schmidt’s least favorite think tank unit. Nationalists, accurately, see a consolidation of power over speech and ideas by social liberals and globalists; the left, accurately, sees consolidated corporate power. Those are the ascendant wings of the Republican and Democratic parties, even before Donald Trump sends the occasional spray of bile Jeff Bezos’s way — and his spokeswoman declines, as she did in June, to defend Google against European regulators.

This has led to a kind of Murder on the Orient Express alliance against big tech: Everyone wants to kill them.

The New York Times recently published an article, Silicon Valley is not your friend. As well, CNBC reported that Netflix board member Rich Barton expects an inevitable government crackdown on Amazon:

Technology entrepreneur Rich Barton says government intervention on Amazon in the future is unavoidable.

Barton was asked about his views on Amazon in relation to the Department of Justice’s antitrust investigation of Microsoft during the 1990s in a Bloomberg podcast interview.

“I lived through that DOJ thing. It was really rough. It’s no fun. And I think it is inevitable as companies get really, really huge,” Barton said in the podcast interview published Friday.

“I think Jeff [Bezos] is probably well aware of that,” Barton said. Bezos “is trying to do everything he can to delay that as long as possible and to play within the rules, but eventually the tall poppy gets chopped in

In this era of Big Data, hacking incidents such as the one experienced at Equifax will undoubtedly raise the concerns of some Senate committee in the future. If these Big Data “surveillance” companies know everything about us, what steps are they taking to keep it safe, and what is the extent of their liability should their firewalls be breached?

The Microsoft template

Still, investors should not expect total disaster if Big Data companies face some form of political intervention. Should it occur, the most likely regulatory response would see the breakup of some of the target companies, such as the forced divestiture of AWS from Amazon, and so on, in the same way that the DoJ went after IBM and Microsoft. The Barron’s article went on to raise legitimate antitrust concerns for these companies:

Amazon, Facebook, and Google all benefit from the same sort of network effects that snagged Microsoft. The more people use Facebook, the more others feel they must use it, in a self-perpetuating fashion. Ditto for advertising on Google or selling goods on Amazon. Wall Street and investors may love this virtuous cycle, or, as it’s commonly known, the “flywheel” that keeps expanding their business.

But others, citing Fisher’s work, see exploitation and unfair leverage. They can argue that Amazon sells its Echo home speaker at roughly break-even prices to bring in more shoppers. It’s conceivable such leverage could be interpreted by regulators as predatory. Another example is Amazon’s bundling of its Amazon Prime membership, which offers free shipping and streaming videos, below Amazon’s cost to provide it. Google’s use of Androis to maintain its search engine as pre-eminent on mobile devices has been likened to the kind of “tying” that Microsoft tried with Internet Explorer.

Should the regulator decide to act, my working template is the Microsoft experience. As the chart below shows, MSFT became a market performer after the Justice Department initiation of the United States v. Microsoft Corp.
 

 

The path forward

If a political backlash were to occur, the most likely economic backdrop would be a recession. I can suggest a couple of analytical frameworks for investors to deal with the change in environment.

First, Marc Chandler suggested that the current growth problems can be attributable to an abundance of capital:

When farmers have a bountiful crop, and the price threatens to fall below the cost of production, governments often invent schemes to buy the crop and warehouse it and let the agricultural produce come to market at a better (i.e., lucrative) time. In some ways, QE can be understood as a similar strategy: Warehouse the surplus capital. This is not a permanent solution. There is a political push back on the grounds that it blurs monetary and fiscal policy. There is an ideological resistance to the “interference” with market forces. There are economic arguments against the distortion of prices and the mutation of printing signals.

Interest rates are low, not simply because central banks are buying bonds and maintaining large balance sheets by recycling maturing issues. Interest rates are low because there is too much capital. It is a recurring source of the crisis in market economies. We should anticipate that returns to capital will remain low until a new strategy to deal with the surplus is devised and accepted, and the risk is that we are still in denial.

An article in HBR outlined some corporate strategies in an environment characterized by an abundance of capital. Investors should look for companies that make many small bets, and don’t put all your eggs in a single basket:

Strategy in the new age of capital superabundance demands a fundamentally different approach from the traditional models anchored in long-term planning and continual improvement. Companies must lower hurdle rates and relax the other constraints that reflect a bygone era of scarce capital. They should move away from making a few big bets over the course of many years and start making numerous small and varied investments, knowing that not all will pan out. They must learn to quickly spot—and get out of—losing ventures, while aggressively supporting the winners, nurturing them into successful new businesses. This is the path already taken by firms innovating in rapidly evolving markets, but in an era of cheap capital, it will become the dominant model across the business economy. Companies that practice this strategy will have the edge so long as capital remains superabundant—and according to our analysis, that could be the case for the next 20 years or more.

Another effect might see the reversal of the tangible vs. intangible investment rates identified by Gu and Lev as a winner-takes-all environment erodes.
 

 

In that case, equity analysis might return to a more conventional framework, where a focus on earnings, and ROI on invested capital matter more to investment returns. In that case, we may see capex intensity return to historical norms.
 

 

In that case, a return to higher capex levels as the economy returns to “normal” wouldn’t be such a terrible outcome either.

Beware the expiry of the 19th Party Congress Put Option

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.

A China-led reflationary recovery?

Copper and industrial metal prices have been on a tear lately. Prices bottomed out in early 2016, and the latest rally has seen a recovery to levels last seen in 2014.
 

 

China is a major driver of commodity demand, and her economic growth has been surging recently. It is therefore no surprise that copper and industrial metal prices have been soaring.
 

 

The latest upside surprise in Chinese PPI prompted David Ingles at Bloomberg to ask if China is leading a bout of global reflation.
 

 

Callum Thomas at Topdown Charts also observed that China is at the epicenter of the global reflation theme.
 

 

The developed markets are also experiencing a synchronized upswing.
 

 

On the other hand, China is currently holding its 19th Party Congress. It doesn’t take a genius to understand that any bureaucrat who creates conditions that causes either a growth slowdown or financial instability during this critical period will have made his own life very difficult. In effect, Beijing has given a 19th Party Congress put option to the market, where nothing bad would be permitted to happen to the economy ahead of the meeting.
 

 

Skeptics could therefore ask if the current growth revival is real, or window dressing ahead of the Party Congress. What happens after the expiry of the 19th Party Congress Put as the meeting winds up next week?

Deleveraging with Chinese characteristics*

Despite the widespread concerns about the extended state of China’s debt levels and the lip service paid to deleveraging, Chinese authorities have been juicing the Chinese economy with credit driven growth ahead of the Party Congress. Tom Orlik had the perfect observation that describes China’s deleveraging efforts.
 

 

The latest September report of Total Social Financing (TSF), which represents the broadest measure of debt, rose 13% YoY and an astonishing 23% MoM. At a 13% growth rate, Christopher Balding pointed out that TSF growth has hardly slowed when compared to the past few years. Nominal TSF growth is well above nominal GDP growth, based on a real GDP growth rate of 6.8% and inflation rate of 1.6%.
 

 

This is deleveraging?

What`s even worse, the WSJ reported that the government has been supporting the real estate market by ordering local authorities to buy up surplus properties:

Under Beijing’s direction, more than 200 cities across China for the last three years have been buying surplus apartments from property developers and moving in families from condemned city blocks and nearby villages. China’s Housing Ministry, which is behind the purchases, said it plans to continue the program through 2020.

