Things you don’t see at market bottoms, 23-Jun-2017 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). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, I am starting a one in an occasional series of lists of “things you don’t see at market bottoms”:

  • Argentina’s 100-year bond offering
  • Irrational Exuberance Indicator at fresh highs
  • The E*Trade Indicator flashes a warning
  • More signs of excesses from the Chinese debt time bomb

Argentina’s 100-year bond

Earlier in the week, Argentina announced that it had received USD 9.75 billion in its financing for a 100-year USD denominated bond offering (via Reuters). Demand was strong, and the deal was priced at a yield of 7.9%.

Excuse me? Didn’t Argentina just emerge from default? Who in his right mind would lend Argentina money at 7.9% for 100 years? This financing is evidence of how starved the market is for yield.

If you don’t think that financing is unreasonable, then I have the following question for anyone who voted for Donald Trump. The latest small business confidence figures from NFIB shows confidence surged in after the November election. Undoubtedly, much of the rise was attributable to the renewed optimism of Trump supporters in the small business sector.
 

 

How much would you lend money to a Donald Trump led government? The yield on a 7-8 year Treasury, assuming a two-term Trump presidency, is about 2%.

Is 2% enough for 7-8 years? If not, then how much more would you want?

Irrational exuberance

Jeroen Blokland recently pointed out that the Irrational Exuberance Indicator, which is calculated from Yale’s survey of confidence that the “market will be higher one year from now” compared to confidence in “valuation of the market”, has risen to levels that were higher than past market peaks.
 

 

This is definitely another thing that you don’t see at market bottoms.

The E*Trade Indicator

Joe Wiesenthal recently made an off-beat observation about E*Trade (ETFC):
 

 

Rather than just focus a single stock, the chart below shows the relative performance of ETFC against the market and the Broker-Dealer ETF (IAI) against the market. Both relative performance ratios topped out before the last two major market peaks.
 

 

Both ETFC and IAI are struggling to achieve new highs even as the SPX rises to new highs. Is this another warning of a market top?

The China debt time bomb

Economic recessions serve to unwind the excesses that occurred in the previous expansion. In the US, there are no significant excesses, if unwound, are likely to totally tank the economy. While some valuation excesses can be found in unicorns, the implosion of Snapchat, Uber, or other Silicon Valley darlings are unlikely to cause significant economic damage.

From a global perspective, however, much of the excesses can be found in China. The New York Times recently reported that the market was getting spooked because Beijing was cracking down on the foreign takeover financing of a number of large Chinese conglomerates:

Some of China’s largest companies may pose a systemic risk to the country’s banks, a senior banking official said on Thursday, in the latest signal that Beijing is ratcheting up scrutiny of a financial system plagued with hidden debt that poses a hazard to the health of the economy.

The official, Liu Zhiqing of the China Banking Regulatory Commission, did not name any companies. But shares of some of China’s biggest global deal makers plunged on Thursday.

They included the publicly traded arms of Fosun International, which in recent years bought the Club Med chain of resorts and other properties; Dalian Wanda, which owns the AMC Theaters chain in the United States and has long sought deals in Hollywood; and the HNA Group, an acquisitive conglomerate with murky ownership.

At a briefing on Thursday in Beijing, Mr. Liu, deputy head of the commission’s prudential regulation bureau, said that his agency was looking into “systemic risk of some large enterprises,” according to numerous media accounts, and that the risk could spread to other institutions.

Bloomberg columnist David Fickling revealed that much of the concerns stemmed from the fact that many of the large Chinese acquirors have been free cash flow negative. In other words, these companies are relying on the kindness of the financial system to maintain both solvency and their acquisition sprees.
 

 

By contrast, FCF of recent major American acquirors have been consistently positive.
 

 

These two charts dramatically illustrate the point of the differences in the levels of financial excesses between China and the US. While I am not predicting an imminent collapse of the Chinese economy, this is another thing that you don’t see at market bottoms.

Despite these negatives, I reiterate my contention that this is not the top of the equity market. In a future post, I will explain why the global reflation trade still has some life left.

A market breadth model that works

Posted by Cam Hui -

Mid-week market update: Technical analysts monitor market breadth, as the theory goes, to see the underlying tone of the market. If the major market averages are rising, but breadth indicators are not confirming the advance, this can be described as the generals leading the charge, but the troops are not following. Such negative divergences are signs of technical weakness that may be a precursor to future market weakness.

That’s the theory.

I have been highly skeptical of breadth indicators as a technical analysis tool because breadth divergences can take a long time for the market to resolve, if at all. The chart below shows the SPX, the “generals”, along with several indicators of how the “troops” are behaving, namely the mid-cap and small cap indices, as well as the the NYSE Advance-Decline Line.
 

 

The behaviour of these indicators during and after the Tech Bubble was problematical. During the advance from 1998 to 2000, the NYSE A-D Line fell and flashed a negative divergence sell signal. At the same time, both the mid- and small-cap indices continued to rise and confirmed the market advance. Which divergence should investors believe?

After the market peaked in 2000, the mid and small caps traded sideways, which represented a non-confirmation of the bear market. Investors who followed this buy signal would have seen significant drawdowns during this bear market.

To be sure, there were periods when breadth indicators worked. The NYSE A-D Line traded sideways during the market decline of 2011, which was a buy signal. As well, it correctly warned of market weakness in 2015.

Putting it all together, the report card for these indicators can best be described as inconsistent and the timing of the signal uncertain. At a minimum, no investor would use breadth indicators in a trading system.

I believe that I discovered a solution to the problems that technicians struggle with when they use breadth indicators.

An apples-to-apples breadth indicator

Part of the problem of breadth indicators can be attributable to an apples-to-oranges comparison of breadth. The NYSE breadth universe contains many closed-end funds and REITs whose trading patterns are different than the SPX. Similarly, mid-cap and small cap sector weights can be considerably different than the SPX.

I solved that problem by using the Equal-Weighted SPX (SPXEW) as a breadth indicator. Both the equal-weighted and float-weighted SPX have the same companies in the index, with the only difference being the individual company weights in each index.

I studied the return pattern of SPXEW and SPX from 2003 and created a trading system based on the following rules:

  • Look for divergences: I first calculated a rolling 26-week correlation, the SPXEW/SPX ratio with SPX. We define a divergence as the 26-week correlation falling below 0.25. The first occurrence of a divergence would create a trade signal.
  • Signal direction: The trading system then buys or shorts the SPX based on whether SPXEW/SPX was outperforming or underperforming. An outperformance would translate into a buy signal, and underperformance, a short signal. In other words, we allowed the “troops” to tell us what the “generals” are likely to do.

The chart below shows the results of our study. There were 15 signals during the test period, and average returns beat the SPX one week after each signal.
 

 

Another way of analyzing the model is to monitor the success rate, or percentage of times the returns are positive, after the signal. Based on the combination of the chart above showing average returns, and the chart below showing success rate, the optimal holding period is roughly 7–10 weeks after a signal.
 

 

Negative divergences everywhere

What is the SPXEW Breadth Model telling us now?

The chart below graphically depicts the results of our study of this model. It shows the SPX (black, top panel), the SPXEW/SPX ratio (green, top panel) and the rolling 26-week correlation (bottom panel) since 2007. Past positive divergence are marked in blue, and negative divergences marked in red.
 

 

Currently, the SPXEW Breadth Model is on a severe negative divergence, and therefore a sell signal, which began in early March. I am somewhat puzzled by these readings. Either the model is turning out to be ineffective this time as we are almost past the optimal holding period, or it is warning of a significant correction in the near future.

The negative divergence exhibited by the SPXEW Breadth Model has been confirmed by negative divergences elsewhere. As the chart below shows, The SPX is showing negative RSI-5 and RSI-14 divergences even as it tested upside resistance at all-time highs this week.
 

 

In addition, negative divergences could be seen in the weekly SPX chart, though only one out of the last three negative RSI divergences on the weekly chart was resolved bearishly.
 

 

In conclusion, the US equity market still faces near-term downside risks and sloppy market action. As long as the US Economic Surprise Index (ESI) remains weak, the market may continue to struggle. As the chart below shows, a far more likely outcome is some degree of convergence between eurozone ESI and US ESI in the months ahead.
 

 

Disclosure: Long TZA

Goldman’s “The death of value” and what being contrarian means

Posted by Cam Hui -

Recently, Ben Snider at Goldman Sachs published a report entitled “The Death of Value”, which suggested that the value style is likely to face further short-term headwinds. Specifically, Snider referred to the Fama-French value factor, which had seen an unbelievable run from 1940 to 2010 (charts via Value Walk).
 

 

Goldman Sachs went on to postulate that the value style is unlikely to perform well because of macro headwinds. This style has historically underperformed as economic growth decelerates. However, the investment implications are not quite as clear-cut as that, based on my analysis of how investors implement value investing.
 

 

Naive or pure value?

Consider how you might implement a value strategy. Imagine if you ranked all the stocks in your investment universe by the P/E ratio, which is a well-known value factor, and you created a buy list consisting of all the stocks in the bottom 20% by P/E. This buy list would have enormous sector bets. Since bank and utility stocks tend to have lower P/E ratios when compared to technology stocks, the buy list would be overweight banks and utilities, and underweight technology. That is what is known as a naive value factor.

Supposing that you didn’t want to a buy list that had sector and industry bets. You could rank your investment universe by P/E net of other factors, such as sector and industry, market cap (size), and so on. That’s what quants call a pure value factor.

This explanation is not meant to denigrate any single investment style. Some value investors, such as Warren Buffett, has successfully implemented naive value for many years by avoiding technology stocks as “too hard to understand”. Other quant investors have implemented pure value factor investing as a way of controlling risk.

The Fama-French value factor is a form of a pure value factor. By contrast, the Russell 1000 Value Index (RLV) and Russell 1000 Growth Index (RLG) have significant sector weight differences and can be better characterized as naive value bets.

That’s where the difference in value investing lies.

Sizing up the macro bets

One way of sizing up the value bet is to consider the sector weightings between RLV and RLG. As the chart below shows, a long naive value (RLV)/short growth (RLG) portfolio would be long Financial Services and Energy, while underweight Technology and Consumer Cyclical, though much of the latter is an AMZN effect because of the large weight that stock has in the Consumer Cyclical sector.
 

 

While Tech stocks have been on a tear for most of 2017, I would caution that differences in sector weights do not fully explain the value style shortfall. Analysis from GMO stated:

It should be noted that value’s underperformance cannot be explained solely by its relative underweight of the Information Technology sector. For example, in the US, a sector-neutral value portfolio consisting of the cheapest quartile of stocks from within each sector would still have underperformed a sector-neutral growth portfolio by approximately 4% in the first 5 months of 2017.

Nevertheless, let us consider the macro implications of these value and growth sector bets using the yield curve. The shape of the yield curve has been long been used by fixed income investors to measure the market’s growth expectations. A steepening yield curve is taken as a sign that the market expects rising economic growth, while a flattening yield curve is a sign of growth deceleration.

The chart below shows the relative performance of Technology stocks against the market (black line, top panel), and the 52-week rolling correlation of the market relative performance against the yield curve (bottom panel), along with a 5-year moving average of the rolling correlation. As the chart shows, the relative performance has had a slight negative correlation to the yield curve. In other words, In the last five years, Tech stocks have tended to outperform when the yield curve is flattening, which indicates a growth deceleration.
 

 

By contrast, here is the same chart for Financial stocks, which has shown a positive correlation with the shape of the yield curve. These stocks tend to perform better when the yield curve steepens.
 

 

A similar analysis of the Energy sector came to the same conclusion. In the last decade, Energy stocks have outperform when the yield curve steepens, indicating accelerating growth.
 

 

In conclusion, the Goldman Sachs macro analysis of how value performs under differing economic growth conditions only tells part of the story. It’s not the current state of the economic growth conditions that matter, the direction of change of growth, whether it’s accelerating or decelerating, matters just as much.

A contrarian setup

The foregoing analysis has led me to believe that Goldman’s publication of “The Death of Value” report is setting up for a revival of the value factor. Consider how such a pain trade might unfold. The latest BAML Fund Manager Survey shows that US institutions are overweight the big growth sectors (Tech and Discretionary) and slightly underweight the big value sectors (Banks and Energy).
 

 

In my last post (see The risks are rising, but THE TOP is still ahead), I suggested that the stock market is poised for a revival of the global reflation trade after a brief June swoon, or hiatus. The recovery would be characterized by the leadership in capital goods stocks, which may be just staring now, and capped off by a surge in inflation hedge sectors such as gold, energy, and mining. The resurgence of the reflation investment theme would also be accompanied by a steepening yield curve.

Should the market’s perception shift to a better growth outlook, then the yield curve will begin to steepen again, which would benefit the big value sectors of Banks and Energy while hurting Technology.

As well, current positioning suggests that a long value (Energy and Banks) and short growth (Technology and Discretionary) is a promising contrarian setup. That trade may be still a little bit early. I would prefer to wait for definitive signs that Energy and Mining stocks have shown signs of a relative market bottom before committing to that trade.
 

 

An alternative signal to buy value stocks might be a bottom in the Citigroup US Economic Surprise Index (ESI). This index is designed to measure whether macro releases are beating or missing expectations, and it is also designed to be mean reverting. As the chart shows, ESI has been correlated with Treasury yields. When ESI does turn up, yields will also rise, which will probably coincide with a steepening yield curve.
 

 

That will also be a signal of a more friendly environment for Russell 1000 Value stocks.

Risks are rising, but THE TOP is still ahead

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Four steps, where’s the stumble?

Wall Street traders know about the “Three steps and a stumble” adage, which states that the stock market tends to suffer substantial setbacks once the Fed takes three tightening steps in a row. Now that the Fed has raised rates four consecutive times, where`s the stumble?

Despite my recent post which suggested that the odds of a hawkish rate hike was high (see A dovish or hawkish rate hike), my social media feed was full of misgivings that the Fed is in the process of making a serious policy error like the 1937 rate hike cycle, where the central bank tightened the economy into a recession.
 

 

Another policy error that occurred in recent memory is the Jean-Claude Trichet led European Central Bank’s policy of tightening into the Great Financial Crisis.
 

 

Similar kinds of concerns are rising today. There are preliminary signs of a weakening economy, and the Fed’s willingness to stay the course on its rate normalization policy in the face of soft inflation statistics is raising anxiety levels.

