A passive index fund built to outperform?

Posted by Cam Hui -

A long time reader sent me this Seeking Alpha article entitled “Monish Pabrai Has Created An Index Fund Built To Outperform”, which described a “passive index fund” built using the following three investment themes deployed in three portfolio buckets:

  • Share buybacks: Companies that are buying back their own shares
  • Selected value manager holdings: The holdings of 22 selected value managers, based on their 13F filings
  • Spin-offs: Companies that were recently spun off from their parent

It’s difficult to have a detailed opinion on the pros and cons of this fund. That’s because the article only described what this “index fund” would hold, it did not describe the portfolio construction method, or how much of each stock it would hold. So it`s impossible to understand the risk profile of the fund, the size of its factor exposures, as well as its sector and industry exposures.

All the marketing hype aside, this investing approach is really a re-packaged form of factor investing, otherwise known as “smart beta”. Therefore investors who buy into such a vehicle should expect similar kinds of results as “smart beta”, though in a multi-factor format.

1980’s technology

The approach outlined in the “index fund” is nothing new. I remember deploying similar kinds of investment themes in institutional equity portfolios as a bottom-up equity quant back in the 1980’s and 1990’s. This was later re-packaged as “smart beta”.

Certainly, smart beta factor investing is becoming more and more popular, Just look at the Google searches (via BAML).
 

 

The number of factors in multi-factor models have grown, as quantitative managers have embraced greater complexity.
 

 

On the other hand, it isn’t clear at all that quant managers have outperformed traditional active managers.
 

 

I see a crowded trade here. Everyone is looking at the same data. Everyone is using the same databases. Equity quant funds briefly blew up in August 2007 (see Are Quants the victims of their own success?).

When these factors become well known and overly exploited, they don’t fail. Rather, they go through an up-and-down cycle, much like the value/growth cycle. If the factor possesses a valid investment thesis, then patient investors who are willing to look through the cycle should experience superior returns. In the short term, however, consider Michael Batnick’s description of the ups and downs of the “low volatility” strategy:

And investors did what they have been doing since the beginning of time. In the first chart, when low-vol was doing well, $1,354,750,000 poured in, and then when the tide came out, so did investors, pulling out $1,737,700,000, around 20% of total assets.

 

Factors for all seasons?

The genesis of factor investing came from the early “anomalies research” of finance academics. Back in the 1970’s there was a big debate over the Efficient Market Hypothesis (EMH). The prevailing thinking at the time was you couldn’t beat the market. All the information that is known about a stock is already known to the market, so how could anyone gain an advantage?

Then came a whole slew of “anomalies” literature. Academics found that you could construct a well diversified portfolio of companies with low price to book ratio, high dividend yield, small caps, and so on, and each of these portfolios would beat the market. That became known as the value anomaly, the small cap anomaly, etc. EMH defenders replied that these studies were flawed, because risk was mis-specified in the studies.

It didn’t matter. Eventually finance professionals picked up on academic research, and quantitative investing was born.

Back in those days, investment professionals naively thought that the alpha from these anomalies would last forever, but they didn’t. Value worked very well, until it got overly exploited. The market then went through a series of value-growth cycles where each style became dominant.
 

 

The same thing happened with other factors. Price momentum worked, but only in bull markets. In bear markets, the market would gouge your eyes out if you bought price momentum (see The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation).

There are no factors for all seasons! That’s the simple lesson for equity quants. However, intelligent quants who are market savvy can still exploit factor anomalies by combining bottom-up factor based stock picking techniques with an assessment of the macro-economic conditions and economic cycle.

The CFA Institute recently published a book entitled Factor Investing and Asset Allocation: A Business Cycle Perspective that is required reading for anyone interesting in this topic. While the book advocates factor rotation, or picking factors, the process is more art than science. There is no magic bullet, but factor rotation can yield alpha if properly implemented.

Incidentally, my own Ultimate Market Timing Model is an implementation of that investment philosophy. The essence of my model is to stay long equities and try to sidestep recessions, which are bull market killers. Once the macro models start to see a recession on the horizon, use the trend following models from technical analysis to time entry and exit points.

Could “animal spirits” rescue the Trump 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 shift in tone

Well, that shift in tone came out of nowhere! It seems that as the focus shifted from “tax cuts” to “Obamacare”, the stock market began to lose steam and retreated.
 

 

Before the bulls get overly discouraged, Main Street’s enthusiasm for the Trump agenda may spur enough growth to keep the Trump rally going. Megan Greene recently highlighted this now familiar chart of the large gap between soft (expectations) and hard (reported) data.
 

 

I had also raised the same question just after Inauguration Day (see Could “animal spirits” spark a market blow-off?“>).

A question of sentiment

As an example, the latest update of small business confidence from NFIB shows that confidence edged down slightly in February, but levels remains elevated after the surge after the election (annotations in red are mine).
 

 

Here is the alternate view. When expectations are this high, it may be time to ask if expectations are excessive and therefore represent a contrarian sell signal. Indeed, the chart below shows that excessively high levels of University of Michigan Consumer Sentiment have been signals of cycle and stock market peaks.
 

 

Michelle Meyers at BAML published a comprehensive analysis of the bifurcation between confidence and spending. Not surprisingly, consumer confidence rose the most in the regions and demographics that went for Trump in the election.

The biggest gain in confidence was among those aged 55+ where confidence climbed by an impressive 25 points since October. In contrast, those aged 35 – 54 saw a more measured 9.2 point gain while those under the age of 35 are feeling worse with confidence down 7.8 points.

 

 

However, the people with the greatest gains in confidence were not the ones with the most money to spend. Meyer believes this divergence is setting up for a disappointment in expectations.

We find that the cohorts that have seen the biggest gains in confidence are not the main drivers of spending. This could help explain some of the divergence between strong sentiment and trend-like consumer spending. Using the BLS Consumer Expenditure Survey, we find that the bulk of consumer spending – 42% as of the end of last year – is done by middle-aged households (35 – 55 years old). The youngest and oldest cohorts make up about 30% of spending each. In other words, the strong gain in sentiment among the older cohort is offset by the deterioration in sentiment among the younger generation.

The split in spending by income group is even more extreme. Nearly 40% of consumer spending is done by the highest income quintile (the top 20% of the income distribution). In contrast, the middle quintile only makes up 16% of total consumer spending. The higher income households have only had a measured increase in confidence in contrast with the jump in confidence among middle-income households. This tells us that the cohort with the greatest ability to spend is not feeling quite as confident as the aggregate surveys show.

The NFIB small business survey also told a similar story of likely sentiment disappointment. Even though expectations (thin line) have surged, actual sales results (dark line) barely rose to above to flat line. Moreover, past large gaps between rocketing expectations that left large gaps between soft and hard data have resulted in disappointment.
 

 

In its February statement, NFIB president Juanita Duggan stated: “Small businesses will begin to turn optimism into action when their two biggest priorities, healthcare and small business taxes, are addressed. To small business, these are both taxes that need reform. It is money out the door that strangles economic growth.”

Ummm, the Obamacare repeal initiative has gone down in flames. Maybe small business owners can look forward to lower tax rates in the future…

Capex hurdles

From a macro perspective, one of the key hurdles to growth is capital investment to spur productivity. But there may be an additional snag. NFIB reported that small business owners were having difficulty hiring and retaining qualified staff. “Many small business owners are being squeezed by this historically tight labor market. They are not confident enough to raise prices on consumers, which limits how much they can increase compensation and makes them less competitive in attracting qualified applicants.”

At the same time, the Atlanta Fed’s Macroblog reported that businesses found that a big hurdle to capital investment was qualified staff to run the machines.
 

 

You see the problem here. The economy needs companies to invest in more, but companies aren’t willing to invest because they can’t find enough people. Moreover, businesses are having trouble raising prices in order to compete for talent. Instead, their margins get squeezed, and they don’t want to expand.

In reality, this sounds like the characteristics of a late cycle expansion. Moreover, the latest release of Markit US PMI saw some growth deceleration, which is consistent with Q1 GDP growth at the 1.7% level (via Markit).
 

 

Similarly, we are also seeing signs of lower growth expectations from the bond market. The yield curve is starting to flatten, which is reflective of the bond market`s expectations of lower growth.
 

 

In effect, the surge of optimism underlying much of the Trump rally is over. But does this doesn’t mean the bull market is over.

Global growth tailwinds

The bulls can be comforted by the following factors which can put a floor on stock prices. Firstly, the post electoral Trump rally was not just spurred by the expectations of tax cuts and deregulation. The fundamentals had been improving before the election – and the scope was broad and global.

I had already written about the growth tailwinds from China (see China’s revival and what it means), but the surge in growth can be found in Europe a well. Friday’s release of European PMIs surprised to the upside, which bodes well for employment and growth in the eurozone.
 

 

In the US, the latest update of forward 12-month EPS estimates from Factset have kept on rising, which reflect greater optimism about improving fundamentals (annotations are mine).
 

 

Sure, the market looks pricey based on forward P/E. However, a 5-10% correction would put valuation back into a reasonable level. (If you are afraid of a 5-10% pullback, then equity investing not for you).
 

 

Better news ahead

In addition, investors should see better news in the near future. The market’s focus is likely to shift back to tax reform by May, according to Trump’s budget director Mick Mulvaney (via Reuters):

A detailed version of President Donald Trump’s budget to be released in May will lay out plans to eventually erase U.S. deficits, White House budget director Mick Mulvaney said on Sunday.

“We’re getting into that now. By May, I think it’s mid-May we’re shooting for right now, we’ll have that larger budget…” Mulvaney said on NBC’s “Meet the Press” program.

In addition, Bloomberg reported that Treasury Secretary Steve Mnuchin is aiming for a complete tax overhaul proposal by the August recess, though he acknowledged that the August deadline might be overly ambitious. Bottom line, the market will be thinking about tax cuts again by May. The subtext of the failure of the Republican controlled Congress to repeal ACA is that while it will make tax reforms more difficult, it makes a simple package of tax cuts, such as offshore cash repatriation incentives, more easily achievable. That’s a very bullish outcome.

As well, we should see some better news from Europe. The second round of the French presidential election is scheduled for May 7. The first round of voting will occur on April 23, and the top two candidates with the most votes will go to the second round. Despite all of the nervousness about populism in Europe, centrist Emanuel Macron is expected to prevail over Marine Le Pen. As this chart of the OATs-Bunds spread shows, political risk is falling and the market is already starting to discount a Macron victory.
 

 

The latest update of insider activity from Barron’s shows this group of “smart investors” remain relatively upbeat on stocks. This, along with the other factors mentioned so far, should keep any corrective action relatively shallow.
 

 

Don`t panic. It`s only a minor correction, not the start of a major bear market.

Correction ahead

However, expect some choppiness in the near term. The SPX has suffered some technical damage by violating a key uptrend. Such episodes usually resolves themselves with either a period of sideways consolidation or correction. The most logical first support level would be the 50 days moving average, currently at 2330. After that, the first Fibonacci retracement target is at 2280.
 

 

On an intermediate term basis, then there just doesn’t seem to be enough fear to make a durable bottom. I wrote about some bottom spotting models for traders last week (see Three bottom spotting techniques for traders). None of those models have flashed fearful oversold readings yet.

Indeed, the CNN Money Fear and Greed Index has been falling and stood at 30 as of Friday’s close. Historically, the market has bottomed with this index falling below 15.
 

 

Various measures of risk appetite have been rolling over and they are now in decline. Until these metrics start to form a bottom, it’s hard to call the end of the correction.
 

 

Tactically, we have to allow for the possibility that the market may fake out bulls and bears alike by rallying up to test its highs before falling again to make a final corrective low. Ryan Detrick of LPL Financial pointed out that the SPX saw its first 1% drop after a 109 trading streak without a 1% drop. Though the historical count is low (N=12), such episodes has typically seen a strong rebound afterwards.
 

 

In all likelihood, the correction isn’t over but volatility is rising. Longer term, however, the broad based Wilshire 5000 remains on a buy signal. These conditions are consistent with a correction in an uptrend.
 

 

My inner investor remains bullishly positioned. He expects further highs in the major indices once the market gets over its current bout of anxiety. There are no signs of a recession on the horizon – and recessions are sure fire bull market killers.

My inner trader remains short (see Sell St Patrick’s Day?). However, he is getting ready to resize his positions and to recalibrate the risk profile of his holdings in light of the probable higher volatility ahead.

Two broad possibilities exist for the week ahead. A bear flag may have formed in the SPX hourly chart late last week, which broke down with bearish implications. He is watching to see if the market breaks support, defined as the lows of last week. A support break would have bearish implications, with targets at the 50 dma (2330) and further at the Fibonacci retracement level of 2280 (see above).
 

 

On the other hand, should support hold and the market rallies, we could also see a possible test of the highs before the correction is complete (see Ryan Detrick analysis above).

Disclosure: Long SPXU, TZA

Three bottom spotting techniques for traders

Posted by Cam Hui -

Mid-week market update: Regular readers will know that I have been tactically cautious on the market for several weeks, but can the blogosphere please stop now with details of how many days it has been without a 1% decline?
 

 

The market fell -1.2% on Tuesday with no obvious catalyst. Despite today’s weak rally attempt, Urban Carmel pointed out that the market normally sees downside follow-through after 1% declines after calm periods.
 

 

Within that context, I offer the following three approaches to spotting a possible market bottom, with no preconceived notions about either the length or depth of the correction.

The Zweig Breadth Thrust oversold setup

The Zweig Breadth Thrust (ZBT) was originally conceived by Marty Zweig as a momentum buy signal for markets rocketing upwards (via Steven Achelis at Metastock):

A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

However, the setup for a ZBT can be a useful signal of a deeply oversold market. While we are not there yet, It is something to keep an eye on (use this link if you want to follow along at home).
 