The strategy, supported by central-government bank lending, has rescued housing developers and lifted the property market, which accounts for a third of China’s economic growth according to Moody’s Investors Service…

China’s government used to build homes for families who lost theirs to development or decay. But last year, local governments, from the northeast rust belt to this city of 3.7 million amid the croplands of central Anhui province, spent more than $100 billion to buy housing from developers or subsidize purchases, according to Gavekal Dragonomics.

Underpinning the strategy is a cycle of debt. Cities borrow from state banks for purchases and subsidies, then sell more land to developers to repay the loans. As developers build more housing, they, too, accrue more debt, setting up the state to bail them out again. The burden on the state rises, as does the risk of collapse.

The government has tried other ways of filling apartments, such as offering cash subsidies to encourage rural migrants to buy in urban areas, but the program is the first large-scale case of the government becoming a home buyer itself.

Tom Orlik also pointed out that Beijing continues to follow the same-old same-old practice of infrastructure spending to drive economic growth.
 

 

Fathom Consulting had this brutal takedown of China`s policies:

Of the ten indicators included within our CMI 2.0 (see Fathom Consulting, ‘Our expanded China Momentum Indicator shows growth rebounding – for now’ for a detailed look at our CMI 2.0 indicator), half have expanded at significantly higher rates than in the slump of late 2015: railway and port freight, electricity consumption, real imports and the commodity price index. Meanwhile, growth in those indicators representative of the services sector of the economy remains subdued. This supports our call first presented to our clients in a note in the first half of 2016 (see Fathom Consulting, ‘China’s growth is bottoming out’) that Chinese policymakers have doubled down: recommitting to the model of export- and investment-led growth rather than a reorientation towards the consumer.

This amounts to a continuation of credit being channelled to unproductive assets within the economy. As we explained in a note sent to clients (See Fathom Consulting, ’Productivity puzzle the drugs won’t work’), the accumulation of non-financial debt beyond 250% of GDP stops being effective and starts to damage growth significantly. China passed this point in the third quarter of last year.

 

Translation: As China continues with its credit-driven growth model and makes little effort to rebalance its economy, the day of reckoning draws ever closer. Call this deleveraging with Chinese characteristics*.

Commodity bull with Chinese characteristics*

The current commodity bull may also turning out to be a bull with Chinese characteristics*. China Beige Book, which monitors the health of the Chinese economy from a bottom-up basis, recently wrote that the so-called “supply side reforms” of cutting commodity production capacity is a smokes and mirrors exercise. The withdrawal of supply is only a window dressing exercise ahead of the Party Congress:

Finally, and again contrary to government claims, China hasn’t slashed overcapacity in commodities sectors. Xi has incessantly touted what he calls “supply-side reforms,” which would seem to give Chinese companies very strong incentive to report results showing such cuts.

Yet for more than a year, firms have indicated the opposite. While some gross capacity has been taken offline to much fanfare, net capacity has continued to rise. From July through September, hundreds of coal, steel, aluminum and copper companies reported a sixth straight quarter of overall capacity rising, not falling.

This will soon come to a head. For over a year, blistering demand and flows of speculative capital have combined to keep metals prices rising and mask the lack of genuine supply cuts. In the third quarter, though, firms across sub-sectors reported poorer revenue and profit results. Most telling, domestic orders weakened sharply, signaling that there’s no quick rebound on the way. Unless true supply cuts are imposed, it’s a matter of when, not if, speculative inflows unwind and many investors find themselves running for cover.

More worrisome is the observation that it is Chinese speculative demand, not physical demand, that is driving the commodity rally. The WSJ reported that commodity trading volumes in China are overtaking traditional western venues, such as the LME, with *ahem* Chinese consequences:

Chinese speculation was “the key driver of the rally” in base metals this year, said Michael Widmer, chief metals strategist at Bank of America Merrill Lynch. “We’ve virtually not seen any improvement in underlying fundamentals.”

China has long been a focal point for commodities markets. The nation is the world’s largest metals consumer. But now, it has also become home to massive trading in metals. Because the government has taken steps to cool the property market and the country’s normally volatile stock market has calmed, Chinese retail investors have turned to base metals in recent years to generate rapid returns. Analysts said they prefer to trade on an exchange within the country because it is easier than trading on foreign exchanges like the LME…

On some days this year, the reactions in prices to reports left many in the metals market confounded. Prices rose even after information that typically sends copper and other base metals lower. On such days, some fundamental investors and analysts blamed speculators.

Data on Aug. 13 showed the pace of Chinese industrial output, retail and housing sales, and fixed-asset investments decelerated in July. Still, after two days of muted moves, prices of copper, aluminum and nickel went on to rally for the week and continued rising for the rest of August.

On Aug. 29, U.S. mining giant Freeport-McMoRan reached an agreement with the Indonesian government over a key mine—a potential blow to copper prices since disputes between the company and country had limited supply. Yet prices went on to advance in five of the next six sessions. Many analysts use copper as a benchmark to gauge the performance of the wider industrial-metals complex because of its widespread uses and prominence.

“Bullish news is being used to buy, but bearish news is being ignored,” said Daniel Briesemann, an analyst at Commerzbank .He said the 16% gain by an LME base metals gauge between May and August appeared largely driven by short-term players. Before then, the LME gauge had been roughly flat this year.

Copper prices have fallen 1.5% from a nearly three-year intraday high last month. After about a four-month rally earlier this year, prices of nickel and iron ore have each tumbled at least 8%. Still, prices of copper, aluminum and zinc are each up more than 20% this year.

One measure of the surge in Chinese speculative demand is the relative performance of the China Materials ETF (CHIM) against the global Materials ETF (MXI). If market dynamics are stable, then the pair should trade in a fairly narrow band. As the chart below shows, China Materials stocks have been rising against their global counterparts and the rally is coincidental with the rally in industrial metal prices. The CHIM/MXI pair is rapidly approaching a key relative resistance level, which may be a signal that the China driven commodity rally is about to stall.
 

 

Other market internals are also deteriorating. The China Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, is falling.
 

 

As well, the AUDCAD currency cross has been trending downwards. Both Australia and Canada are commodity producers and therefore their currencies have similar levels of commodity sensitivity. Australian commodity exports are geared towards bulk commodities and China, while Canadian exports have a greater US sensitivity and more exposed to the energy sector. The downtrend in AUDCAD represents a negative divergence, particularly when industrial metals have been outperforming oil prices.
 

 

Call this a commodity bull, but with Chinese characteristics*.

Market implications

Business Insider reported that Goldman Sachs published a research note suggesting that the US stock market has an 88% chance of entering a bear market within 24 months.
 

 

The GS Market Risk Indicator has risen to levels seen at previous tops and stands at 67%, which indicates that there is an 62% chance that US equities will enter into a bear market within 12 months, and 88% chance of a bear market within 24 months.
 

 

The typical profile of a bear market looks like this. The market tops, corrects, and rallies to make a double top before the actual slide begins.
 

 

This is consistent with my own observation that stock prices tend to top out when the DJ Global Index makes a double top with a negative RSI divergence (see Market melt-up and crash?).
 

 

As well, it is consistent with my past analysis that late cycle bulls are characterized by inflation hedge sector leadership such as Materials (see Buy the breakout?). I am continuing to monitor the relative performance of the gold, energy and materials sectors to see how this scenario is playing out.
 