While I believe that recession risks in 2018 are rising, my base case scenario still calls for one last blow-off top in stock prices before the equity party comes to a close. Current concerns about the Fed tightening into a weakening economy can be summarized by this chart of the Citigroup US Economic Surprise Index (ESI), which measures whether macro releases are beating or missing expectations. As the chart shows, ESI has been weak, and the 10-year yield has declined in sympathy. But ESI is already at very low levels. How much worse can the macro picture get before it rebounds?
 

 

A weakening economy?

Evidence of a slowing economy is piling up. Markit wrote that “Weak PMI confirmed by official data”, as illustrated by this comparison of Markit PMI and manufacturing output.
 

 

Similarly, weakness in the consumer goods component of PMI also led softer retail sales.
 

 

Friday’s release of housing starts (blue line) and housing permits (red line) was another month of weakness in housing, which is a highly cyclical sector that is part of my suite of long leading indicators. Nascent weakness in this sector is confirmed by the deceleration in construction job growth, which remains positive on a year-over-year basis. If housing activity does roll over, then the likelihood of a recession next year rises significantly.
 

 

Over at Calculated Risk, Bill McBride raised concerns about the rising risk levels in commercial real estate:

There are several warning signs for commercial real estate. As an example, even as the economy approaches full employment – and the demand for office space will likely slow – new construction is still strong and vacancy rates are already high.

 

Edward Harrison at Credit Writedowns Pro sounded a similar warning:

Commercial real estate is near its pre-recession peak in terms of value as a percentage of GDP. And that level will soon be broken given the huge slug of projects now in the works.

This is an interest-sensitive business because a lot of it is done using leverage in order to multiply profits. And this makes commercial real estate vulnerable to the Fed’s present rate hike cycle.
Bottom Line: Commercial real estate is a sector that continues to do well and power the US economy forward. But there are signs of overbuilding in the absolute number of units coming online right now, particularly in residential property. This makes the commercial property market vulnerable, and we should pay attention to signs of weakness in the sector.

I had pointed out before that corporate profits (red line), which is another key long leading indicator, may have peaked this cycle. As well, a 4.3% unemployment rate is likely to lead to greater wage pressures (blue line), which will further depress corporate margins.
 

 

Indeed median nominal wage growth is beginning to accelerate as unemployment probes historically low levels, notwithstanding the hand wringing over tame inflation statistics.
 

 

Risks are also rising on both the monetary and fiscal policy fronts. In past posts, I pointed out the risks of a significantly more hawkish Fed as Trump appointees join the Board of Governors (see More surprises from the Fed? and A Fed preview: What happens in 2018?). At the same time, Trump Administration officials are still going up a steep learning curve. Business Insider reported that Treasury Secretary Steve Mnuchin seemed to be preparing the country for a government shutdown as legislation to raise the debt ceiling could be in jeopardy:

During a hearing before the Senate Budget Committee, Mnuchin was asked by Democratic Sen. Tim Kaine about a May 2 tweet from President Donald Trump that suggested the federal government needs a “good shutdown.”

“It’s an unfortunate outcome. At times there could be a good shutdown, at times there may not be a good shutdown.” Mnuchin said. “There could be reasons at various times why that is the right outcome.”

Office of Management and Budget director Mick Mulvaney echoed Mnuchin’s warning back in May.

“What we just did this week was fine and passable but not ideal,” Mulvaney told CBS’ Fact the Nation on May 7. “The appropriations, the spending process, Congress using the power of the purse has been broken here in Washington for more than 10 years. And I think a good shutdown would be one that could help fix that. It’s part of that overall drain-the-swamp mentality about Washington, DC.”

Mishaps such as a government shutdown is something that this market doesn’t need. (As another example of Trump officials’ steep learning curve, the Washington Examiner reported that OMB director Mick Mulvaney looked through the ADP jobs report for government job data as he didn’t realize that ADP only covered private sector employment).

Storm clouds are beginning to gather on the horizon. The risks to this expansion are rising, but there is no need to panic just yet.

Slowdown fears premature

Market fears about the Fed tightening into a slowing economy are premature. The near-term outlook for the economy and market remains bright. The Atlanta Fed’s GDPNow nowcast of Q2 GDP currently stands at 2.9%, which is roughly in line with Street expectations.
 

 

At the same time, Q1 earnings season came in ahead of expectations. As this chart from BAML shows, the percentage of companies that showed both sales and earnings beats were at the top end of historical experience.
 

 

The latest update from FactSet shows that forward 12-month EPS continues to rise, indicating Wall Street optimism about the growth outlook.
 

 

As well, the latest update from Barron’s shows that the insider activity has retreated from several weeks of buy signals to a hold signal. Readings for this indicator tends to be noisy from week to week, but the current pattern is constructive for stock prices.
 

 

In short, the nowcast and near-term outlook for equities are still rosy. While storm clouds may be forming on the horizon, those concerns are unlikely to materialize until later this year. New Deal democrat`s weekly assessment of the economic outlook concluded this way:

While the present remains positive, as does the near term forecast, there were two significant negative events for the longer term forecast this week. The first was the Fed raising rates, which caused the yield curve to flatten some more. It is just barely positive now (as opposed to neutral). The second was the poor housing starts and permits report, which was just bad enough to turn housing, on net, negative. As a result the longer term forecast is now just slightly above neutral.

The outlook for 2018 is decelerating from positive to neutral. Add in the possibility of a more hawkish Fed, then the likelihood of a recession in 2018 rises significantly.

Timing the market top

Conor Sen, who wrote in Bloomberg View, recently postulated the following sequence for the current late cycle expansion: full employment, followed by an oil spike, and then a Fed-induced recession. I would concur with that assessment, but amend the oil spike to a spike in commodity prices as crude oil has been dragged down by idiosyncratic supply factors. As well, the scenario outlined by Sen also conforms to the market cycle framework of technical analysis (see In the 3rd inning of a market cycle advance), where market leadership begins a bull move with interest sensitive stocks early in a cycle, then rotates through to consumer spending sensitive stocks, capital goods sectors as capacity utilization gets pressured, and ends with the inflation-hedge commodity producing sector.

Already we are starting to see life in the capital goods industrial stocks, indicating a possible revival in the global reflation trade. As the chart below shows, industrial stocks have staged a breakout out of a trading range relative to the market. The bottom panel shows that the global nature of the move. European industrial stocks have already been in a relative uptrend compared to Dow Jones Europe for all of this year. If the relative breakout in US industrial stocks holds, then expect the reflation theme to revive, a recovery in the Economic Surprise Index, and the yield curve to start steepening again.
 

 

By contrast, late stage cyclical stocks, such as gold, energy, and mining need more time to base relative to the market. Golds and mining stocks are starting to bottom and consolidate on a relative basis, though energy stocks (middle panel) remain in a relative downtrend.
 

 

If my hypothesis is correct, the stock market will see a second wind after a shallow June swoon. A surge in inflation hedge groups would be the signal that the market is in the late stages of a blow-off top.

The week ahead: Seasonal headwinds for stocks

Looking ahead to the next couple of weeks, the stock market is performing in line with historical experience. Urban Carmel observed that stock prices and bond yields tend to be weak after the Fed has raised rates (N=3). That has turned out to be true so far.
 

 

LPL Research also pointed out that the second half of June has tended to be seasonally weak, which is consistent with my short-term trading bias.
 

 

Last week was option expiry week (OpEx). According to Jeff Hirsch of Almanac Trader, the week after June OpEx has shown a bearish tilt, with the SPX down 20 out of 27 times (74%) since 1990.
 

 

The short-term technical condition of the market can best be described as exhibiting negative momentum, but not at an extreme. The SPX is on RSI-5 and RSI-14 sell signals, with initial support at 2420, and secondary support at the 50 dma at about 2390. Should the market weaken in a panic sell-off, watch for an oversold condition should the VIX Index (bottom panel) spike above its upper Bollinger Band.
 

 

Even the badly beaten up NASDAQ 100 stocks are only mildly oversold, but not enough to sound the all-clear signal.
 

 

We may need more panic for Tech stocks for a durable bottom. The short-term ARMS Index for NASDAQ stocks (TRINQ) never traded above 2, which would indicate a “margin clerk” liquidation market. In all likelihood, there may be more pain to come for Tech in the short-term.
 

 

Urban Carmel analyzed past instances of NDX retreats and found that whenever the NDX fell 4% or more (it fell 4.5% last week), the SPX has followed.

During the past 7 years, whenever NDX has fallen 4% from a recent high (blue zig zag line), SPX has also fallen at least 3% (red line). There were two lags between NDX and SPX dropping (yellow shading), but no exceptions, even during the remarkable 2013-14 period. This implies a move of 236.5 for SPY [and about 2360-2370 for SPX].

 

My inner investor remains constructive on equities. My inner trader is still short the market and waiting for oversold conditions to cover his shorts.

Disclosure: Long TZA

More surprises from the Fed?

Posted by Cam Hui -

In my last post, I suggested that the odds favored a hawkish rate hike (see A dovish or hawkish rate hike?) and I turned out to be correct. However, some of the market reaction was puzzling, as much of the policy direction had already been well telegraphed.

As an example, the Fed released an addendum to the Policy Normalization Principles and Plans, which should not have been a surprise to the market:

The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

  • For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
  • For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
  • The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

These steps were discussed in length in separate speeches made by Fed Governors Jerome Powell and Lael Brainard:

Under the subordinated balance sheet approach, once the change in reinvestment policy is triggered, the balance sheet would essentially be set on autopilot to shrink passively until it reaches a neutral level, expanding in line with the demand for currency thereafter. I favor an approach that would gradually and predictably increase the maximum amount of securities the market will be required to absorb each month, while avoiding spikes. Thus, in an abundance of caution, I prefer to cap monthly redemptions at a pace that gradually increases over a fixed period. In addition, I would be inclined to follow a similar approach in managing the reduction of the holdings of Treasury securities and mortgage-backed securities (MBS), calibrated according to their particular characteristics.

The only details that were missing were the exact numbers of the caps. Further, there are no discussions about active sales from the Fed’s holdings, which was also not a surprise.

The Fed’s gradual approach of allowing securities to mature and roll off the balance sheet means that investors who are watching the shape of the yield curve will not have to worry too much about Fed actions in the long end that might distort market signals. This chart, which I made from data via Global Macro Monitor, shows that the Fed holds an extraordinary amount of the outstanding Treasury issues once the maturity goes out 10-15 years.
 

 

These facts are all well known to the public and therefore the Fed’s plans for normalizing the balance sheet should not be a big surprise.

Waiting for Marvin

The bigger surprise that is not in the market are the views of Marvin Goodfriend, who is rumored to be a nominee for a post on the Fed’s Board of Governors. Reading between the lines, as there are three board vacancies, three rumored nominees, and historical experience has shown that new Fed chairs are already Fed governors at the time they are nominated, that means Trump will either keep Yellen as Fed chair in February, or her replacement will come from the new crop of new governors. The most likely candidate is Marvin Goodfriend.

This recent video of Marvin Goodfriend is highly revealing of his views (use this link if the video is not visible).
 

 

In the video, Goodfriend reviewed his Jackson Hole paper that advocated negative interest rates when interest rates fall below zero. He believes that the Fed can drive rates to significantly negative levels by breaking the link between the value of money in the banking system and paper currency. The Fed could take steps to either restrict or refuse the issuance of paper currency, e.g. $100 bills. It could also encourage banks to charge customers a service charge if a depositor withdraws money in paper currency. Those steps would discourage customers from asking for currency and coins, and therefore remove the arbitrage between balances earning negative interest rates in a bank and taking the money out and putting it under a mattress.

Goodfriend has also made it clear that he is no fan of balance sheet policies, otherwise known as quantitative easing, in response to interest rates at the zero lower bound. Here is the key quote [which is visible at about the 25:00 mark]: “Inflation is financial anarchy…Resorting to higher inflation to get away from this [zero bound] problem to me is the equivalent to appeasement in international affairs.”

It is clear that Goodfriend is a traditional monetarist in philosophy and he would push monetary policy in a much more hawkish direction. As this hawkish outcome has not been discounted by the market, the market would freak out once the news of his nomination hits the tape.

A dovish or hawkish rate hike?

Posted by Cam Hui -

Mid-week market update: I am writing my mid-week market update one day early. FOMC announcement days can be volatile and it’s virtually impossible to make many comments about the technical condition of the market as directional reversals are common the next day. Mark Hulbert suggested to wait 30 minutes after the FOMC announcement, and then bet on the opposite direction of the reaction. For what it’s worth, Historical studies from Jeff Hirsch of Almanac Trader indicated that FOMC announcement days has shown a bullish bias and the day after a bearish one.
 

 

The Fed has signaled that a June rate hike is a virtual certainty. The only question for the market is the tone of the accompanying statement. Will it be a dovish or hawkish rate hike?

The case for a hawkish hike

Despite expectations that the Fed may tone down its language because of tame inflation statistics, there is a case to be made for a hawkish rate hike. Tim Duy thinks that the Fed will be mainly focused on employment, rather than inflation, in setting monetary policy:

The recent inflation data doesn’t exactly support the Federal Reserve’s monetary tightening plans. Chair Janet Yellen and her colleagues will surely take note of the weakness at this week’s Federal Open Market Committee meeting, but they will downplay any such concerns as transitory. At the moment, low unemployment remains the focus. Add to that loosening financial conditions and you get a central bank that is more likely than not to stay the course on its plan to hike interest rates.

FOMC participants will follow the logic of San Francisco Federal Reserve Bank President John Williams and attribute recent inflation trends to “special factors,” notably the decline in cellular service prices as measured by the Bureau of Labor Statistics. With this explanation in hand, they will hold firm to their medium term projections that anticipate inflation will soon return to target. The stability of those forecasts is more important for the anticipated course of policy than recent inflation deviations.

Matt Busigin observed that average inflation is already above the Fed’s 2% target (though core PCE, the Fed’s preferred inflation metric, remains muted).
 

 

Across the Curve highlighted analysis from Chris Low of FTN Financial, who pointed out that the Fed is likely to stay on its three rate hike path for this year because the Goldman Sachs Financial Condition Index is signaling easier credit conditions even as the Fed has tightened:

The front page Fed-vs-the-financial markets article in today’s WSJ dives into what ought to be the most controversial reason the Fed is raising rates this year: They have decided stocks are overvalued and they can’t stand when long-term interest rates fall when they raise short rates. The paper notes the Goldman Sachs Financial Conditions Index, which has fallen considerably since December, suggesting markets have eased more than the Fed has tightened. The GSFCI is just exactly the sort of thing the Fed loves to watch while tightening because it allows FOMC participants to ignore the economic damage they are doing to real world economic activity.