 

Watch the VIX!

The recent low level of the VIX Index, at least by historical standards, has been puzzling. Nevertheless, the VIX does tend to spike during periods of market stress, and this episode should be no different.

I have been watching for an oversold condition, defined as the VIX rising above its upper Bollinger Band. So far, that hasn’t happened yet.
 

 

A mean reversion below the upper BB once the VIX has achieved the market oversold reading has been a reliable buy signal, as this study shows.
 

 

If you want to follow along at home, use this link for real-time updates.

Trifecta bottom spotting model

Finally, regular readers will be familiar with my Trifecta Bottom Spotting Model (click link for full details). The model uses the following three components to see if a market is oversold:

  1. VIX term structure: Everyone knows about the VIX Index as a fear indicator, but did you know about the term structure of the VIX? The VIX Index is the implied volatility of nearby at-the-money options. There is an additional index, the VXV, which is the implied volatility of at-the-money options with a three-month term. When the VIX/VXV ratio is above one, it indicates that anxiety levels in the option market is much higher today that it is in the future, which is an indication of excessive fear. The term structure of the VIX is far more useful as a sentiment indicator than sentiment surveys as it measures what traders are doing with their money in real-time.
  2. TRIN: The TRIN Index compares the number of advancing/declining issues to the volume of advancing/declining issues. When TRIN is above 2, selling volume is overwhelming even the advance/decline ratio – that is a sign of fear-driven and price-insensitive margin clerk market.
  3. Intermediate-term overbought/oversold indicator: The Trader’s Narrative showed me one of my favorite intermediate term overbought/oversold indicators. It is calculated by dividing the number of stocks above the 50 day moving average (dma) into the 150 dma. In effect, this ratio acts as an oscillator showing how quickly the market is moving up, or down. A reading of 0.5 or less usually marks an intermediate-term oversold condition.

In the past, the simultaneous trigger of all three components within a 2-3 day window of each other has been an uncanny signal of a market bottom. Even the trigger of two of the three components, which I call an Exacta Signal, has been pretty good. Right now, we are nowhere close (click this link if you want to follow along at home).
 

 

The caveat to the Trifecta Bottom Spotting Model, as well as all of the other models, is that they are oversold indicators. Oversold markets can, and do, get more oversold. So these models not totally infallible. Nevertheless, the use of these three tools should be able to allow traders to spot the likely inflection points in this market.

My inner trader has been short the market, and he is enjoying the ride.

Disclosure: Long SPXU, TZA

China’s revival and what it means

Posted by Cam Hui -

I was reviewing RRG charts on the weekend (click here for a primer on RRG charting) using different dimensions to slice and dice the market. When I analyzed the regional and country leadership, I was surprised to see that the dominant leadership were all China related (note that these ETFs are all denominated in USD, which accounts for currency effects).
 

 

From a global and inter-market perspective, this is bullish for the global reflation trade.

Strength from “Greater China”

Indeed, the stock markets of China and of her major trading partners, which I will call “Greater China”, have all been performing well. All are holding above their 50 day moving averages (dma) and several have rallied to new highs.
 

 

What about re-balancing the economy? Macro level data suggests that rebalancing from investment to household consumption is under way.
 

 

For a “real time” market based assessment, this chart of “new consumer China” vs. “old financial and infrastructure” China pairs trades also shows the ascendancy of the New China.
 

 

What doom and gloom?

There have been a number of negative stories written about China recently, from myself included. But the data seems to be turning around. I had highlighted tanking China Economic Surprise Index (ESI), which measures whether macro reports are beating or missing expectations. China’s ESI appears to be enjoying a rebound.
 

 

Tom Orlik at Bloomberg observed that property prices are picking up again. If they continue to rise, it could spur higher growth estimates.
 

 

To be sure, Callum Thomas recently highlighted the leading effect of interest rates on Chinese property prices. Based on this chart, property prices are likely to plunge in late 2017.
 

 

For now, the reflationary party is in full force. Undoubtedly the Chinese leadership wants to hold everything together until their autumn meeting when Xi Jinping can consolidate power. Problems like falling real estate and their effects on an over-leveraged financial system can wait another day.

There is still time to party.

Rate hikes ≠ The Apocalypse

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.

Pundits vs. the bond market

As expected, the FOMC delivered a rate hike last week, From the bond market`s perspective, you would have thought that the Fed cut rates. The stock market rallied, and bond yields fell.
 

 

From the viewpoint of some of the pundits, I thought that the Apocalypse was at hand. David Rosenberg warned that “There have been 13 Fed rate hike cycles in the post-WWII era, and 10 landed the economy in recession”.

Not to be outdone, Bill Gross said that “Our highly levered financial system is like a truckload of nitro-glycerin on a bumpy road”.

What’s going on? Who is right, the bond market, or the pundits?

The bear case

Let’s start with the risks. Focusing strictly on the US, Ned Davis Research studied past tightening cycles and categories them as either fast or slow. They found that the current rate hike cycle is most like the ones that began in 1946 and 1963 (highlighted in yellow).
 

 

If history is any guide, then expect the forward one year equity performance to be about -10%.
 

 

David Rosenberg identified 10 key risks to the stock market in a note published Friday:

  • Valuations are stretched
  • Leverage is extended
  • Retail investors are suddenly rushing to buy
  • The technicals are showing vulnerability
  • Investors are complacent
  • The Fed is raising rates
  • Inflation is picking up
  • The gap between economic growth and sentiment is large
  • Households have over-ownership of stocks
  • Credit markets are frothy

Bill Gross also elaborated on the risks facing the global financial system in a recent CNBC interview. It’s not just about the Fed, but the global reflationary trend and the dampening effects of the re-synchronization of monetary policy:

Monetary policy in both Europe and Japan is causing international investors to buy U.S. Treasurys, he explained.

The European Central Bank is currently buying 80 billion euros ($85.7 billion) a month in bonds and Japan’s 10-year is pinned at zero to 10 basis points, said Gross, who runs the Janus Global Unconstrained Bond Fund.

“Once [ECB President Mario] Draghi begins to taper, that probably won’t happen for a few months, but once he begins to taper and reduce that $80 billion a month, once that zero to 10 basis point cap is eliminated in Japan, then hell could break loose in terms of the bond market on a global basis,” he told “Power Lunch.”

Reuters reported that China has already followed suit by raising rates in the wake of the FOMC decision. I wrote before that we are already seeing upside inflation surprises all around the world (see 3 steps and a stumble: The bull and bear cases).
 

 

This chart (via Credit Suisse) shows the scale of monetary accommodation around the world. It is only a matter of time before other central banks ease off their extremely easy monetary policies.
 

Global central bank balance sheets

 

In light of the medium term upward pressure on interest rates, Ned Davis Research expressed concern about what that would do to debt service ratios as rates rise.
 

 

I did some back of the envelope calculations, using this chart from the JP Morgan Asset Management’s excellent quarterly review. Currently, household balance sheets are in good shape, with debt service ratios and net worth in healthy positions. But if we were to assume that everyone pays a floating rate debt at the prime rate and disposable income remains unchanged, then a 75bp increase in rates in 2017 would raise debt service costs by 28%. Household debt service ratios would surge to levels last seen just before the Great Financial Crisis, and the household sector would be very stressed. The caveat to this analysis is not everyone has floating rate debt, and most pay a rate higher than prime, so the percentage increase would be lower. Therefore the 28% rise in interest expense should be regarded as a worst case analysis. The actual figure would probably fall somewhere within the box shown in the figure below.
 

 

So far, this is a “this will not end well” investment story, with no immediate bearish trigger. Investors should relax. This is not Zero Hedge. Rate hikes are not the Apocalypse. Don’t panic, and watch the data.

Here is what I am watching.

Rising consumer stress

The biggest risk to the stock market is a Fed policy mistake that tightens monetary policy in the face of economic weakness. Such an error would push the economy into recession. Despite Janet Yellen’s assertion that the economy is doing fine, there are some signs of incipient weakness on the consumer front. Wages are starting to lag behind inflation (yes, I know the chart shows headline CPI, but households have to eat, drive, and heat their homes).
 

 

When the consumer stops making progress on real wage gains, they have a number of coping mechanisms in order to keep the party going. One simple way is to save less. As the chart below shows, the real savings rate is retreating, but not to danger levels. This metric has fallen to zero just before the last few recessions but remains positive today.
 

 

New Deal democrat observed that households are tapping home equity as another way of coping with the lack of progress in real wages. When consumers run out of ways to cope with falling real incomes, a recession develops. For now, real retail sales has been holding up well. This indicator has turned down ahead of past recessions – so the party is still going.
 

 

As well, consumer confidence remains upbeat. These readings reflect greater confidence and a willingness to spend. Households want to party, despite signs of rising stress on their finances.
 

 

Another way of thinking about how consumers cope with financial stress was addressed by the New York Fed’s Liberty Street Economics blog, which asked the question: When debts compete, which wins? As the chart below shows, households stopped paying mortgages (gold line) in the wake of the Great Financial Crisis as real estate prices tanked and strategic mortgage defaults mounted. More recently, they’ve been lowering the priority on their car loans (blue line) in favor of mortgages. As long as the housing market holds up, it is difficult to envisage a scenario of sufficient consumer stress consistent with a recession.
 

 

That’s why housing is such an important cyclical sector of the economy. A slowdown in housing has accompanied every past recession. So far, housing starts remain robust, though mortgage rates have ticked up (red line, inverted scale on right). In effect, the housing party is still going.
 

 

Since stressed households appear to be giving a lower priority to car loans, then vehicle sales will be a key cyclical indicator. The progress of vehicle sales is an emerging dark cloud on the horizon, as they seem to have peaked and may be in the process of rolling over. I do not regard this development as a definitive signal of weakness and it would only be a very early warning sign.
 

 

Another key indicator to watch is the growth in money supply, which is especially important when the Fed is committed to a tightening cycle. M2 growth was part of the group of leading indicators, but got dropped because it wasn’t as predictive as expected. Nevertheless, real M1 growth has dipped below zero and real M2 growth has dipped below 2.5% before past recessions. While these indicators are slowing, they are not flashing danger signals yet. Something to keep an eye on.
 

 

Don’t fight the tape

For the time being, the stock market is enjoying the reflation party. The message of powerful momentum from the market is, “Don’t fight the tape.” Global stock markets have been on a tear. Recently, the Dow Jones Global Index has made a new high, with European indices rallying to new recovery highs.
 

 

Over in Asia, the Chinese market and the markets of China’s major Asian trading partners are all looking very healthy. Of particular interest is the cyclically sensitive South Korean market, which shrugged off the impeachment of its president and rallied to a new high.
 

 

Another cyclically sensitive indicator, the industrial metals, fell below its 50 dma, but eventually rallied to hold above that key support.
 

 

The fundamental driver of stock prices, namely earnings, are still going strong. The latest update from Factset shows that forward 12-month EPS is still rising. These readings are also consistent with the observations by Brian Gilmartin, who also sees a pattern of rising EPS estimates. The party is still going, according to Wall Street.
 

 

All of these readings are consistent with New Deal democrat’s latest observations of strength in coincident and short leading indicators, but long leading indicator are starting to roll over from positive to neutral territory. There is no need to panic and sound a recessionary alarm (yet).

Peak reflation growth?

Even though there has been a surge in reflationary growth around the world, the magazine cover of The Economist which accompanies this story about a synchronized global recovery, provides a sobering contrarian magazine cover warning.
 

 

The bulls should relax. Some time ago, The Economist highlighted a study by Citigroup analysts showing that Economist covers were ineffective as contrarian indicators after six months, but works well on a one-year horizon:

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

In other words, the reflation growth party is still going for the next six months.
 

 

The week ahead: The start of a correction?

In the near term, there are a number of ominous signs of equity weakness ahead. I pointed out on Friday that a number of broad based indices have violated their uptrends, which suggests a period of either sideways consolidation or correction.
 

 

In addition, Rocky White at Schaeffer’s Research noted that the DJ Transports had significantly underperformed the DJ Industrials in the last three months.
 

 

While this is not technically a Dow Theory sell signal, past episodes have led to market weakness.
 

 

The Fear and Greed Index has plunged below the neutral 50 level, which is usually an indication that it will move to a “fearful” oversold reading. Such readings generally only occur during corrections.
 

 

Lastly, Tim Duy observed that there are a total of 11 Fed speakers next week. As the market has already interpreted the rate hike as a dovish hike, it’s difficult to see how much more dovish the Fed could get. They have already committed to a tightening cycle and penciled in three rate hikes for 2017. Equity risk is therefore tilted to the downside.

My inner investor remains bullishly positioned. He thinks that the highs for this bull cycle have not been achieved yet. My inner trader re-entered his short positions on Friday (see Sell St. Patrick’s Day?).

Disclosure: Long SPXU, TZA

Sell St. Patrick’s Day?

Posted by Cam Hui -

I hope that you are enjoying the stock market rally this week. My inner trader covered his short positions last week and stepped aside to await a better short re-entry point. St. Patrick’s Day may be it.

Ryan Detrick pointed out that St. Patrick’s Day is one of the most positive days of the year, though as of the time of this writing, the market has been flat.
 

 

As well, Rob Hanna at Quantifiable Edges highlighted March option expiry week (OpEx) is one of the most consistently bullish OpEx weeks of the year. As I will show later, OpEx+1 week tends to mean revert and see market weakness.
 

 

The latest readings from Index Indicators show that the market is rolling over after flashing a short-term overbought reading.
 

 

In addition, a number of broad based indices had violated their uptrends, which is setting up the market up for a period of correction or consolidation.
 

