A summer reading list

Posted by Cam Hui -

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

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

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

The basics

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

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

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

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

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

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

Corporate strategy and fundamental analysis

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

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

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

Top down analysis

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

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

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

Personal journeys in technical analysis

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

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

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

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

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

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

 

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

Bought for a good time, not a long time

Posted by Cam Hui -

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

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

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

 

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

Debt ceiling default?

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

 

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

 

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

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

A determined Fed

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

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

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

 

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

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

 

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

 

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

Turbulence ahead

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

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

 

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

“Fire and Fury” is hard

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

War is hard

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

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

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

 

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

North Korean capabilities

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

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

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

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

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

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

His assessment of Kim Jong-un:

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

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

The speed bumps to war

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

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

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

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

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

Comrade Xi’s veto

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

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

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

 

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

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

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

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

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

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

Reading past the rhetoric

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

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

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

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

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

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

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

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

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

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

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

 

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

 

The week ahead

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

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

 

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

 

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

 

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

 

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

 

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

 

Incomplete correction

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

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

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

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

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

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

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

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

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

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

A similar sentiment was expressed by outside analysts and economists.

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

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

Correction ahead

Posted by Cam Hui -

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

 

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

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

Overbought sectors

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

 

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

Negative seasonality

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

 

Breadth overbought and rolling over

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

 

Negative momentum in Fear and Greed

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

 

Waiting for the bearish trigger

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

 

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

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

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

Disclosure: Long SPXU

Can China save the world again?

Posted by Cam Hui -

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

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

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

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

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

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

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

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

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

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

Vulnerable China

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

 

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

 

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

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

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

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

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

Mitigating factors

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

 

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

 

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

 

As good as it gets?

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

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

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

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

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

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

 

What deleveraging?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What rebalancing?

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

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

 

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

 

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

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

Will overheating spoil the market rally?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A late cycle market

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

The “Goldilocks” rally still has juice.

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

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

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

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

 

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

The bull case

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

 

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

 

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

 

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

Inflation pressure on the horizon

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

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

 

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

 

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

 

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

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

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

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

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

 

A possible policy mistake

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

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

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

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

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

 

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

A weakening consumer?

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

 

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

 

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

 

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

 

This interpretation is confirmed by the falling savings rate.
 

 

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

Spotting the inflection point

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

 

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

 

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

 

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

 

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

The week ahead

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

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

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

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

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

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

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

 

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

 

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

Disclosure: Long SPXU

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

Posted by Cam Hui -

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

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

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

 

There are plenty of other examples of fearlessness.

The new money market

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

 

[Shudder]

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

 

[Double shudder]

A kid’s market

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

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

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

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

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

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

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

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

 

Booming retail “client engagement”

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

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

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

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

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

 

Surging Street employment

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

 

No fear in credit markets

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

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

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

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

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

 

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

 

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

Bullish exhaustion

Posted by Cam Hui -

Mid-week market update: You can tell a lot about the tone of the tape by how it reacts to news. There is growing evidence that the stock market is becoming immune to good news, which is a signal of bullish exhaustion. In all likelihood, the near-term path of least resistance for stock prices is down.

The results from Q2 Earnings Season has been stellar. Experienced investors know that corporate management is plays the “beat the earnings” game well. According to FactSet, the average 5-year EPS beat rate is 68%. On the other hand, it’s harder to play accounting game with sales, as the average 5-year sales beat rate is only 53%. This quarter, sales beat rates are off the charts when compared to their historical experience.
 

 

FactSet‘s update of earnings from last Friday shows that forward EPS is being revised upwards as well. That should be good news for stock prices.
 

 

Instead, the SPX has been mired in a narrow trading range and it has been unable to stage an upside breakout to new highs.
 

 

The lack of a bullish impulse in response to positive news is a warning for the bulls.

Immune to good news

Business Insider highlighted analysis from BAML that showed the market is barely reacting to sales and earning beats, while punishing misses.
 

 

This asymmetric reaction function to news is an open invitation to some bearish catalyst to spark a downdraft in prices.

Bad breadth a drag on stock prices

Jeff Hirsch at Almanac Trader recently sounded a warning from a chartist’s viewpoint. He observed that the Advance-Decline Lines of major market indices appear to have peaked, which is bearish.
 

In the above chart appear DJIA, SP 500, NASDAQ and Russell 2000 indexes above Advance/Decline lines. NASDAQ and Russell 2000 Advance/Decline lines appear to have peaked last week and have turned lower. SP 500 and NYSE have turned flat and appear to be leaning lower. Generally, when the majority of and index’s components are declining the index already is doing the same or may soon do so.

We can observe a similar effect by analyzing the relative returns of the Russell 2000 small cap stocks against the megacap DJIA. Even as the Dow made fresh highs this week, small cap stocks weakened, indicating a negative breadth divergence.
 

 

Negative momentum

The Fear and Greed Index is also showing some ominous signs of intermediate term weakness. This index peaked recently at 81 and began to retreat to the current reading of 67. As the chart below shows, the market historically hasn’t bottomed until this index falls to a minimum of 40. We are not there yet.
 

 

In short, the stock market appears to be poised for a correction of unknown magnitude. While the fundamental are supportive of higher prices, the combination of a crowded long positioning and faltering price momentum indicates that traders should adopt a tactically bearish view on stock prices.

Disclosure: Long SPXU

How Covel inadvertently exposed the chasm between investors and traders

Posted by Cam Hui -

As a rule, I don’t do book reviews. However, regular readers know that I am a big fan of trend following models and I use them extensively in my asset allocation work. When a publicist offered a free review copy of Michael Covel’s Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets, I jumped at the chance.
 

 

The book also featured a forward by Barry Ritholz. Ritholz’s partner Josh Brown recently wrote that they use trend following techniques for tactical asset allocation, which is a sensible decision that I wholeheartedly agree with:

At my firm, we use trend for tactical asset management. It takes everything above into account- not only the things, but people’s actual reaction to the things, a sort of realpolitik for markets. Will it always work? Doubtful. What is the downside when it doesn’t work? What is the expected benefit when it does? Is there a behavioral aspect to why it makes sense to include tactical in client portfolios? We think so. Not everyone would agree that this is worthwhile.

After all that buildup, the book left me vaguely disappointed. Covel’s approach has been to be a cheerleader for traders who use trend following techniques without digging into the deeper issues that face investors. He treats trend following almost as a magic black box that everyone should use. He doesn’t take the next step to discuss the characteristics of this class of strategies, which sophisticated investors think about when they consider the use of such techniques have a place in their portfolio.

An evangelical cheerleader

This excerpt from the book explains how trend following works:

Trend following, and assorted derivatives of price-based trading, is not a new concept. It goes back across names like David Ricardo, Jesse Livermore, Richard Wyckoff, Arthur Cutten, Charles Dow, Henry Clews, William Dunnigan, Richard Donchian, Nicolas Darvas, Amos Hostetter, and Richard Russell. Believe it or not, it literally goes back centuries, with data to prove it.

AQR’s Cliff Asness clarifies: “Historically, it’s been a strategy pursued primarily by futures traders and in the last 10–20 years by hedge funds. The trading strategy employed by most managed futures funds boils down to some type of trend following strategy, which is also known as momentum investing.”

Excerpted with permission of the publisher, Wiley, from Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets by Michael Covel. Copyright (c) 2017. All rights reserved. This book is available at all booksellers.

Covel extols the virtues of the technique with a touch of evangelical fervor:

Nonetheless, if you look at how much money trend following has made before, during, and after assorted market bubbles, it becomes far more relevant to the bottom line of astute market players.

Yet, even when over the top trend following success is thrown onto the table, skeptical investors can be tough sells. They might say markets have changed and trend following no longer works. But philosophically trend following hasn’t changed and won’t change, even though markets might not always cooperate.

Let’s put change in perspective. Markets behave the same as they did hundreds of years ago. In other words, markets are the same today because they always change—humans are involved, after all. This behavioral view is the philosophical underpinning of trend following. A few years ago, for example, the German mark had significant trading volume. Then the euro replaced the mark. This was a huge change, yet a typical one. If you are flexible and have a plan of attack—a solid strategy—market changes, like changes in life, won’t kill you. Trend followers traded the mark; now they trade the euro. That’s how to think.

Excerpted with permission of the publisher, Wiley, from Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets by Michael Covel. Copyright (c) 2017. All rights reserved. This book is available at all booksellers.