 

Ned Davis Research confirmed my late cycle thesis when they observed that SP 500 sales growth ex-energy has been rolling over. Unless the economy comes through with better than expected growth, the fundamentals are likely to start stalling next year (chart annotation is mine).
 

 

The path forward

From a tactical viewpoint, we have not seen the first downside break in stock prices, as shown in the Goldman Sachs chart of the idealized top, nor in my DJ Global Index chart above. However, the market is significantly overbought, but exhibiting signs of powerful positive momentum. It is impossible to know ahead of time what will trigger the downside break.

China’s 19th Party Congress winds up next week, and which will signal the expiration of the Party Congress Put. However, that doesn’t mean that the Chinese economy and commodity prices will instantly tank, but that could be one trigger of market weakness.

In the US, there is plenty potential for negative surprises. We could see the nomination of a hawkish Fed chair (see What would a Taylor Fed look like? and Melt-up and crash?). As well, Axios reported that it is a matter of when, not if, Trump sends a notice of withdrawal from NAFTA. Such a development would spark protectionism fears as the US has much to lose should it withdraw from NAFTA.
 

 

In the meantime, the stock market has not crossed my bearish lines in the sand. The latest update from John Butters of FactSet shows that Q3 earnings season results are beating both the top and bottom lines at an above average historical rates. Forward 12-month EPS is still rising, which indicates positive fundamental momentum. Butters also stated that “the market is rewarding upside earnings surprises more than average and punishing downside earnings surprises more than average”, which is an important indication of bullish undertones to market psychology.
 

 

The SPX remains above its weekly upper Bollinger Band, and overbought on its weekly RSI. My inner trader is nervously long, and watching for a downside break as his sell signal.
 

 

Any early warning of a downside break should come from the daily chart. It would be seen first from RSI-5, followed by RSI-14. Neither has happened.
 

 

My inner investor remains constructive on the market. In all likelihood, we have not seen the final top yet, and his equity weight is roughly at the target set by his investment policy.

* In case readers don’t understand the reference, Mao called his rule of China as Socialism with Chinese characteristics because it differed from the Soviet implementation of Marxist thought.

Disclosure: Long SPXL

A continued grind upwards

Posted by Cam Hui -

Mid-week market update: I wrote last weekend that there was a possibility that the stock market may undergo a melt-up, followed by a crash (see Market melt-up and crash?). That scenario may well be occurring, and I sent out an email to subscribers on Monday stating that my trading account had moved from all-cash to being long stocks.

There are a number of reasons for my tactical position. First, I had set a line in the sand on the weekend. The SPX was overbought, as evidenced by the combination of a weekly close above the upper Bollinger Band, and RSI-14 above 70. In the past, a mean reversion of RSI-14 below 70 was a signal for a correction of 2-5%. That sell signal has not occurred yet.
 

 

In fact, RSI-14 has not even mean reverted below 70 on the daily SPX chart.
 

 

A “good overbought” reading

My former Merrill Lynch Walter Murphy used to call these “good overbought” readings. Andrew Thrasher observed that three consecutive weekly closes above the upper BB are rare events. Such occurrences, which are marked by the dots below in the chart, have not historically been overly bearish.
 

 

Here is the history of the signals during the 1980-1997 period, which was even more bullish than the 1998-2017 time frame.
 

 

It illustrates my point that these are momentum thrusts, and upside momentum have a tendency to carry on for longer than anyone thinks.

Constructive sentiment

A funny thing happened as stock prices advanced, sentiment became more cautious, which is contrarian bullish. The Fear and Greed Index has retreated from nosebleed levels that was north of 90 and stands at 82 today.
 

 

As well, the term structure of the VIX began to flatten, indicating growing fear, even as the market rose. That`s another contrarian bullish sign.
 

 

Upside target

How far does the market rise from these levels? It’s impossible to know once the animal spirits start to run wild as they have today. However, I did point out two weeks ago that a combination of techniques pointed to an upside S&P 500 target of about 2600 (see Nearing upside target, now what?).

Jeff York also observed that the index is nearing an important pivot, with important resistance at 2573-2615. York found that “price fails at the Yr2 pivots 82% of the time. The average pullback is roughly 100 SPX points or 1,000 DJIA Points.”
 

 

The combination of these factors suggests that stock prices can continue to grind upward from current levels, though the potential upside is somewhat limited. My inner trader is tactically staying long, but keeping his stops tight.

Disclosure: Long SPXL

What would a Taylor Fed look like?

Posted by Cam Hui -

Bloomberg reported that Donald Trump interviewed John Taylor for the position of Fed chair and “Trump gushed about Taylor after his interview”, as “Kevin Warsh has…seen his star fade within the White House”. The current list of leading candidates under consider are said to be Jerome Powell, John Taylor, Kevin Warsh, and Janet Yellen. Taylor’s rise in the candidate stakes is a bit of a surprise, as he had been regarded as a dark horse.

The question for investors is, “What would a Taylor Fed look like?”

Taylor is famous for the “Taylor Rule”, which is a rules-based method of determining the Fed Funds rate. The rules-based approach is a favorite of the Republican audit-the-Fed crowd, and therefore Taylor will have substantial support should he get nominated. The standard application of the Taylor Rule would see the Fed Funds target substantially higher than it is today.

 

Despite these dire projections, Matthew Boesler at Bloomberg argued that a Taylor led Fed would not be substantially different from a Yellen Fed, because Taylor would have difficulty bringing the members of the FOMC to such a hawkish tilt to monetary policy:

Resistance from the other participants on the rate-setting Federal Open Market Committee, which currently numbers 16 participants, is why investors need not worry too much about Chairman Taylor leading the Fed onto a much faster rate-hike path than the three rate increases next year penciled in by officials in quarterly forecasts updated in September.

“Taylor would have a very hard time persuading the rest of the FOMC to abide by the prescriptions of his original rule,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington. “In fact, he won’t be able to persuade hardly anyone — there isn’t much sympathy in the FOMC for a policy that blindly follows rules.”

On the other hand, uber-dove Neel Kashkari of the Minneapolis Fed argued that the application of a Taylor rule would have kept millions out of work:

In December, I wrote an op-ed in the Wall Street Journal explaining that forcing the Federal Open Market Committee (FOMC) to mechanically follow a rule, such as the Taylor rule, to set interest rates can cause tremendous harm to the economy and the American people. My staff at the Minneapolis Fed estimates that if the FOMC had followed the Taylor rule over the past five years, 2.5 million more Americans would be out of work today. That’s enough to fill the seats at all 31 NFL stadiums simultaneously, almost 6,000 more people out of work in every congressional district.

Who is right? How should we assess John Taylor as a potential Fed chair?

Interest rate policy

For investors, the market impact of a Fed chair should be evaluated on two criteria. How will the chair conduct interest rate policy under “normal” circumstances, and how would he behave under periods of stress? Note that this framework passes no judgment on whether any person has the correct approach to the conduct of monetary policy. Our only interest is the impact of policy.

John Taylor recently gave a speech at the Boston Fed defending the use of rules-based approaches to the conduct of monetary policy (see Rules Versus Discretion: Assessing the Debate Over the Conduct of Monetary Policy: Are Rules Made to be Broken? Discretion and Monetary Policy). While he was not explicitly defending the Taylor Rule for determining a Fed Fund target, it was clear that Taylor favored a rules framework for the Fed.