 

Risk appetite, as measured by the junk bond market, is flashing a minor negative divergence.
 

 

When I put these conditions together with my own study of OpEx week, it adds up to a tactical sell signal on the stock market.

OpEx study

While I am indebted to Rob Hanna for his studies of OpEx week, I decided to go further and see how the market behaved during OpEx week and afterwards. I have always been a little wary of these calendar studies, there are well known reasons for unusual market activity during the week. Market players often try to “pin” indices to certain levels in order to their advantage, so that either their long positions are in the money, or their short positions expire worthless.

The table below shows the behavior of the market during different OpEx weeks during the year. Based on this data, I can make the following observations:

  • OpEx weeks tend to outperform
  • OpEx+1 weeks, or the week after OpEx, tend to underperform
  • The greatest mean reversion from outperformance to underperformance occur in March and September
  • December OpEx is special, as OpEx+1 tends to show positive returns, possibly as a reflection of the seasonal Santa Claus rally at that time of the year

 

 

For a different perspective, here is a chart of the median returns by month. It tells the same story of the outsized mean reversion return characteristics in March and September.
 

 

And a chart of % positive by month.
 

 

Today is the last day of March OpEx, and the week has been positive for stocks. I went further and asked the question, “What are the returns of OpEx+1 week when OpEx week was positive?” As it turns out, OpEx+1 week returns are worse than all OpEx+1 weeks when OpEx week is negative.
 

 

Here is equity curve chart for March OpEx, OpEx+1, and a long/short strategy of buying OpEx and shorting OpEx+1.
 

 

Based on all of the aforementioned factors, the market is poised for some short-term weakness of unknown magnitude. My inner trade therefore re-entered his short positions today.

Disclosure: Long SPXU, TZA

3 steps and a stumble: The bull and bear cases

Posted by Cam Hui -

Mid-week market update: It was no surprise that the Fed raised rates, as they had spent the last month widely telegraphing their intentions. This morning’s release of February CPI tells the story. Headline CPI is near a 5-year high. Though core CPI (ex-food and energy) edged down, the latest reading of 2.2% is above the Fed’s 2% targeted inflation rate.
 

 

The big surprise was the dot plot, which the market anticipated would edge upwards. Instead it remained mostly unchanged for 2017, though rate expectations were nudged up for next year.
 

 

Since this is the third rate hike for the Federal Reserve, the key question for equity investors is whether they should be concerned about the traders’ adage of “three steps and a stumble” (via MTA):

Similar to Zweig’s Fed policy indicator and in line with the desire to measure when the Federal Reserve is tightening credit, Edson Gould, a legendary technical analyst from the 1930s through the 1970s, developed a simple rule about Federal Reserve policy that has an excellent record of foretelling a stock market decline. The rules states that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback” (Schade, 2004). This simple rule is still relevants. Although it tends to lead a market top, it is something that should not be disregarded.

Here are the bull and bear cases under “three steps and a stumble”. In particular, the current economic cycle is elongated and shallow compared to past recoveries, and therefore it would be premature to worry about Fed actions to cool down the economy just yet.

The bull case for stocks

Jim Paulsen at Wells Fargo Asset Management summarized the bull case well by arguing that it’s far too early to worry about the effects of rising rates on stock prices:

When assessing the impact rising yields may have on the stock market, obviously it is important to gauge whether investor mindsets are primarily focused on inflation or deflation. Rising interest rates in a world where investors worry about inflation (i.e., when the correlation in Chart 1 is negative) is typically damaging for both the stock market and the bond market. However, if the predominant concern is deflation (i.e., when the correlation is positive), when yields rise, the stock market often performs well.

In the last year, bond yields have risen and the Fed now appears poised to raise the funds rate for a third time this week. Does this mean the stock market is headed for a stumble? Perhaps, but as shown in Chart 2, as long as the correlation between the stock market and bond yields remains so positive, history suggests it is more likely that the stock market simply keeps climbing as yields rise.

When stock and bond correlations are high, the market is worried about deflation. Therefore stock and bond prices move together. When the Fed first raises interest rates (which is usually in response to rising inflationary pressures), that’s good news for stocks because rising inflation implies better growth.
 

 

Paulsen divided the above stock bond correlation chart into quintiles. He found that stock prices tend to perform well when bond yields rise in the top quintile, which is where we are now.
 

 

In a separate analysis, Paulsen showed that stock have tended to perform very well when the Global Economic Surprise Index (ESI) is high. (For newbies, the ESI measures whether high frequency economic data is beating or missing expectations),
 

 

Currently, Citigroup Global ESI readings are very upbeat.
 

 

In conclusion, investors should not worry about the intermediate term outlook for equity prices when growth is rising, even in the face of rising interest rates.

The bear case

There are a number of cracks in Paulsen’s bull case for equities in the current rising rate environment. First of all, inflation is rising, and it is just a matter of time before central bankers act decisively to head off an inflationary spiral. The chart below of Citigroup’s Inflation Surprise Index shows that the inflation surprise trend is global in scope. US inflation, which is the Fed’s focus, is a laggard among the major economies of the world.
 

 

Paulsen also focused the global ESI as a way of defining the equity return environment. While the global (G10) ESI remains upbeat, the synchronized global recovery isn’t that global anymore. In particular, Asia is starting to weaken. Here is the Japan ESI:
 

 

Here is the China ESI, which has recently plunged precipitously.
 

 

Bloomberg reported that Goldman Sachs strategists are getting concerned about equities because the global reflation cycle may be peaking:

“With growth momentum nearing its peak and rates increasing further with a hawkish Fed, the asymmetry for equities is turning increasingly negative,” Goldman analysts including Christian Mueller-Glissmann wrote in a note for institutional clients. “A slowing cycle makes equities more vulnerable to higher rates and also shocks, e.g. from European politics, U.S. policy, commodities or China.”

In addition, the current low volatility environment makes stock prices vulnerable to an violent unwind should the environment shift to risk-off:

The Goldman analysts also warned about trading dynamics in equities. Historically low volatility has pulled in “risk parity funds” that take their cue from risk levels, according to the team. “Commodity trading advisors” who gauge trends or momentum and use futures also tend to pile in to markets with low volatility and established trends, they wrote.

“In the event of a reversal of the trend, these systematic investors are likely to reduce equity exposure quickly, which could exacerbate an equity drawdown and result in a faster and larger volatility spike,” the Goldman analysts wrote.

Getting late in the party

I interpret these readings as the party is still going, but it’s getting late in the evening. It may be more appropriate to reset the timing of the first rate hike on the “three steps and a stumble” rule set last December’s raise as the first hike, with today’s as the second.

Paulsen is correct in that the rising growth outlook during the initial stages of a rate hike cycle overwhelms the negatives of rising interest rates. On the other hand, Goldman Sachs is also correct in their assessment of a deteriorating inflation and growth outlook. Don’t overstay the party.

The key canary in the coalmine to watch is the yield curve. A steepening yield curve is an indication that the market expects better growth, while a flattening yield curve suggests that monetary policy has become aggressive and growth is likely to slow. The 2/10 yield curve had been steepening into the Fed meeting, but flattened in the wake of the FOMC decision, I am always wary of noisy instant market reactions. It’s always better to wait a few more days to see if the trend holds.
 

 

I remain of the view that US equity market highs have not been seen in this cycle. Therefore an SPX target of in the 2500-2600 range is still achievable as the ultimate peak for this year and for this bull market cycle.
 

 

But beware! The market is intermediate term overbought. Broad based indices like the Wilshire 5000 and Value Line Geometric have violated key uptrends, which may be a signal for a correction or consolidation. A 5-10% pullback could happen at any time.
 

 

Be prepared for volatility, but my inner investor is getting ready to buy any dip as long as the yield curve doesn’t sound any alarms.

To BAT or not to BAT? Trump’s tax reform dilemma

Posted by Cam Hui -

As the market awaits the FOMC decision and statement this week, there are a number of other critical market moving events to watch for. The Trump White House is expected to release its “skinny budget” this week, which may contain some broad outlines of the tax reform package. In addition, Angela Merkel’s White House visit Tuesday could bring important news on the trade front.

Donald Trump came into office promising a series of tax cuts and offshore cash repatriation incentives for Wall Street. But tax cuts have to be offset with either revenue increases or spending cuts. Trump adviser Gary Cohn recently stated on CNBC that the White House is aiming for to be revenue-neutral over a 10-year period. As this chart from Morgan Stanley shows, this level of fiscal stimulus is highly unusual at this point of the economic expansion.
 

 

The main strategy for paying for the many of the proposed tax cuts is the imposition of a Border Adjustment Tax (BAT), which will penalize imports while encouraging exports. The BAT proposal, however, is likely to run into a number of major objections from America’s largest trading partners.

Those objections have come from Canada, which is America’s biggest customer, and from Germany, the sixth largest (chart via CNN Money).
 

 

Last week, Canadian prime minister Justin Trudeau spoke at a Houston energy conference and cautioned that a BAT would be bad for all parties (via Bloomberg):

A levy on goods imported to the U.S. would damage business on both sides of the northern border and could impede the growth of energy, automobile and steel industries that benefit from bilateral cooperation, Trudeau said at a press conference in Houston.

“A border adjustment tax would be bad not just for Canada but for the United States as well,” the prime minister told reporters Friday. “No two countries in the world have the close friendship, alliance, relationship and level of economic integration that Canada and the U.S. have.”

German chancellor Merkel is expected to be far less diplomatic than Trudeau.

EU objections to BAT

Der Spiegel reported that Angela Merkel is expected to warn about a potential trade war if the US were to impose a BAT. Undoubtedly she will not only be speaking on behalf of Germany, but the rest of the European Union as well.

On her first visit with Trump, Merkel plans to be very open about her views on the tax plans. Her preparatory paper for the meeting states that she plans to call the punitive import measure a “protective tariff” and the tax relief for American exports a “export subsidy.” She views both as being hostile acts that could trigger a trade war.

Merkel also plans to note that a levy like that would violate the pre-existing tax agreement between Germany and the U.S. They would also be out of compliance with World Trade Organization rules. The implicit threat is that Germany would not shy away from lodging a complaint with the World Trade Organization (WTO).

If none of that bears fruit, the Chancellery has begun reviewing ways it could strike back at the U.S. One idea would be to incrementally increase duties on American imports. Agreements reached within the World Trade Organization framework provide enough maneuvering room to allow for that. Another possibility would be to allow German companies to write off the U.S. import tax on their German tax declarations, thus compensating them for their competitive disadvantage.

Can a tax reform legislation that includes a BAT make it through Congress over the objections of America’s biggest customers?

A 170% tax rate?

Here is the clincher. The CEO of JC Penney recently stated in CNBC interview that a border tax would raise its effective corporate tax rate from 34% to 170%:

When asked if it was possible to operate in the black if the proposal goes into effect as written, Ellison said simply, “It will be very difficult. In the short run, virtually impossible.”

J.C. Penney has run its financial models and Ellison said its tax rate swells exponentially.

“It takes our tax structure, as an example, from roughly a 34 percent corporate tax to over 170 percent,” he explained. “So that gives you an idea of the financial impact to a company like J.C. Penney. And that’s very consistent with other companies, companies like Best Buy, Target, Kroger, Wal-Mart — I mean, you name it, we’re all in this same precarious position because we don’t have a manufacturing capacity that exists in the United States.”

Such a proposal amounts a decision to carpet bomb the retailing industry. Either retailers have to go out of business, or prices that consumer pay would have to go up – a lot. Either way, employment in that sector would shrink.

For some perspective, here is a comparison of employment in retailing compared to manufacturing. I doubt that the Republican rank-and-file in Congress have the stomach to devastate the retailing industry like that, especially as it looks ahead to mid-term elections.
 

 

In all likelihood, either the tax cuts proposals will get watered down considerably, or Trump will opt for a “damned the torpedoes” approach and try to pass the tax cuts without any offsetting tax revenue. In the former case, stock prices will fall due to disappointment as much of the tax cuts have been priced in. In the latter, expect an inflationary boom and blow-off before the Fed responds with a series of rapid rate hikes that crash the economy and the market.

Be prepared, and pick your poison.

A toppy market, but not THE TOP

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.

Valuation and sentiment vs. momentum

Last week, I wrote about signs of stretched stock market valuation (see  Why I am cautious on the market). Last Wednesday, I warned about excessively bullish sentiment, which suggests that stock prices are likely to pull back (see A sentimental warning for bulls and bears).

Despite these red flags, I would caution that both valuation and sentiment models are notoriously bad at timing market tops. Expensive markets can get more expensive, and stock prices don`t necessarily go down if investors get into a crowded long. These models serve the highlight the risks to a market.

Here is another take on valuation. Taking a very long term 30-year view, Urban Carmel observed that the SPX goes up and down in fits and starts after adjusting for inflation. The key to achieving superior long-term returns is to buy when valuations are low, which is not the case today.
 

 

Michael Batnick at Irrelevant Investor showed that the Cyclically Adjusted PE ratio (CAPE) is elevated when compared to its own history.
 

 

But average CAPE has been rising over time.
 

 

If valuation doesn’t work for short term market timing, what should investors do? In the intermediate term, a focus on fundamental and macro momentum in addition to factors like valuation and sentiment. Current conditions can more useful for market timing. Using this framework, it suggests that risks are rising, but there is no need to panic just yet.

The market is looking toppy, but this is not “the top”.

Another valuation perspective

Matt Busigin wrote a terrific piece of analysis last June that outlined a framework for valuation analysis that related returns to valuation and profit growth. In particular, his approach of using inflation adjusted metrics has shown itself to highly useful (also see this post from Wesley Grey that uses inflation adjusted CAPE for successful asset allocation).