While I believe that these techniques have their place, trend following models represent only one tool out of many in an investor’s toolbox. Trend following, when applied properly, is no different from the fundamental analyst who digs into a company financials and operations to discover that the shares are dramatically undervalued because of some hidden asset on the balance sheet.

Unanswered questions

For some perspective, here are the questions I ask when someone presents me with an investment or trading strategy:

  1. Why does it work, or what is the source of the alpha?
  2. Under what circumstances does it not work?

Covel scratches at the surface of the first question in his book, by referring to behavioral finance research from the likes of Daniel Kahneman and then asserting “you have to believe”. He went on to blame non-believers for their own failure for the following reasons:

  • Lack of discipline
  • Impatience
  • No objectivity
  • Greed
  • Refusal to accept truth
  • Impulsive behavior
  • Inability to stay in the present
  • False parallels

What`s more, he doesn’t really address the second question at all. This issue is particularly important in light of the poor performance exhibited by trend following Commodity Trading Advisors (CTAs) in the past few years, as shown by the BarclayHedge CTA Index.
 

 

A glance at the above chart raises a couple of important questions.

  • Are the models broken? Perhaps CTAs have hit some magic aggregate capacity limit for trend following.
  • If not, then what are the characteristics of this strategy that made it fail?

I found no answers in Covel’s book.

Alpha becoming beta?

I believe that Michael Covel’s book illustrates the wide chasm between professional traders and investors. Simply put, they don’t think the same way.

Covel’s approach has been to be a cheerleader for trend following principles by showing how successful traders and hedge funds have used these techniques to make a lot of money. War stories are great, but they don’t get at the heart of the how, why, as well as the pros and cons of these techniques.

By contrast, here is an article from Pension and Investments that illustrate how institutional investors think about the managed future and trend following space:

Competition for institutional investor assets is fierce in the managed futures market — widely accepted as the most commoditized in the hedge fund industry — with intense price competition between old-school firms such as Man AHL, Winton Capital Ltd. and Aspect Capital Ltd. and banks, alternative risk premium managers and replicators offering lower-cost exposure to trend-following strategies.

“Institutional investors are forward-looking now in the face of predicted market declines and this is playing out in the managed futures space,” said Mark S. Rzepczynski, co-managing partner and CEO of AMPHI Research+Trading LLC, Boston, a global macro/managed futures advisory and brokerage firm.

“Chief investment officers are ​ looking for crisis alpha production from systematic trend strategies that will make money in down markets but they aren’t willing to pay high fees for them. Pricing is the biggest issue with these asset owners,” Mr. Rzepczynski said.

In other words, alpha is turning into beta. Institutional investors view these strategies as “crisis alpha” because trend following strategies are uncorrelated to the returns of risky asset classes, such as equities. At the same time, institutions are putting fee pressure on managers because they’ve figured out that these models can be turned into a factor beta:

The response from institutionally oriented trend-followers has been to break apart and reassemble their traditional strategies into cheaper, stripped-down versions without the modulating factors that adjust the systematic portfolio’s model response to real-world factors, sources said. Also on offer are new alternative risk premium strategies that replicate the beta of the core strategy’s systematic trend-following approach.

The result is a 50- to 100-basis-point flat fee range for most risk-premium strategies, sources agreed. Fees for traditional systematic trend-following strategies range between 0.75% and 1% for management fees and 10% to 20% for performance fees.

The rise of hedge fund replication strategies means that you can more or less turn trend following into a “smart beta” ETF that anyone can use. The barriers to entry for using these techniques are falling very quickly.

In that case, trend following doesn’t sound like such a magic black box anymore. That represents my main source of disappointment. Covel’s book is in its fifth edition, and therefore he should be the authority on this topic. Where is he on these crucial issues of the characteristics of trend following?

No one rings a bell at the top, but…

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.

The message from sector leadership

It is said that no one rings a bell at the market top, but a review of sector leadership shows that late cycle inflation hedge sectors are poised to assume the mantle of market leadership (see Nearing the terminal phase of this equity bull), which would be the signal for a blow-off in inflationary expectations. Such an event would be the trigger for the Fed to become more aggressive in its rate normalization policy, and raises the risk of a policy mistake that could push the economy into recession.

If investors are looking for a bell to ring at the top, then there are signs that someone is slowly ascending the bell tower.

Consider the Relative Rotation Graphs, or RRG chart, of the market today. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
 

 

Wayne Gretzky famously said that his secret was to skate where the puck is going to be. Using that principle, the top left hand quadrant shows the sectors that are the likely emerging market leadership. These groups, with the exception of Financial stocks, are all in the inflation hedge and resource extraction industries, namely Energy, Metals and Mining, and Materials.

In short, the message from the evolution of sector leadership indicates that the market is poised for a blow-off in inflationary expectations, which will likely prompt a response from the Fed.

Resource extraction as emerging leadership

Let us consider each of the groups within the resource extraction sectors. The chart below depicts industrial metals (top panel), with Metals and Mining stocks (XME, middle panel), and the market relative performance of XME against SPY (bottom panel). Industrial metals are in the process of making a saucer bottom but they have not staged an upside breakout yet. XME shows a similar saucer bottom formation after breaking out of a downtrend. Similarly, the XME relative performance chart also shows a rounding bottom after rallying out of a relative downtrend. The price action of these related groups suggest that a cyclical upturn is at hand.
 

 

The performance of crude oil and the Energy sector is not as well developed. Oil prices (top panel) is testing resistance at a downtrend line. Energy stocks (XLE, middle panel) has staged an upside breakout out of a downtrend, and so has the market relative performance of XLE (bottom panel). These patterns are constructive for the oil and Energy sector, but if these groups follow the pattern of XME, then expect some back and forth consolidation before oil prices and Energy stocks can rise in a sustainable manner.
 

 

While we are on the topic of resource extraction stocks, the chart below shows the same analytic on gold and gold stocks, as many readers are interested in this group. Gold and gold stocks are not as well developed in their near-term market leadership potential as Metals and Mining, or Energy stocks. Gold (top panel) remains range-bound, and gold stocks (GDX, middle panel) is testing resistance at a downtrend line. However, the market relative performance of GDX (bottom panel) shows that GDX has rallied through a minor relative downtrend line, but still faces further overhead relative resistance that’s not that far away.
 

 

From a global perspective, the RRG chart shows a similar pattern of emerging resource leadership at a country and regional level. Emerging leaders are resource based economies, such as Canada and Australia, while the Eurozone, and the markets of China’s major trading partners are rolling over in relative strength.
 

 

The relative performance of MSCI Canada (EWC) against MSCI All-Country World (ACWI) is a typical example (all returns are in USD). EWC staged an upside breakout from a relative downtrend and it is in the process of forming a saucer shaped relative bottom against ACWI.
 

 

Janet and the yield curve

I would like to add a word about the other emerging leadership sector, the Financials. Financial stocks are driven by slightly different, but related, fundamental expectations. The top panel of the chart below shows that Financial stocks (XLF) recently pulled back after staging an upside breakout out of a range. The bottom panel shows the market relative performance of this sector is correlated to the shape of the yield curve. A bet on this sector is therefore a bet on a steepening yield curve, which is a signal that the bond market expects better growth ahead. That’s why the relative performance of resource extraction stocks and financial stocks are related, because higher growth tends to put upward pressure on inflation and inflationary expectations.
 

 

I would add a caveat to the analysis of Financial stocks using the yield curve. Janet Yellen recently stated that the Fed is watching the yield curve in its conduct of monetary policy (via Marketwatch):

Federal Reserve Chairwoman Janet Yellen on Thursday said the central bank would consider the bond market yield curve as it slowly reduces its $4.5 trillion balance sheet, which it had used to help stimulate the economy.

Yellen, in front of the Senate Banking Committee, was speaking of the Fed’s plan to stop reinvesting the principal on Treasury- and mortgage-backed securities.

Yellen explained that the Fed would set caps on the amount of reinvestment allowed to occur, and that the caps would gradually rise over time.

“So once we trigger this process, I expect it to run in the background, not something that we’ll be talking a lot from meeting to meeting,” she said.

“Now, we think that our purchases of assets did have some positive effect in depressing longer-term interest rates relative to short-term interest rates. But of course we will take that into effect, namely a steepening of the yield curve, in how we set the federal funds rate, which I hope will remain our primary tool for adjusting the stance of monetary policy.”

If the Fed is “watching” this indicator so closely, then the yield curve may cease to function as a recession indicator in this cycle. The Fed may not allow the yield curve to invert by using its powers to intervene in the market.
 