Low went on to criticize the construction methodology of the GSFCI and thinks its readings are misleading:

The GSFCI falls when the Fed tightens because it fails to recognize a flat yield curve as a sign of tight financial conditions. In the index, the drop in long yields offsets the rise in short rates. The GSFCI was very low in 2007, for instance, a year in which millions of borrowers were driven into default. And the Fed, watching things like the GSFCI instead of real-life activity in the financial sector – you know, like lending and borrowing activity – failed to recognize how tight financial conditions were in 2006-07. In fact, they did not just fail to recognize it at the time, FOMC participants failed to admit excessive tightening even three years later, in the aftermath of the worst credit crunch since the Great Depression.

Notwithstanding any problems with GSFCI, both the St. Louis Fed Financial Stress Index (blue line), and the Chicago Fed National Financial Conditions Index (red line) have eased even as Fed Funds (black line) rose.
 

 

Low went on to forecast a more hawkish tone from the Fed:

As far as predicting what the Fed will do, the drop in the GSFCI significantly raises the odds of more aggressive behavior. After all, NY Fed President Bill Dudley cited the GSFCI two weeks ago, right before the Fed’s communications blackout, saying there is no reason to think the Fed has tightened too much if financial conditions are easing. Dudley is the Fed’s go-to financial-markets guy.

What to watch for

I don`t know if the reasoning for a hawkish hike will turn out to be right, but the hypothesis sounds plausible. Here is what I am watching after the announcement:

  • What happens to the dot plot? The “dot plot” is an interest rate projection of each individual member of the FOMC based on their own beliefs of how the economy is likely to evolve. If the dot plot edges down, then that is a signal that a group within the FOMC thinks the Fed should pause its normalization program.
  • How does the yield curve react? Assuming that the Fed hikes by a quarter-point, will the long end rise, or fall? A flattening yield curve would reflect the credit market’s expectation of decelerating growth. The 2/10 yield curve has been flattening and stands at 0.84%, and it is approaching the lows set last fall.

 

 

Watch this space. Just keep in mind that Warren Buffett stated in a recent CNBC interview that interest rates are the biggest factor in stock market returns: “If these rates were guaranteed to stay low for 10, 15 or 20 years, then ‘the stock market is dirt cheap now’.”

The risk to growth and growth stocks

Posted by Cam Hui -

Ed Yardeni may have top-ticked large cap growth stocks last week by postulating that a melt-up may be underway, led by the FAANG names. As the chart below shows, FAANG as a percentage of SPX market cap has been rising steadily for the last few years and now account for 11.9% of SPX market cap.
 

 

Despite the air pocket that these stocks hit on Friday, the relative market performance of the NASDAQ 100 still looks like a blip in an uptrend.
 

 

The relative performance of the Russell 1000 Growth Index compared to the Russell 1000 Value shows a higher degree of technical damage, but the relative uptrend of growth over value stocks also remains intact.
 

 

Looking into the remainder of 2017, however, there is a potential threat to earnings growth that investors should keep an eye on.

Are expectations too high?

Ed Clissold at Ned Davis Research highlighted a possible threat to equity prices from 4Q 2017 earnings expectations. He noted that the current earnings rebound is real, as measured by earnings quality and the diminished level of buybacks, 4Q earnings expectations have been rising dramatically and therefore prone to disappointment.
 

 

Here is what is unusual about the upward revision in 4Q estimates. Historically, Street analysts have tended to estimate high and drop them as time passed. That`s why I have normalized estimates by using forward 12-month EPS to calculate forward P/E ratios.
 

 

As Ed Clissold indicated in his analysis, 4Q EPS estimates bucked the historical trend by rising instead of falling. This chart from FactSet shows that the upward revisions in 2017 EPS from March to today have been broad based, and represent seven sectors with 86.2% of index weight. (Note that while the Energy sector is projected to have the greatest YoY growth, they were revised downwards).
 

 

EPS growth expectations are high for 4Q 2017 earnings. With growth stocks getting hammered Friday and today, it will be useful to keep the possibility of disappointment in mind, and not just for the high flying Technology glamour stocks.

A Fed preview: What happens in 2018?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Marvin Goodfriend for Fed chair?

Over at Calculated Risk, Bill McBride asked the following questions after featuring analysis from Goldman Sachs which expected a June rate hike:

Almost all analysts expect a rate hike this week, even though inflation has fallen further below the Fed’s target. A few key questions are: Does the FOMC see the dip in inflation as transitory? Will the Fed keep tightening if inflation stays below target? Will the next tightening step be another rate hike or balance sheet normalization?

Those are all good questions, but as the market looks ahead to the FOMC meeting next week, it’s time to look beyond what the Fed might do at its June meeting, or even the remainder of the year. The bigger question is how the Fed reaction function might change in 2018 as the new Trump nominees to the Board of Governors assume their posts.

Another key question to consider is whether the Trump administration plans to keep Janet Yellen as Fed chair. As there are three open positions on the board, and there are three rumored nominees, any potential new Fed chair would come from the current list of new appointees. Of the three, the most likely candidate is Marvin Goodfriend.

Current market expectations show that December 2017 Fed Funds (black line) to be relatively steady, but December 2018 Fed Funds (red line) have been declining.
 

 

Regardless of whether Goodfriend becomes the new Fed chair, I examine this week how the influence of the three likely appointees may change the path of monetary policy in 2018 and beyond.

The Fed’s current analytical framework

Let’s start with the analytical framework of the current Fed. There has been much hand wringing about the decline in inflation. However it’s measured, whether using the Fed’s preferred metric of core PCE inflation, trimmed-mean PCE, or sticky-price inflation, inflation is falling.
 

 

For now, evidence of falling inflation is likely to be ignored. As Fed watcher Tim Duy pointed out, “The Fed’s focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year.”
 

Here is how the employment picture looks like right now. Unemployment (black line) has fallen to the historically low level of 4.3%, while median nominal real earnings (blue line, quarterly data) has been accelerating, and the more timely average hourly earnings (red line, monthly data) has softened.
 

 

As the Fed has traditionally been cautious, and believed that monetary policy operates with a lag, the natural tendency would be to hike in June and wait for more data.

Transitory weakness?

The FOMC’s June statement is likely to feature an interpretation of the current patch of soft economic conditions as being “transitory”. Sure, the Citigroup Economic Surprise Index has been falling, indicating that macro releases have mostly missed market expectations.
 

 

Looking around the world, however, the global economy remains robust. At the margin, buoyant non-US economies are likely to provide a boost to the US economic growth. As the chart below shows, a comparison of the SPX and non-US markets show that while the SPX led the rally in weeks after the November election, non-US markets have caught up and have been outperforming since early March. Even if a case could be made that the US equities were rallying because of the anticipation of Trump tax cuts and deregulation, the same argument would not hold for non-US stocks. The Trump trade is dead, but the global reflation trade lives on.
 

 

Callum Thomas of Topdown Charts observed that indicators of global trade are rising, which is bullish for growth.
 

 

The latest Chinese trade statistics also point to a similar conclusion (via Tom Orlik).
 

 

Across the Atlantic, Reuters reported that eurozone growth was revised to the highest rate in two years.
 

 

In short, while US economic conditions may appear to be a bit soft, but the global outlook is strong. In the absence of strong evidence to the contrary, the Fed should continue on its path of monetary policy normalization, which translates to three rate hikes this year and the initiation of balance sheet reduction in either late 2017 or early 2018.

Here comes the new Fed governors

So far, what I have described is the most likely outlook of the current Fed, which is likely to change soon. The New York Times reported that Trump is about to nominate Randy Quarles, a former Treasury official in the George W. Bush administration, and Marvin Goodfriend, former Richmond Fed economist and academic, to the Federal Reserve Board of Governors. Bloomberg also reported that Robert Jones, the chairman of a community bank in Indiana, is being considered for a seat on the Fed board (Indiana Jones at the Fed?).

If these nominations do go forward, then it begs the question of who the next Fed chair might be. Any new Fed chair would have to be on the Board of Governors, and there are three vacancies with three potential nominees. We can either interpret the identification of these potential candidates as Trump’s intention to keep Janet Yellen as Fed chair, or her replacement will come from one of the three new governors.

Consider the background and likely jobs of the three candidates for clues to Yellen’s possible replacement. Jones would fill the seat reserved for small bank representation. Quarles’ mandate is likely to be deregulation. By process of elimination, the most likely candidate to replace Janet Yellen is Marvin Goodfriend.

Who is Marvin Goodfriend?

The next question for investors is, “Who is Marvin Goodfriend?” Gavyn Davies recently wrote an endorsement of Goodfriend in the FT, “Marvin Goodfriend would be good for the Fed”, Here is a brief summary:

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

In other words, Goodfriend has the academic credentials and ticks off all the boxes to be a good Republican Fed chair.

I believe that the most important difference between Goodfriend and the current Fed is Goodfriend seems to favor price level targeting, instead of inflation targeting. Here is one explanation of the difference of the two approaches:

The main difference between inflation targeting and price-level targeting is the consequence of missing the target.

  • Unanticipated shocks to inflation lead to corrective action when the price is the target.
  • Under inflation targeting, past mistakes and shocks are treated as ‘bygones’.

If, for example, inflation is unexpectedly high today, this would be followed in the future by below average inflation under a price-level targeting regime. By contrast, inflation targeting aims for average (i.e. on-target) inflation in future years regardless of the level of current inflation.

 

Once you adopt a price level target, you try to play catch-up if you undershoot or overshoot inflation. Even with rates so low, Goodfriend doesn’t believe that the zero bound is a problem for central bankers. He presented a paper at the Fed’s 2016 Jackson Hole symposium with an unusual proposal to drive interest rates to highly negative levels:

The zero bound encumbrance on interest rate policy could be eliminated completely and expeditiously by discontinuing the central bank defense of the par deposit price of paper currency. The central bank would still stand ready to exchange bank reserves and commercial bank deposits at par; and it could stand ready to convert different denominations of paper currency at par. However, the central bank would no longer let the outstanding stock of paper currency vary elastically to accommodate the deposit demand for paper currency at par.

Instead the central bank could grow the aggregate stock of paper currency according to a rule designed to make the deposit price of paper currency fluctuate around par over time. The paper currency growth rule would utilize: i) historical evidence relating currency demand to GDP, ii) the estimated interest opportunity cost sensitivity of the demand for currency relative to GDP, and iii) the GDP growth rate.

In other words, a dollar doesn’t have to be worth a dollar anymore under a Goodfriend Fed. FT Alphaville also reported that Goodfriend thinks that the Fed’s reaction function should be more decisive as a way of demonstrating the central bank’s credibility:

We recently had the chance to chat with a former student who was in Goodfriend’s spring 2015 business school class on monetary policy. (We attempted to contact Goodfriend to confirm the recollection of the former student but have yet to get a response.)

Goodfriend repeatedly spoke about the importance of a public and legally-binding inflation target. In his view, the current “longer-run goal” for inflation is too mealy-mouthed.

Moreover, it lacks legislative authority. Current law instructs the Fed to promote “stable prices” and “maximum employment” without defining either term. Unelected policymakers get to interpret their mandate as they see fit. They also have considerable leeway to change their interpretations on a whim. (This includes ignoring the third part of the Fed’s legal mandate, which is to promote “moderate long-term interest rates.)

In Goodfriend’s view, all this weakens the Fed’s credibility and partly explains the slow rate of inflation since the downturn.

The 2015 episode is a good example of a Fed policy error, according to Goodfriend [emphasis added]:

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

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

The view that the Fed should move quickly and decisively and “commit to a relatively short and uninterrupted campaign” clashes with the general accepted wisdom of a gradual approach to changes in monetary policy. Consider this recent “docking the boat” metaphor voiced by San Francisco Fed president John Williams, who has been one of the more hawkish voices on the FOMC board:

When you’re docking a boat, you don’t run it in fast towards shore and hope you can reverse the engine hard later on. That looks cool in a James Bond movie, but in the real world it relies on everything going perfectly and can easily run afoul. Instead, the cardinal rule of docking is: Never approach a dock any faster than you’re willing to hit it. Similarly, in achieving sustainable growth, it is better to close in on the target carefully and avoid substantial overshooting.

Great! We will get both Indiana Jones and James Bond at the Fed.

A more hawkish and activist Fed: What dual mandate?

In short, should the all three rumored candidates be nominated and appointed to the Fed’s Board of Governors, the direction of monetary policy will change quite dramatically, possibly as soon as Q4 2017. At a minimum, the Fed is likely to get more hawkish. Quarles has stated that he favors a rules-based approach to monetary policy, and any rules based model is sure to set a Fed Funds target that is significantly higher than what rates are today. Marvin Goodfriend said in a March 2017 interview that he believes that the Fed is behind the curve.

The approach advocated by both Quarles and Goodfriend of a singular devotion to a explicit rules-based monetary policy also implies a downgrade of the Fed’s attention to the other half of its dual mandate of full employment. Moreover, should the Fed adopt Goodfriend’s “relatively short and uninterrupted campaign” tactic to monetary policy normalization, then the likely outcome is a more volatile growth path for the economy. The bigger risk is the economy will experience more frequent and deeper recessions and panics, much like the way it did during the 19th Century.
 

 

The current market environment features a high level of stock-bond correlation, which is an indication of complacency. In the past, such environments have been resolved with market disruptions, though not all of which were equity unfriendly.
 

 

Add in Marvin Goodfriend’s decisive and activist approach to monetary policy to the mix, the risk of a volatility spike over the next few years rises significantly. And none of that has discounted by the markets.

Market potholes in late 2017?

Despite these possible bearish outcomes for the market, the possibility of changes in Fed policy is really a H2 2017 investment story. The Trump administration has not officially nominated any of these candidates yet. Relax!

For now, US economic policy uncertainty is low by historical standards.
 

 

The latest update from Barron’s of insider activity shows that these “smart investors” remain buyers of their companies equities.
 

 

Wall Street continues to revise earnings estimates upwards, according to Factset.
 

 

The current positive fundamental backdrop is a sign that the intermediate term trend for stocks is still up, and any pullbacks should be relatively shallow.