That said, even the Taylor Rule has several input parameters that lead to very different results, depending on the model assumptions.

Imagine that John Taylor is the new Fed chair, and he may have some difficulty in forming a consensus on the FOMC on how quickly to normalize policy. As a way of conducting sensitivity analysis on the various models, the Cleveland Fed has a monetary policy tool that determines a Fed Funds target under different assumptions. The median Fed Funds target for December 2018 is 2.24%, which is a reasonable estimate for a compromise solution in light of the differences in opinion.
 

 

I would then point out that the median 2.24% 2018 year-end target is higher than the current dot-plot projection of 2.13%. Moreover, the current dot-plot projection is substantially higher than market based expectations for the Fed Funds rate.
 

 

That’s just the base case scenario. I pointed out in my last post (see Market melt-up and crash?) that the FOMC is likely to adopt a more hawkish tilt in 2018, irrespective of the identity of the chair. Virtually all Fed governor candidates favor rules-based approaches to monetary policy, which would put the Fed on a more hawkish path than it is today. As well, the rotation of votes among regional Fed presidents indicate a more hawkish shift, from Evans and Kashkari to Meester and Williams.

In short, the appointment of John Taylor as Fed chair is likely to see a far more hawkish Fed than under Yellen.

Crisis management

The other criteria for the evaluation of a Fed chair is how he is likely to react under stress. As interest rates have barely lifted the zero lower bound, how will the Fed behave in the next recession?

For some clues, we turn to the past writings of John Taylor. On November 15, 2010, Taylor was a signatory to the Open Letter to Ben Bernanke which urged the Fed to refrain from engaging in quantitative easing.

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in The Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

At about the same time, Taylor penned a joint opinion letter with Paul Ryan which laid the blame on the Financial Crisis on the Fed’s failure to follow a rules-based regime:

Quantitative easing is part of a recent Fed trend toward discretionary and away from rules-based monetary actions. The consequences of this trend are clear: The Fed’s decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble. And while the Fed did help to arrest the ensuing panic in the fall of 2008, its subsequent interventions have done more long-run harm than good.

QE1 failed to strengthen the economy, which has remained in a high-unemployment, low-growth slump, and there is no convincing evidence that QE2 will help either. On the contrary, QE2 will create more economic uncertainty, stemming mainly from reasonable doubts over whether the Fed will know exactly when and how to contract its balance sheet after such an unprecedented expansion.

Not only were Taylor and Ryan opposed to QE2, which was about to begin, but QE1, and interpreted QE as a way of bailing out fiscal policy:

QE1 involved the Fed in areas of fiscal policy, such as credit allocation, that are properly (and constitutionally) the domain of Congress. QE2 would double down on these expansions, as the planned purchases of Treasury securities would constitute a large fraction of soon-to-be-issued federal debt.

This looks an awful lot like an attempt to bail out fiscal policy, and such attempts call the Fed’s independence into question.

For the sake of the argument, let us assume that Taylor was correct in his assessment that the Fed’s easy monetary policy blew an asset bubble in the years leading up to the GFC, and that it fell behind the curve in its efforts to control inflationary pressures. He would be put in a similar situation today should he become the new Fed chair, as the economy is already in the late cycle phase of an expansion.

Taylor stated in a Bloomberg interview on March 27, 2017 that he believed that the Fed was behind the inflation fighting curve. A Taylor Fed would then aggressively tighten in 2018, which is likely to send the economy into a slowdown. How would he react in the downturn?

As interest rates are already relatively close to zero bound, what would a Taylor Fed do? He has stated on the record that he is opposed to unconventional monetary policy, such as QE. In that case, radical steps of helicopter money would be out of the question.

In conclusion, John Taylor nomination as a Fed chair would be a surprise, despite the reports of Trump’s gushing. While Taylor is a Republican and likely to look favorably upon financial deregulation, which is one of Trump’s priorities, a Taylor Fed would be more hawkish than the Yellen Fed and see greater economic volatility during a recession. Taylor most certainly does not fit Trump`s desire for a “low interest guy”. However, Fox Business News reported that VP Mike Pence, Heritage Foundation economist Steve Moore, conservative economist Larry Kudlow, and former Reagan adviser Arthur Laffer are involved in the search for the new chair, which could tilt the odds in Taylor’s favor.

Janet Yellen is scheduled to meet with President Trump on Thursday. Stay tuned for further developments.

Market melt-up and crash?

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.

The challenges of a late cycle bull

I have been making the point that the American economy is in the late stages of an expansion. This presents some investment challenges as an inflection point may be near. As the chart below shows, while every equity downdraft has not signaled a recession, every recession has seen an equity bear.
 

 

The question is, “How far away are we from a recession?” I try to answer that question this week by focusing on three components of the economy using the leading indicators in my Recession Watch Monitor:

  • The household sector;
  • The corporate sector; and
  • Monetary conditions.

Further, I analyze the nowcast of the economy and the market outlook from both macro and technical viewpoints. The market may be setting for a scenario where stock prices melt-up, followed by a market crash of unknown magnitude.

Signs of a late cycle expansion

The market was pleasantly surprised on Friday by the better than expected retail sales figure, and tamer than expected CPI release. As well, consumer sentiment surged to a new cycle high.
 

 

While Friday’s data represents good news in the short term, the combination of strong retail sales (red line) and the lack of wage growth (blue line) means that the household sector will eventually have trouble supporting consumer spending at the current pace.
 

 

There are a number of ways that the household sector can cope. More members of the household can find jobs. Employment statistics remain strong, though the pace of improvement is decelerating. While a deceleration in non-farm payroll employment is not a warning of recession, it does indicate that the economy is well past the mid-cycle phase of its expansion.
 

 

Another way the household sector can keep on spending is by cutting back its savings rate.
 

 

Finally, households can take on more debt as a last resort to maintain spending patterns. I call this the “keeping up with the Joneses” effect. As the chart below shows, household debt levels are rising again after deleveraging in the wake of the last financial crisis.
 

 

The stresses are already showing up in big ticket consumer durable purchases. Auto sales appear to have peaked for this cycle, though the latest spike is probably related to the replacement of hurricane damaged vehicles.
 

 

The housing sector, which is an important cyclical part of the economy, has also peaked for this expansion.
 

 

In summary, while headline retail sales remain strong, internals reveal signs of underlying weakness. By themselves, none of these indicators are signals to hit the panic button. They are just signs of a late cycle expansion.

Rising corporate stress

The corporate sector is another story. NIPA corporate profits have peaked for the current expansion and they are starting to roll over.
 

 

As well, the debt financing costs of corporations have bottomed for this expansion. Corporate bond yield bottoms have generally occurred ahead of past recessions.
 

 

The corporate sector has also re-levered its balance sheet to levels seen at past cycle peaks. The combination of consumer spending poised to turn down, peaks in corporate profits, and bottom in debt financing costs makes the companies vulnerable to a downturn.
 

 

Still, these are not reasons to hit the panic button just yet. They just represent a “this will not end well” investment thesis, with no obvious clues on timing.

An easy Fed

The one single factor that is still holding up the US economy is Fed policy. Despite the Fed’s professed desire to normalize rate, monetary policy remains loose. As the chart below shows, real money supply growth is falling but still positive. If history is any guide, nominal money growth has fallen below CPI inflation (black line) ahead of recessions in the past.
 