 

In addition, Goldman Sachs believes that unwinding the Fed’s balance sheet is likely to steepen the yield curve (via Marketwatch):

Goldman Sachs Group Inc.’s strategist predict that Treasury prices will fall, pushing the 10-year yield up. Goldman forecast that the 10-year yield will rise an additional 20 basis points in 2017, assuming reductions kick off this year as predicted. Then, the bank sees an annual increase of 12.5 basis points in yields over the following two years. Bond prices and yields move inversely…

Applying a model from the Fed, Goldman has sought to understand the ramifications of erasing the legacy of extraordinary monetary policy. Researchers at the board of governors of the Fed had estimated quantitative easing had depressed the term premium by a 100 basis points. A term premium represents the extra yield investors demand for holding longer-term and potentially less liquid securities.

Bottom line: While a steepening yield curve may be beneficial to Financial stocks, it may be ineffective as a recession forecasting tool in this cycle.

Market turbulence ahead?

Looking ahead, intermediate term sentiment and technical indicators are starting to look a little stretched on the bullish side, which is contrarian bearish. I had pointed out that the Fear and Greed Index rose above 80 last week, and such conditions have led to either sideways or corrective markets in the past.
 

 

As well, the 10 day moving average of the CBOE put/call ratio has fallen to crowded long levels where market has had trouble advancing in the past.
 

 

The NYSE Common Stock only McClellan Summation Index is also getting into overbought territory, indicating a pause may be needed.
 

 

The stock market sold off on Thursday when JPMorgan’s Marko Kolanovic derivatives strategist put out a research note warning about the risks of low volatility (via Street Insider):

It is safe to say that volatility has reached all-time lows and this should give pause to equity managers. Low volatility would not be a problem if not for strategies that increase leverage when volatility declines. Many of these strategies (option hedging, Volatility targeting, CTAs, Risk Parity, etc.) share similar features with the dynamic ‘portfolio insurance’ of 1987. While these strategies include concepts like ‘risk control’, ‘crisis alpha’, etc. in various degrees they rely on selling into market weakness to cut losses. This creates a ‘stop loss order’ that gets larger in size and closer to the current market price as volatility gets lower. Additionally, growth in short volatility strategies in a self-fulfilling manner suppresses both implied and realized volatility. This in turn prompts other investors to increase leverage, and those that hedge with options lose out and eventually throw in the towel. The fact that we had many volatility cycles since 1983, and are now at all-time lows in volatility, indicates that we may be very close to the turning point.

Kolanovic went on to warn about complacency, as shown by low stock correlation and the risk presented by the Fed’s normalization of monetary policy:

Over the past year, correlation of stocks and sectors declined at an unprecedented speed and magnitude (Figure below). A similar decorrelation occurred on only 2 other occasions over the last 30 years: in 1993 and 2000. Both of those episodes led to subsequent market weakness and an increase in volatility (in 1994, and 2001). The current decline in market correlations started following the US elections and was largely driven by macro (rather than stock specific) forces. Expectation of Fiscal measures, deregulation and higher interest rates set in motion large equity sector and style rotations. For instance, the correlation between Financials and Technology dropped to all-time lows (similar level to during the tech bubble). The correlation between equity styles also dropped (e.g. Value was lifted by rates, and Low Volatility was impacted negatively). Declining correlations pushed market volatility lower (see here), and the ~25% market rally further suppressed correlations and volatility. To investigate what are potential implications for the future price action we look at the 1993 and 2000 decorrelation events…

The current episode of correlation decline shares some similar features to both 1993 and 2000. The decline of correlation was in part driven by the market rally and elevated valuations; after a period of falling, interest rates are expected to rise (as in 1993), sector valuations (e.g. Internet) and sector rotations play an outsized role in market price action (similar to 2000), and record low levels of volatility increased the level of risk taking (as in 1993). Normalization of monetary policy will most likely lead to an increase of correlations and volatility, and that will at some point result in market weakness. While it seems that the 1993/1994 analogy is more appropriate (implying an orderly price action), investors should be aware of hidden leverage and tail risk of a more significant correction, such as the one in 2001.

 

The combination of excessively bullish sentiment, and market positioning by dynamic hedging strategies identified by Kolanovic suggests that stock prices are poised to hit an air pocket of unknown magnitude.

The good news

The good news is that any correction is likely to be brief and stock prices are well supported by fundamentals. The negative estimate revision that I identified last week (see What would a contrarian do?) turned out to be a data blip. The latest update from John Butters of FactSet shows that forward 12-month EPS rebounded strongly after a solid Q2 Earnings Season.
 

 

The recent history of weekly forward 12-month EPS revisions shows that estimates rebounded strongly in the most recent reporting period.
 

 

As well, the spike in insider sales reported by Barron’s also turned out to be data blip and readings are back at a “buy” signal again.
 

 

The week ahead

Does this mean that the bulls can buy with both hands? Well…

I interpret current conditions as an overbought market in need of a pullback, but downside risk is likely to be relatively limited unless Kolanovic’s scenario of a disorderly unwind of positions were to occur. The market may need some volatility to shake investors and traders out of their complacent mood. According to Ryan Detrick of LPL Financial, a 5% pullback would not be unusual by historical standards (via Marketwatch):

61 of the past 67 years have had a 5% downdraft at least once, or 91% of all years, according to Ryan Detrick, senior market strategist, at LPL Financial.

“The inevitable 5% drop will be a shock to nearly everyone,” Detrick said. “We’ve been historically spoiled so far this year, but as the economic cycle ages, we fully expect more volatility the remainder of this year and the likely 5% correction to take place as well,” he said.

 

Under these circumstances, my inner trader is relying on breadth indicators from Index Indicators to time his exit from his short positions. The short term (1-2 day time horizon) breadth model is showing negative momentum, but readings are neutral and not oversold yet.
 

 

The longer term (1-2 week time horizon) models are also showing similar readings.
 

 

My inner investor remains constructive on stocks, though he believes that this bull is nearing the end of his run. My inner trader is short the market, and he is watching for oversold readings on short term indicators in order to close out his position.

Disclosure: Long SPXU

Curb your (bullish) enthusiasm

Posted by Cam Hui -

Mid-week market update: Subscribers received an email update of the tactically fragile environment for US equities on Monday. There are plenty of reasons to be cautious.

Trade Followers observed that the Twitter breadth of all sectors are bullish, and such conditions are reflective of overbought market conditions:

Last week, sector sentiment gleaned from the Twitter stream had every sector positive. When this occurs a short term market top materializes usually within the following week. Once in a while, the sectors will paint another week with all of them in positive territory, then the top comes. Basically, when every sector is being bought aggressively it signals that the market is overbought.

 

That`s the just first warning. There are others.

Fear and Greed overbought

The Fear and Greed Index hit 81 yesterday, but retreated to 79 today. In the past, the market has either consolidated for a few weeks or weakened from these levels. As a reminder, the corrective action that began in late 2016 began when this index peaked in the high 70`s.
 

 

Good results, “meh” guidance

I wrote on the weekend that I was seeing the unusual condition where Q2 EPS and sales beat rates were well ahead of historical averages, but forward 12-month estimate revisions was falling. I then questioned if the negative revision was a data blip (see What would a contrarian do?).

Savita Subramanian at BAML confirmed my observation of negative revisions with a report entitled, “Good results, ‘meh’ guidance’. She found that Q3 2017 guidance was well below the historical average.
 

 

As a result, Q3 estimates are falling much faster compared to the past few quarters.
 

 

Should this trend continue, history shows that similar episodes of flat to down forward 12-month EPS has seen sloppy stock markets.
 

 

Disclosure: Long SPXU

Why the labor market is tighter than you think

Posted by Cam Hui -

As the FOMC meets this week, one key question for Fed policy makers is, “How tight is the labor market?” A related question is, “In the face of tame inflation statistics, when are we going to see evidence of rising wage growth?”

Both questions are important for monetary policy. The New York Times had an article that lamented the lack of inflation. The WSJ reported late last week that, in effect, the Fed has no idea of what is going on with inflation:

The Federal Reserve is likely to stand pat on policy when it concludes a two-day meeting next week, but it faces a debate about the future path of interest-rate increases because of a deepening puzzle over inflation.

Officials will likely leave short-term rates unchanged and wait until September before announcing plans to slowly shrink their $4.5 trillion portfolio of bonds and other assets.

They face a dilemma, however, because the two sets of economic indicators they most closely monitor are sending conflicting signals about the urgency of additional rate increases.