Interpreting the NASDAQ break

In the short-term, however, the downside break in Technology and NASDAQ stocks on Friday caught almost everyone by surprise. The decline had occurred on high volume, though NASDAQ TRIN did not reach 2, which would be indicative of downside capitulation. The break was not a big surprise from a technical perspective as the NASDAQ Advance-Decline Line had been moving sideways even as the index advanced.
 

 

It is unclear whether the downside break is a correction in an uptrend, the start of a correction, or just a sector rotation featuring a sideways consolidation of the other major averages. The weakness was evident in all Technology and high-beta momentum stocks. However, the relative uptrends of these groups all remain intact, though the NASDAQ 100 and Technology groups retreated to test their trend lines.
 

 

Some of the funds that left the high flyers went into other sectors, such as Financials. This sector also benefited from the early signs of a steepening yield curve.
 

 

Some of the logical leaders a sector rotation scenario would be capital goods intensive Industrials and other cyclicals. However, the jury is still out on these groups. Industrial stocks (top panel) remain range bound relative to the market, though they did stage a rally on Friday. By contrast, European industrial stocks have been in a relative uptrend for most of this year. On the other hand, the DJ Transports did not rally on Friday, though they appear to be tracing out a bottoming formation relative to the DJIA. While Friday`s action in the Industrials are supportive of leadership rotation into cyclical stocks, the behavior of the DJ Transports do not.
 

 

Short-term breadth charts from Index Indicators show that NASDAQ stocks to be oversold (though oversold markets can get more oversold).
 

 

On the other hand, longer term (1-2 week) indicators have only retreated to neutral.
 

 

Similar indicators for the SPX are only showing mixed readings. The % of stocks above their 10 dma are neutral.
 

 

Net 20 day highs-lows for SPX stocks is neither overbought or oversold.
 

 

Bottom line, we need further evidence before declaring Friday`s Tech break to be either the start of a general market correction, a pause in an uptrend for high beta stocks, or the start of an internal rotation into other sectors.

The week ahead

Looking to the week ahead, the most obvious potential market moving event is the FOMC meeting on Wednesday. Urban Carmel observed (N=3) that the past three FOMC meetings where the Fed has raised interest rates has seen flat to down stock markets, and falling 10-year yields, which imply a flatter yield curve that is a signal of slower economic growth.
 

 

Next week is also June option expiry. As Rob Hanna at Quantifiable Edges showed, The seasonal bias for June OpEx has been weak compared to other OpEx weeks.
 

 

The SPX remains range bound, and Friday`s doji like candle is indicative of market indecision. Both the 5 and 14 day RSI flashed sell signals last week, and I indicated that the market may be setting up for a volatility spike (see A possible volatility spike ahead). While I still have an open mind to all possibilities, the short-term bias is to the downside, with likely support at about the 50 dma level at about the 2380-2390 level.
 

 

My inner investor remains constructive on equities. My inner trader still has a small short position in small cap stocks.

Disclosure: Long TZA

A possible volatility spike ahead

Posted by Cam Hui -

Mid-week market update: So far, the stock market seems to be following Jeff Hirsch’s seasonal map of June. The market was strong in the first couple of days, and it has mostly been flat this week. If history is any guide, it should start to weaken late this week.
 

 

Evidence is building that of a volatility spike ahead. As volatility is inversely correlated with stock prices, rising vol therefore implies a stock market pullback. The chart below of the ratio 9-day VIX (VXST) to 1-month VIX (VIX) shows that anxiety is rising, but levels are nowhere near where past corrections have bottomed in the past.
 

 

Indeed, there are a number of binary events coming up. Thursday will see the ECB meeting, the UK election, and the Comey testimony before Congress. Next week is the FOMC meeting. No wonder the 9-day VIX is rising.

Tame VIX, but rising anxiety

The level of the VIX Index has recently been low and stable, but there are signs of rising anxiety beneath the surface. I am grateful to a reader for pointing out the market internals of XIV, the inverse VIX ETN. As the chart below shows, both the weekly RSI and MACD on XIV are showing the kind of deterioration that have been precursors to short-term stock market corrections in the past.
 

 

I pointed out before that hedge fund leverage as a measure of risk appetite is at a crowded long level where pullbacks have occurred in the past.
 

 

What`s the trigger?

To be sure, none of this means that stock prices have to weaken right away, if ever. These are weekly charts and the time frame of a possible correction is uncertain. However, a possible technical trigger for near-term market weakness was seen this week.

The chart below of the SPX shows that stock prices had recently an episode where the market rallies on a series of “good overbought” reading on RSI-5 (top panel). These “good overbought” signals have been bullish and can continue for some time. However, market advances have stalled when RSI-14 (second panel) pulled back to neutral from an overbought reading, which happened on Monday.
 

 

In summary, the weight of the evidence suggests that a pullback could happen at anytime. As the chart above shows, past corrective episodes like these have been halted at or above the 50 dma, which current stands at about 2380, which represents a shallow correction.

My inner trader remains short the market, with an exposure to the high-beta small cap stocks.

Disclosure: Long TZA

Peak smart beta?

Posted by Cam Hui -

A recent comment by Michael Mauboussin of Credit Suisse that nailed the dilemma of active managers, namely that using traditional approaches to alpha generation is akin to mining lower and lower grade ore:

Exhibit 1 shows that the standard deviation of excess returns has trended lower for U.S. large capitalization mutual funds over the past five decades. The exhibit shows the five-year, rolling standard deviation of excess returns for all funds that existed at that time. This also fits with the story of declining variance in skill along with steady variance in luck. These analyses introduce the possibility that the aggregate amount of available alpha—a measure of risk-adjusted excess returns—has been shrinking over time as investors have become more skillful. Investing is a zero- sum game in the sense that one investor’s outperformance of a benchmark must match another investor’s underperformance. Add in the fact that in aggregate investors earn a rate of return less than that of the market as a consequence of fees, and the challenge for active managers becomes clear.

 

I got into quantitative investing back in the 1980`s when ideas and models were fresh and plentiful. Today, factor investing has become increasingly mainstream, and so-called “smart beta” may have exceeded their best before date.

Smart beta a crowded trade?

A market study by State Street Global Advisors tells the story. In this era of a shift towards passive investing, smart beta strategies have become more popular as a substitute for many investors. In the space of a year, the number of SSgA survey respondents who plan to use “smart beta” strategies surged from 25% to 68%.
 

Source: State Street Global Advisors’ “2017 Mid-Year Survey,” as of 5/2017

 

Today, the barriers to entry to factor based investing has disappeared. Investment technology has become so ubiquitous that virtually anyone could come up with a smart beta strategy. Bloomberg documented how Dani Burger created a factor which returned an astounding 849,751% return:

This is the story of the time I designed my own factor fund as a way of learning about one of Wall Street’s hottest trends — and its pitfalls. There are already ETFs that focus on themes, such as “biblically responsible” companies or ones popular with millennials. Quants have hundreds of style tilts, and their exploding popularity has created a gold rush for creators. I wanted in.

I notified Andrew Ang, head of factor investing strategies at BlackRock Inc. Everything in my program was by the book, I assured him. It was rules-based, equal-weighted and premised on a simple story — that people love cats.

How did she create her factor?

My model buys any U.S. company with “cat” in it, like CATerpillar, or when “communiCATion” is in the name. It rebalances quarterly to keep trading costs low. That’s important for when Vanguard or BlackRock license it and charge a competitively low fee.

 

Of course, the first iteration of buying stocks that began with “Cat” didn’t work very well, so she tweaked the results, again, and again.
 

 

She eventually got it right, and got astounding returns to her factor that we see today. While the exercise was tongue in cheek, it does illustrate the point that there are many, many quantitative researchers testing a zillion factors that sound good, but suffer from a case of torturing the data until it talks. Burger got the last word from Cliff Asness of AQR:

Like any enterprising quant, I decided to get another opinion. For this, I conferred with Cliff Asness, founder of AQR Capital Management and a pioneer of factor investing.

“Everything you can sort on can be a factor, but not all factors are interesting. Factors need some economics, theory or intuition even, to be at all interesting to us. Thus the cat factor fails as we have no story for why it should matter at all,” Asness said. “Now, in contrast, we are active traders of the dog and parakeet factors, which are based on hard neo-classical economics married to behavioral finance and machine learning. But the cat factor is just silly.”

He’s got a point. Seems like the tail risks here might be a little high.

The perils of data mining

The combination of a surge in the popularity of smart beta funds and the problems of factor backtesting is indicative of a crowded trade in many bottom-up quantitative factor strategies. Good quant factors need pass several tests:

  • The factor needs an economic or market-based rationale and intuitive, such as value stocks with low P/E ratios are indicative of investor fear about a company’s outlook.
  • The factor needs to be implementable. A lot of the early research uncovered factors with excess returns, but much of the alpha was in micro-cap stocks that could not be traded in reasonable size.
  • The factor needs to pass the Watergate test of “what did you know and when did you know it”? Many researchers do not build in sufficient time lags into their backtests. Consequently, backtest results can suffer from a lookahead bias in their data. In addition, some companies have been known to re-state financial results. Did the backtest use the financials that were reported were reported at time, or the re-stated figures?
  • The backtest database does not suffer from survivorship bias. Survivorship bias is the bane of quantitative researchers. I once worked at a hedge fund where a trader’s backtest assumed that companies never went bankrupt. His strategy had shown stellar results, until he bought Enron all the way down to zero. Notwithstanding obvious errors like that, the problem of dead and merged companies is a non-trivial one in financial databases. Consider the history of Time Warner, which began as Time Inc. and Warner Communications. Starting from the 1980’s, this company had bought, sold or spun off Atari, Time-Warner Communications, Turner Broadcasting, Six Flags, AOL, Time Warner Cable, and so on. Were all of these companies in the backtest database, all at right times?

It’s the hidden survivorship bias that can torpedo quantitative factor, or smart beta, strategies.
 

Thrust and bust, or lower for longer?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

A Fed pause ahead?

So far, my base case for the American economy and stock market has been a “thrust and bust” scenario, where the economy continues to grow and overheats, which is then followed by a Fed induced bust. However, the combination of softer macro-economic data, as exemplified by the falling Citigroup Economic Surprise Index…
 

 

And an undershoot in inflation expectations has caused the market to re-assess the probability of the “thrust and bust” scenario. In particular, the decline in inflationary expectations has been global in scope, though the US (red line) has stabilized.
 

 

Friday’s release of the May Jobs Report is a typical example of the weak macro theme. Not only did headline employment miss expectations, employment for previous months was revised downwards. Even though a June rate hike is more or less baked in, the big question is whether the Fed is likely to pause its rate normalization policy in light of disappointing inflation and growth statistics.

The official Federal Reserve view

Fed governor Lael Brainard laid out the official party line in a speech she made last week. Brainard had been an uber-dove on the Fed board, but she made it clear that it’s time to start normalizing monetary policy:

On balance, when assessing economic activity and its likely evolution, it would be reasonable to conclude that further removal of accommodation will likely be appropriate soon. As I noted earlier, the unemployment rate is now at 4.4 percent, and we are seeing improvement in other measures of labor market slack, such as participation and the share of those working part time for economic reasons. There are good reasons to believe that the improvement in real economic activity will continue: Financial conditions remain supportive. Indicators of sentiment remain positive. The balance of risks at home has shifted favorably, downside risks from abroad are lower than they have been in several years, and we are seeing synchronous global growth.

She went on to acknowledge that a shrinkage of the Fed’s balance sheet is also a form of monetary tightening. Both the Fed Funds rate and balance sheet reduction are tools of monetary policy and therefore substitutes for each other:

These effects [of balance sheet normalization] are, of course, in many respects, similar to the effects of increases in short-term interest rates. Thus, away from the zero lower bound, the two tools are, to a large extent, substitutes for one another. As a result, the FOMC will be in the unfamiliar posture of having two tools available for adjusting monetary policy.

However, she favors the use of the Fed Funds rate as the primary monetary policy tool. Once the Fed begins to reduce its balance sheet, the process is likely to be put on “auto-pilot”:

Under the subordinated balance sheet approach, once the change in reinvestment policy is triggered, the balance sheet would essentially be set on autopilot to shrink passively until it reaches a neutral level, expanding in line with the demand for currency thereafter. I favor an approach that would gradually and predictably increase the maximum amount of securities the market will be required to absorb each month, while avoiding spikes. Thus, in an abundance of caution, I prefer to cap monthly redemptions at a pace that gradually increases over a fixed period. In addition, I would be inclined to follow a similar approach in managing the reduction of the holdings of Treasury securities and mortgage-backed securities (MBS), calibrated according to their particular characteristics.

However, Brainard did conclude with a cautionary remark that the Fed may reassess their monetary policy normalization path should inflation continue to decelerate:

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

Despite the soft May Jobs Report, Bloomberg reported that Fedspeak showed no wavering of its policy normalization course:

Fed officials speaking on Friday expressed no disappointment with the payrolls gain of 138,000 last month, which was below economists’ expectations. Philadelphia Fed President Patrick Harker called it a “good number,” while Dallas Fed President Robert Kaplan said “if we are not at full employment, we are moving closer.”

What’s the Fed’s reaction function?

What Lael Brainard outlined is the current view of the Fed. However, there are a couple of questions marks that revolve around the trajectory of Fed policy.

First of all, it is unclear what the Fed’s reaction function to inflation actually is, despite her promise to “reassess the appropriate path of policy”. The current policy framework is based on the Philips Curve, which assumes a trade-off between unemployment and inflation and inflationary expectations. The chart below shows the history of annualized monthly change in core PCE, which is the Fed’s preferred inflation metric, and the Fed Funds Rate. Recently, core PCE has experienced considerable volatility and actually fell an annualized -1.6% in March. On the other hand, there was a dramatic change in tone of policy that began in March, when Fed officials went on an active campaign to warn the market that a rate hike was more or less inevitable at its March FOMC meeting. So how quick will the Fed be to react to slowing inflation?
 

 

Historically, the Fed has become more aggressive in raising rates when the incidence of annualized monthly core PCE above 2%, which is the Fed’s inflation target, has exceeded 6 in the past 12 months, with the exception of the Greek debt crisis of 2011. As the chart below shows, this metric reached 5 but it has begun to back off, indicating falling inflation pressures.
 

 

Here is an uncomfortable question for equity bulls. If the Fed is intent on raising rates in the face of falling inflation pressures, what happens when inflation really heats up?