Busigin outlined his model this way (LERP = Leveraged Equity Risk Premium, see this link for the paper explaining the concept). Note that his model forecasts 5-year returns and the fit is pretty good, with an R-squared of about 0.7.

Asset returns can be considered a function of the differential between expected real earnings growth, and realised real earnings growth. This can be borne out by solving for future S+P 500 alpha over short-term corporate bonds, using starting valuation (LERP), realised inflation, and realised EPS growth:

 

Busigin plugged in the (then) inflationary expectations from the bond market to derive an implied earnings growth rate of 6%, which he found problematical. Profit margins were likely to get squeezed as labor costs rise in the late stages of an expansion. (Remember he wrote this last June, when Clinton was the consensus pick for the White House. Trump’s “America First” policies are likely to put more upward pressure on wages).

The past 5 years of NGDP growth have compounded annually to 3.65%. If we extrapolate that, to get to our 6.34% EPS growth, we need profit share of GDP to rise around 84bps.

There are a few problems with this scenario. The most immediate is that the profit share of GDP is falling, and precipitously — from its peak of nearly 11% in 2012, it has fallen to almost 9%.

That analysis was done in June 2016. Busigin updated his model recently with a series of tweets:
 

 

Based on Busigin’s analysis, the market is pricing in real EPS growth of 5%, which is roughly of 75th percentile of historical experience. But real unit labor costs is in the 96th percentile. The Fed is about to embark on a rate hike cycle, something has to give.

Soft vs. hard data

I have been writing about the bifurcation between soft (expectations) data and hard (reported) data (see Watch what they do, not just what they say). Variant Perception recently reiterated that point, namely that expectations are running ahead of reality and stock prices are vulnerable to a pullback.
 

 

Goldman Sachs also highlighted the gap between asset prices and the economy (via Tracy Alloway).
 

 

The music is still playing

Before you get overly excited, most of the cases where Variant Perception highlighted disparities between expectations and hard data were resolved with corrections, not bear markets. For a bear market to occur, the Fed has to tighten sufficiently to push the economy into recession, which is not happening yet.

In the words of Jamie Dimon, the music is still playing. There is still time to get in another dance, another visit to the bar, or the buffet table.

David Tepper of Appaloosa Management summarized the bull case well, even as he acknowledged the challenge of stretched valuations (via Marketwatch):

“The day we had three Republican ‘houses’… that alone releases animal spirits,” Tepper said, referring to Republican Trump’s Oval Office victory over Democratic rival Hillary Clinton and both the House and Senate under GOP leadership.

“It is hard to go short when you say…when the punch bowl’s still full,” he told CNBC during a Wednesday morning interview.

Tepper said equity valuations may be pricey presently, but said a better economic environment across the globe has provided stock-market benchmarks purchase to climb higher.

“I don’t think the market’s cheap by any stretch…but look at the backdrop around the world…with the sugar that is still being put on by the [European Central Bank], the Bank of Japan…you can’t be short in that kinda set up,” he said. Tepper is referring to quantitative-easing measures that are still in use in the eurozone and Japan.

The consensus view seems to be in the Tepper camp. The latest BAML Fund Manager Survey shows that managers believe that stocks are overvalued.
 

 

But managers are still long risk, with an overweight in equities, underweight in bonds, and neutral weight in inflation and cyclically sensitive commodities.
 

 

That’s because they believe that the global reflationary trend will continue.
 

 

New Deal democrat has been monitoring high frequency economic releases and splits them into coincident, short leading, and long leading indicators. His recent analysis shows that virtually all of his short leading indicators are all pointed upwards, though his long leading indicators are starting to deflate. As the Fed starts its rate hike cycle, the long leading indicators are likely to weaken further. Current readings indicate that fundamental and macro momentum are likely to be positive for the remainder of 2017.

As well, the yield curve has been steepening even as the market anticipates a tighter monetary policy. A steepening yield curve is a signal that the bond market is expecting better economic growth.
 

 

Bottom line: Despite any concerns over stretched valuations, the music is still playing.

Investment implications

For a big picture perspective, here is Jean-Paul Rodrigue of Hofstra University, who is the creator of the this chart showing the different stages of an asset bubble (via Business Insider):

“I have given up a long time ago trying to make any precise assessment about market bubbles, particularly their blow-off, since a lack of rationality is more the norm than the exception these days,” Rodrigue said.

Based on the stages he outlined, though, the market is most likely somewhere between “enthusiasm” and “delusion,” before the top, he said. It’s just impossible to know how long it’ll take to peak.

 

For investors concerned about valuation excesses, I have a number of suggestions. If I had still been managing institutional funds, where it can take several months to re-position a portfolio, I would be moving from an aggressive risk-on position to a neutral asset allocation in line with investment policy target weights.

Investors who are not geographically constrained can diversify their US equity weight into foreign stocks. Eurozone equities appear to be more attractive relative their American counterparts (see the Barron’s article Why investors should say ‘oui’ to European stocks). As the relative performance chart of eurozone equities show (all figures in USD), the Euro STOXX 50 is trying to bottom against the SPX. Investors may find better returns from exposure from eurozone equities.
 

 

Ironically, Donald Trump’s anti-EU rhetoric is shoring up support for European integration (see CNN article). So are comments from Trump administration’s trade czar Peter Navarro, who has called for trade negotiations with Germany outside the EU framework (see Reuters), which is as absurd as Cuba proposing a free trade agreement with Puerto Rico.

Europeans have begun to close ranks in reaction. The next big test will be the Dutch election scheduled for next Wednesday. Geert Wilders, the populist anti-immigrant Dutch politician, has been badly losing ground in the polls (via Bloomberg). In France, centrist Emmanuel Macron has been gaining ground. These are all signs of greater European unity and falling political tail-risk in the region, which should be viewed bullishly.

By contrast, UK equities remain in a downtrend against the SPX, which suggests that Britain remains under a cloud until the Brexit question is resolved.
 

 

Investors who are willing to take more risk can consider emerging market equities (see the latest GMO commentary on EM). As the chart below shows, EM equities are also tracing out a bottoming pattern against US equities. These are constructive patterns that point to the potential of better relative performance ahead.
 

 

Toppy, not THE TOP

In conclusion, the combination of stretched valuation and overly bullish sentiment makes this stock market appear toppy, but we probably have not seen the price high for this market cycle yet. Stock prices are vulnerable to a 5-10% correction, but they should rally again as the news of tax cuts and tax reform revive expectations.

Bloomberg reported that GOP senators stated that an August time frame for passing tax reform is unrealistic. More realistic is the Goldman Sachs projection of the Trump administration’s legislative timeline. The White House is currently preoccupied with the details of ACA repeal and replacement. We likely won’t get much action on tax reform until the fall (via Bloomberg):
 

 

Undoubtedly there will many twists and turns on the path along the way between now and then. As well, much depends on the state of the economy and the Fed’s reaction function.

Ultimately, this cycle is not going to be too different from previous cycles. In all likelihood, it will be the Fed’s action to fight inflation that will send the economy into recession. A recession is when valuations will matter the most. Ben Carlson, writing at Bloomberg, highlighted research from Star Capital showing that markets go down a lot more when valuations are expensive than when they are cheap:
 

 

Recessions are also periods when excesses get unwound. While there are few excesses in the American economy, the same could not be said of the rest of the world. In particular, China has been struggling to control its debt growth. As this chart Callum Thomas shows, economies crash harder when debt levels are high.
 

 

In the meantime, investors should channel Janet Yellen, “Remain data dependent.”

The week ahead: Both overbought and oversold

Looking to the week ahead, the market is facing a number of tricky cross-currents. From a technical viewpoint, the market is intermediate term overbought, but short-term oversold. The monthly SPX chart depicts the rare conditions when the market closed above its monthly Bollinger Band, and it was overbought on the 14-month RSI, which are both overbought signals. Even though the sample size is small (N=3), these episodes were resolved in the past with minor corrections and consolidation.
 

 

In the short run, the market has fallen enough to flash an oversold reading, which warrants a bounce. This chart from Index Indicators is typical of the short-term oversold conditions in the market. Friday’s NFP rally could be the spark for a rally up to test the old highs.
 

 

The chart below shows the NYSE McClellan Oscillator (NYMO), which fell last week to an oversold condition last week. Past instances of mean reversion in this index has also typically marked short-term rallies. However, the current episode is different because it occurred with a small decline of less than 2%. It is therefore unclear how much of a bounce the market is likely to see under these circumstances. Please note that the only time this indicator failed in the last three years occurred in September 2014, when NYMO became oversold as the market fell 3%.
 

 

I would also point out that next week is option expiry week. Rob Hanna at Quantifiable Edges pointed out that March OpEx week have tended to be particularly bullish.
 

 

My best guess is the market is poised for a countertrend rally within the context of a correction. The week ahead will see a number of potentially market moving events with binary outcomes that are difficult to forecast. So brace for greater volatility.

  • Dutch election (Wednesday)
  • FOMC decision (Wednesday)
  • Treasury reaches its debt ceiling and will have to take “extraordinary measures” to continue funding the federal government (Thursday)
  • The Trump White House presents its “skinny budget” (estimated to be between Tuesday and Thursday)

My inner investor remains bullishly positioned, though he is starting to get nervous about the market environment.

My inner trader covered his shorts and moved to an all cash position on Friday. In the interest of risk control, he has decided to step aside in light of the likely volatile environment next week.

A sentimental warning for bulls and bears

Posted by Cam Hui -

Mid-week market update: Recently, there have been numerous data points indicating excessive bullishness from different segments of the market:

  • Retail investors are all-in
  • Institutional investor bullish sentiment is off the charts
  • Cash is at a two-decade low in global investor portfolios
  • RIA sentiment are at bullish extremes
  • Hedge funds are in a crowded long in equities

These giddy sentiment readings are comforting to the bear camp (chart via Business Insider) and it will be difficult for stock prices to advance under such conditions. When everyone is bullish, who is left to buy?
 

 

However, I would warn the bears that they should not go overboard and short the market with both hands. In the past, euphoric sentiment has not a good indicator for pinpointing market tops.

Too much bullishness

In the past few days, I have been surprised at the number of reports of excessively bullish sentiment. The latest readings from TD Ameritrade Investor Movement Index shows that retail investor bullishness at an all-time high (annotations in red are mine).
 

 

The Yale School of Management survey of investor confidence, which has been surveying investors for close to two decades, shows that both individual and institutional investor confidence have been surging. In particular, institutional confidence have risen to an all-time high.
 

 

Equally worrisome, Ned Davis Research found that cash is at historic lows in global portfolios (via Bloomberg):

Here’s another way of thinking about how far stocks have come in nine years. Relative to balances in money market funds and cash among mutual fund managers, the value of global equities is the highest in almost two decades.

That observation courtesy of Ned Davis Research, which framed the comparison as an indication “cash is underweight” in Planet Earth’s asset portfolio. Another way of describing it is that equities have risen so much from the depths of the financial crisis that their value is blotting out everything else to an extent not seen since the dot-com bubble…

In a Ned Davis calculation that treats the global investment portfolio as an amalgamation of stocks, bonds and cash, the latter now makes up about 17 percent of investor portfolios, less than half of its allocation in 2009 and close to the lowest since 1980. While bond holdings remained relatively steady over the same period, surging equity values pushed its share to about 60 percent, well above the long-term average.

As a sentiment gauge, the study is a distant relation of popular studies of investor and newsletter-writer optimism or even price-earnings ratios. In the options market right now, the CBOE Equity Put/Call Ratio fell to 0.53 last week, tied for the lowest since Dec. 9 and 20 percent below the measure’s one-year average.

In addition, the latest NAAIM survey of RIAs, who manage the funds of individual investors, show sentiment to be at a bullish extreme (annotations in red are mine).
 

 

Finally, Archaea Capital recently observed that the implied equity exposure of hedge funds show a crowded long reading.
 

 

If the sentiment of individuals, institutions, RIAs, and hedge funds are all at bullish extremes, who is left to buy?

Sentiment an inexact top calling indicator

I would warn the bears, however, that sentiment models have a spotty track record at calling tops. Consider this chart of AAII sentiment (black) and Rydex cash flow sentiment (green). The blue vertical lines are the buy signals indicating periods of panic, while the red vertical lines show the bullish extremes. As the chart shows, the buy signals work much better than sell signals.
 

 

The same story holds for NAAIM sentiment. They are much better at calling bottoms than calling tops.
 

 

Caution, not panic

Most of these studies have only analyzed one single sentiment indicator in isolation. What happens when all the sentiment indicators show excessively bullish readings?

I have no good answer for that, but I interpret these conditions as the market poised for a correction. Ed Clissold of Ned Davis Research (see above) stated: “It’s a way of showing stocks are pretty stretched, but that’s not to say they’re going to go down tomorrow. It just means there’s not a lot of cash to act as a shock absorber. This measure does tend to mean revert over time, and we’re near the low-end of the range, so this ratio will go back up again.”

Art Cashin of UBS recently called for a 5-7% correction on CNBC.

As major indexes hovered in the red Tuesday and some stocks were coming off 52-week lows, Art Cashin told CNBC that the market could be setting a stage for a minor correction.

“It’s a mild warning signal, to tell you the truth,” Cashin told “Squawk Alley.” “When we’ve seen those kinds of moves before, the market has either stalled or actually pulled back somewhat. Not anything climactic, but you could be setting up for [a] 5 to 7 percent pullback.”

In light of the recent technical breaks by the major stock indices, that sounds about right.
 

 

Disclosure: Long SPXU, TZA

A track record update

Posted by Cam Hui -

I have had a number of subscribers ask me to extend the chart of my longer term calls, which had only gone back two years. The chart below shows the highlights of my posts back to 2013, which are intended for investors with a 6-24 month time horizon. I haven’t been always right. On occasion, I was early, late, or simply mistaken.
 