The unemployment rate, which hit a 16-year low in May, shows labor markets are tightening. That argues for the Fed to keep lifting interest rates to prevent the economy from overheating. But inflation is drifting away from the central bank’s 2% target, suggesting borrowing costs should stay low to strengthen price pressures.

I recently highlighted analysis from Adam Ozimek of Moody’s Analytics showing that there is no wage growth mystery. Ozimek found that the Phillips Curve, which postulates a trade-off between unemployment and inflation, is alive and well once he substituted the prime age non-employment rate for the unemployment rate (also see my recent post In search of the elusive inflation surge).
 

 

Using this analytical framework, the Fed is on the right track in normalizing monetary policy. Additional data indicates that the labor market is tighter than the market consensus, and a rise in inflation is just around the corner.

Adjusting for the opioid epidemic

One drag on the Labor Force Participation Rate (LFPR), which affects the actual supply of labor, is the growing opioid epidemic in the United States. This chart (via Adam Toze) shows some perspective on the magnitude of the problem.
 

 

CNBC reported that Janet Yellen expressed some concerns about the effects of opioids on the LFPR in her Senate testimony:

In her testimony before the Senate Banking Committee on Thursday, Yellen said rampant opioid abuse in the U.S. is related to the decline in labor force participation among prime-age workers.

“I don’t know if it’s causal or symptomatic of long-running economic maladies that have affected these communities and particularly affected workers who have seen their job opportunities decline,” Yellen said in response to questioning from Sen. Joe Donnelly, D-Ind., on the issue.

I used a couple of ways to estimate the opioid effect on labor force dynamics. The chart below shows Adam Ozimek’s metric, the prime age non-employment rate (PNER blue line), and the disability rate for people over 16. The effects of the opioid epidemic really hit the economy at the start of the Great Financial Crisis, one way of estimating its effects is to observe the rise in disability rate during that period, which was about 2%. If we subtract 2% from PNER (red dot), we can see that it is at levels where PNER has bottomed in the last two cycles.
 

 

Since opioid abuse is correlated with criminality, another way of estimating the opioid effect on LFPR is to observe the criminality effect on LFPR. The Sentencing Project estimated that roughly 2.5% of the American population has been disenfranchised because they were felons and unable to vote (via Business Insider). Further research shows that American incarceration rates are exceptionally high when compared to other developed economies, and even arrest records without convictions can depress someone’s chances of getting a job (see Solving the data puzzle at the center of monetary policy).
 

 

When we subtract the 2.5% disenfranchisement rate as a ballpark estimate for the opioid effect, we arrive at a similar conclusion. In conclusion, the labor market is probably much tighter than market expectations.

Where are the wage increases?

If the labor market is so tight, then where is the wage growth? Average hourly earnings stands at just over 2% and the rate of increase is decelerating.
 

 

Wage growth is where you find it, and it depends on which statistical measure you use. Matt Busigin recently observed that the 3-year rate of growth in real median weekly earnings has hit a cycle high.
 

 

Here is the same statistic, but using nominal YoY growth rates.
 

 

Indeed, the WSJ recently reported that small business have had to compete for talent with higher wage increases, with some handing out raises as much as 15%.
 

 

In conclusion, the US labor market is a lot tighter than expected. Don’t be surprised to see wage pressures rising in the near future, which is a development that will be a surprise for the market.

What would a contrarian do?

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.

What’s the contrarian asset class?

Being a contrarian is a lonely life. You don’t hang out with the popular kids. You are probably the nerd in the class. You get picked last in team sports. You don’t get invited to any of the parties. And even if you do, everyone laughs at you.

Over at Macro Man, he put us in a contrarian state of mind by asking, “What’s the unloved asset class?”

The question was not in the context of a trade, such as short FAANG, but an asset class that you buy and hold for the next few years. Going down the list, he rejected US equities for the reasons of high valuation.
 

 

He also rejected developed market fixed income, as well as all forms of credit. The cap rates on commercial real estate isn’t offering great value either.
 

 

Private equity? Just look at the cash on the sidelines waiting for deals.
 

 

At the end, he concluded, “Hmm, cash and gold seem to check a lot of boxes.” No wonder contrarians don’t get invited to parties.

Cash? Gold? While I believe that it’s still a little early to get overly bearish on equities, but here is how a scenario that favors cash, gold and other commodities may develop.

Sentiment extremes

Cash makes sense if an investor is looking over the next couple of years. As I have demonstrated in my series “Things you don’t see at market bottoms”, sentiment is getting a little frothy.

Consistent with the frothy theme, Callum Thomas pointed out that BAML private client (GWIM = Global Wealth and Investment Management) cash levels are extraordinarily low levels.
 

 

Those readings are consistent with my past observation that the T-D Ameritrade Investor Movement Index at an all-time highs, indicating a crowded long in equities. TD-Ameritrade CEO Tim Hockey confirmed the bullishness in his Q2 2017 earnings call:

We are seeing this quarter very broad-based engagement in the market, so everyone from brand-new customers opening their first account to very active traders seem to be engaged in the market. We saw a good activity across pretty much all of our products, futures were down a little bit year-over-year, because we had such a strong comparable. In terms of holdings, we are still seeing the trend where the ETF’s are increasing a bit as a percentage of assets. We continue to see good holdings in mutual funds and really across all of the products that we typically see.

 

As for the claim of gold as the contrarian asset class, I would generalize that category to commodities. Marketwatch recently highlighted analysis from Incrementum AG indicating that the equity/commodity ratio is hitting an extreme.
 

 

An opportunity in commodities?

From a technical viewpoint, a glance at the two major headline commodities, oil and gold, shows that both are bottoming. Crude oil seems to be a bit further ahead in that process when compared to gold. The chart below of energy equities relative to the market shows that these stocks are tracing out a broad based bottom. Energy stocks have tested the relative downtrend, but have not been able to rally through the downtrend yet.
 

 

Gold stocks remain in a relative downtrend as well, though the pattern is not as well developed as energy stocks.
 

 

By contrast, metals and mining stocks, which represent the base metals, have managed to rally through the relative downtrend and they are now showing signs of a nascent market leadership role.
 

 

These chart patterns are constructive for the commodity complex as a whole, though it is still a little early for traders to aggressively take long positions in this sector.

The bull case for oil

Tactically, oil prices have been strengthening for the last two weeks on the news of falling production and better than expected inventory declines. Knowledge Leaders Capital (formerly known as GaveKal) summarized the intermediate term bull case for oil prices well in their quarterly presentation.

First, global demand is rising.
 

 

Low oil prices have provoked a supply response. Investment in new production has fallen dramatically.
 

 

In the meantime, old fields are getting depleted. Annual depletion rates are equivalent to projected OPEC cutbacks.
 

 

Could US shale and tight oil save the day? Well…the productivity of shale formations have either peaked or plateaued. While producers can easily ramp up production quickly in the short-run, it doesn’t solve the longer supply problem unless exploration budgets rise accordingly.
 

 

In the interim, where will the oil come from? The rate of discoveries have fallen dramatically, largely because of reduced exploration budgets.
 

 

Putting it all together, the Renaissance Macro oil demand model price forecast is $90 per barrel.
 

 

By contrast, a more conservative inventory model calls for oil prices to rise to the $60-65 level in the next 6-18 months.
 

 

Setting up for an inflation surprise

Should oil and gold prices start to rise, it would have important implications for monetary policy. I have pointed out before that the bond market’s inflationary expectations (blue line) are correlated with changes in gold and oil prices (black line).
 

 

Today, the inflation outlook looks very benign. In fact, there is a long of hand wringing over how the lack of inflation is affecting monetary policy, not just at the Fed, but at the ECB as well.
 

 

Instead, I would argue that a turnaround in commodity prices would put upward pressure on inflationary expectations. In turn, that would also put upward pressure on central bankers to continue their course of monetary policy normalization.

That will the surprise of the 2nd half of 2017. Such a development will also be negative for equity prices. It is said that no one rings a bell at the top. Watch oil and gold prices for signs that someone is ascending the tower to ring the bell.

The near-term market outlook

Looking out the next few weeks, the outlook is a little mixed. On one hand, it’s hard to argue with price momentum and all-time highs in the major averages. What’s more, the fresh highs were achieved with no signs of negative divergences. The SPX Advance-Decline Line is behaving well and it has confirmed the fresh highs in SPX.
 

 

As well, signals from the high yield (HY) bond market is showing signs of rising risk appetite.
 