Political wildcards

As well, there are several political wildcards in play as three Fed board seats are still open and the future of monetary policy is dependent on who gets appointed, as well as the fate of Janet Yellen as Fed chair because her term ends in February 2018. The New York Times reported on Friday:

The Trump administration has selected candidates for at least two of the three open positions on the Federal Reserve’s Board of Governors, according to people with direct knowledge of the decision. The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.

It turns out both of these candidates are hard-money advocates who favor a rules-based approach to monetary policy:

Mr. Quarles and Mr. Goodfriend have expressed support for the idea that the Federal Reserve should adopt a more formulaic approach to policy-making. House Republicans have proposed legislation that would require the Fed to articulate a policy rule — a mathematical approach to determining the level of interest rates — that would limit the role of human judgment in monetary policy.

“If you’re going to be transparent in an activity like the Fed, you have to be much more rule-based in what you’re doing,” Mr. Quarles told Bloomberg Television in 2015. He described the Fed’s current approach as “a crazy way to run a railroad.”

If you read nothing else, Goodfriend’s paper “The Fed Needs a Credible Commitment to Price Stability“, is all you need to know about his philosophy. Moreover, FT Alphaville pointed out that Goodfriend has some unconventional ideas about implementing negative interest rates, and believe therefore that central banks should not afraid of the zero bound.

The appointment of Quarles and Goodfriend would steer Fed policy in a much hawkish direction than the current Fed. That’s because any rules-based monetary policy decision process would see that the Fed Funds target dramatically higher than what it is today. As the chart below shows, unemployment (red line) is already 4.3%, which is at the low end of the historical range, why is the real Fed Funds rate (blue line) still negative?
 

 

On the other hand, the website Axios reported that Trump’s chief economic advisor Gary Cohn is interested in the job of Fed chair. Bloomberg later reported that Cohn denied his interest in the job. Although Cohn has little publicly about the conduct of monetary policy, his appointment would set a very different tone for the Fed. Fed chairs and governors have traditionally come from academia, and academics tend to go through a learning curve about the markets once they settle into their position. Cohn is no academic, but comes from the rough and tumble world of Wall Street. The best parallel to a possible Cohn Fed would be the Greenspan Fed. Alan Greenspan had been a Wall Street forecaster and he was a far more market savvy Fed chair than a Bernanke or Yellen, who came from universities.

As an example, the pair of Greenspan at the Fed and Rubin at Treasury was a formidable duo when it came to currency intervention. Instead of starting intervention during US trading hours, programs would begin during Tokyo hours when the market was far less liquid. Traders would then wake up and find that they were dramatically underwater on their positions.

In all likelihood, a Fed led by Gary Cohn, or someone else with a similar Wall Street profile, would be far more pragmatic than the typical Republican hard-money, audit-the-Fed, rules-based monetary policy favoring academic. In fact, he might exactly the kind of low interest rate person that Donald Trump would want at the Fed.

In conclusion, I have no idea of how all these factors will pan out. My crystal ball is in the shop right now. In the absence of influence of new Fed governors, Fed watcher Tim Duy believes that the Fed will be relatively slow to react to slowing inflation and growth:

The Fed’s focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year. One of those rate hikes will come this month. If sustained, weak inflation will eventually push them to rethink the path of policy. But the impact of those changes might fall more on 2018 than on 2017.

If Duy is correct about the slowness of the current Fed’s reaction function, then the “lower for longer” scenario is not likely to have much credence, especially in light of the Fed’s about-face in March of guiding rates higher when Q1 economic conditions were softening. In addition, monetary policy is likely to take a more hawkish turn if Quarles and Goodfriend, or others with their profile, are appointed to the Fed’s board of governors.

The message from the market

In the meantime, the market has developed its own opinions about handicapping the “thrust and bust” and “lower for longer” scenarios. The bond market thinks that the economy is starting to slow, and therefore a “lower for longer” policy is probably the more appropriate policy.

The 2/10 Treasury yield curve is flattening and it fell to 87bp on Friday, which is a reflection of slower growth expectations. Though readings are far from zero, which has historically been a recession signal, the dramatic change is worrisome and something to keep an eye on.
 

 

Risk appetite, as signaled by the bond market, is also diminishing. The top panel of the chart below shows the relative price performance of high yield, or junk bonds, compared to equivalent duration Treasuries (blue line). As the chart shows, even as the SPX rallied to new all-time highs, the relative performance of HY did not. On Friday, even as the SPX made another fresh high, HY relative returns edged down for another negative divergence.
 

 

The second panel of the chart shows that even as the stock market rose to new highs, investors would have been better off in long Treasury bonds. The blue line shows the relative performance of stocks vs. bonds declining since March, which is another negative divergence in risk appetite.

The bond market is spooked by the longer term growth outlook.

The message from the stock market

By contrast, the stock market appears to be focused on the shorter term growth picture. The inverse correlation between initial jobless claims (blue line, inverted scale), which is a coincident economic indicator, and stock prices (red line) has been one of the more remarkable and stable relationships in this cycle.
 

 

The latest update from FactSet shows that forward 12-month EPS is still rising nicely.
 

 

The latest report from Barron’s of insider activity shows that this group of “smart investors” continue to be in buy mode. So what are you so worried about?
 

 

The risks to stock prices

Here are the key risks to stock prices. Looking into 2018 and beyond, the global monetary policy environment is likely to be far less stimulative than it is today. This chart from JP Morgan shows how the balance sheets of G-4 central banks are likely to peak out next year and begin to shrink in 2019 as QE programs reverse themselves.
 

 

One of the fears for market bulls is that the Fed is headed for a policy error as it misses signals of economic weakness and tightens into a flagging economy. A sign that the economic cycle may be peaking comes from an analysis of tax receipts. FT Alphaville pointed out that YoY federal tax receipts are falling. The bull case is these are just the signs of a late cycle expansion. The bear case is declining tax receipts indicate a weakening economy.
 

 

Another warning sign comes from housing, which is a highly cyclical component of the economy and a key long leading indicator. This sector may have peaked for this cycle. Both housing starts (blue line) and housing permits (red line) are showing signs of rolling over. To be sure, both of these data series are very noisy and can be weather dependent. As well, the May Jobs Report showed that construction jobs +11K m/m and +191K y/y, so there is no need to panic just yet.
 

 

In addition, New Deal democrat warned that corporate profits may have seen the highs of this cycle. That’s important because “corporate profits as deflated by unit labor costs is one of the four long leading indicators identified by Prof. Geoffrey Moore, who was responsible for the publication of the Index of Leading Indicators for several decades.”

However you measure corporate profits, whether normalized by inflation (blue line) or (unit labor costs), the chart below shows that they appeared to have peaked out. Past instances of peaks have been precursors to economic recessions.
 

 

NDD sounded a warning similar to the one I voiced last week (see When will the market top out?):

This relationship makes it look like there is not a lot of upside potential in stock prices, at least as measured quarterly. Moreover, if corporate profits have peaked for this cycle, then it would be expected that a cycle peak in stock prices in the next 12 months is a pretty good bet.

As well, Ed Yardeni recently sounded a warning on equity valuation. He observed that the Rule of 20, which states that forward P/E plus CPI inflation should not be above 20, had flashed a sell signal.
 

 

To be sure, Yardeni did concede that not all models were that bearish. The Fed Model still shows that stocks are undervalued by 61.9%, as long as rates stay low, growth continues, and inflation remains tame:

This confirms Buffett’s assessment that stocks are relatively cheap compared to bonds. If more investors conclude that economic growth (with low unemployment) and inflation may remain subdued for a long while, then they should conclude that economic growth and inflation may remain historically low.

Contrarian alarm bells

From a contrarian perspective, alarm bells began ringing when the FT reported that well-known value investor Jeremy Grantham threw in the towel on equity valuation and declared this a new era:

“Even a crash like 2008 wasn’t enough to knock the market off this new rail,” Mr. Grantham said. “The ground has shifted quite a bit.”

Arguing that this time is different, and valuation metrics have climbed to a long-term new average, is near sacrilege for many value investors, who base their style on seminal work done by academics such as Benjamin Graham in the 1930s and popularised by the likes of Warren Buffett.

Mr. Grantham admits his new tone gets “groans from fellow value investors” where it has “rattled a lot of cages”, but argued that previously dependable rules have to be re-examined and some even cast aside, given that the the “world has changed”.

At a tactical level, Bamabroker tweeted on Friday that his most contrarian client had also thrown in the towel and was chasing AMZN and NFLX.
 

 

The week ahead

Looking to the week ahead, I was regrettably early in tactically turning bearish (see Possible market turbulence ahead). However, short-term (1-2 day time horizon) breadth from Index Indicators shows that the market is rolling over from overbought levels.
 

 

As well, longer term (1-2 week) breadth is also flashing similar cautionary readings.
 

 

From a historical perspective, Jeff Hirsch at Almanac Trader pointed out that June seasonality shows that stock prices tend to plateau next week and weaken the following week.
 

 

Looking further at the market’s behavior the following week, Urban Carmel observed that equity prices tended to be flat to down after the last three Fed rate hikes, while bond yields have fallen.
 

 

Even if you are an equity bull, some caution is warranted for the next few weeks.

A matter of time horizon

My inner investor remains bullishly positioned, though he is starting to get a little nervous. He is unlikely to alter his portfolio positioning until he gets greater confirmation of fundamental and macro weakness, or indications of a more hawkish Fed. The difference of opinion between the stock and bond markets can be attributable to a difference of time horizon. The stock market appears to have a shorter time horizon (2-3 months), which is still bullish, while the bond market is focused longer term (6-12 months), which is a bit more wobbly. New Deal democrat summarized current conditions well in his weekly monitor of high frequency economic releases:

There were a few more neutrals and negatives this week, primarily among coincident indicators.

Nevertheless, the nowcast for the economy remains positive, as does the near term forecast. The longer term forecast also remains neutral to positive, shading a little closer to neutral based on recent data.

My inner trader is modestly short and he may add to his short position should stock prices grind higher next week.

Disclosure: Long TZA

Possible market turbulence ahead

Posted by Cam Hui -

Mid-week market update: Rob Hanna at Quantifiable Edges highlighted a historical study of what happens if the market pulls back after a persistent move to new highs, where yesterday (Tuesday) was day 0. If history is any guide, stock prices should grind higher over the next 10 days.
 

 

Today was day 1 of that trading setup, and the market did not cooperate. The market’s failure to rise despite statistical tailwinds is a sign that it faces some near-term turbulence.

Let me explain.

Breadth divergences

A number of tactically bearish factors are becoming evident for the US equity market. The first is the appearance of a number of negative breadth divergences. As the chart below shows, the SPX has been rallying despite downtrends in net new highs-lows (second panel), % bullish (third panel), and % above 200 dma (bottom panel). In addition, the stock bond ratio (green line, top panel), which is a measure of risk appetite, is also exhibiting a negative divergence.
 

 

However, negative market breadth can only provide a warning as breadth is an uncertain market timing metric. It can take weeks, or months before breadth divergences resolve themselves with price action, if at all.

Hedge funds all-in on risk

There are other warning signs. This chart from Callum Thomas sounded a contrarian warning. Hedge funds net leverage (light blue line) has risen to levels consistent with either short-term market tops, or consolidating tops (red line). By contrast, low net exposure has been signals of market bottoms.
 

 

In short, hedge funds are all in on risk. Be fearful when they are that greedy.

Faltering Twitter breadth

As well, Trade Followers wrote that Twitter breadth is starting to falter. This is important as Twitter breadth measures the sentiment of short-term high frequency traders, and this is a group who tends to gravitate towards FANG-like names that have been the market leaders.

Trade Followers observed that Twitter momentum broke up out of a downtrend, which is positive. However, this does not look like a positive pattern as the market tests all-time highs.
 

 

Despite the market’s apparent strength (post was written on the weekend), the breadth of bearish stocks was rising, which is not a good sign.
 

 

In conclusion, the combination of poor breadth, faltering momentum in Tech names, and contrarian signals from hedge fund positioning all point to near-term weakness ahead. This is purely a tactical call. As long as we continue to see positive momentum in fundamental and macro indicators, any pullback should be relatively shallow.

The trading model is therefore flipping from a bullish to a bearish signal. The “arrow” in the weekly chart will therefore change to an down arrow this weekend.

Disclosure: Long TZA

Thinking Straight 101

Posted by Cam Hui -

Good afternoon, class. Welcome to another session of “Thinking Straight 101”. Your assignment today is to choose one of the topics below and write an essay for next week’s class:

  • North Korea: George Friedman at Geopolitical Futures recently warned, “All the signs are there: The U.S. is telling North Korea, in no uncertain terms, that war is approaching.” Discuss the probability of war.
  • Small cap technology buy signal: Marketwatch recently highlighted Jonathan Krinsky’s bullish outlook for small cap Technology stocks. Disentangle the source of potential alpha in the buy signal.
  • China: While there has been much angst over China’s crackdown on the shadow banking system, there is a school of thought that, no matter what happens, Beijing can take steps to avoid a hard landing. Discuss the consequences of socializing losses.

Each of the stated positions have their own inherent contradictions.

The drumbeats of war

The threat of war is heating up. I had highlighted a Bloomberg articled which stated South Korean “chipmakers produce almost two-thirds of the world’s memory semiconductors” and a prolonged conflict on the Korean peninsula is likely to disrupt global supply chains and spook the markets in a big way.

George Friedman of Geopolitical Futures recently warned of war on the horizon:

The U.S. Navy has announced that the USS Nimitz will leave Bremerton, Washington, on June 1, for the Western Pacific. This is the third carrier battle group to be sent to the region – enough to support a broader military mission – and it will take roughly a week to get to its station, after which it will integrate with the fleet.

So here’s the situation: Soon the United States will have its naval force in waters near North Korea. It already has strategic bombers in Guam, and it already has fighter aircraft in Japan and South Korea.

The United States is preparing for war, which is still several weeks away – if indeed war actually breaks out. Between now and then, diplomacy will intensify. The international community will demand that North Korea abandon its nuclear program and allow inspectors to monitor the destruction of missiles, fissile material and reactors. And after Pyongyang refuses to heed those calls – which it probably will – the United States will have to decide whether it will strike.

The US has certainly assembling a formidable strike force, consisting of three carrier strike forces, plus two submarines, and bombers based in Guam. These assets certain signal a serious intention of air strikes on North Korea should diplomacy fail.

On the other hand, SecDef James Mattis told CBS News on the weekend:

U.S. Secretary of Defense James Mattis says that war with North Korea — should tensions ever come to that — would be “catastrophic.”