 

In addition, the yield curve has not inverted. An inverted yield curve has been a surefire signal of recession in the past. The possibility exists that the yield curve may not invert this time because of the Fed’s balance sheet normalization program. By the Fed’s own estimates, its QE programs flattened the yield curve by about 100 bp. The reversal of that program should have a steepening effect on the yield curve, and therefore this indicator may not be as effective recessionary signal as it had been in the past.
 

 

Financial conditions are not showing much signs of stress. This underscores New York Fed president Bill Dudley’s point that, as long as financial conditions are not stressed, the Fed should continue to normalize monetary policy.
 

 

Future Fed policy as wildcard

In effect, the future trajectory of Fed policy will be the wildcard for determining capital market returns. That is where a lot of policy uncertainty comes in.

It is said that the Trump administration will announce the nomination for the Fed chair in the next few weeks. By all accounts, Janet Yellen is unlikely to be re-appointed. The two front-runners are said to be Jerome Powell and Kevin Warsh. It appears that Donald Trump will look for three qualities in a Fed chair. In no particular order, they are:

  • Deregulation bias
  • Easy money bias
  • Personal chemistry and loyalty 

No candidate is perfect and ticks off all the boxes. Kevin Warsh is well-connected and he is likely to score well on the “personal chemistry” criteria. and if anyone is able to offer Trump personal loyalty, it would be Warsh. He is the son-in-law of major Republican contributor and Estée Lauder heir Ronald Lauder. Warsh believes in aggressive deregulation of the financial sector, but his speeches reveal him to be a rules-based monetary hawk. Wall Street would view a Warsh appointment as a negative, as the consensus view is he has a history of being behind the curve on monetary policy. A Warsh Fed is likely to introduce a higher degree of volatility to the US economy. For more, see this devastating takedown of Warsh by Sam Bell.

By contrast, Jerome Powell is viewed as the compromise candidate. Jerome Powell is a Republican technocrat and unlikely to offer Trump his personal loyalty. He has shown himself to be mildly in favor of further deregulation. A Powell Fed would represent continuity with the Yellen Fed’s direction in monetary policy. The markets would view a Powell nomination as an equity bullish outcome.

Regardless of what happens, it is important to look behind the headlines of a Fed chair nomination. The Fed in 2018 is likely to be more hawkish than the Fed in 2017. As I pointed out last week (see Is 3% for 6 months enough to take equity risk?), not only is the Fed chair unknown, there are three vacant seats on the Fed’s Board of Governors out of a total seven seats. Virtually all Fed governor candidates favor rules-based approaches to monetary policy, which would put the Fed a more hawkish path than it is today. As well, the rotation of votes among regional Fed presidents indicate a more hawkish shift, from Evans and Kashkari to Meester and Williams. If you think that there is a gulf between the Fed’s dot plot and market expectations of monetary policy today, wait until the full composition of the FOMC is known.
 

 

If the Fed turns significantly more hawkish, that’s when investors should batten down the hatches. That will be the signal of an inflection point for the economy and the markets.

Nowcast vs. forecast

For investors, navigating a potential turning point like this is problematical. The nowcast of the economy, such as consumer confidence and retail sales, are bright, but leading indicators are deteriorating. I agree with New Deal democrat’s latest weekly assessment of economic conditions:

After several months of boring sameness, the weekly indicators are beginning to show a change in trend. The short leading indicators are literally ALL positive. Coincident indicators except for LIBOR are also all positive. The present and near future economy looks stronger than at any time I can recall during this entire expansion (although job growth is decelerating and wage growth is still paltry).

But enough of the long leading indicators (including monthly and quarterly ones) have deteriorated to neutral or even negative for me to downgrade the longer term outlook to neutral. The change in real M2 may prove ephemeral, as the oil-fired surge in inflation abates, But on the other hand, even nominally, M2 has been decelerating. As usual, I will remain entirely data driven.

As one example of upbeat nowcast condition, the most recent update of Q3 earnings season is positive. Even though 6% of index components have reported, John Butters at Factset pointed out that both the earnings and sales beat rates are well above historical averages, and forward 12-month EPS continues to rise.
 

 

That said, Butters also stated that “the market is not rewarding earnings beats”, which is a warning flag of investor psychology. In addition, the forward P/E is now 18.0. Combined with a headline CPI of 2.2%, the sum of the two violates Ed Yardeni’s “Rule of 20“, which states that the market is at risk of stalling when the sum of the two exceeds 20.
 

 

Possible melt-up and crash

CNBC recently reported that Ed Yardeni put the probability of a market melt-up, followed by a market crash at 55%. Such a scenario is well within the realm of possibility.

Here is what I am watching from both an intermediate term and shorter term basis. The US equity market has been buoyed by evidence of synchronized global growth, and it will be difficult for stocks to decline without signs of deterioration around the world. Past global equity tops have seen negative RSI divergences, which has not occurred.

If global stock markets were to make a cyclical top, the most likely scenario would see a correction, followed by a rally to test the old high or make a marginal new high which is unconfirmed by RSI. That pattern was evident even during the Tech Bubble melt-up. Current conditions show that while the index is overbought on RSI, we have not seen the first correction yet. So it’s far too early to panic.
 

 

At the same time, Callum Thomas of Topdown Charts observed that global market breadth is deteriorating. Keep in mind, however, that breadth deterioration is an inexact sign of a market top. It can take months for breadth to top out before the broader averages actually does.
 

 

In the shorter term, I pointed out that the combination of the SPX trading above its weekly upper Bollinger Band and overbought on RSI-14 made it vulnerable to a pullback (see Peak small cap tax cut euphoria?). Such corrections have been relatively mild, in the order of 2-5%. While the market remains overbought, and we have not seen the sell signal yet when the weekly RSI falls below 70. To be sure, the RSI indicator cannot stay elevated forever and a retreat can occur at any time.
 

 

Should the market continue to grind upwards and stay overbought, the melt-up and crash scenario comes into play. The sentiment backdrop for a major top is already in place. As a reminder, I have detailed extensively in the past how sentiment is getting overly froth with my series “Things you don’t see at market bottoms”.

My inner investor remains constructive on equities. Even though the trading model is flashing a buy signal, my inner trader is stepping aside as he does not believe the risk-reward is in his favor. He is waiting for market weakness to buy the dip.

Peak small cap tax cut euphoria?

Posted by Cam Hui -

Mid-week market update: The intermediate term technical trend remains bullish, it`s hard to argue with the strong momentum that the market has displayed. Ari Wald recently pointed out that the market is experiencing a “good overbought” condition (my words, not his) that has the potential to carry the market much higher.
 

 

However, the current market environment may be setting up for a short correction. The SPX is trading above its upper weekly Bollinger Band (BB). Past episodes, when viewed in isolation, have been relative benign. The market has either continued grind upwards, or move sideways. That said, I am monitoring the weekly RSI-14 indicator when the market is above its upper BB. Past breaks below the 70 after an overbought reading have seen the market pull back. (Note that the weekly RSI reading remains above 70, and therefore no sell signal has been generated.)
 

 

I am watching the evolution in small cap leadership, which may be in the process of breaking down. Such a development could be a signal of near term market weakness.
 