 

On the other hand, FactSet reported that while Q2 Earnings Seasons earnings and sales beat rates were well above their historical averages, forward 12-month EPS fell. This surprising development will have to be monitored to see if it represents just a blip in the data, or the start of something more serious.
 

 

Indeed, the latest BAML Fund Manager Survey shows that global growth expectations are starting to roll over. The downward EPS revisions may be reflective of that change in trend.
 

 

As well, Jeroen Blokland pointed out that falling estimate revisions is a global trend. Estimate revisions in June were considerably lower than they were during the January to May period.
 

 

The chart below confirms the trend of falling revisions observed by Blokland. It shows the history of weekly forward 12-month US EPS revisions from FactSet since early May. As the chart shows, the pace of forward revisions has been decelerating, even if the last data point, which showed a negative revision, is excluded.
 

 

Another disturbing sign for the bull camp comes from the Barron’s report of insider transactions, which saw a spike in sales by this group of “smart investors”. This is a noisy data series and there was a similar spike about three months ago, which could have been caused by a “quiet period” during earnings season when insiders could not trade. Nevertheless, the appearance of twin data blips from both EPS estimate revisions and insider activity is worrisome.
 

 

Possible consolidation next week

Looking to the week ahead, my base case scenario calls for a period of consolidation. The SPX hourly chart shows that RSI-5 reached an overbought reading of 90 twice last week. Historically, such episodes have been resolved with brief periods of consolidation before a major directional move.
 

 

Jeff Hirsch of Almanac Trader observed that the historical pattern of the next few days in July tends to have a weak bias.
 

 

My inner investor continues to be constructive and bullish on stocks. My inner trader is giving the bull case the benefit of the doubt and remains long the market. He is inclined to lighten up his long positions as a way of managing risk as we approach the FOMC meeting next week.

Disclosure: Long SPXL

Things you don’t see at market bottoms: Wild claims edition

Posted by Cam Hui -

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

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

It is said that one of the signs of a market top is when participants (and scam artists) start making wild claims for the future. Here are some examples:

  • USA Today: Millennials fear of stocks could cost them $3.3 million
  • Chinese offshore property stampede: Start of a trend?
  • A sucker born every minute, or more signs of unbridled greed

USA Today: Millennials, buy stocks!

It is said that the magazine headline is a sign of a market turning point. When popular magazines write a story, it usually indicates the end of a trend. So it was with some surprise when I read that USA Today breathlessly proclaimed that Millennials’ fear of stocks could cost them $3.3 million.

Here is the graphic that goes with the analysis.
 

 

This study reminds me of the old days when a corporate treasurer would hire an actuarial consultant to evaluate the company`s defined benefit plan. The discussion would go something like this. “The assets of the pension plan is $X. Make it work so that we don’t look under-funded.” The actuary would then feel pressured to make unrealistic return assumptions in order to “make it work”.

If you read the fine print, the USA Today return projections are laughable. They are based on the historical returns of 4.6% on 3-month T-Bills and 10.96% returns on equities. Someone please tell me where I can find a 4.6% return on a T-Bill. Then explain the market implications of such an environment. It would take a highly aggressive Fed for the T-Bill yield to reach 4.6%. Moreover, the following FactSet chart of forward P/E ratios shows that current forward P/E levels are highly elevated compared to its own history. In effect, some of the past returns for the equity asset class can be attributable to multiple expansion. Can we realistically expect a similar level of P/E expansion in the future? If so, what does that mean for interest rates (and is that consistent with a 4.6% T-Bill yield)?
 

 

To realistically achieve a return of 11.0% on equities, the market would need a downdraft of 50-70% in equity prices. To get to a 4.6% T-Bill yield, interest rates would have to rise dramatically.

The Chinese offshore property stampede

In support of its Chinese offshore property business, Juwai recently projected that Chinese investors will spend USD 1 trillion on offshore real investment in the next 10 years (via Huffington Post Canada):

Toronto and Montreal have surpassed Vancouver as the Canadian cities that Chinese homebuyers are most interested in, according to data from Juwai, China’s largest real estate portal.

The company predicts that Chinese investors will pour some $1 trillion (C$1.27 trillion) into real estate around the world over the next decade, of which a considerable amount is likely to land in Canada. The country is the fourth-largest destination for Chinese real estate investment, behind the U.S., Australia and Hong Kong.

 

It’s not that hard to project trends into the future. There are signs of a voracious Chinese appetite for American real estate. The Avison Young Q2 review of Manhattan commercial real estate reported that Chinese interests had accounted for roughly half of large scale property transactions:

Increasing foreign capital is redefining the City’s buyer pool, with a particular affinity to the trophy asset class. Chinese capital has accounted for half of the total dollars invested since the beginning of 2017, which has helped buoy market volume and pricing. Threatening a strong market rebound are the capital controls from the Chinese government, rising interest rates, the wall of maturing CMBS debt originated around the 2007 peak, and e-retail’s war on brick and mortar stores.

Christine Duhaime, a Canadian lawyer who specializes in money laundering issues, recently estimated that about $2 trillion in corruption proceeds had been spirited offshore from China, most of which went into property investments.

Is this the start of a trend of outbound Chinese fund flows? Or does this feel like past episodes of hubris, such as:

  • Bob Campeau‘s foray into American retailers Bloomingdale’s and Federated Department Stores using junk bond financing during the mid-1980’s
  • Japanese investors buying up American trophy properties, such as Pebble Beach, in the late 1980’s
  • Jean-Marie Messier (Moi-Même-Maître-du-Monde), the CEO of Vivendi, making wild takeovers for the media assets of Seagram’s, MP3.com, Houghton Mifflin, and USA Networks before and after the peak of the Tech Bubble. The episode culminated with Messier using corporate funds to buy a $17.5 million apartment for his personal use in New York City. We know what happened to the TMT sector afterwards.

A sucker born every minute

In the meantime, the British Columbia Securities Commission has warned about anyone raising funds with the so-called “Vancouver Stock Exchange Corp” (via Global News).
 

 

The Vancouver Stock Exchange (VSE) was merged with the TSX in 1999 and its functions were primarily taken over by the TSX-Venture Exchange. The VSE no longer exists. The new “Vancouver Stock Exchange Corp” (VSEC) has an office in Kitimat, BC, and in Shenzhen, China. For readers who are unfamiliar with Kitimat, here is a map of British Columbia, with Vancouver and Kitimat shown, to illustrate the remoteness of the VSEC office.
 

 

In the current environment, get-rich-quick speculators are crawling out the woodwork. The following tweet is an antidote to the USA Today’s story on under-invested millennials.
 

 

This will not end well, but…

Bullish sentiment excesses that I have cited in this and past posts represent a “this will not end well” investment story. But sentiment doesn’t function well as precise market timing tools. For now, the nowcast of short-term indicators such as initial jobless claims remain bullish…
 

 

So does forward EPS estimate revisions (via FactSet).
 

 

At the same time, investors should recognize that overall risk levels are rising and react accordingly, depending to their own investment time horizon.

What’s the upside target in this rally?

Posted by Cam Hui -

Mid-week market update: As the major US equity indices reach fresh all-time highs, it is time to ponder the question of how far the current upleg is likely to carry us. While technical analysts have several techniques available at their fingertips, I rely mostly on the venerable point and figure charting system (click link for primer), which was first used in the late 19th Century, to determine upside targets.

Using the point and figure charting tool at stockcharts, I get an upside target of 2549 for the SPX with a traditional box size and 3 point reversal.
 

 

If I vary the parameters to a 1% box size and a 3 point reversal, the upside target is 2524. The difference seems to be the width of the consolidation pattern and the site of the upside breakout.
 

 

Is the target 2524 or 2549? What gives?

Your mileage will vary

Good technical analysts understand that point and figure charting is a tool. Just like any tool, it has its limitations. Your mileage will vary, depending on what question you ask of the tool.

With the point and figure tool, you can use different time frames, such as daily, weekly, or monthly prices, depending on your own time horizon. As well, you can vary the sensitivity of your analysis with differing box sizes and reversal parameters.

As a test of the sensitivity of this tool, the table below shows the SPX upside targets using daily, weekly, and monthly prices. As well, I used both traditional, 0.5% and 1% box sizes, along with 2 and 3 box reversals.
 

 

The results were remarkably similar. There were a few outliers, which are highlighted. Most of the upside targets were clustered between 2500 and 2600. The monthly price analysis using a 1% box and 3 box reversal arrived at an astounding 3350 target. On the other hand, monthly price analysis using a 2 box reversal, regardless of box size, showed that market had exceeded its target.