“A conflict in North Korea, John, would be probably the worst kind of fighting in most people’s lifetimes,” Mattis told CBS News’ “Face the Nation” host John Dickerson in his first official interview as defense secretary.

The North Korean regime has hundreds of artillery cannons and rocket launchers within range of one of the most densely populated cities on Earth — Seoul, the capital of South Korea, Mattis said.

North Korea is a threat to the surrounding region, including Japan, China and Russia, he said.

“But the bottom line is it would be a catastrophic war if this turns into a combat if we’re not able to resolve this situation through diplomatic means,” Mattis said.

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

The US lost about 3,000 in civilian casualties in the 9/11 attacks. Are they willing to risk Hiroshima and Nagasaki scale casualties on their South Korean allies? The newly elected South Korean President Moon Jae-in has favored a policy of rapprochement with the North. Is the US willing to attack the North without the approval or cooperation of the South?

Please discuss in your essay the likelihood of an American attack on North Korea in 2017.

For bonus points, CBS News also reported that the Pentagon is preparing the test of an anti-missile system should the North Koreans fire ICBMs at the United States:

Preparing for North Korea’s growing threat, the Pentagon will attempt to shoot down an intercontinental-range missile for the first time in a test this week, with the goal of more closely simulating a North Korean ICBM aimed at the U.S.

The American interceptor has succeeded in nine of 17 attempts since 1999. The most recent test in June 2014 was a success, but that was only after three failures. North Korean leader Kim Jong-un has vowed to possess a missile capable of reaching the U.S., and though he hasn’t yet tested such a missile, Pentagon officials are on their toes.

The current prototype anti-missile system has a historical success rate of 53%. Discuss how credible the North Koreans view the threat of an American attack given this new piece of information.

Buy signal on small cap Tech

Marketwatch highlighted a call from technical analysis Jonathan Krinsky of MKM Partners to buy small cap Technology stocks. Small cap Tech has lagged their large cap counterparts, and Krinsky believes that they are ready to show some leadership.
 

 

The chart below shows the relative performance of the large cap market vs. small cap market (black line) and small cap tech vs. large cap tech (green line).
 

 

Now compare and contrast the relative performance of large cap tech vs. large cap stocks (black line) and small cap tech vs. small cap stocks (green line).
 

 

In your essay, disentangle the size effect from the sector effect of the buy signal. Discuss whether the signal is based on a small cap revival thesis, or a small cap technology revival thesis. Justify your conclusions.

Invincible China

I have in the past highlighted the growth debt bubble in China (as an example, see When will the market top out?).
 

 

There is a school of thought that the central government will not allow the financial system to collapse into a hard landing. Beijing has many levers available to cushion a crash. The reserve ratio current stands at 17% and there is lots of room for it to fall. Chinese interest rates are nowhere near zero bound and therefore the PBoC has room to lower rates and stimulate the economy. The major banks are all state-owned, and the government will not allow them to fail, and so on.

Those are all valid points, but the presence of a government guarantee doesn’t necessarily mean that the economy will not suffer negative repercussions from a collapsing debt bubble.

Compare the Chinese situation with that of Canada, which has been caught in a property induced debt bubble. Here is how Bloomberg described the Great White North’s economy:

A combination of foreign money, local speculation and abundant credit has driven Canadian house prices to levels that even government officials recognize cannot be sustained. In the Toronto area, for example, they were up 32 percent from a year earlier in April. David Rosenberg, an economist at Canadian investment firm Gluskin Sheff, notes that it would take a decline of more than 40 percent to restore the historical relationship between prices and household income.

Granted, the bubble bears little resemblance to the U.S. subprime boom that triggered the global financial crisis. Although one specialized lender, Home Capital Group, has had issues with fraudulent mortgage applications, regulation has largely kept out high-risk products. Homeowners haven’t been withdrawing a lot of equity, and can’t legally walk away from their debts like many Americans can. Banks aren’t sitting on the kinds of structured products that destroyed balance sheets in the U.S. Nearly all mortgage securities and a large portion of loans are guaranteed by the government.

Excesses in the Canadian mortgage market are, in some ways, not as bad as the American ones at the heighten of the subprime crisis. Canadian mortgages are not non-recourse loans, and the lender can pursue the borrower even after seizing the collateral. More importantly, virtually all residential mortgages are guaranteed by the Canadian government through the Canadian Mortgage Housing Corporation (CMHC), just as virtually all Chinese bank paper is guaranteed by the Chinese government.

For your essay, please discuss the differences between the Chinese and Canadian debt bubbles, and in case the bubble collapses, who pays?

For bonus points: A number of Vancouver residents have complained that while developers have attributed the reason for high property prices is because of lack of supply, but when given permits to develop new buildings, the developers then market the units in Hong Kong instead of to local residents. In one case, the Globe and Mail documented a developer opening a measly 30 day window for locals to buy in before marketing the condos elsewhere.
 

 

Please discuss the linkage mechanisms between the Chinese economy and the price of Canadian real estate in Vancouver and Toronto.

When does the market top out?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

History rhymes

Last week’s post (see A market top checklist) generated many questions and much discussion. While there was general acceptance of my thesis that an intermediate top is not imminent, most of the questions revolved around how far away the market top is. As well, there were some queries about equity downside risk in the next bear market.

The respected Jesse Livermore, who writes at Philosophical Economics, recently chimed in on the topic:
 

 

I believe that those questions could be answered in a number of ways. Consider this chart from Jan Hatzius of Goldman Sachs that I showed several weeks ago (see Are the Fed and PBoC taking away the punch bowl?). One reasonable approach might be, “Since major bear market episodes are caused by economic recessions, how far away were previous market tops when the 9 quarter recession risk reached 30%, which is the current reading today?”
 

 

The answer is somewhat surprising, and a closer examination of the data shows that a simplistic application of historical studies can lead investors astray. In other words, history doesn’t repeat itself, but rhymes.

Recessions and bear markets

Here are the numbers. Though the sample size is small (N=3), the arrows in the chart below marks the past instances when 9 quarter recession risk rose to 30%. If we were to discount the Crash of 1987, which did not result in a recession, the stock market topped out about 2.5 to 3 years after recession risk reach the 30% level.
 

 

So can the bulls rejoice and hang on for another 2.5-3 year? Not so fast! This exercise shows how simple analogues can create false conclusions.

In the chart, I have also shown the Fed Funds rate (blue line) and unemployment rate (red line) to illustrate the macro conditions at the time of the 30% recession probability signals. As the current unemployment rate stands at 4.4%, I subtracted 4.4 from the unemployment rate as an easy way of comparing past unemployment rate levels to today.

The chart shows how different each of the bear market episodes were from each other. When recession risk first reached 30% in the 1980’s, unemployment had been declining since the recession of 1982, but were well above current levels, and the Fed had begun to raise rates. Monetary policy had become overly aggressive, which contributed to the 1987 crash. The economy, however, remained resilient and did not fall into recession, and the stock market did not see a recession induced bear market until about 2.5 years after the 30% recession risk signal.

The 1990’s episode was completely different. Unemployment had been falling but was still well above today’s 4.4% level. Interest rates were stable. The dot-com bubble followed and the market did not top out until 2.75 years after that signal.

During the 2000s, the signal occurred when the unemployment rate was also higher than it is today, and the Fed had just begun a tightening cycle. It took a full 3 years before the stock market reached a top.

Passing the sanity test

Based on this analysis, we could simplistically conclude that the equity bull has a minimum of 2.5 years to run. Such a conclusion would be based on monetary policy assumptions that are highly improbable.

Consider the unemployment rate. If we were to make the assumption that the economic expansion were to continue and unemployment were to improve at the current pace, it would reach somewhere between 2.9% and 3.4% before the stock market tops out.

Can anyone imagine such a dovish Federal Reserve? The minutes of the May 2017 FOMC meeting stated that the (then) unemployment rate of 4.5% was below the natural rate, which the Fed believes would create inflationary pressures:

Labor market conditions strengthened further in recent months. At 4.5 percent, the unemployment rate had reached or fallen below levels that participants judged likely to be normal over the longer run.

And then there was this more hawkish possibility:

Several participants, however, pointed to conditions under which the Committee might need to consider a somewhat more rapid removal of monetary accommodation–for instance, if the unemployment rate fell appreciably further than currently projected, if wages increased more rapidly than expected, or if highly stimulative fiscal policy changes were to be enacted.

The idea that the Fed would stand idly and allow the economy to continue on its current expansionary course while unemployment is already at 4.4% simply doesn’t pass the sanity test. I have made the case that the main risk to stock prices is tighter monetary policy (see How the bull will die). Arguably, the Yellen Fed has been extremely accommodative by historical standards. Imagine a new Fed chair taking over next year and asking the following uncomfortable question, “Unemployment is already very low by historical standards, why are real Fed Funds so low?”
 

 

Even if Janet Yellen were to be re-appointed as Fed chair, it is difficult to envisage a scenario where the Fed stays accommodative for such a long time. Sooner or later, rising interest rates is going to kill this bull market, and it won’t be 2-3 years from now.

When does the market actually top?

So if a market top in 2.5-3 years is an unrealistic projection, what is a better estimate?

Last August, I highlighted analysis by Chris Ciovacco that applied a trend following model of crossing moving averages to the NYSE Composite to generate a buy signal (see The roadmap to a 2017 market top). Ciovacco’s trend model buy signal has worked out well, as stock prices have advanced strongly since then.
 

 

In that post, I also analyzed the length of past Ciovacco buy signals and found the length bull runs tended to cluster. If the bull last more than 1 1/2 years, it had the potential to last another 3-5 years.
 

 

When I consider the combination of macro and technical conditions today, the current bull phase is likely to be of the shorter variety. While I had postulated a market top in 2017 last August, I am inclined to revise that forecast and allow that the market could top out up to a year from now. The trajectory of stock prices is dependent on how economic conditions develop, and the Fed’s reaction function to those conditions.

In short, expect a market top in the next 6-12 months.

How far down from here?

When I turn to the issue of downside risk, the best way to estimate a bear market objective is to see what excesses need to be unwound in the next recession, defined as excess valuation and leverage, which can magnify downside risk as bad debt gets resolved. The chart below shows equity holdings + real estate as a % of total household assets (black line), as a rough guide to asset valuation, and household debt to assets (red line), as a guide to leverage.
 

 

As the chart shows, valuations got very bubbly at the last two cycle tops. The dot-com bubble of the late 1990’s moved the valuation line to historical highs, and the subsequent real estate reflation bubble saw valuation recover to NASDAQ bubble peaks and leverage to elevated levels. By contrast, current valuation and leverage readings are more similar to the tops seen in the early and late 1980’s. This analysis indicates that the next equity bear will see downside risk similar to the 1980-82 and 1990 bear markets, which saw prices fall 20-30%.

For a different perspective, analysis from the Leuthold Group (via Callum Thomas) a downside SPX potential of 27-35% from current levels.
 

 

The risks from abroad

This conclusion of downside risk of about 30% is correct if viewed strictly from an US-centric context. There are few excesses to be unwound in the US, except for perhaps a few too many unicorns in Silicon Valley. This cycle, however, the sources of risk are global in scope.

In a recent article, Lakshman Achuthan of ECRI showed that global inflation cycles have become far more synchronized in the 21st Century when compared to the 20th Century. By implication, the synchronization of inflation cycles indicates a synchronization of economic cycles.
 

 

If the Fed were to induce an economic slowdown in the US, what are the effects on other major economies in this era of globalization? In particular, the biggest global macro risk is a Fed induced downturn that drives China into a hard landing. The sequence would go something like this. The US would falls into a mild recession, which craters the exports of Chinese goods in the US. The Chinese economy then slows, which stresses its already over-levered balance sheet, which is a ripe environment for an economic crash.

Moody’s downgrade of Chinese debt last week highlighted the growing financial risks in China. By now, virtually everyone knows about the ticking time bomb in China, it’s just a question of how the problem gets resolved.
 

 

To be sure, virtually all Chinese debt is held domestically. Should China slow into a hard landing, this will not be your typical emerging market crisis.
 

 

Just because a potential debt crisis could be contained in China doesn’t mean that the rest of the world gets off scot-free (see How a China crash might unfold). It would begin with the collapse of selected over-levered SMEs. Contagion seeps into SOEs and the local government bond market. While Beijing has plenty of ways to mitigate the damage, someone still has to pay for the fallout. In the end, the socialization of losses means that the household sector will have to pay. The price is a period slower economic growth.

As China has relatively low levels of external debt, financial contagion risk is limited. However, global growth is likely to be affected through the trade channel. Most of Asia, as well as the resource based economies, such as Australia, Canada, Brazil, and South Africa, would fall into recession. Bloomberg highlighted that Hong Kong is already experiencing a property bubble that could end very badly. Undoubtedly, the rise in property prices was the result of excess liquidity sloshing in from China.
 

 

Should Chinese growth start to wobble, another source of global vulnerability is the European banking system. This ECB Q4 2016 report shows that the most exposed banks are in Italy and Portugal, indicating that peripheral Europe credit risk really hasn’t gone away. European bank exposures are exacerbated by the practice of eurozone banks to load up on the debt of their own sovereigns. Should a banking crisis occur, it would be the responsibility of each member state to rescue their banks, which is stuffed full of paper of their own countries. (Wait a minute, how do you rescue yourself?)
 

 

This is another illustration of how history doesn’t repeat, but rhymes. A repeat of history would indicate that stock prices would fall no more than 20-30% in the next recession induced bear market. However, downside risk could be exacerbated by the unwind of excesses in China, as well as financial contagion from the eurozone banking system.

In conclusion, my forecast is a market top at 2500-2550 in the next 6-12 months. The subsequent decline would be in the 30-50% range, depending on the triggering event, and the nature of the global contagion.

Intermediate term bullish

For now, the risk of a major near-term downdraft in equity prices is low. The latest update from FactSet shows that forward 12-month EPS estimates are rising, and Q2 earnings guidance is upbeat by historical standards.
 

 

As well, Barron’s report of insider activity shows that these “smart investors” are buying.
 

 

The week ahead

Looking to the week ahead, I recently detailed the headwinds that the market faced after the recent VIX based trading buy signal (see The market’s hurdle to sustainable new highs). The latest readings from Index Indicators suggest that the market is due for a breather, either in the form of sideways consolidation or mild pullback. Short-term (1-2 day) breadth indicators rose to an overbought reading and began reversing, indicating possible weakness early in the week.
 