 

Small caps as tax cut plays

Small cap stocks have been on a tear lately, largely because of tax cut hopes. Small cap companies tend to be more exposed to the domestic economy and should therefore benefit more from corporate tax cuts. The market was encouraged when the House of Representatives approved a fiscal 2018 spending blueprint to help advance an eventual tax bill that can be passed by a simple majority vote in the Senate. At about the same time, the Senate Budget Committee approved its own budget resolution and sent it to the full Senate for a vote. In addition, news broke that the centrist “blue dog” Democrats were open to discussions on tax reform (see Bloomberg). CNBC reported that Goldman Sachs assigned a 65% probability that some form of tax reform would get passed.

Corporate tax cut math

Notwithstanding how the horse trading winds up in Washington, Matthew Yglesias made the point of a basic problem with aggregate picture of corporate tax cut math. Currently, the effective corporate tax rate is much lower than the statutory rate of 35%, but above the targeted rate of 20%. It is impossible to lower the rate to 20% and pay for it by cutting loopholes (easier said than done) and achieve revenue neutrality at the same time.
 

 

Assuming that the eventual agreed upon rate settles in at above 20%, achieves revenue neutrality and closes loopholes, then the net tax effect would be zero. To be sure, there will be winners and losers under the new tax code, but don’t expect much in the way of aggregate boost to net earnings under such a scenario.

Should that the Republicans abandon the revenue neutrality constraint and let the fiscal deficit to rise, current rules allow for an incremental $1.5 trillion in deficit spending in the next 10 years. The current proposal of corporate tax cuts and middle class tax cuts leaves a hole of $2.2-2.5 trillion, depending on the sources of the estimates. That’s only the base case assumption, before individual legislators lobby to keep their favorite tax deduction, such as the deduction for state and local taxes.

Tax reform is hard, just as healthcare reform is hard. FiveThirtyEight pointed out that the different wings of the Republican party have not come to agreement on three key questions, which makes the tax cut and reform process especially difficult:

  1. How much does increasing the deficit matter?
  2. Is it temporary tax cuts or permanent tax reform?
  3. Who gets the cuts?

Tax cut euphoria

Meanwhile, on Wall Street, investors seemed to have forgotten to differentiate the individual companies’ tax regimes in their stampede to buy small cap stocks for their higher potential tax cut exposure. Ned Davis Research observed that there was no performance spread between high and low tax stocks within the small cap index.
 

 

A similar analysis by Business Insider of the relative performance of high tax large caps found a similar effect.
 

 

Waning confidence

I have no idea of when or whether small cap bullishness will break, but one sign of a deterioration in confidence comes from the latest NFIB small business. NFIB reported that small business optimism slid in September, and the decline was widespread across the country and not just related to hurricane related events.
 

 

Small business confidence surged in the wake of the election of Donald Trump, but the most recent pullback could be the sign of the start of a post-Trump hangover. In particular, actual sales and sales expectations have been falling, which is reflective of actual conditions on Main Street.
 

 

Ed Yardeni demonstrated that investor confidence is highly correlated to consumer confidence. If small business confidence is sliding, can consumer and investor confidence be far behind?
 

 

The VIX also rises

Posted by Cam Hui -

Deep in the recesses of my memory from my youth, I recall reading an Ernest Hemingway quote that went something like this:

How did you go bankrupt?
Two ways. Gradually, then suddenly.

From The VIX Also Rises

The VIX closed at an all-time low last week. Anyone who bought volatility in the last couple of years would have suffered the same fate outlined in the Hemingway novel.
 

 

To be sure, there are good reasons for the VIX decline. One reason is the drop in pair-wise correlation between stocks. When this happens, the diversification effect of owning different stocks rises, which depresses index volatility relative to individual stock volatility.
 

 

It isn’t just the VIX, but the volatility of other asset classes have also fallen. The MOVE Index, which measures interest rate volatility, is also at depressed levels.
 

 

Charlie Bilello recently asked if shorting volatility is a free lunch. The answer is an emphatic “no”, because traders who take on that trade have to live with the possibility of 90%+ drawdowns. Bilello went on to state that drawdowns from a short VIX position “is not a question of if but when”, though he was silent on the timing, or the trigger for such an event.
 

 

With overall realized volatility at historically low levels across all asset classes, the trigger for a VIX spike might come from a non-equity asset class.

How the Fed may spike volatility

An obvious trigger might come from the Fed, as it prepares to wind down its balance sheet. The Fed’s Quantitative Tightening (QT) program is likely to have an outsized effect on the mortgage market, when compared to the effect on the Treasury market. Here is the base case projections of MBS holdings from the New York Fed.
 

 

The issue is MBS convexity. For investors unfamiliar with bond math concepts, the duration of a bond measures the sensitivity of bond prices to interest rates. As rates rise, bond prices fall, and vice versa. Everything else being equal, duration (rate sensitivity) rises as coupon rates fall. As well, duration also rises as time to maturity lengthens. The convexity of a bond is the sensitivity of duration to changes in interest rates.

Here is why convexity matters for MBS holders. The Fed is committed to raising rates as part of its process of normalizing monetary policy. Assuming a parallel shift in the yield curve, fixed income portfolios will get hurt as rates rise. The duration and convexity characteristics of plain vanilla Treasury paper are well known. On the other hand, mortgages will experience prepayment risk if rates fall, which makes MBS paper negatively convex. The duration (rate sensitivity) rises as rates rise, but declines as rates fall. It’s the worst of both worlds.

As the Fed begins raises rates and normalizes its balance sheet, it will introduce greater volatility to the MBS market. Here is FT Alphaville:

The Fed’s effect on the market is even bigger when you consider its dominant position as a buyer of newly-issued agency MBS. In 2009, 2013 and 2014, the central bank bought about half of all new issuance.

Some of that spending came from the large-scale asset purchases but much of it came from the decision in October 2011 to reinvest prepaid mortgage principal into new bonds. Since then they have spent more than $1.8 trillion rolling over their portfolio — on top of what was bought during the third round of large-scale asset purchases. There has been about $8.2 trillion of new issuance over the same period, so the Fed bought more than a fifth just through reinvestments. So far this year the Fed has bought nearly 30 per cent of new issuance.

Under the baseline scenario the Fed will return about $1 trillion in agency MBS to private investors by 2025. It will have switched from selling cheap options that protect against interest rate volatility to effectively buying them back. The extra risk will have to be borne by the private sector. Fed economists think this could add nearly a percentage point to longer-term interest rates.

How Wall Street problems migrate to Main Street

In short, expect volatility to rise in the MBS market in 2018. How much of the higher volatility gets transmitted to the other asset classes is anyone’s guess. However, here is one way higher MBS vol will eventually affect the real economy.

For now, mortgage rate spreads against Treasury yields remain tame. Investors have not demanded much of a premium to be in the MBS market. Expect risk premiums to widen as MBS volatility rises.
 

 

Now imagine what rising risk premiums in the MBS market might do to a fragile housing market.
 

 

A downturn in the economy’s most cyclically sensitive sector will not be good news, for either Main Street or Wall Street. But that’s a problem for later. Here at Humble Student of the Markets, we try to teach readers how to fish. Consider this as a teachable moment of where the fish might be in late 2017 or early 2018.

Is 3% for 6 months enough to take equity risk?

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.