The median upside target 2536, and the average was 2586. If we take the midpoint of the two, we get 2561. Interestingly, the midpoint of the median and average targets if we removed the highlighted outliers comes to 2563, which is indicative of the stability of the estimates.

Based on this analysis, the target for this upside breakout is 2536 to 2586, or about 2560.

Nearing THE TOP?

Here is some context to those upside targets. What is remarkable about this exercise is the convergence of the targets to the 2560 region using daily, weekly, and monthly prices (except for a few outliers). By implication, a long-term cyclical top is not very far away.

About a year ago, I wrote that the likely cyclical market top would occur in the second half of 2017 (see The roadmap to a 2017 market top). I amended that forecast in May 2017 to allow for the timing of a top to extend to the first half of 2018 (see When does the market top out?).

As stock prices break out to new highs, but with the upside point and figure target only about 4% away, the technical picture suggests that a market top is likely to occur in the next few months, if not weeks. With the Fear and Greed Index at an elevated reading of 73, it also suggests that the market is likely to top out when this index reaches an overbought condition.
 

 

My base case scenario still calls for a Fed induced economic slowdown from tight monetary policy, which drags down stock prices (see How the bull will die). There are still many moving parts to this scenario. Much depends on the path of wages, inflation, the growth outlook, the Fed’s reaction function, as well as possible changes at the Fed’s Board of Governors. I am not ready to turn bearish just yet.

My short-term indicators are mainly bullish, but I remain, as always, data dependent.

Disclosure: Long SPXL

In search of the elusive inflation surge

Posted by Cam Hui -

US bond yields began to settle down last week when Fed Chair Janet Yellen stated in her Congressional testimony that the neutral rate for Fed Funds is roughly the inflation rate, which is much lower than market expectations. In addition, she allowed that the Fed is likely to re-evaluate its tightening path in light of tame inflation figures.

Even Fed Governor Lael Brainard, whose Fedspeak had recently taken on a more hawkish tone lately, sounded dovish in a speech last week:

Once that [normalization] process begins, I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE (personal consumption expenditures) inflation…I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target.

The June CPI print came in below expectations, which reinforced the view that low inflation releases may prompt a shallower path for rate hikes in 2017 and 2018. Brainard stated on Thursday, before the CPI release, “I don’t think anybody can give a fully satisfactory answer to why we’re seeing the inflation trajectory that we see today.”

In the past, we have seen inflationary surges whenever the unemployment rate falls substantially below 5%. The graph below depicts the unemployment rate (blue line, with the zero level set at 5%), with CPI (red line). The rise in inflation has been quite tame by historical standards, which is creating a dilemma for policy makers.
 

 

The Fed’s underlying model of inflation is the Phillips Curve, which posits a trade-off between inflation and unemployment. As the chart from this Money and Banking primer shows, the inverse relationship between inflation and unemployment has been flattening since 2000. Falling unemployment should drive up wages, which is the price of labor, and put upward pressure on inflation. This time, the wage and inflation response has been muted.
 

 

Questions are being asked at the Fed. Is the Phillips Curve broken? Why aren’t wages rising?

The answer is “no”. Fresh analysis from Moody’s shows that the Phillips Curve is alive and well. Should the Fed pause in its tightening path, it will find itself behind the inflation fighting curve. This would set the stage for a series of staccato rate hikes next year that would undoubtedly push the economy into recession.

The “right” Phillips Curve

Adam Ozimek of Moody’s Analytics recently solved the wage growth mystery. Instead of comparing the unemployment rate to inflation, he found that the prime age non-employment rate was a much better fit when using the Phillips Curve as an analytical framework:

However, the unemployment rate is not the right measure of labor market slack right now. If instead we look at the prime age non-employment rate (which is 100% minus the prime aged employment rate), we see an even tighter wage Phillips curve. According to this curve, wage growth is exactly where we would expect given the level of slack in the labor market. To get to 3.5% to 4% or higher wage growth, this graph suggests another 3 percentage points of improvement in the non-employment rate will be needed.

 

Ozimek went on to state that the prime age labor market still had some slack left before wage inflation reaches 3.5%-4.0% wage growth. As last week’s JOLTS reports showed that the all important “quits” rate continues to rise, this signals continuing labor market strength.
 

 

These trends indicate that wage pressures should begin to appear in the near future.

Investment implications

What does that mean for investors?

As an investor, I find the exercise of watching for economic statistics that show up in the rear-view mirror somewhat disconcerting. Instead, I offer some real-time, or near real-time indicators to watch.

First, the S&P 500 and weekly initial unemployment claims has shown a remarkable pattern of inverse correlation during this cycle.
 

 

The chart below shows 5 year x 5 year inflation expectations (blue line), along with the average YoY change in oil and gold prices (black line). Commodity prices have shown themselves to be highly correlated to market based inflationary expectations. If gold and oil prices were to start turning up, rising inflationary expectations from the bond market will eventually pressure the Fed to adopt a more hawkish stance.
 

 

A glance at the Citigroup US Economic Surprise Index (ESI), which measures whether high frequency economic data is beating or missing expectations, shows that ESI is starting to bottom and turn up. This indicates a likely upturn in growth expectations, which should put upward pressure on commodity prices and inflationary expectations.
 

 

Johnny Bo Jakobsen of Nordea Markets observed that ESI typically sees a seasonal trough at about this time of year.
 

 

Too early to buy the inflation trade

Tactically, an analysis of the breadth of gold equities show that they are not quite ready to rally just yet. The silver/gold ratio, which measures the relationship between the high beta precious metal silver against gold, is still in a downtrend. As well, the % bullish metric (bottom panel) does not appear to be sufficiently washed out to indicate a durable bottom.
 

 

Downside risk for gold prices is limited. The latest Commitment of Traders report shows that speculative positions in gold are nearing capitulation levels, but may need a bit further to go (via Topdown Charts).
 

 

As well, energy equities remain in a relative downtrend against the market. Even though the XLE/SPY ratio shows signs of bottoming, I would prefer to see a rally through the relative downtrend line before embracing the rising inflation trade.
 

 

These trades are likely to take a few more weeks to develop. Investors can begin to accumulate positions and overweight resource sectors, while traders should watch for the upside breakout of inflationary expectations.

Looking for froth in the wrong places

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.

Where’s the Bubble?

Ben Carlson at A Wealth of Common Sense recently detailed the four criteria for a market bubble:

In a recent conversation with Meb Faber, William Bernstein discussed how his criteria for seeing a bubble has more to do with sociological factors than econometric indicators. Here are his four signs of a financial market bubble:

(1) Everyone around you is talking about stocks (or real estate or whatever the fad asset of the day is). And you should really start worrying when the people talking about getting rich in certain areas of the market don’t have a background in finance.

(2) When people begin quitting their jobs to day trade or become a mortgage broker.

(3) When someone exhibits skepticism about the prospects for stocks and people don’t just disagree with them, but they do so vehemently and tell them they’re an idiot for not understanding things.

(4) When you start to see extreme predictions. The example Bernstein gives is how the best-selling investment book in 1999 was Dow 36,000.

He said he’s not worried about a bubble at the moment but seeing 3 out of these 4 conditions being met would be a warning sign.

Despite my series on investor sentiment, Things you don’t see at see at market bottoms (which had four editions that were published 13-Jul-2017, 7-Jul-2017, 29-Jun-2017, and 23-Jun-2017), market psychology has not reached the “OMG I have to quit my job/mortgage the house to buy/trade the hot asset of the day”. While there are some excesses, such low levels of institutional cash (chart via Business Insider), the lack of over-the-top froth suggests that the next stock market downturn from a recession may be relatively mild in the manner of a 10-20% decline seen in the 1990 bear market.
 

 

While I am somewhat sympathetic to that view, investors who are looking for signs of froth are looking in the wrong places. One of the processes that occur in recessions the correction of excesses in the past expansion. Most of the real excesses are not to be found within US borders, but abroad.

The China Bubble

I have detailed in these pages of the risks posed by excessive Chinese debt (see How bad could a Chinese banking crisis get?) and outlined some scenarios of how it could all unravel (see How a China crash might unfold). This chart from Kevin Smith of Crescat Capital shows how the China bubble has migrated, mainly through hot-money flows into Australian and Canadian property (also see my post How China’s Great Ball of Money rolled into Canada).
 

 

One of the signs of excesses that accompany a market top is a surge in mergers and acquisition activity. Does this Bloomberg chart of Chinese outbound acquisitions count?
 