 

Here are the links to the past posts shown in the above chart.
 

A correction, not a bear June 2013
A buy signal from the option market September 2013
Are stocks tumbling too far too fast? January 2014
Global growth scare = Trend Model downgrade July 2014
Onwards and upwards August 2014
3 reasons to get more cautious on stocks September 2014
Getting close to a bottom, but not yet October 2014
Why I am bearish (and what would change my mind) May 2015
Relax, have a glass of wine August 2015
Why this is not the start of a bear market September 2015
The reason why the bulls should be cautious about a January hangover December 2015
Buy! Blood is in the Streets January 2016
Super Tuesday special: How President Trump could spark a market blow-off March 2016
How the S+P 500 can get to 2200 and beyond June 2016
 

In addition, these are the buy and sell calls of the trading model, which are designed for traders with a 1-2 week time horizon. Again, I haven’t been always right. The most recent failure occurred when the trading model got caught long (and wrong) in the correction in late 2015.
 

 

Judge for yourself.

Why I am cautious on the market

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: 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.

An over-valued and frothy market

As the major market indices hit new all time highs, I have become increasingly cautious on the short-term outlook. I view the stock market through the following lenses, and all of them are showing either a neutral to bearish outlook:

  • Valuation
  • Interest rates outlook
  • Growth
  • Psychology

The one wildcard continues to be political developments from Washington. A recent AAII survey indicated that roughly 75% of respondents cited politics as affecting their investment decisions:

This week’s Sentiment Survey special question asked AAII members what factors are most influencing their six-month outlook for stocks. Nearly three-quarters of respondents (73%) cited national politics, particularly President Donald Trump’s polices and what actions Congress may take. Tax reform was mentioned by many (20% of respondents), followed by regulatory reform and uncertainty over what legislation will actually be passed. Just under 23% of all respondents listed the ongoing rally and the prevailing stock valuations, with several of these respondents expressing concerns about the level of valuations or that a drop could be forthcoming. Monetary policy was cited by 8% of all respondents, followed by corporate earnings growth (7%) and investor sentiment (7%). Some respondents listed more than one factor.

Any changes in the path of fiscal or trade policy have the potential to create further market volatility.

An expensive market

There are many ways of measuring market valuation. A number of different approaches are all pointing to an expensive market. I would warn, however, valuation is a poor short-term market timing indicator. As this chart from JPM Asset Management shows, while forward P/E has an inverse relationship with subsequent returns, the R-squared of the relationship with a one-year return is a low 10%, indicating that P/E explains 10% of actual returns. By contrast, the R-squared of forward P/E against five-year return is a much higher 42%.
 

 

Nevertheless, plenty of valuation metrics are flashing warning signs. The SPX EV to EBITDA ratio, is at nosebleed levels that are comparable to Tech Bubble era.
 

 

A more sophisticated valuation model is the Morningstar Fair Value Estimate, which shows the market to be about 4% overvalued. In the past, the stock market has experienced difficulty advancing when readings get this high.
 

 

Another indirect way of discerning whether the market is over or under valued is through the behavior of corporate insiders. This group of “smart investors” are not day or swing traders. They invest with longer time horizons because they prefer to take advantage of the lower tax treatment of long-term capital gains on sales. As the chart from Barron’s below shows, readings are volatile but the pattern of prolonged selling is evident. When insider selling coincides with overvaluation as measured by the Morningstar Fair Value Estimate, the warning signs are clear.
 

 

In addition, the cautious forecast made by the analyst Mark Hulbert characterized as one of the respected market forecasters made me sit up and take notice. Former Value Line research director Sam Eisenstadt set a six month target of 2230 last December. The chart below depicts Eisenstadt’s multi-track record that show his six month forecasts and actual subsequent SPX level.
 

 

Back in December, Eisenstadt had a six month SPX target of 2230, which is well below the current level of the index. The chart below depicts his recent track record going back to 2013. During that period, his model have tended to be overly bullish and in only one case did the actual index level overshoot his forecast.
 

 

Hulbert wrote that rising interest rates was the principal reason for Eisenstadt’s cautious outlook:

What are the factors driving Eisenstadt’s current forecast? In an interview, he said that the largest factor by far is the recent increase in interest rates. He added that he finds it surprising that most investors don’t seem to be paying attention or to care about this increase, given how obsessed they were not that long ago with the interest rate outlook.

The Fed has spoken

Speaking of interest rates, I wrote in my last post (see A frothy, over-extended market): “When a dove like Brainard sounds this hawkish, there is little doubt about whether the Fed will raise rates at its March meeting.”

In a speech last Friday, Fed chair Janet Yellen signaled a rate hike at the upcoming March meeting is more or less baked-in:

In short, we currently judge that it will be appropriate to gradually increase the federal funds rate if the economic data continue to come in about as we expect. Indeed, at our meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.

Stock prices are driven by two main fundamental factors, the E in the P/E ratio, and the level of the P/E ratio. If we invert the P/E ratio to an E/P, we get an earnings yield, which can then be compared to the risk-free rate. If the Fed raises the risk-free rate, then it puts downward pressure on P/E multiples.

An uncertain growth outlook

During the initial stages of a Fed rate hike cycle, bearish P/E compression from rising rates are often offset by a rising growth forecasts (see Scott Grannis: Rising rates are still bullish for equities).

However, the market is now hearing different forecasts of growth from the stock and bond markets. As the chart below shows, both stocks rose and the yield curve steepened since the election, which reflect better growth expectations. But these two indicators began to diverge in early February. Stock prices continued to rise, while the yield curve began to flatten, indicating that bond market expectations of slowing economic growth. To further add to the confusion, the 2/10s steepened a bit last week in response to the Fed’s rate hike message, while the 5/30s flattened. What’s going on?
 

 

One explanation for the bifurcation is the stock market is focused on earnings, while the bond market is focused on economic growth and inflation. While the two growth outlooks are correlated, they are very different animals. As the chart below shows, the recent advance in equities has been global in scope, and it has been correlated with positive macro surprises, which suggests a cyclical element to the stock market rally (chart via Jeroen Blokland).
 

 

This analysis begs an important question. As Luke Kawa pointed out, the Global Economic Surprise Index (ESI) has hit the highest level since the world emerged from the Lehman Crisis. How much upside is left? By implication, what happens to equities should ESI start to roll over?
 

 

Another clue about the difference between the bond and equity growth outlook comes from Sam Eisenstadt’s SPX forecast of 2230 (see above). Remember, equity investors focus on earnings. When Eisenstadt developed that forecast in December, his model likely did not incorporate the effects of Trump’s proposal of corporate tax cuts and offshore cash repatriation incentives. Past top-down Street estimates of these fiscal effects add about 10% to SPX earnings (see How Trumponomics could push the SP 500 to 2500+). We can surmise that current market levels are discounting the positive effects of the Trump tax cuts. How long the market will remain patient with lack of detail from Trump fiscal policy therefore becomes an open question.

One positive development came from Factset. After several weeks of wobble, forward 12-month EPS have started to rise again, which is bullish for the earnings growth outlook. Should forward EPS continue to rise, continued growth should put a floor on any equity price correction.
 

 

Despite this positive development, growth bulls may not be totally out of the woods yet. New Deal democrat pens a regular weekly column where he analyzes high frequency economic data by splitting them into coincident, short leading, and long leading indicators. His latest analysis shows that short leading indicators are robust and pointing up, which reflects the strong performance by ESI and the revival in forward EPS estimates. However, his set of long leading indicators are starting to wobble as they weaken into neutral territory. While he is not ready to call a recession yet, Fed action may push more leading indicators into the danger zone.

Another interpretation of the bifurcation between bond and equity markets is a difference in time horizons. The bond market is focused more on the weakness in NDD’s leading indicators, while the equity market is focused on the upbeat short leading indices.

The Trump effect on growth

To be sure, the effects of Trump’s fiscal and trade policies are the wildcards for this market. Ed Yardeni nailed it when he outlined two main scenarios for the economy:

There are two alternative economic scenarios that follow from the above discussion. The economy continues to grow in both, though running hotter in one than the other. Of course, there is a third scenario in which the economy falls into a recession. That’s possible if Trump’s protectionist leanings trump his pro-growth agenda. However, I believe that Trump is intent on maintaining free trade, but on a more bilateral basis than a multilateral basis. So here are the two growth scenarios in brief:

Very hot. If Trump delivers a guns-and-butter fiscal program—including most of the tax cuts he has promised along with more defense spending and public/private-financed infrastructure spending—economic growth could accelerate. But so might inflation, given that the economy is at full employment. Government deficits would probably remain large or widen, causing public debt to increase. In this scenario, the Fed would be emboldened to increase interest rates in a more normal fashion rather than gradually. Bond yields would rise. This should be a bullish scenario, on balance, if the boost to earnings from lower corporate tax rates and regulatory costs is as big as promised.

Not so hot. Alternatively, if Buffett is right, and interest rates stay at current low levels, that would imply that Trump’s grand plans for the economy won’t be so grand after all in their implementation. Animal spirits would evaporate. Interest rates would stay low, but valuations would be hard to justify if earnings don’t get the boost that was widely discounted after Election Day.

My base case is Yardeni’s “not so hot” outcome, which is mainly driven by legislative paralysis. While the equity market starts to discount the effects of lower tax rates, it may be disappointed. History shows that parties that have taken the White House and both chambers of Congress have struggled with their legislative agenda.
 

 

The Trump administration is unlikely to be different in that respect. Consider the accounts of the House Republican approach to the repeal and replacement of ACA, otherwise known as Obamacare. The GOP House leadership has unveiled a secret bill which only selected legislators and staff are allowed to read, and only in a secure room. Democrats and Republican senators need not apply (via Bloomberg).

Similarly, the tax reform proposals are getting bogged down in the White House and Congress. The Washington Post reported that the Trump administration is split on the issue of a Border Adjustment Tax, with Bannon, Miller, and Navarro in favor, and Mnuchin and Cohn against. CNBC reported that there is widespread opposition to a BAT within the Republican Senate. Any attempt to pass a tax reform bill with a BAT component will die on the Senate floor. Even if it were to pass, Nouriel Roubini pointed out that the imposition of BAT is likely to push up inflation by 1% or more, which invites a Fed response to raise interest rates at a even faster pace.

Conceivably, the Trump White House could try to pass a tax cut bill without BAT, which would explode the fiscal deficit. It is unclear whether such legislation could get passed over the objections of GOP deficit hawks. This “guns and butter” approach is highly inflationary and it would initially create a market blow-off. But the Federal Reserve would be forced to respond with surging interest rates to offset the inflationary effects of the fiscal expansion.

A frothy market

Another emerging sign of caution for equity investors are signs of froth, or excess enthusiasm. Some of the anecdotal evidence are reminiscent of the dot-com bubble era. As an example, when you have KKK leader David Duke tweeting about Technology IPOs, the market is much closer to a top than the bottom.
 

 

And why is Mike Tyson promoting trading platforms? Is he the modern version of the Pets.com sock puppet?
 

 

Moreover, Rydex investors have gone all-in on the bull side. The past two episodes has seen stock prices pull back. So far, the Rydex crowd has been correct in its positioning, but for how long?
 

 

Bloomberg also reported that Goldman Sachs found that investors are abandoning downside hedges in the most recent run-up:

Data from Goldman Sachs Group Inc. show investors have discarded hedges bought in the first leg of the global rally — between the November election and the end of last year — as they rush headlong into risk.

“Our indicator is now in-line with its most complacent level in the past six years, suggesting investors are generally unhedged across both equities and credit,” derivatives strategists at Goldman, led by John Marshall, wrote in a note on Friday.

Marshall and his colleagues calculate that investors are paying a low premium for the most liquid options across equity and credit, which offer a haven for investors during times of stress. So pronounced is the apathy over prospects for a broad market selloff that protective options have become too cheap to pass up, the analysts say.

Jesse Felder highlighted an equally disturbing development (via Marketwatch).  Normally, the VIX Index and stock prices move in inverse directions. However, they have become correlated lately, which spells trouble for stock prices.
 

 

My own historical study of these episodes is shown in the table below. If history is any guide, the market is poised for a correction.
 

 

When I put it all together, the likelihood of a market correction is high. However, downside risk is mitigated by the upbeat growth outlook. Rising economic and forward earnings growth should act to put a floor on stock prices.

The week ahead

My base case scenario calls for risk appetite to weaken, based on the combination of legislative disappointment and rising interest rates. The downside risk on any correction is unlikely to be worse than 5-10%.

In all likelihood, a correction is likely to start at any time. Technical conditions are deteriorating. For example, Twitter breadth as measured by Trade Followers is exhibiting a negative divergence, as bullish breadth failed to confirm the new high.
 

 

My inner investor remains bullishly positioned as he is not overly concerned about minor pullbacks. My inner trader has entered into a small SPX short position. and he is waiting for a confirmed technical break before adding to his position.
 

 

Disclosure: Long SPXU

A frothy, over-extended stock market

Posted by Cam Hui -

I just wanted to follow up to yesterday’s post (see Don’t relax yet, the week isn’t over). One of the key developments that I had been watching has been the recent hawkish evolution in Fedspeak. Last night, uber-dove Lael Brainard gave an extraordinarily hawkish speech. She started with the following remarks:

The economy appears to be at a transition. We are closing in on full employment, inflation is moving gradually toward our target, foreign growth is on more solid footing, and risks to the outlook are as close to balanced as they have been in some time. Assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path.