 

Longer term (1-2 week) breadth indicators is showing disturbing signs of a negative divergence, which is also not good news for the bulls.
 

 

Similarly, risk appetite in the high yield bond market is also flashing cautionary signals. The relative price performance of high yield, or junk bonds, against equivalent duration Treasuries failed to make a new high even as stock prices staged an upside breakout.
 

 

My inner investor remains bullishly positioned. My inner trader is giving the bull case the benefit of the doubt for now, but he is tightening up the stops on his long positions.

Disclosure: Long SPXL

The market`s hurdles to sustainable new highs

Posted by Cam Hui -

Mid-week market update: So far, my recent VIX based buy signal has worked out according to plan (see A market top checklist). I emailed subscribers the buy signal from the trading system on Friday, which was triggered when the VIX Index rises above its upper Bollinger Band and then mean reverts below.
 

 

If history is any guide, stock prices should continue to grind upwards for the next couple of weeks.
 

 

As the market tests resistance at all-time highs, further strength would imply a sustainable advance to further highs. However, an analysis of market breadth and sector leadership indicates the equity market faces a number of technical headwinds.

A case of bad breadth

First, consider the leadership of the market. If we were to focus on the 52 week new high/new low ratio, we can see that market leadership is dominated by large caps and NASDAQ stocks.
 

 

For another perspective, the chart below shows the relative performance by market cap. As the chart shows, large cap stocks are dominating performance right now by beating both mid-cap and small cap stocks. In fact, returns degrade as we go down the market cap ladder. Small caps have been underperforming mid-caps for all of 2017, and they have lagged for the past few weeks.
 

 

If the intent of studying market breadth is to determine whether the troops are following the generals, this is not a good sign.

Narrow sector leadership

Now consider the composition of the index by sector, as shown by the chart below.
 

 

The chart below shows the relative performance of the top six sectors by weight, which comprise roughly 82% of total index weight. As the chart shows, Technology (22.5% weight) has been the leader; Financials (14.1%) has underperformed; Consumer Discretionary (12.5%) were showing leadership qualities but has started to roll over; while the other major sectors have been flat against the market.
 

 

In other words, the market’s advance has been carried by Technology stocks! The chart below shows the relative performance of the Tech sector, along with selected high octane groups within the sector. All are in relative uptrends and showing few signs of weakness.
 

 

By contrast, the relative performance of the next biggest sector, the Financials. As the chart below shows, the relative returns of this sector is closely correlated to the shape of the yield curve. The flattening yield curve has not been good news for this sector.
 

 

Since none of the other major sectors are showing signs of leadership, the ability of the SPX to advance to fresh highs is therefore a function of the tug-of-war between Technology and Financial stocks. A breakout to all-time highs therefore requires one or more of the following factors to occur:

  • Continued enthusiasm for Technology stocks (watch the NASDAQ vs. SPX ratio).

 

  • The yield curve reverse its flattening trend and begin steepening, which is a function of economic growth expectations (watch the Citigroup Economic Surprise Index).

 

  • Renewed enthusiasm for the reflation trade, which is characterized by leadership from cyclical industries, such as Industrial and Consumer Discretionary stocks (also watch the Citigroup US ESI above, and Global ESI).

 

I don’t pretend to know what will happen should the SPX test its all-time high resistance in the near future. All I can do is provide guideposts of what to watch. That’s how my readers learn how to fish.

(Chinese) blood in the streets?

Posted by Cam Hui -

The worries about China ebbs and flows. The latest BAML Fund Manager Survey shows that China fears are at flood levels again.
 

 

Indeed, developments such as the inverted Chinese yield curve is creating a sense of peak anxiety.
 

 

I recently highlighted analysis indicating that China fears are overblown (see Are the Fed and PBoC taking away the punch bowl?). Bloomberg Asian economist Tom Orlik observed that, despite the crackdown on credit, there are no signs of an imminent downturn: “Credit is down but land sales and profits are up – businesses and local governments still have funds to work with.”
 

 

Investors should relax! The slowdown was policy induced, and policy can (and will) be reversed should the economy shudder, especially ahead of the 19th Party Congress later this year.

China has suffered enough pain. It looks like its near-term outlook is turning up again.

Maximum pain

I am seeing multiple independent analysis indicating China is at the maximum point of pain. Here is UBS with an analysis of China’s past credit impulse cycles.
 

 

Nautilus Research observed China through the iron ore price prism and concluded that the current episode of credit tightening is nearing an end.
 

 

Investment implications

A glance at the stock market in China and the markets of her major Asian trading partners show that the markets are starting to anticipate a turnaround. The first sign that the Chinese credit slowdown was nothing to worry about was the weakness in stock prices was contained in China while other Asian markets remained in uptrends. Now, the Shanghai Composite is trying to bottom and possibly turn upwards. The only blemish in the Asian markets has been commodity sensitive Australian stocks, which is currently testing a support level.
 

 

China has been a major source of demand for raw materials, and the commodity markets have bottomed and may be turning up. One of the key technical developments to watch is whether industrial metals and the CRB Index can rally about their downtrend lines.
 

 

This brings up to our trade setup of a rotation into resource extraction sectors. As the chart below shows, the USD has been weakening, aided in part by political turmoil in Washington. As the USD tends to be inversely correlated with commodity prices, USD weakness creates a tailwind for natural resource stocks. Already, we can see that the relative performance of gold stocks tracing out a bottom. The other stocks in this sector, namely energy and mining, remain in relative downtrends in both the US and Europe.
 

 

Chinese blood is running in the streets. This may be the time to start accumulating long positions in gold, energy, and mining stocks in anticipation of better performance in the near future.

Disclosure: Long XIU.TO (TSX 60 ETF)

A market top checklist

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

Late cycle = Market top?

Ben Carlson recently published some research that related the unemployment rate to long-term equity returns. The current unemployment rate currently at 4.4% is indicative of a late cycle expansion and a possible signal of an impending bear market just around the corner.
 

 

Carlson showed that it pays to buy stocks when unemployment is high (and therefore blood is running in the streets) and lighten up positions when they are low.
 

 

Several readers sent me Carlson’s article and asked me how far I believed we are from an equity bear market. With that question in mind, I offer the following checklist of a market top, based on four different categories of indicators:

  • Sentiment: Is it getting frothy? Are silly deals getting done?
  • Equity market internals: Are there signs of breadth deterioration, or defensive sector leadership?
  • Credit market signals and monetary policy: What does the bond market tell us about growth expectations and credit conditions?
  • Macroeconomic conditions: Is the US economy starting to falter?

Frothy sentiment

By many measures, long-term investor sentiment is starting to show signs of froth. I have noted before the highly elevated levels of the TD-Ameritrade Investor Movement Index.
 

 

As well, the latest BAML Fund Manager Survey shows that institutional managers are throwing caution to the wind, as the incidence of hedging has been falling dramatically.
 

 

I have also highlighted anecdotal evidence of market froth in the past, such as the SEC approval of a quadruple leverage ETF, and Mike Tyson becoming the front man for an online brokerage firm. These are not things that you find at market bottoms.
 

 

While there is little question that long term sentiment metrics are showing signs of froth, the market has not seen the signs of a FOMO (Fear of Missing Out) blow-up top just yet. The BAML Fund Manager Survey shows that cash levels are still above average. On the other hand, portfolios are showing high beta characteristics. Institutions are nearing a crowded long in equities, a crowded short in bonds, and roughly neutral weight in commodities. Within the equity portion of their portfolios, managers are underweight the US and UK, while overweight Europe and Japan, which are of high beta reflationary trades.
 

 

I would add, however, that not all sentiment surveys agree with the BAML results. Ned Davis Research observed that mutual fund cash is at historical lows, which is a negative for equity prices.
 

 

Score sentiment as becoming excessive, but no signs of a blow-off top. Call it a cautionary flag.

Few signs of breadth deterioration

Market tops are often preceded by the deterioration of market internals. Breadth begins to lag. Sector leadership rotates to defensive stocks. There are few signs of that happening today.

The chart below depicts the 15 year history of the SPX and selected breadth indicators. The NYSE Advance-Decline Line (top panel, green line) topped out a few months before the actual market top in 2007, and it flashed a negative divergence when the market retested its high. Both the % bullish on point and figure chart (middle panel) and % above 200 dma (bottom panel) indicators deteriorated before the actual market top in 2007 and also gave advance warnings of the correction in 2015. There are no signs of significant breadth deteriorating today.
 

 

On the other hand, a glance at the relative performance of stocks against bonds tells a slightly different story. While the stock/bond ratio is not a traditional breadth indicator in technical analysis, it does nevertheless measure risk appetite. This ratio has warned with negative divergences at past market tops and the correction of 2015. Currently, there is a minor negative divergence that will have to be monitored.
 

 

Here is another way of thinking about the above chart. If equities were to rise to fresh new highs, but the stock/bond ratio were to continue their negative divergence, then that would mean higher bond price that offsets stock price strength. If this is happening in an environment where the Fed is raising interest rates, then it would only mean that the yield curve is flattening. A flattening yield curve is the bond market’s way of anticipating slower economic growth. An inverted yield curve, where long yields are lower than short yields, has been a surefire signal of recession.

As for the rise of defensive leadership, you have got to be kidding! The chart below shows the strong relative performance of Technology (top panel) and momentum stocks (second panel). By contrast, the relative returns of the defensive Consumer Staples (third panel) and Utilities (bottom panel) show that these sector are basing, and not showing any leadership qualities.
 

 

Score market internals as still bullish.

Credit market are still healthy

Another way of telling if an equity bear is lurking in the bushes is to watch how the credit markets are behaving. So far, credit market conditions are still healthy.

One sign of an impending recession are rising real interest rates that choke off growth. As the chart below shows, real Treasury Bill rates have been in a downtrend but ticked up recently. Current conditions are not indicative of an imminent economic slowdown. However, real T-Bill yields will need to be monitored as the Fed proceeds with its course of rate normalization this year.
 

 

Another sign of economic stress are widening credit spreads. The canary in the coalmine is high yield credit, or junk bonds. So far, the HY market is showing few signs of stress.
 

 

Here is another perspective on the credit cycle from Calculated Risk. The trend in household debt delinquencies have flattened, but not turned up. Wait for the signs of an uptick before getting concerned.
 

 

The yield curve has been an uncanny forward looking recession indicator. The 2/10 curve has inverted, or gone negative, ahead of every recession. Here, the data is starting to raise a cautionary flag, as the 2/10 spread has been flattening and fell below 100bp last week. Still, readings are above levels seen last October and nowhere close to inverting yet. Nevertheless, the trend is negative and the shape of the yield curve is something I am keeping an eye on (also see above comment about the stock/bond ratio).
 

 

Score credit conditions as still positive, for now.

Macro: Clear skies today but possible storms on horizon

The picture on the macro front is still bright, but with some caveats. Short term indicators are still bullish. Short leading indicators, such as the Chemical Activity Barometer that leads industrial production, is strong (via Calculated Risk).
 

 

In addition, market coincidental indicators such as forward 12-month EPS estimates from FactSet are still being revised upwards. Q2 earnings guidance is also coming in at above historical norms, which is indicative of an upbeat outlook for the next three months.
 

 

On the other hand, housing may be showing early signs of turning down, according to New Deal democrat. This is one of the most cyclically sensitive sectors of the economy and forms an important part of the set of long leading indicators that are designed to spot recessions a year in advance. Last week’s release of housing starts and permits figures came in weaker than expected. More worrisome are possible signs of a stall in this sector, which could be an early warning sign of economic weakness. The Fed’s stated desire to raise rates will create a headwind for housing and construction.
 

 

Score macro conditions as bright today, but with possible storm clouds gathering on the horizon. New Deal democrat summarized current conditions well in his weekly monitor of high frequency economic indicators this way:

The nowcast for the economy remains positive The longer term forecast remains neutral to positive, shading a little closer to neutral based on the tightening yield curve, less robust growth in real money supply, and the last several months’ decline in housing permits.

No signs of a market top

In conclusion, there are no signs of an imminent intermediate term market top. I continue to believe that the SPX point and figure target of 2549 is achievable this year, especially if the market surge to a blow-off top.
 

 

The near term outlook appears bullish as well. I emailed subscribers Friday that the trading model had flashed a buy signal because  the VIX Index rose above its upper Bollinger Band during the week and mean reverted. The decline of the VIX below its upper BB coincided with the SPX rallying above its 50 dma, which is a key level of technical resistance.
 

 

Friday was day 0 of the VIX buy signal. If history is any guide, the coming week should see an upward bias in stock prices.
 

 

The latest breadth charts from Index Indicators show that readings has only recovered to neutral after getting oversold, which leaves the market room to rise should bullish momentum continue.
 

 

This chart of Twitter breadth from Trade Followers show that there are reasons for optimism about bullish momentum. The breadth of tweets about bullish stocks (green line) remains in an uptrend, while breadth breadth (red line) has stalled at resistance.
 

 

My inner investor remains bullishly positioned. My inner trader covered his short positions on Friday and reversed to the long side.

Disclosure: Long SPXL

From alpha to actual returns: Why your mileage will vary

Posted by Cam Hui -

One of the characteristics of a good financial modeler is to know his model’s limitations. He know how and why they work, and under what circumstances they will fail.

I have been asked a number of times in the past to disclose the returns of my trading account, or the signal dates of my trading model, whose out-of-sample buy and sell signals are shown below. I have resisted those requests because the disclosure of the data leads to a false level of precision in return that readers cannot expect.
 

 

The process of turning a forecast alpha, or signal, into actual portfolio return is a tricky one. There are three decisions that have to be made:

  1. What and when do you buy and sell?
  2. How much do you buy and sell?
  3. How do you time the trade?
The “arrows” in the above chart only answer question 1.

The answer to the second question depends on the trader’s personal circumstances. What is his risk tolerance, or pain threshold? What are the tax consequences of the trade? How much conviction does he have in the signal? Should he scale into a position? If the trade turns against him, how does he manage his risk, or should he average down? Conversely, should he take partial profits if the trade moves in his favor?

I know nothing about my readers. I know nothing about the answers to any of the above questions. If I was a portfolio manager of an actual fund that uses this strategy, then there would be disclosure documents specifying the kinds of risks an investor can expect, as well as the tax implications of investing in the fund.

Execution timing

Then there is the problem of timing the trade. The above chart is a weekly price chart that uses closing prices. The chart below shows the same signals overlaid on daily high/low/closing prices. This chart highlights the problems of noise relating to trade execution.