 

Chinese insurance conglomerates have been going on a shopping spree for overseas assets. One worrisome aspect of these deals is a pattern of the lack of positive free cash flow by acquiring companies, indicating that purchases have to funded by ever growing levels of debt from the banking system.
 

 

Business Insider recently detailed the vulnerability of the global financial system to changes in credit availability from China:

There is a new worry coming out of China, and it’s slowly taken hold of Wall Street.

The country’s government is cracking down on massive financial firms that have grown by making acquisitions overseas. You’ll recognize some of these names; Anbang Insurance, which recently bought the Waldorf Astoria; HNA; Fosun; Rossoneri; and Wanda.

So what happens to these overseas acquisitions if the money dries up?

Now, that doesn’t mean these companies will go bankrupt. Credit Suisse pointed out that the Chinese government isn’t interested in shocks to the system either, so it may backstop disaster (and it may not). Even so, that means these once high-flying international dealmakers are now pariah’s in China’s banking sector and will have to use their cash reserves to pay down debt for no-one-knows-how long.

“If they cannot honour their financial obligations, there is a chance that it could create a domino effect on other institutions/individuals which have lent money to them,” said Credit Suisse. “Among them, the development of Anbang Insurance is worth the most attention, as it probably is having the closest relationship with retail investors through its insurance products. ”

This relationship is likely why Anbang Chairman Wu Xiaohui — who last year met with President Trump’s son in law, Jared Kushner, about investing in Kushner’s real estate company — was taken into custody by Chinese authorities earlier this year. Anbang also has a 20% stake in China’s largest private bank, China Minsheng Bank.

Wu’s disappearance happened much like most executive disappearances do in China. It started with a rumor, which was countered with a denial, until finally the story was eventually confirmed.

Sometimes that’s how bankruptcies start too.

This table from a separate Bloomberg article shows how solvency ratios for Chinese insurance companies have deteriorated.
 

 

The risk is a series of cascading defaults with unknown effects on the global financial system. The latest report from BIS warned about high indicators of stress in the banking systems in China, Hong Kong, and Canada, which is one of the countries with high debt levels shown in the Kevin Smith chart above.
 

 

Earlier this year, International Business Times reported that the IMF cited the risk of a global recession should China experience a hard landing because of extensive financial linkages with the rest of the world:

An economic crisis in China could result in a world-wide recession, warned the International Monetary Fund (IMF). This was because China’s financial links with the rest of the global economy was set to increase, the organisation said ahead of its spring conference in Washington next week. “It is likely that China’s spillovers to global financial markets will increase considerably in the next few years”, the IMF said.

Canada and the Quinoa Problem

Canada can be regarded as a case study of the aforementioned linkages, largely because of a flood of Chinese money into the property markets in Vancouver and Toronto.

The causes of the Canadian property bubble (yes, it is a bubble) comes from the combination of several factors. First, excessive demand from foreign buyers, mainly from Mainland China. The price rise was further exacerbated by low interest rates, which pulled in local speculators who piled into the market. If you are looking for the William Bernstein criteria of a bubble, come to Vancouver or Toronto:

(1) Everyone around you is talking about real estate. (One of the major issues in the last provincial election in British Columbia, which is where Vancouver is located, was housing affordability).

(2) When people begin quitting their jobs to enter real estate. (One acquaintance quit his job in a high yield management organization to get into property management.) And you should really start worrying when the people talking about getting rich in certain areas of the market don’t have a background in finance. (As a point of reference, WorkSafeBC is the provincial agency that deals with worker injuries and disabilities).
 

 

(3) When someone exhibits skepticism about the prospects for property and people don’t just disagree with them, but they do so vehemently and tell them they’re an idiot for not understanding things. (Unusual contortions by local real estate boosters to justify why Vancouver houses are more expensive than New York and beachfront Malibu).

(4) When you start to see extreme predictions.

Amber Kanwar of BNN recently pointed out that real estate transfer fees are roughly 2% of GDP in Canada (compared to about 1.5% in the US at the peak of the last bubble).
 

 

To put the 2% of GDP into some context, NATO countries are targeting defense spending of 2% of GDP. As the chart below shows, Canada is only spending 1% of GDP on defense, which is especially important given Donald Trump’s complaints about defense spending levels of NATO members. In effect, real estate transfer fees are twice the size of the Canadian defense budget.
 

 

BNN also reported that 27% of Canadians are in over their head on their mortgage obligations, and this was before the BoC raised rates last week:

An alarming number of house-poor Canadians are teetering close to the edge in terms of meeting their debt obligations, according to a poll conducted on behalf of MNP. The report from the chartered accountancy firm says even a modest increase in interest rates could push many homeowners over the edge.

“Three in ten home owners say that they will be faced with financial difficulties if the value of their home goes down,” the report read. “Even if home values don’t decline in the near future; more than a quarter of Canadians (27 per cent) who have a mortgage agree that they are ‘in over their head’ with their current mortgage payments.”

In the meantime, the property markets in Vancouver and Toronto suffer from a “quinoa problem”. Quinoa was originally grown in the Andean regions of Peru, Bolivia, Ecuador, Colombia, and Chile. When the West discovered quinoa as a food source, foreigners began to bid up the price of quinoa, and local inhabitants could not afford to use it as a food source. The same thing has happened in Vancouver and Toronto. As local residents began to get priced out of those cities, developers began to market new construction offshore. As an example, see this sponsored article in SCMP in Hong Kong extolling the virtues of Vancouver and Toronto property.

These kinds of financial excesses not only put the Chinese economy at risk, but contagion risk has spread to countries that have seen a surge of Chinese demand for property. Indeed, the IMF has expressed concerns about risks from high housing prices in Australia, Canada, and New Zealand.

European banking not fixed

I had originally envisaged a global slowdown sparked by Fed tightening that slows the American economy and then spreads to China through the trade channel. The emergence of over-leveraged Chinese financial conglomerates with overseas interest raise the risk of contagion through the finance channel as well. In particular, financial stress would be heightened in Hong Kong because of the HKDUSD peg as rising US interest rates will force HK rates upwards.

Under such a scenario, the eurozone banking systems is a source of concern. Vítor Constâncio of the European Central Bank recently openly worried about nearly €1 trillion of unresolved non-performing loans in the eurozone banking system. That’s because Europe never fixed the problems of excessive bank leverage that caused much of the problems in the last crisis.

The “financial innovation” of CoCo bonds, which were supposed to have more equity-like characteristics and be part of the Tier 1 capital cushion, does not seem to solved the problem of shoring up bank capital. FT Alphaville recently detailed the unforeseen consequences of CoCo bonds (AT1) with the failure of Banco Popular.

One flaw with additional tier 1 bonds is that, while they have in-built triggers which boost a bank’s capital ratio, they also act as extremely effective triggers, or warning signals, for depositors to place their cash elsewhere.

The effect of the secondary market for AT1 here exacerbates the existing problem of publicly traded banks, which may be vulnerable to retail or corporate withdrawals in the instance of a sudden share price collapse. If AT1s were hit while the bank were still running, its easy to imagine an extremely negative response from depositors.

Once the prices of the AT1 bonds started to fall, depositors took that as a signal to bail, which exacerbated the solvency problems faced by Banco Popular.

Bottom line: While recessionary effects are likely to be mostly contained within US borders, the same cannot be said outside the US. While the most likely trigger is rising US interest rates, we cannot forecast their effects, largely because the nature and magnitude of the transmission mechanisms. Will the primary effects occur through the trade channel, or financial channel? We have no idea.

So far, this is a “this will not end well” story with an unknown trigger, and unknown timing. Investors should be aware of these risks, but not overreact.

The path forward

For now, investors should remain calm. Beijing still has many levers to cushion a downturn. Callum Thomas at Topdown Charts pointed out that M2 money growth remains supportive of liquidity in China.
 

 

The latest update from John Butters at FactSet shows that preliminary Q2 Earnings Season beat rates for both sales and earnings are well above historical averages. More importantly, forward 12-month EPS estimates continue to rise, indicating improving fundamental momentum.
 

 

In addition, the latest update of insider activity from Barron`s shows that these “smart investors” are still buying.
 

 

In short, the intermediate term outlook remains bullish. Stay calm and stay long equities.

The week ahead

Looking to the week ahead, the SPX staged an upside breakout to an all-time high. The index appears to be overbought on the hourly chart and could see some weakness early in the week. In the past two months, RSI-5 readings of 90 or more have resolved themselves with either a sideways consolidation or a mild pullback.
 