As a reminder, Brainard had been the Federal Reserve governor who, if given 10 reasons to raise rates and one reason to wait, she would focus on the single reason as a way of mitigating systemic risk. The last paragraph of her speech concluded, not so much with a discussion of whether to raise rates, but what to do with the Fed’s balance sheet after the rate normalization process had begun:

To conclude, recent developments suggest that the macro economy may be at a transition. With full employment within reach, signs of progress on our inflation mandate, and a favorable shift in the balance of risks at home and abroad, it will likely be appropriate for the Committee to continue gradually removing monetary accommodation. As the federal funds rate continues to move higher toward its expected longer-run level, a transition in balance sheet policy will also be warranted. These transitions in the economy and monetary policy are positive reflections of the fact that the economy is gradually drawing closer to our policy goals. How the Committee should adjust the size and composition of the balance sheet to accomplish its goals and what level the balance sheet should be in normal times are important subjects that I look forward to discussing with my colleagues.

When a dove like Brainard sounds this hawkish, there is little doubt about whether the Fed will raise rates at its March meeting.

What about Buffett’s bullish comments?

In a recent CNBC interview, legendary investor Warren Buffett stated that stocks are on the cheap side, but that assessment would change if rates were to rise:

Billionaire investor Warren Buffett told CNBC on Monday U.S. stock prices are “on the cheap side” with interest rates at current levels…

“We are not in a bubble territory” in the stock market, he said on “Squawk Box.” If rates were to spike, however, then the stock market would be more expensive, he added.

It looks like the Fed is about to raise start a rate hike cycle. So what now?

Isn’t growth rising?

Bulls could be comforted by this historical analysis from JPM Asset Management indicating that when 10-year yields are below 5%, rising rates have meant rising stock prices (annotations in red are mine).
 

 

However, that analysis was only applicable because interest rates were historically much higher than they are today. Stock prices rise during the initial phase of a rate hike cycle because the bullish implications of expected higher growth overwhelms the bearish forces of higher rates and lower P/E multiples.

The latest update from Factset shows that a stalling forward 12-month EPS, which is the best normalized indicator of expected earnings growth. Past episodes of flat to falling forward EPS have seen equity markets struggle or correct.
 

 

We are seeing a similar message from the bond market. The chart below depicts the 2/10 yield curve. A steepening yield curve is interpreted as the bond market’s expectation of higher economic growth, while a flattening yield curve reflects expectations of slower growth. Growth expectations bottomed out last summer and started rising in conjunction with the global cyclical rebound. However, they have started to flatten in 2017, indicating a slowing growth outlook.
 

 

Meanwhile, Barron’s reports that the “smart money” insiders are selling at a torrid pace. Note that the period of heavy insider selling seems to parallel the latest episode of slowing growth expectations. Coincidence?
 

 

Does the combination of these conditions look like the start of a bullish thrust to you?

What about price momentum?

I received several comments from some readers that went something like this, “Don’t be an idiot. You’re fighting the (bullish) tape.”

Yesterday (Wednesday) saw the major market indices rise over 1%. As Urban Carmel pointed out, these kinds of momentum thrusts tend to occur at market bottoms, not when the market is making new highs.
 

 

I went all the way back to 1990 and looked for instances when the SPX rose 1% or more while making a 52-week high. As the table below shows, the market tended to underperform, but it was not an outright sell signal for traders.
 

 

This is a frothy and over-extended market. This combination of a hawkish Fed, a faltering growth outlook, and the overbought momentum are suggestive of an exhaustion top, rather than the start of a bullish momentum thrust.

Disclosure: Long SPXU

Don’t relax yet, the week isn’t over

Posted by Cam Hui -

Mid-week market update: Boy, was I wrong. Two weeks ago, I wrote Why the S&P 500 won’t get to 2400 (in this rally). Despite today’s market strength, stock prices may be restrained by a case of round number-itis as the Dow crosses the 21,000 mark and the SPX tests the 2,400 level.

In addition, the market’s reaction to President Trump’s speech to Congress was at odds to the reaction from Street strategists. While the market went full risk-on in the wake of the Trump speech, this Bloomberg summary of strategist comments made it clear that the speech was long on themes and short on details. Perhaps stocks are rallying because Trump did not go off script and sounded statesmanlike and presidential. How long the market remains patient with his lack of the specifics on tax reform, which is Wall Street’s major focus, remains an open question.

In the meantime, the SPX has broken above its trend line and appears to be staging an upside blow-off. When animal spirits start to stampede like this, you never know when the rally will end.
 

 

Does this mean it’s time to jump back on the bullish bandwagon? Not so fast. The week isn’t over and there are a couple of other major developments (other than the Trump speech) that warrant consideration.

The state of the (European) union

I suggested about a month ago that we may be nearing a peak in political populism based on the magazine cover indicator (see Peak populism?). The latest developments from Europe indicates that we may be nearing a political inflection point.
 

 

The populist Geert Wilders is losing ground in the upcoming Dutch election on March 15. Bloomberg reports that Wilders’ Freedom Party is running neck and neck with the establishment Liberals, which forms the current government:

Dutch Prime Minister Mark Rutte’s Liberals are making up ground on populist frontrunner Geert Wilders in the polls, suggesting that voter support is crystallizing in the final weeks of the campaign in favor of keeping Rutte in power.

Two polls released on Tuesday showed the Freedom Party with a one-seat advantage or even with the Liberals. That’s down from a lead of as many as 12 seats at the start of the year. A poll aggregator released Wednesday showed the Liberals narrowly ahead for the first time since November.

Business Insider also reported that Wilders has slipped to second place in one recent poll.

In France, conservative presidential candidate François Fillon’s political fortunes are imploding, based on the news that investigating magistrates have summoned him and his wife on charges that he put his wife on a government payroll for nonexistent work. In a press conference, Fillon decried the move as “political assassination” and vowed to fight on. This development has cleared a path for the centrist Emmanuel Macron to the French presidency. The latest Betfair odds shows Macron surging at Fillon’s expense. The anti-establishment and populist Marine Le Pen remains in second place, with little hope of winning the election.
 

 

As a consequence, the French-German yield spread has begun to narrow.
 

 

The state of the European Union is getting stronger.

A March rate hike?

In a Bloomberg interview on February 21, Cleveland Fed president Loretta Mester stated that the Fed does not like to surprise the market on interest rate decisions. At the time of that interview, the odds of a March rate hike was in the 20-30% range. It is now about 70% after one Fed speaker after another warned that not only is the March FOMC meeting “live”, there is a distinct possibility that they may raise rates at that meeting. San Francisco Fed president John Williams said that he expect that the FOMC will a rate hike will warrant “serious consideration” at the March meeting. In a CNN interview, New York Fed president William Dudley said that the Fed will raise rates “fairly soon”.

What does this all mean?

Fed watcher Tim Duy thinks that the question is whether the Fed wants to be preemptive, or it wants to wait to see how fiscal policy develops:

When I read the interview, it is hard for me to see that he has a strong conviction for drawing forward the rate hike to March. It seems odd to do so if he sees no change in the forecast and downplays the impact of the upside risks. If he does want to move in March, it tells me then it has little to do with either factor and is entirely about staying ahead of the curve. It is about the need for a preemptive rate hike. If his forecast is for three hikes and he wants to hike in March, then his patience has ended and he wants those hikes frontloaded. If for FOMC participants as a whole the forecast has yet to change much, then it is possible that the even if they raise in March, the median projection of three rate hikes this year remains steady.

Much of the data has been coming on the “hot” side, indicating a robust economy with rising inflationary pressures. By the book, the Fed should be thinking seriously about starting a rate hike cycle about now. Indeed, there were several data points that were released today that are supportive of that view.

The Beige Book, which released today, showed a lot of “modest to moderate” growth. Labor markets are tight, with “moderate” employment growth. Some districts reported labor shortages. These are the kinds of conditions that Dudley referred to when he described an “economy continues on the trajectory that it’s on, slightly above-trend growth, gradually rising inflation” as the prerequisites to the removal of monetary policy accommodation.

This morning also saw the release of the ISM Manufacturing Survey, which rose and came in ahead of expectations, as it continued a trend of beating market expectations.
 

 

As well, month-over-month Core PCE, the Fed’s preferred inflation metric, was released this morning. It also came in ahead of expectations and surged to an annualized rate of 3.8%, well ahead of the Fed’s 2% inflation target.
 

 

To put this data point into context, I counted the times in the last 12 months that annualized m/m Core PCE has exceeded 2%. As the chart below shows, the Fed has historically begun a rate hike cycle whenever the count reached six (dotted line). The count currently stands at five, which begs the question, “How preemptive does the Fed want to be?”
 

 

Fed chair Janet Yellen and vice chair Stan Fischer are scheduled to speak on Friday. If they want to give the market further direction, we should get it then. In addition, Fed governor Lael Brainard is scheduled to speak a 6pm ET today (Wednesday). Brainard is one of the most dovish governors on the Board, if her tone sounds hawkish, then watch out!

A market blow-off

In summary, the stock market is undergoing a blow-off with no end in sight. We are starting to see bullish political developments out of Europe, but one wildcard is the possibility of a March rate hike. Should the Fed preemptively raise rates, not only would the normal macro effects of slowing the American economy be applicable, it would push up the US Dollar. A rising USD would be bearish in three ways. First, a strong greenback squeezes the margins and therefore the earnings of large cap multi-nationals companies. It would be supportive of the “America First” contingent within the Trump administration in their protectionist policies. As well, a strong USD would pressure the emerging market countries and companies with USD debt and raise the odds of an EM debt crisis.

My inner trader initiated a small SPX position on Tuesday. He is maintaining his position in view of the downside risks to the market.

Brace for further volatility.

Disclosure: Long SPXU

How Buffett’s business empire could unravel

Posted by Cam Hui -

Josh Brown had a terrific comment about the secret of Warren Buffett’s success. Buffett is unabashedly “permabullish” on America:

One of the hallmarks of Berkshire’s success has been its willingness to raise or lower its formidable cash hoard in response to the presence (or lack thereof) of viable investing opportunities. One of the other hallmarks of Buffett’s approach has been to tune out forecasts and de-emphasize the importance of them in general.

The one thing Buffett has never given up on is the idea that American productivity, innovation and economic dynamism will always lead to substantially greater prosperity in the future. And he’s been right for decades, through all sorts of setbacks, crises and challenges for the nation.

So if the choice is to be in the Buffett camp vs the David Stockman camp or the Peter Schiff camp, well, I regard that as no real choice at all.

Lastly, permabulls need not be blind to the possibility of market declines, economic catastrophes (real or imagined) and other momentary trials and tribulations. Buffett’s got these possibilities built right into his manifesto:

Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

That formula has worked out well. Stay bullish on the belief of the dynamism of America, and buy good businesses when they become cheap. In a post-election interview with CNN, Buffett expressed confidence in the supremacy of the American businesses (click on this link if the video is unavailable).
 

 

There is much to be said about the Buffett formula. According to Credit Suisse, US real equity returns has been the highest in the world. Though the stock market has experienced serious losses, prices have always come back.
 

 

A value orientation, as proxied by a high price to book, outperforms the market. Buffett then couples the value discipline by buying companies with a moat, or a sustainable competitive advantage. The combination of buying value companies with a moat has been the secret of success.
 

 

However, we may be reaching an inflection point for Buffett`s brand of investing. In the Age of Trump, the tailwinds on Buffett`s value approach may be coming to an end.

The end of Pax Americana?

This chart from BCA Research (via Tiho Brkan) tells the story. Buffett’s successful run coincides with the era of Pax Americana and rising global trade. What would happen if the growth in global trade were to come to a screeching halt? What kinds of stresses would the global economic system face?
 

 

Value investing depends on valuation a mean reversion effect, or the tendency of cheap stocks to return to becoming more reasonably priced. What if mean reversion were to stop occurring? What would happen to some of those business moats if global trade were to start shrinking?

Donald Trump’s America First policies certainly raises the risk level. Politico reported last week that Trump wants to re-negotiate trade treaties upon a moment’s notice whenever the US gets into trouble:

Trump has said he wants to include a clause in trade agreements that would allow the United States to get out within 30 days if the other country balks at fixing any problem that occurs. Last week, White House trade adviser Peter Navarro upped the ante by telling Senate Finance Committee members that the administration also wants to include a provision that would trigger a renegotiation whenever the United States runs a trade deficit with the partner country, Morning Trade has learned.

WTF? This is the same Peter Navarro who dismissed analysis from Citigroup outlining how retailers would be losers under a Border Adjustment Tax (BAT) as “fake news” (via Business Insider):

CNBC’s Melissa Lee pointed to a Citigroup estimate that said this new tax would be a massive hit to company earnings. That means people working in retail would likely lose their jobs as companies try to cut costs.

Navarro immediately got defensive.

“Well, first of all, this is a false narrative and a fake study,” he countered.

Lee was a bit surprised. “Let me get this right,” she said, “Citigroup did a fake study?”

“Citigroup has no credibility,” Navarro said. He called the bank’s analysis, and analysis from the Peterson Institute for International Economics, “garbage studies and scare tactics” and compared them to media outlets like MSNBC and CNN.

“We are not backing off,” he said.

Lee pointed out that Citigroup isn’t the media — it’s research written for investors looking to find out if companies are healthy. Navarro ignored that point.

“Yeah, well, the Dow just hit 20,000, how you like them apples?” he said. “There are winners and losers.”

America First Protectionism = EM debt crisis

If the Trump administration is intent on going down that trade policy path in the name of “America First”, then the risks are rising very, very quickly. Here is one immediate problem that market analyst and Texas Republican John Mauldin is worried about:

Paul Ryan and House Ways & Means Committee Chair Kevin Brady know everything I just said and probably agree with much of it. They believe the BAT’s negative effects will disappear quickly due to currency flows. As the trade deficit shrinks, fewer dollars will flow from the US to the rest of the world. That trend will make the dollar rise against other currencies, thereby nullifying the higher prices we will pay for imported goods.