A lukewarm buy signal

Mark Hulbert recently updated the market forecast of former Value Line research director Sam Eisenstadt. Eisenstadt has had a remarkable record of forecasting equity returns, according to Hulbert.

The reason to take this projection seriously is Eisenstadt’s track record. Consider a statistic known as the r-squared, which measures the degree to which one data series predicts or explains another. If the first series perfectly predicted the second, the r-squared would be 1.0; if the first series had absolutely no predictive ability the r-squared would be zero.

For the data plotted in the chart below, the r-squared is 0.31, which is significant at the 95% confidence level that statisticians often use when determining if a pattern is genuine. Though you might be disappointed that this r-squared isn’t higher, you should know that most of the models that get attention on Wall Street and in the financial press have r-squareds that are far lower—if they’re not actually zero.

 

 

Eisenstadt`s latest six month SPX forecast is 2620 to 2640, which represents a gain of about 3%. The chart shows Eisenstadt`s forecasts, as documented by Hulbert, since 2013. The forecast levels are shown in blue, with the actual below (black if the market beat his target, red if it missed).
 

 

Hulbert wrote that Eisenstadt has two critical inputs to his forecast, both of which are mildly bullish:

Eisenstadt constructs his model to include all factors he has found to have an ability to project the stock market’s subsequent six-month return. Though his model is proprietary, Eisenstadt has told me that two of the more important inputs are low interest-rates and market momentum. Both factors are mildly positive right now.

No forecast is complete without some understanding of the risks to the forecast. When I peek under the hood of the Eisenstadt’s model, interest rates and momentum represent sources of both risk and opportunity to the market. Investors will have to judge for themselves whether a potential 6-month gain of 3% is worth the risk.

Can interest rates support stock prices?

Warren Buffett recently stated that equities remain attractive, but interest rates represent the most important factor in determining valuation.

“The most important thing is future interest rates,” Buffett said. “And people frequently plug in the current interest rate saying that’s the best they can do. After all, it does reflect the market’s judgment. And the 30-year bond should tell you what people are willing to put out money for 30 years and have no risk of dollar gain or dollar loss at the end of the 30-year period. But what better figure can you come up with? I’m not sure I can come up with a better figure. But that doesn’t mean I want to use the current figure, either.”

The current rate environment is a good news and bad news story. Long rates are falling, which is supportive of equity valuations. On the other hand, the yield curve is flattening, which is a signal that the bond market expects slower growth.
 

 

The key question for equity valuations then becomes a question of how interest rates will change in the future. Current market expectations for Fed Funds envisages a Federal Reserve that is considerably more dovish that the September dot plot.
 

 

There has been much speculation about the identity of the next Fed chair, and whether the new chair will be dovish or hawkish. While the news of who gets nominated will get the headlines, the more important dynamic is the composition of the FOMC next year. The rotation of voting regional Fed presidents is going to see the replacement of doves (Kashkari and Evans) with hawks (Williams and Meester). Moreover, there are three vacancies (not counting Janet Yellen if she doesn’t get re-appointed) at the Federal Reserve Board of Governors out of a total of seven seats. Randal Quarles, who was just confirmed by the Senate as vice chair for bank regulation, is known to have hawkish views. Virtually all rumored potential nominees are known to be rules-based Republicans with views who are more hawkish than the current board.

The current Fed’s expectations calls for a December rate hike, with three more quarter point hikes next year. Notwithstanding the views of any new Fed chair, a more hawkish Fed could see four or more hikes in 2018, and it is difficult to see how the 2018 FOMC could become more dovish than the 2017 FOMC. That translates to a negative rate surprise in either late 2017 or early 2018.

That said, the equity market still has a safety cushion. The June 2017 BAML Fund Manager Survey (last time the question was asked) indicated that institutional equity investors are unlikely to panic unless 10-year yields rises to 3.5-4.0%, which is slightly over 1% from current levels.
 

 

However, the more hawkish tone from the Fed has strengthened the USD, which is likely to pose a headwind to the earnings of large caps with foreign operations.
 

 

John Butters at Factset pointed out that companies with greater foreign operations are seeing much better earnings and sales growth than ones with a domestic focus.
 

 

For now, all of these concerns are 3-6 months in the future. The current environment is dominated by positive momentum, which is causing a surge in stock prices.

Strong momentum

There is no doubt that both the stock market and the US economy is enjoying strong positive momentum. Virtually all of the major market averages have seen new all-time highs last week. As Jonathan Krinsky pointed out, strength begets more strength.
 

 

As well, top-down macro indicators have been stronger than expected. The Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, have regained the zero line and it is entering a period of positive seasonality.
 

 

Examples of positive surprises included continued strength in both ISM Manufacturing and Services.
 

 

As well, the latest update of earnings expectations from Factset shows that forward 12-month EPS continue to grind upwards, indicating positive fundamental momentum from Wall Street.
 

 

Too far too fast?

Despite the onslaught of positive price, macro, and fundamental momentum, the recent risk-on stampede calls into question of how much has been discounted by the market. The Fear and Greed Index is now at a nosebleed 92, which represents a minor retreat from last Thursday’s close of 95. How much more upside is there?
 

 

Kevin Muir, writing at The Macro Tourist, believes that sentiment has turned so much that the pain trade is now down. (Incidentally, I was bullish six months ago.)

Think back six months. Do you remember all the warnings from the legendary hedge fund managers about the impending stock market doom? Paul Tudor Jones, Scott Minerd, Larry Fink, Seth Klarman, the list is long but distinguished. At the time I penned It’s too easy to write bearish pieces. Even in late summer, gurus like Gundlach were bragging about the 400% he would make on his S&P 500 put purchases – Billionaire Bears. Given the atmosphere, I knew posts about the coming collapse would be greeted with tons of words of encouragement. Yet if I wrote something about the stock market continuing higher, crickets… Or worse yet, remarks about my cluelessness regarding the problems in the global financial system. I didn’t think stocks were going higher because everything was roses, no in fact just the opposite. Stocks were being pushed higher because everything was so FUBAR’d. Central Bank balance sheet expansion was pushing risk assets higher, and for the longest time, everyone wanted to fade it.

Fast forward to today. Even the most ardent bears have given up and embraced the idea Central Bank buying will push stocks higher. Investors that were previously doom and gloomers are now speaking of blow off-tops. I can hear the capitulation in their voices. No more brave predictions of the coming collapse. Instead, meeker forecasts of a high volume runaway euphoria. There are no bears left. None. Not a soul.

The bears have been replaced by gloating bulls that are openly bragging about how high the S&P 500 futures will gap up Sunday night. They are mocking the bears with taunts of how much money will they lose fighting the rally. They joke about buying the dip, which increasingly is becoming more and more nothing more than a couple of downticks.

I might not know much, but I know the Market Gods do not take kindly to that sort of behaviour. What was that quote from Bernard Baruch? “The main purpose of the stock market is to make fools of as many men as possible.”

Muir points to contrarian indicators such as the latest cover of The Economist as a bearish indicator.
 

 

Remember the last time this happened?
 

 

To be sure, a past study cited by the Buttonwood blog at The Economist found that Economist cover indicators work well as a contrarian indicator at a one year horizon, but have little or no utility in the short run.