 

Short-term indicators with a 1-2 day time horizon from Index Indicators also show an overbought reading.
 

 

Longer term indicators appear to be constructive for the bulls and not overbought. Further positive momentum could carry the market to further highs.
 

 

Looking out to the next few weeks, the Fear and Greed Index remains at a neutral reading. As long as the positive fundamental backdrop remains in place, stock prices are likely to grind up to new highs this summer.
 

 

My inner investor remains bullish on stocks. My inner trader is bullishly positioned, but may pare back some of his long positions should the market remain strong on Monday in anticipation of a short-term pullback.

Disclosure: Long SPXL

Things you don’t see at market bottoms, Retailphoria edition

Posted by Cam Hui -

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

I have stated that while I don’t believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, this is another post in an occasional series of lists of “things you don’t see at market bottoms”. This week, I focus on more signs of retail giddiness.

  • The TD-Ameritrade Investor Movement Index hits an all-time high
  • E-Trade parties like it`s 1999
  • If the market is chasing yield, corporations can get away with murder

TD-Ameritrade IMX at ATH

The TD-Ameritrade Investor Movement Index measures the sentiment of the firm’s customers. The latest update shows IMX at an all-time high since its inception in 2011.
 

 

E-Trade parties like it`s 1999

I present this E-Trade ad without further comment, other than it is reminiscent of a certain other era of investing.
 

 

Cov-lite goes wild

Tracy Alloway highlighted this chart of plunging covenant quality of new US corporate bonds. If the market is chasing yield, issuers can virtually get away with murder…
 

U-S-A! U-S-A!

Posted by Cam Hui -

Mid-week market update: Having reviewed sector rotation last week (see More evidence of an emerging reflationary rebound), it is time to apply the same analysis to countries and regions.

First, let’s start with a primer of our analytic tool. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

Here is the RRG chart of the major countries and regions of the world. All ETFs are priced in USD and therefore all currency effects are already part of the returns. The rotation analysis was performed relative to MSCI All-Country World Index (ACWI).
 

 

My interpretation of the RRG chart indicates that US stocks are poised to take the leadership position again, after a brief hiatus. Emerging leadership can also be found in the resource producing countries of the world, such as Australia, Canada, Latin America, and Russia. European and Asian stocks, which had been the leaders, are starting to consolidate and they are likely to begin to weaken on a relative basis. These patterns are consistent with my thesis of a developing reflationary blow-off equity market top.

Eurozone: A Merkel and Macron acid test

Let’s review each region, one by one, starting with the Eurozone. Eurozone equities, as represented by the Euro STOXX 50 (FEZ), has shown a history of “false dawns”. The chart below shows the relative performance of FEZ against ACWI for the past 10 years. While FEZ has been in a long-term relative downtrend against ACWI during that period, it has exhibited a pattern of rallying out of a relative downtrend, consolidate, and the resume its underperformance again. Each time, the market has been seduced by the false promise that the European authorities have finally gotten their act together, only to be disappointed.
 

 

Will the promise of a Merkel/Macron led Europe prove to be another mirage? The market is starting to show some signs of disappointment, despite the series of better than expected economic growth statistics emerging out of the euro area.

Investor sentiment is at crowded long levels, so expectations are high. The June 2017 BAML Fund Manager Survey shows institutions at a crowded long in eurozone equities.
 

 

Tony Welsh at Ned Davis Research also pointed out that funds flows into Europe have switched from net outflows last year to inflows. Europe is becoming the consensus long.
 

 

From an economic news perspective, the Citigroup Eurozone Economic Surprise Index is already at elevated levels. With bullish sentiment already elevated, the risk/reward ratio of upside to downside surprises is not favorable.
 

 

U-S-A!

By contrast, US ESI is bottoming and starting to turn up. As ESI is designed to be a mean reverting index that naturally adjusts to market expectations over time, the scope for American economic surprises is far higher than it is in Europe.
 

 

The relative performance of US stocks relative to ACWI is also starting to show some promise. SPY has rallied out of a relative downtrend against ACWI and it is now exhibiting a consolidation pattern.
 

 

If the standard RRG rotation pattern holds, then expect SPY to begin outperforming ACWI in the weeks ahead.

Chinese Asia rolling over?

Over in Asia, the stock indices of China’s major trading partners are starting to roll over in relative strength. The relative strength patterns of Asian indices reveal a mixed bag. China remains range-bound compared to ACWI, while Hong Kong and Singapore have violated their relative uptrends, and Taiwan and South Korea remain in relative uptrends.
 

 

The one anomalous pattern is Australia, which has rallied out of a relative downtrend and its relative strength is staring to turn up.

Late cycle leadership

The relative turnaround in Australia is consistent with a pattern shown by the stock indices of other resource based economies. The chart below shows the relative returns of Canada, Latin America, Russia, and South Africa. All are showing similar patterns of making relative bottoms and possible upturns.
 

 

These patterns are consistent with my thesis of a reflationary blow-off in global stocks (see Nearing the terminal phase of this equity bull and More evidence of an emerging reflationary rebound). In all likelihood, the direction of the next major move in stock prices is up, rather than down.

Disclosure: Long SPXL, XIU.TO (TSX 60 ETF)

Are stocks being stalked by a silent Zombie Apocalypse?

Posted by Cam Hui -

There was some minor buzz on the internet when Jonathan Tepper tweeted the following BIS chart and rhetorically asked if zombie firms was the cause of falling productivity during this expansion. BIS defines a “zombie” firm as a company that has been listed for 10 years or more and has an EBIT interest coverage of less than 1. As the charts show, the number of “zombie” companies have been rising steadily, while advanced economy (AE) productivity and CapEx has been muted during this expansion.
 

 

While the zombie hypothesis has much intuitive appeal, especially to the permabear and doomster set, a deeper examination reveals some unanswered questions that casts doubt about this explanation for the muted productivity gains of this cycle.

Falling monetary velocity

There is much to be said about the zombie theory. I had pointed out in my last post (see A mid-year review of 2018 recession risk) that one anomaly we are seeing this cycle is the continued decline in monetary velocity. In the past, negative YoY real money supply growth had been a warning of recession, but past episodes of negative growth occurred in the context of rising velocity. This time, monetary velocity has been steadily falling, which may be interpreted as a failure of monetary policy to stimulate economic growth. Here is a history of M1 growth and velocity.
 

 

M2 growth and its velocity tells a similar story.
 

 

The rising presence of zombie companies could explain all that.

Japanese zombies

Japan has been the land of corporate zombies for quite some time. The banking system has had a long history of propping up insolvent firms as a way of deferring the recognition of bad loans. Indeed, Japanese monetary velocity has been falling since the bursting of their bubble and the commencement of their Lost Decades.
 

 

Zombie firms holding down productivity and CapEx has an intuitively appealing explanation. Izzy at FT Alphaville pointed out that if Uber in its present state were to be publicly listed could qualify as a zombie company in two years. This explains why zombie companies can survive. As long as unprofitable companies had sufficient financing capacity, either in the form of equity or additional debt, they can continue to operate.

By implication, easy central bank money and overly enthusiastic equity markets as a source of zombie financing is also an appealing thesis for the permabear and doomster set.

The productivity and velocity anomaly

However, there are a number of anomalies to that explanation. The chart below shows the history of productivity (blue line) and M2 velocity. Productivity had a tendency to jump after recessions, because companies saw sales ramp up while staffing levels remained lean. That combination caused an apparent jump in productivity levels. However, we can also observe two periods, the expansion of the 1960`s and early 1970`s, when productivity was high but monetary velocity was falling.
 

 

That is the first anomaly, namely the productivity and monetary velocity puzzle. It could be that zombie companies are only correlated with falling monetary velocity, and the effect is not causal.

The balance sheet puzzle

Another anomaly comes from Andrew Lapthorne of Societe Generale. Lapthorne has been known to be a permabear, but in this case, he throws a wrench into the zombie hypothesis (via FT). The chart below depicts the difference between the financing capacity of megacap stocks and smaller companies. Lapthorne worried aloud that the interest coverage ratios of smaller companies are already strained by historical standards. As the Fed begins to raise rates, the risk of widespread corporate stress will spike.
 

 

Here is a difficult question for the zombie hypothesis. If there are so many zombie companies with EBIT coverage below 1, shouldn’t the dark red line of small company interest coverage ratios be much higher by historical standards?

Something just doesn’t add up.