That’s the theory. In fact, most economists do agree that the dollar is likely to rise significantly if this proposal is adopted. So, the theory is that Walmart shoppers really won’t pay higher prices, at least in dollar terms. I do not think things will work that way in practice, at least not as quickly as they hope…

Here we see once again how debt constrains us from doing what might otherwise make sense. Emerging-market countries own massive amounts of dollar-denominated debt. A stronger dollar means they must somehow come up with more of their local currencies to repay their dollar debts. And they will have to do it fast, even as their exports are shrinking because US consumers are being encouraged to “buy American.”

It gets worse. To whom is all that emerging-market debt owed? Primarily to Western banks and bondholders, who are often themselves excessively indebted. The potential financial contagion is massive. Ambrose Evans-Pritchard of the London Telegraph describes it in his characteristically colorful style:

Yet getting there constitutes a global shock of the first order. “This will trigger a series of emerging market crises,” said Stan Veuger from the American Enterprise Institute. He estimates that the burden for companies and states in developing countries with dollars debts will jump by $750bn. Turkish firms alone would face a $60bn hit.

It does not end there. Studies by the Bank for International Settlements show that a rising dollar automatically forces banks in Europe and the Far East to shrink cross-border lending through the mechanism of hedge contracts.

A dollar spike of anywhere near 20pc would send the Chinese yuan smashing through multiple lines of psychological resistance. The People’s Bank (PBOC) is already intervening heavily to defend the line of seven yuan to the dollar. Ferocious curbs would be needed to stop the Chinese middle classes funneling money out of the country if it crashed by a fifth.

Junheng Li from Warren Capital says the China’s exchange regime is more brittle than it looks. Official data overstates the PBOC’s fighting fund by $1 trillion, either because reserves are “encumbered” by forward dollar sales or because they must be held in reserve as a “fiscal backstop” for Chinese firms at risk of default on dollar debts. She expects the system to snap at any time, and without warning.

I strongly doubt whether the Trump-Ryan axis in Washington has any idea what could happen if they detonate a debt-deflation crisis in China, or if they ignite a short-squeeze on $10 trillion of off-shore dollar debt with no lender-of-last-resort behind it. Nor do they care.

A surging USD from the imposition of a BAT could spark another emerging market currency crisis. This time, the world won`t have the benefits of rising global trade to cushion the blow.

When confidence cracks

The blogger Jesse Livermore at Philosophical Economics wrote an insightful post last weekend about the interaction of valuation and cash in a low yielding world:

A useful way to estimate that value for a security you own is to ask yourself the question: what is the most you would be willing to pay for the security if you couldn’t ever sell it? Take the S&P 500 with its $45 dividend that grows at some pace over the long-term–say, 2% real, plus or minus profit-related uncertainty. What is the most that you would be willing to pay to own a share of the S&P 500, assuming you would be stuck owning it forever? Put differently, at what ratio would you be willing to permanently convert your present money, which you can use right now to purchase anything you want, including other assets, into a slowly accumulating dividend stream that you cannot use to make purchases, at least not until the individual dividends are received?

When I poll people on that question, I get very bearish answers. By and large, I find that people would be unwilling to own the current S&P 500 for any yield below 5%, which corresponds to a S&P 500 price of at most 1000. The actual S&P trades at roughly 2365, which should tell you how much liquidity–i.e., the ability to take out the money that you put into an investment–matters to investors. In the case of the S&P 500, it represents more than half of the asset’s realized market value.

Much of the valuation of equities in the current environment depends on confidence:

Now, here’s where the parallel to banking comes into play. As with a bank, a market’s liquidity is backed by a network of confidence among its participants. Participants trust that there will be other participants willing to buy at prices near or above the current price, and therefore they themselves are willing to buy, confident that they will not lose access to their money for any sustained period of time. Their buying, in turn, supports the market’s pricing and creates an observable outcome–price stability–that reinforces trust in it. Because the investors don’t all rush for the exits at the same time, they don’t have a need to rush for the exits. They can rationally collect the excess returns that the market is offering, even though those returns would be insufficient to cover the cost of lost liquidity.

When the network of confidence breaks down, you end up with a situation where people are holding securities, nervous about a possible loss of access to their money, while prevailing prices are still way above intrinsic value, i.e., way above the prices that they would demand in order to compensate for a loss of liquidity. So they sell whatever they can, driving prices lower and lower, until confidence in a new price level re-emerges. Prices rarely go all the way down to intrinsic value, but when they do, investors end up with generational buying opportunities…

The question comes up: in a low rate world, with assets at historically high valuations, offering historically low returns, what should investors do? Should they opt to own assets, or should they hold cash? The point I want to make in all of this is that to answer the question, we need to gauge the likely strength and sustainability of the market’s network of confidence amid those stipulated conditions. We need to ask ourselves whether investors are likely to remain willing to buy at the high valuations and low implied returns that they’ve been buying at. If the conclusion is that they will remain willing, then it makes all the sense in the world to buy assets and continue to own them. And if the conclusion is that they won’t remain willing, that something will change, then it makes all the sense in the world to choose hold cash instead.

Now imagine that global trade starts to unravel and EM countries experience a currency crisis, which morphs into a global financial crisis. What happens to confidence then?

If we want to get in front of things that are going to break a market’s network of confidence and undermine people’s beliefs that they’ll be able to sell near or above where they’ve been buying, we shouldn’t be focusing on valuation. We should be focusing instead on factors and forces that actually do cause panics, that actually do break the networks of confidence that hold markets together. We should be focusing on conditions and developments in the real economy, in the corporate sector, in the banking system, in the credit markets, and so on, looking for imbalances and vulnerabilities that, when they unwind and unravel, will sour the moods of investors, bring their fears and anxieties to the surface, and cause them to question the sustainability of prevailing prices, regardless of the valuations at which the process happens to begin.

Under that scenario, would buying the dip work? Could Berkshire Hathaway depend on the moats of these companies that Buffett purchased? How many of those moats would be breached if global trade tanks? Could you depend on the resiliency of a leaderless capitalist system when America is no longer willing to be its leader? What happens to the political systems of the leading industrialized countries in the world?

As per Credit Suisse, remember what happened the markets of major countries that underwent major political upheaval in the 20th Century:
 

 

Do you still want to bet on mean reversion and the sustainability of business moats under those kinds of scenarios?

Brace for a volatility spike

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.

Sell the news?

There has been much written lately about low level of stock market volatility, as measured by the VIX Index. It’s interesting that these concerns have even surfaced in the latest FOMC minutes:

Financial asset prices were little changed since the December meeting. Market participants continued to report substantial uncertainty about potential changes in fiscal, regulatory, and other government policies. Nonetheless, measures of implied volatility of various asset prices remained low.

A little noticed change has occurred in the markets since mid-February. Even though stock prices were grinding upwards, VIX term structure began to steepen as 3-month VIX futures rose but 1-month VIX remained stable. As well, the bottom panel shows that SKEW, which measures the price of tail-risk protection, is rising. These readings indicate that the market is anticipating a near-term volatility event.
 

 

The most likely spark for a volatility event is Trump’s address to Congress on Tuesday, when he is expected to outline his tax reform proposals. This speech has the potential to raise the “uncertainty about potential changes in fiscal, regulatory, and other government policies”.

The stock market has rallied substantially in anticipation of Trump’s proposal of tax cuts, tax holiday for offshore cash repatriation, and deregulation. As Trump’s tax reform proposals become more clear, it is becoming evident that there are two likely outcomes. Either Wall Street will have to swallow the bitter pill of the protectionist measures of a Border Adjustment Tax (BAT), or they will get delayed and bogged down in Congress.

As the market has bought the rumor of tax cuts, it may now be time to sell the news.

Waiting for tax reform

Here is where we stand right on tax reform. In a recent Reuters interview, here is what Donald Trump said when asked about the prospects for tax cuts and deregulation:

“We’re going to have a corporate tax cut … anywhere from 15 to 20 percent (as a target for the corporate tax rate). … We’re going to have other things that are very good and we’re going to have a tremendous regulatory cut because the regulations are piled up on top of each other and you’ll have many regulations for the same thing within different industries and it’s out of control. The regulations in this country are out of control. And it makes it hard for businesses to even open in the United States. We’re going to get rid of a lot of the unnecessary regulations.”

That’s the good news. The bad news is they will likely be accompanied by a BAT as a way to pay for the tax cuts:

“It could lead to a lot more jobs in the United States. … I certainly support a form of tax on the border because everybody else does. We’re the only country, we’re one of the very few countries, possibly the only country, that has no border tax. And that’s not a tax to the consumer, because that’s going to be a tax to companies and it’s going to be a tax to other countries much more so than it is to the consumer. That’s a tax to other countries. And what will happen is, don’t forget there is no tax if we make our product in the United States. So I don’t consider it a tax. That’s a tax if companies are buying their product outside of the United States. But … if they make their product in the United States, there is no tax. So what is going to happen is companies are going to come back here, they’re going to build their factories and they’re going to create a lot of jobs and there’s no tax.”

For readers who are unfamiliar with the BAT concept, here is a discussion of BAT from market analyst and Texas Republican John Mauldin:

Under the BAT plan, imports will be penalized and exports rewarded, which, theoretically, in a perfect world without pushback, would leave our economy nicely balanced and undisrupted. That’s the idea. But I doubt it will happen that way, because the importers and exporters are not the same businesses.

A vast number of businesses import products from other countries and sell them to Americans. Toy companies are a good example. Virtually all the shiny presents under your Christmas tree were made outside the US. The companies that import them could be border-adjusted right out of business under the Better Way plan.

Here’s an example. Suppose you are a toy company and you spend $1 million to bring in toys from China. You package and distribute them to retailers around the country, generating an additional $500,000 in costs for yourself. You sell them at wholesale for $2 million. What’s the tax consequence?

You just spent $1.5 million to generate $2 million in revenue. But the $1 million you spent on the imports is no longer deductible on your tax return. So your taxable profit isn’t $500,000, it’s $1.5 million. At 20%, your corporate income tax is $300,000 instead of $100,000. This plan triples your taxes…

At best there will be an adjustment period, which will be far longer than those who propose this plan think, as workers retrain for new jobs. We’ve heard this story before, and it didn’t work out as advertised. So count me skeptical.

The problem is that the importers and exporters don’t all operate in the same states and counties, so the people who lose their jobs because of the import tax will end up having to move to where the exporting jobs are. How did that work out for the Rust Belt when the steel jobs left? For whatever reason, the data clearly shows we are moving less than we ever have before.

Liberty Street Economics, a blog run by the New York Fed, which believes that a BAT is unlikely to substantially promote exports:

How will U.S. exporters fare? An unintended consequence of the proposed border tax is that it is likely to depress rather than stimulate exports. As export prices are also invoiced in U.S. dollars, the tax exemption on export revenue will mostly boost exporters’ profit margins rather than increase their export sales. And with the accompanying partial appreciation in the U.S. dollar, the prices of U.S. exports in foreign currencies will rise. This will provide incentives for our trading partners to switch their demand away from U.S.-produced goods, resulting in lower U.S. export sales.

Those are just the first order effects. John Mauldin thinks that a BAT will set off a global trade war:

When you talk to Republican leaders and ask them why other countries wouldn’t react to the BAT and impose larger tariffs or sanctions on US goods, they respond with a question of their own; and it’s a logical one: “But why would they? We’re only doing with the BAT what they’re already doing to us.” And they are correct. US corporations are at a massive competitive disadvantage today because we have high corporate taxes and no VAT. Other nations do not charge a VAT tax when their companies export products. That means a German car sold in Asia or a Japanese car sold in Europe has a competitive tax advantage over a car made in the US and on sale in those countries. The Republicans are simply trying to rectify that competitive disadvantage.

The problem is that other countries are simply not going to say, “Oh, the United States finally figured it out that we were taking advantage of its silly, complicated tax system. There’s really nothing we can do, so let’s just get on with the program.” No, they are going to protect their own businesses. In international trade, it’s every country for itself. They are all going to react to losing anything that they think is a competitive advantage. If you don’t get this, go back to kindergarten and study children trading toys in their sandbox. This behavior is ingrained in every human being.

Mauldin concluded (remember, he is a long-time Texas Republican):

I know this is going to offend a few of my friends, but I’m going to say it anyway: I am afraid that this border adjustment tax, if implemented, will throw the world into a global recession. All of the wonderful tax cuts and beautiful plans that are being proposed along with the BAT will not be enough to keep the US from participating in that recession as well.

Understand, I’m a believer in free markets, and I know that the American enterprise and entrepreneurial system, when given an opportunity, can respond and create growth in this country. But the BAT is not the way to do it.

That’s just the pushback from the “moderate” wing of the GOP. Here is an example of the opposition to BAT from the right wing of the party (via Breibart):

The latest solution from GOP “leadership” grab bag of bad ideas is the ill-conceived proposal to “help” America with her huge ($491 billion) global trade deficit with the Border Adjustment Tax (BAT).

The idea goes like this: The U.S. will tax all imports at 20 percent and provide a rebate of 20 percent on American exports sold abroad. That is not only counterproductive from a trade deficit reduction standpoint; it is skewed to help large American corporations over small and mid-sized American producers…

The solution is the scaled tariff. The tariff looks at the trailing twelve months (TTM) of trade balance between other nations and the United States. The tariff would only be applied to countries that have a significant or chronic surplus with the United States. The tariff would be adjusted quarterly up or down based upon the (TTM) figures. As trade heads toward balance, the tariff will self-adjust downward for that country. If a trading partner retaliates with counter-tariffs or currency manipulation that drive a greater deficit, the tariff will rise in direct relation to the (TTM) figures.