Interestingly, their analysis finds that after 180 days only about 53.3% of Economist covers are contrarian; little better than tossing a coin. After 360 days, the signal is a lot more reliable—68.2% are contrarian. Buying the asset if the cover is very bearish results in an 18% return over the following year; shorting the asset when the cover is bullish generates a return of 7.5%.

Dana Lyons also pointed out that the University of Michigan Survey indicated a historically high level of bullishness. Such episodes have not ended well in the past.
 

 

The slow stochastic of the NYSE Common stock Summation Index is now overbought. In the past, the market advance has tended to stall when readings reached these levels.
 

 

For short-term traders, Tom McClellan warned that the lack of market volatility, as measured by the McClellan Oscillator, could be indicative of near-term market weakness.

Party now, pay later?

The combination of positive momentum, overbought conditions, and excessive bullishness suggests a market that is likely to either consolidate or pull back from current levels. In light of the powerful momentum backdrop, dips should be bought, barring some unexpected exogenous event, such as the one alluded to by Donald Trump’s “calm before the storm” remark. That remark was followed by potentially ominous tweets about North Korea.
 

 

My base case scenario calls for a brief period of consolidation or correction, followed by a rally into year-end. Stock prices could conceivably temporarily overshoot Eisenstadt 2620-2640 target before stalling and pulling back to the low 2600 area.

My inner investor remains constructive on stocks. He has taken some profits and rebalanced his portfolio back to investment policy target weights. My inner trader covered all shorts last week. He is waiting for a dip to buy back in. Despite the trading system’s “buy signal”, the market is too extended to get too long right now.

Be careful what you wish for: Catalan independence edition

Posted by Cam Hui -

The situation in Catalonia is a mess. Catalan frustrations are understandable. The region is the most prosperous of all in Spain, and shares similar characteristics as norther Italy to the rest of Italy, or North Rhine-Westphia and Bavaria to Germany.
 

 

Here at Humble Student of the Markets, we try not to take political positions, but we stand in principle against the suppression of democracy. However, the independence referendum was ruled to be unconstitutional, but the heavy-handed reaction of the Rajoy government did not help matters.

Where do we stand now?

King Filipe IV has condemned the vote, as he has taken the position that it is unconstitutional. Catalan President Carles Puigdemont is offering mediated talks, but threatened to declare independence perhaps as soon as this weekend.

The price of independence

While the slogan “Madrid nos roba” (Madrid is robbing us) may appeal to the populists, there is a price to independence. Imagine if Puigdemont took the plunge and declared independence. Here is what that would mean:

  1. An independent Catalonia would no longer be part of the EU, and it would have to apply for membership that could be vetoed by any EU member, such as Spain. Roughly two-thirds of Catalan exports go to the EU, how would it cope without EU membership?
  2. What about the debt? The Catalan government owes €77bn at the last count, or 35% of the region’s GDP. Of that, €52bn is owed to the Spanish government.
  3. An independent Catalonia would no longer be part of the eurozone. Any Catalan banks would automatically lose ECB support. Already, Catalan banks CaixaBank SA and Banca Sabadell SA are considering changing their domicile in case of independence.
  4. If Catalonia were to gain European Union membership, it would be one of the more wealthy countries in the EU. Instead of sending funds to Madrid and supporting the rest of Spain, it would be sending money to Brussels and supporting the rest of Europe.

From the view of the capital markets, point 2 would have the most immediate impact. A declaration of independence would cut any Catalan lender from ECB support right away, and cause a bank run as depositors transfer their funds into the rest of Europe. The BoS and ECB are under no obligation to support those institutions should a bank run occur.

The price of opportunity

All of this uncertainty is creating an opportunity. The chart below shows the relative performance of Spain stocks (IBEX) against eurozone stocks (Euro STOXX 50). The IBEX is currently testing the lower end of a historical range, which presents an opportunity for speculative position to profit from the panic.
 

 

The pattern for the US listed ETFs (EWP vs FEZ) is similar.
 

 

The Spanish bond market has already begun to recover.
 

 

In all likelihood, the Catalan referendum and its aftermath is another manifestation of European theatre. When the German publication Bild interviewed Puigdemont (English translation at Business Insider), one of the concerns raised was if FC Barcelona would continue to play in the Spanish league after independence, so the problems can’t be that intractable. Hopefully, cooler heads will prevail and the crisis subsides.

That said, I’ve been wrong before. I took a similar optimistic view before the Brexit vote.

Nearing upside target, what now?

Posted by Cam Hui -

Mid-week market update: Back on July 19, 2017, I wrote about using point and figure charting as a way of projecting an upside SPX target when the index stood at 2473 (see What’s the upside target in this rally?). Using different sets of inputs that represent different time horizons and risk tolerances, I arrived at a target range, and a median upside target of 2561. The final targets were roughly the same whether outliers (highlighted in red) were removed or not.
 

 

Now that the index is within about 1% shy of the median target, what now?

Revised targets

I re-ran the point and figure charts on stockcharts.com and came up with some updated targets, with the outliers highlighted in red. The upside objectives are now about slightly higher. The new final target range is now 2587-2596, up from 2561-2563.
 

 

The Rule of 20

Another way of thinking about a price target is Ed Yardeni’s Rule of 20, which calculates a target P/E ratio by subtracting headline CPI inflation from 20. Yardeni credits the rule to his friend and former CJ Lawrence colleague Jim Moltz.

The latest CPI inflation rate is 1.9, which make the target P/E ratio 18.1. Factset reports that the forward P/E is 17.7. Based on those figures, we can then derive a Rule of 20 price target of about 2600.

Limited upside potential

Surprisingly, these two wildly different estimation methods surprising arrive at very similar conclusions. I therefore conclude that the market advance is likely to start stalling at about 2600.

While these estimation techniques are inexact disciplines, this exercise does highlight limited upside potential in stock prices. Momentum is strong, and there is undoubtedly there are further gains for equity investors, but the party may be starting to wind down.

Frothy sentiment

BAML recently updated their “Sell Side Indicator”, which uses Street strategists’ asset allocation as a contrarian signal, and flashed a surprisingly bearish message. The standard interpretation of the Sell Side Indicator uses a 15-year rolling average of the Street consensus. Current readings are neutral, though they have risen quite rapidly.
 

 

However, the BAML strategy team found that shortening the time frame from 15 to 4 years yielded a far more cautious picture.

While we view the 15-year rolling periods as appropriate for capturing secular shifts in sentiment, we have found a better historical track record for sell signals based on shorter time horizons. Specifically, the model yields the lowest expected 12-month returns and higher percentage of negative returns when using a four-year rolling history.

Current readings are at a crowded long: “The current indicator near a six-year high, it is nearly two standard deviations above the four-year average, suggesting weaker returns over the next 12 months”. Note that the backtested results in the table below shows returns when they are 1 standard deviation above the 4-year average.
 

 

From a short-term viewpoint, sentiment is getting a little giddy and short-term upside potential may be limited. Ned Davis Research`s Trading Sentiment Composite is in the excessive optimism zone. Historically, the market has struggled when readings have been this high.
 

 

The Fear and Greed Index exceeded 90 this week, which represents an extremely greedy reading. Even if you are bullish, are you sure you want to be buying here?
 

 

My base case scenario calls for a short-term consolidation or pullback from current levels. The market is likely to then continue grinding upwards towards its ultimate top after a pause. These conditions suggest that investors and traders should refrain from getting overly greedy at these levels.

Disclosure: Long SPXU