 

 

First, I should disclose that the “arrows” were placed on the Friday of each week, regardless of when the trading signal occurred. That’s because the signals were historically published on Fridays and therefore their placement was based on the date of publication. It also underlines the point that this model is meant to be a swing trading model with time horizons of weeks, not hours or days.
Here is where the process of return calculation gets noisy. From January 2, 1990 to today, the median swing from low to high on a daily basis was 1.04%. Assuming “typical” single point execution, that would introduce a return error of 0.52% (half of 1.04%). On top of that, add the variation of a few days from signal generation to the Friday publication date, and returns can change even more dramatically. Similarly, the median daily swing of the SPX on a closing basis during the same time period was 0.52%. Delay the signal by a few days, and it adds even more noise to the return calculations and assumptions.
With those caveats in mind, I have highlighted a number of past signals in the above chart that may prove to be problematical for a trader who is intolerant of drawdowns:
January to March 2013: The market continued to rise after the sell signal. Even after the market weakened, the buy signal occurred late after the bottom.
May 2013: The sell signal was early, and the market rose after the signal before falling dramatically. A risk averse trader could have been either discouraged or got stopped out of that trade.
February 2014: The market was flat and choppy after the sell signal. Depending on how the trader executed the original entry, he could have bounced around between slight breakeven and losses for several weeks before actually profiting. Does he have that kind of temperament?
March 2015: The market action after the sell signal was very similar to the February 2014 signal.
August 2015: Here, the trading model was simply wrong. The market fell and got oversold, which prompted the model to get long. Unfortunately, the market got even more oversold and this was one of the worst drawdowns suffered by the trading model.
June 2016 (Brexit whipsaw): The trading model got whipsawed badly. It flashed a sell signal after being long into the Brexit vote. It then reversed back into a buy signal the following trading day.
These are just some of the examples. In 2017, the trading model has been early in many of its signals, though the subsequent drawdowns have been relatively minor.

A lesson in portfolio dispersion

This exercise is a good illustration of the problems of backtesting. In this case, these were actual out-of-sample signals. But give them to two people and watch them turn the signals into actual portfolio performance.and the results can be wildly different. That’s why I have resisted the publication of a model portfolio. Even the publication of signal publication dates can lead to misleading results*.

The depiction of the signals using weekly price charts is intended to make the point of the time horizon of these trading signals. They last for weeks, not days, or hours. Imposing daily data, or worse still, hourly data, on weekly signals introduces an element of noise and uncertainty into the risk and return calculations.

Here is another example of an exercise in risk tolerance and investment time horizon. On February 24, 2009, which was a week before the Lehman Crisis panic bottom, I wrote a post suggesting the speculative purchase of beaten up, low-priced stocks with insider buying. Pretty good timing, right?

 

 

Unfortunately, the market fell 11.9% from the date of that post to the March bottom. Was that a good trade, or would you have gotten stopped out after a drawdown of over 10%?

Teaching readers how to fish

I built Humble Student of the Markets as a forum to teach my readers how to fish. This is not a site with pre-packaged and pre-digested trading signals. There are trading chatrooms that offer those services (and with a much higher fee structure). 
Your objectives and pain thresholds are different than mine. That’s why your mileage will vary.

* In the interest of full disclosure, the history of the trading signals can be compiled by reading past posts on the current Humble Student of the Markets site, and its old free legacy site. Readers who really want the dates of the signals can compile it themselves. That’s one of the first steps to learning how to fish.

The island at SPX 2400

Posted by Cam Hui -

Mid-week market update: The SPX rose to a marginal new high this week but broken down through a narrow range due to the latest he said-he said dispute in Washington. The index appears to have formed an island reversal with bearish implications. The market has fallen through two gaps to test its support level at about the 50 day moving average (dma).
 

 

Under these circumstances, it may be prudent to think about these near-term bearish influences which are supportive of the bearish island reversal thesis:

  • There are signs of complacency, which is contrarian bearish.
  • Dealer positioning in derivatives could exacerbate downside risk.
  • Political risk is nearing a breaking point that could affect the markets.

Market complacency

Even as stock prices consolidated sideways, the CBOE equity only put/call ratio (CPCE) had been falling, indicating rising bullishness. As the chart below shows, the absolute level of CPCE is not unusually low, but past episodes of falling CPCE have been associated with rising stock prices (blue boxes). The current decline is unusual in that the market did not advance. The only instance that I could find where CPCE spiked and then fell, but the market did not decline is marked with a red box. In that case, market consolidation was resolved with a correction.
 

 

Dealer positioning: Watch the greeks

Further to my recent post about the low level of the VIX Index (see How I learned to stop worrying and love the low VIX), Tracy Alloway at Bloomberg pointed out that dealer hedging is suppressing market volatility. However, dealer positioning could also serve to exacerbate the market downside should volatility spike:

While the hedging needs of big banks have helped keep a lid on volatility by providing a backstop to moves in U.S. equities, the analysts note, the rebalancing requirements of the plethora of exchange-traded products now tied to the VIX could pose a risk to that stability. Such ETPs typically buy VIX futures as the underlying index rises, and sell futures as it declines, creating a so-called ‘short gamma’ position.”

Read more here about how products tied to the VIX could be distorting it.

If the VIX were to spike, then Deutsche Bank calculates those ETPs would have to buy a record amount of “vega” — meaning they’d have to put on trades to bet that volatility will increase. “Vega to hedge on a spike has continued its steady rise since the vol increase around U.S. elections, and sits close to $90 million,” a record, they said.

While the market for VIX futures might be able to absorb some of that buying need in the event that the VIX did make a sudden jump, there’s a risk that the proliferation of ETPs, which have yet to experience a significant increase in volatility, could roil the market. It’s not unlike concerns about credit default swaps in the early days, when analysts were unsure what would happen in case of actual defaults — given the volume of CDS outstanding compared with the bonds they were based on.

Rising political risk

I have often preached that investors shouldn’t pay attention to politics, other than what happens in national capitals affect trade, fiscal, and monetary policy. However, analysis by Ned Davis Research showed that stock prices have historically struggled when the Gallup presidential approval rating falls to 35%.
 

 

As the NDR study was done using Gallup data, the latest Gallup polls show that Trump’s approval at 38% and falling.
 

 

To be sure, Gallup’s polls have understated Trump’s approval ratings when compared to other national polls. The latest polling averages shown by Real Clear Politics and Huffington Post show presidential approval at slightly above 40%.

As political turmoil rises in Washington, presidential approval is something to keep an eye on. Should they fall to 35% or less, it would indicate a loss of confidence by the Republican base, which would jeopardize the prospects of the Trump tax cut proposals.

Upbeat fundamentals

Despite the near term risks to the stock market, the fundamentals remain upbeat, which should make any correction relatively shallow. The perennially bullish Scott Grannis recently outline several reasons for optimism:

  • Industrial production remains strong, both in the US and Europe
  • Chemical Activity, which is a leading indicator of industrial production, continues to rise
  • Housing is resilient, as measured by builder confidence despite the recent weakness in the volatile housing starts figures
  • Swap spreads, which are good indicators of systemic risk, are tame
  • Inflation expectations are stable and consistent with the picture of an economy growing at 2%
  • Credit default swap spreads, which measure corporate credit risk, are falling indicating the lack of financial stress

Bottom line: The market may experience some near term turbulence should it break key support level at the 50 dma, but any correction is expected to be shallow. My inner investor would regard market weakness as a buying opportunity.

My inner trader, on the other hand, is still short and enjoying the ride.

Disclosure: Long SPXU, TZA

How I learned to stop worrying and love the low VIX

Posted by Cam Hui -

Investor angst has been rising over the low level of the VIX Index. A simple glance at Google Trends tells the story of rising anxiety.
 

 

The VIX Index fell to single digits last week, though it recovered to above 10 by the end of the week. Nevertheless, current levels represent multi-year lows.
 

 

James Picerno at Capital Speculator demonstrated in the chart below that changes in the VIX are inversely correlated with stock prices. The combination of a low VIX and the inverse correlation has a lot of people questioning if a VIX spike could spark a rapid or disorderly equity market sell-off.
 

 

The doomsters should calm down and stop reading Zero Hedge. There are several good reasons for the low level of the VIX Index:

  • Realized equity volatility is low
  • Other asset class volatility are low
  • Cross-asset correlations are low, which means that sectors and asset classes are more diversifying, and therefore depresses realized volatility

In that case, why shouldn’t the VIX, which is anticipated volatility, be low? To be sure, a low vol regime does carry its own risks. When vol does spike, it will catch a lot of investors and traders by surprise and has the potential to cause a lot of damage to asset prices.

Look Ma, no vol!

In the current low VIX environment, investors need to look beyond the simple low level of the VIX Index and recognize the historically low level of realized equity volatility in the market. There have only been a handful of instances where realized vol has been this low.
 

 

Renaissance Macro recently pointed out that equity vol is low because of low economic volatility.
 

 

Low vol isn’t just restricted to equities. Bloomberg observed that bond vol has also fallen off a cliff.
 

 

Similarly, vol on other asset classes are also depressed.
 

 

Greater diversification effect

Part of the reason for the low vol environment is the higher diversification effect of low asset class correlations. Marketwatch highlighted analysis from Nick Colas of Convergex showing the low levels of correlations between different equity sectors. Low correlations mean that when one sector is rising, another is falling, which is diversifying. At the same time, these diversification effects serve to lower overall equity volatility.
 

 

Morgan Stanley also observed a similar level of low correlation between asset classes, which also lowers overall volatility.
 

Cross asset correlations have fallen sharply

 

Vol regime clustering

Should investors and traders be worried about the low VIX? Not necessarily. Bill Luby, who is the master of vol analysis at VIX and More, showed that low and high volatility regimes tend to cluster together:

I thought I could use this space to expand upon some of the points I made. Specifically related to the clustering of low volatility, the graphic below shows that when the VIX closes below 12, it tends to persist in these low readings, clustering for several years, before remaining above 12 for even longer periods during high volatility regimes.

A corollary to the above is that while investors often focus a good deal of their VIX analysis on mean reversion, it is important to note that mean reversion is much more predictable and tradeable following a VIX spike than after a significant decline in the VIX.

 

What about the short VIX position?

At this point, some traders will point to the enormous short position in VXX? Kevin Muir at The Macro Tourist demonstrated that the VXX nightmare is not something to really worry about. As the chart below shows, while the number of VXX shares sold short (green line) has skyrocketed, the notional value (white line) is not that elevated by historical standards.
 

 

If the Street was really betting on a rising VIX, Muir then asked, “Why isn’t the shares outstanding in XIV rising instead of falling?
 

 

He went on to conclude that the Street is actually short VIX, not long VIX:

I am aware that these ETF products represent only one portion of the VIX trade. There are futures on VIX, and even more complicated institutional products, like variance swaps. Maybe there is a monster short volatility position out there at the OTC level that I am unaware of. I am not ruling it out.

But I am suggesting that the short term hot money is long VIX, not the other way round. All you need to do is look at the amount of complaining occurring about the lack of volatility. If there really was this massive speculative short vol position, wouldn’t traders be whooping it up? Instead, all I hear is moaning about the collapsing VIX.

The roots of a market demise

Let’s review what we know so far. The VIX Index is low because realized vol is low, not just equities, but all asset classes. Low vol has been exacerbated by the diversification effects of low asset correlations, both within asset classes and across asset classes. As vol regimes tend to cluster together, the market is simply undergoing a low vol regime.

However, these cluster effects contain the roots of a market demise.

In particular, focus on the low return correlations within and across asset classes. Bloomberg recently featured a story, A Warning That the Biggest Risk for Markets Could Be Too Much Harmony, that could be a warning for investors. Risk-parity funds could play the role of portfolio insurance strategies in the Crash of 1987, namely the mechanism that exacerbated downside volatility in a disorderly market retreat:

Briefly: risk-parity funds operate simultaneously in a bunch of different asset classes, weighting their stakes in each according to volatility. If one category of holdings swings around a lot, like stocks, it gets a smaller slice, while quieter bonds get a bigger one. Diversification like this is supposed to balance influences…

Turns out, a bigger threat than volatility to the strategy is cross-asset correlation, the possibility that assets like stocks and bonds start to move in unison. When that happens, diversification-minded risk parity algorithms will sense a threat and start to deleverage, says Brean Capital LLC’s Peter Tchir. Markets may be charting healthily independent courses for now. But if and when that changes, look out, his theory holds.

“The biggest risk, as I see it, isn’t that volatility increases – it is that the correlation between Treasuries and stocks increases (they move in the same direction),” wrote Tchir in a note to clients Wednesday. “That shift would have the largest impact on returns and need to reduce position size for these strategies.”

 

These dire forecasts of risk-parity funds becoming forced sellers in a market melt-down are somewhat overblown. As investors saw during the Lehman Crisis, return correlations all converged to 1 during a crisis, and risk-parity funds would have to adjust their positions accordingly. At the same time, these funds do not use short-term correlations to set their asset allocations, largely because of cross correlations are, well, volatile:

“Because our forecasts for correlation move much more slowly than for volatility, the rate at which changes in these things show up in the portfolio is radically different,” said Croce. “If the market is more volatile for several days, we may sell some of our exposure. But if correlations rise, it will have almost zero short term implications for our holdings.”

A risk parity fund might use a year-long measure for correlation, since shorter-term indicators are noisy and impossible to act on, said Croce. The correlation between the price of the Bloomberg Barclays Global Aggregate Bond Index and the S+P 500 over the past 250 days is negative 0.66, a moderately strong inverse correlation, and the most negative in nearly two years.

Should the negative relationship between stocks and bonds begin to wear off and their correlation rise to as little as 0.1, a hypothetical risk parity portfolio of just those two assets would cut its leverage by 87 percent, according to Salient estimates. That compares to a 120 percent reduction should volatility measures double.

Much of the risk therefore depends on the nature of the vol regime shift. A quick regime shift, such as a flash crash, would not trigger very much action by risk-parity funds. However, a long-lived shift, such as a change from an easy monetary policy to a more normalized environment by the Fed and the ECB (see my last post How the bull will die), could result in forced liquidity by these funds.

How I learned to stop worrying…

In conclusion, the low level of the VIX is nothing to worry about right now. But should the macro environment change significantly, then there is potential for a meaningful regime shift from low vol to high vol. If such a scenario were to unfold, downside volatility could be exacerbated by forced selling by risk-parity funds.