Any BAT will be a bitter pill for the equity market to swallow in order to get its tax cuts. A scaled tariff will even be worse.

Legislative chaos

The other likely scenario is a delay of the tax reform as it gets bogged down in Congress. The Hill reported that Ryan’s tax reform plan won’t get more than ten votes in the Senate:

Sen. Lindsey Graham (R-S.C.) says the House GOP tax plan that Speaker Paul Ryan (R-Wis.) tried to sell to Senate Republicans won’t get 10 votes in the upper chamber.

If Graham is correct, it’ll be a blow for Ryan and House Ways and Means Committee Chairman Kevin Brady (R-Texas), who are pushing a 20 percent across-the-board tax increase on imports to pay for comprehensive tax reform.

The idea has run into staunch resistance in the Senate, which bodes ill for President Trump’s hopes of passing tax reform this year.

The Trump administration is still not fully staffed, which is going to slow down its legislative agenda. Business Insider reported that Trump will delay its proposals for infrastructure spending to next year’s legislative calendar. In addition, AP (via Business Insider) reported that the Trump administration also faces a looming debt ceiling fight and possible government shutdown this spring:

Add a potential government shutdown to embattled President Donald Trump’s growing roster of headaches.

Beneath the capital’s radar looms a vexing problem — a catchall spending package that is likely to top $1 trillion and could get embroiled in the politics of building Trump’s wall at the US-Mexico border and a budget-busting Pentagon request.

While a shutdown deadline has a few weeks to go, the huge measure looms as an unpleasant reality check for Trump and Republicans controlling Congress.

Despite the big power shift in Washington, the path to success — and averting a shuttering of the government — goes directly through Senate Democrats, whose votes are required to pass the measure. And any measure that satisfies Democrats and their new leader, Sen. Chuck Schumer of New York, is sure to alienate tea party Republicans. Trump’s determination to build his wall on the US-Mexico border faces a fight with Democrats, too.

In effect, the market is faced with the unpalatable choice of BAT, or a delay of expected tax cuts until next year, with no idea of how the water down the proposals will be.

Good news, and bad news

If investors had bought the rumor of the tax cuts, does that mean that they should now sell the news?

Before making a decision on that question, there is some good news and bad news about the market. Here is the good news. The market rally was sparked mainly by a reflationary growth rebound. As these charts from Callum Thomas of Topdown Charts show, the rebound is broad and global in scope.
 

 

There has also been a surge in global Economic Surprise Indices, which measure whether top-down economic indicators are beating or missing expectations.
 

 

Specific to the US, the Chemical Activity Barometer, which leads industrial production, is also rising strongly (via Calculated Risk):
 

 

The good news is global macro momentum is pointed upwards.

As good as it gets?

The bad news is conditions may be as good as they get. Liz Ann Sonders observed that consumer stress is rising. While readings are not at danger levels, it does hint at a loss of positive momentum.
 

 

Copper prices, which is an indicator of the global cycle, are starting to weaken. The chart below shows the copper/gold ratio (red line) and the equity/bond ratio (grey bars). While both copper and gold are hard assets, copper has a greater cyclical element and therefore the copper/gold ratio is a sensitive barometer of global cyclical demand. The stock/bond ratio is a measure of market risk appetite, and it has historically been highly correlated to the copper/gold ratio (bottom panel).
 

 

The latest update from Factset shows another sign of stalling momentum Forward 12-month EPS was flat compared to last week and fell compared to two and four weeks ago (annotations are mine).
 

 

Scott Grannis also pointed out that the 2-year swap rate is starting to rise, indicating higher stress levels. Again, these are not panic levels, but this is another warning sign of declining risk appetite.
 

 

What’s more, global macro hedge funds are all-in on their risk exposure.
 

 

Bloomberg reported that analysis by Novus Partners showed that equity holdings favored by hedge funds are showing low levels of liquidity. So what happens if we get a “volatility event” and they all try to head for the exit?
 

 

Is it any wonder why demand for tail-risk protection is rising?

Estimating downside risk

I believe that the prudent course of action for investors would be to prepare for some near-term equity weakness. In that case, the question the becomes, “What’s the downside risk?”

I offer a number of scenarios to answer that question. Urban Carmel pointed out that, from a technical perspective, the stock market has exhibited a period of strong positive momentum. Such episodes tend to resolve themselves with only minor pullbacks before powering higher:

When the current uptrend ends, it is not likely to lead directly into a more significant downturn. Momentum like this weakens before it reverses. In each of the cases highlighted above, after a 3-5% drawdown, SPX either continued higher or retested the prior high before falling lower. Mid-2011, 2012 and 2014 are recent examples of the latter case (shown below). That would be our expectation now as well.

 

 

He also highlighted research from Ari Wald, indicating that low VIX levels tend to be bullish market environments, not bearish:

Much has been made of the persistently low level of the Vix. The three most recent bull markets have each been characterized by a persistently low Vix. Historical instances are severely limited, but a low Vix has been a positive sign for the SPX. The market did not peak in either 2000 or 2007 until Vix had climbed, over the course of years, to more than 25. Since 1990, when the Vix has been below 12, SPX has returned 5% and 10% over the next 6 and 12 months, respectively (from Ari Wald).

 

 

The fundamental answer to the downside risk question depends on how the tax reform measures get resolved. If the tax cuts were to be delayed until next year, then forward P/E ratios may have to adjust downwards. Analysis from Factset shows the forward P/E ratio at 17.6, a 14-year high. Forward P/E is well above its 5-year average of of 15.2 and 10-year average of 14.4. If the global reflation story were to remain intact, a 10-15% retreat in prices would represent a valuation floor for equity risk. I would add, however, that 10-15% represents the probable maximum downside potential, but any pullback could stop well short of that estimate.
 

 

Confused? The following SPX chart offers some technical perspective. There is initial support at about the 2280 breakout point, which roughly coincides with the 50 day moving average (dma). Secondary support is at 2190, which also coincides with the 200 dma. If those support levels break, then long-term support can be found at 2135, which corresponds to about a 10% pullback. Viewed view a technical prism, a 10-15% pullback seems unlikely, unless total panic were to set in.
 

 

If, on the other hand, tax reforms were to pass with a BAT, then it could signal the start of a major bear market. As the chart below shows, global PMIs are closely correlated with global trade. Both have been rising strongly. Imagine the global macro conditions and growth outlook if trade flows were to tank. Earnings estimates would also fall, and would likely spark a major bear market, tax.
 

 

The week ahead: Waiting for the bearish break

Looking to the week ahead, my inner trader continues to wait for the break in the equity market uptrend. While many technical and sentiment indicators are in the bearish zone, there is no obvious bearish trigger.

The Fear and Greed Index is starting to retreat from overbought levels:
 

 

The latest update from Barron’s shows that insiders have resumed their heavy selling.
 

 

While these technical indicators are supportive of the near-term bear case, we haven’t seen technical breaks of the uptrend that marks a bearish break. Neither the SPX has fallen below its 5 day moving average, nor has its RSI-5 or RSI-14 have declined below the overbought reading of 70.
 

 

My inner investor remains constructive on stocks. He is not worried about 5-10% price squiggles when he invests in equities. On the other hand, he will take action to de-risk his portfolio should the more dire scenario of a trade war come to pass.

My inner trader remains in cash. He is still waiting for a technical break before he shorts the market.

Solving the data puzzle at the center of monetary policy

Posted by Cam Hui -

There has been much hand wringing by economists over the falling labor force participation rate (LFPR). As the chart below shows, the prime age LFPR, which is not affected by the age demographic effect of retiring Baby Boomers, have not recovered to levels before the Great Recession.
 

 

The lack of recovery in LFPR has caused great consternation over at the Federal Reserve. These readings suggest that there is still considerable slack in the labor market, despite the sub 5% unemployment rate.

A number of explanations have been advanced for this phenomena, such as jobless Millennials spending all their time playing video games in their parents’ basement instead of looking for a job (via Nicholas Eberstadt of the American Enterprise Institute).
 

 

Another possible explanation is the growth of disability as a shield against unemployment payments run out. As the Great Recession hit, disabled workers became discouraged and chose to rely on their disability payments instead of trying to find another job.
 

 

There may be another very simple alternative explanation for the collapse in LFPR. The answer is so simple, it’s criminal that anyone missed it.

It’s criminal!

Nicholas Eberstadt of AEI, who advanced the theory of the lazy Millennials, suggested an very simple explanation. The explosion in the incarceration rate in the United States has rendered a segment of the population virtually unemployable, which consequently depressed LFPR (via Bloomberg):

A single variable — having a criminal record — is a key missing piece in explaining why work rates and LFPRs [labor-force participation rates] have collapsed much more dramatically in America than other affluent Western societies over the past two generations. This single variable also helps explain why the collapse has been so much greater for American men than women and why it has been so much more dramatic for African American men and men with low educational attainment than for other prime-age men in the United States.

The idea has some merit. Consider that the US has the highest incarceration rate of the major countries in the world, beating the likes of Russia, South Africa, and other industrialized countries (via Wikipedia):
 

 

Prison and jail populations have exploded over the years (via Wikipedia).
 

 

The problem isn’t just the number of people in prison and jail, but what happens to them when they are released. Research from the Sentencing Project found that 60% of former inmates could not find work a year after release.
 

 

That’s just people with criminal records. What if you were arrested but never convicted. The WSJ reports that the proliferation of private databases have created employment barriers for people with arrest records. These are people who were arrested, but not convicted. It could be something as simple as a misdemeanor offense, or a case of mistaken identity.

When Precious Daniels learned that the Census Bureau was looking for temporary workers, she thought she would make an ideal candidate. The lifelong Detroit resident and veteran health-care worker knew the people in the community. She had studied psychology at a local college.

Days after she applied for the job in 2010, she received a letter indicating a routine background check had turned up a red flag.

In November of 2009, Ms. Daniels had participated in a protest against Blue Cross Blue Shield of Michigan as the health-care law was being debated. Arrested with others for disorderly conduct, she was released on $50 bail and the misdemeanor charge was subsequently dropped. Ms. Daniels didn’t anticipate any further problems.

But her job application brought the matter back to life. For the application to proceed, the Census bureau informed her she would need to submit fingerprints and gave her 30 days to obtain court documents proving her case had been resolved without a conviction.

Clearing her name was easier said than done. “From what I was told by the courthouse, they didn’t have a record,” says Ms. Daniels, now 39 years old. She didn’t get the job. Court officials didn’t respond to requests for comment.

Could something like this happen to you?

Estimating the “criminal class” effect

I have a couple of rough ways of estimating the “criminal class” effect on the LFPR.  Using top-down data, the chart below from Bloomberg shows the differences between the “not in labor force” rate (NILF) between the US and other major industrialized countries. The latest data (2015) shows a 2.6% spread in NILF rate between the US and Canada. The NILF rates of those two countries last crossed in 2007. Before that, they crossed in 2001.
 

 

What if the American NILF rate fell to the Canadian rate due to an equalization of incarceration rates? As the chart below shows, if we add back the 2.6% US-Canada NILF spread, the US prime LFPR would jump to 84.1% (red dot), which is above the rate seen before the Great Recession, and slightly ahead of 2001 and 2007, when the NILF rates of the two countries last converged (black dots).
 

 

Bottom-up estimates

Another way I used to estimate the “criminal class” effect on the LFPR is to ask the question, “What if all former inmates found jobs as easily as the rest of the population?”

To answer this question, I used estimates by the academics Shannon, Uggen, Thompson, Schnittker and Massoglia in the paper “Growth in the US ex-felon and ex-prisoner population, 1948 to 2010“. I took the grey bars in this chart (ex-prisoners) as estimates of the former prisoner population.
 

 

The chart below adjustments to the LFPR, assuming different levels of difficulty for former inmate participation in the labor force. The red line shows the actual prime age LFPR (data from FRED). The black line assumes that all former inmates re-entered the labor force and none were discouraged. The grey line assumes that 60% of former inmates get discouraged and left the labor force (see Sentencing Project analysis above).
 

 

Based on this approach, the LFPR would have fully recovered from the Great Recession if we assume a full adjustment for people with criminal records. Assuming a 60% discouragement rate among former inmates, the LFPR has significantly recovered from the Great Recession effects, and the recovery is better than the unadjusted LFPR rate.

A feature, not a bug

I would add that this analysis assumes that there was no employment discouragement effect on people who were arrested but not charged. In reality, this “arrested but not convicted” category undoubtedly also had a depressing effect on the participation rate, as that population would have had sufficient difficulty in finding work that they would be more likely to leave the labor force than the general population.

In conclusion, using two separate approaches, I estimate that the surge in incarceration rate in the United States in the last couple of decades has dramatically affected labor force dynamics. The plunge in labor force participation rate is an unintended consequence of the country`s law-and-order focus. In other words, falling LFPR is a feature of past policy, not a bug.

As a result, the economy is likely far closer to full employment than standard unfiltered statistics, which has bullish implications for cost-push inflation. The slightly more hawkish tone of the latest FOMC minutes should therefore be taken as a welcome sign that the Fed will not fall behind the inflation fighting curve:

Many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the committee’s maximum-employment and inflation objectives increased.

Based on the results of this study, it could be argued that monetary policy should be on an even hawkish trajectory than three hikes in 2017.

Stay cautious, but wait for the break

Posted by Cam Hui -

Mid-week market update: Markets behave different at tops and bottoms. Bottoms are often V-shaped and reflect panic. Tops are usually slower to develop. Hence the trader’s adage, “Take the stairs up, and escalator down.”

I have been writing that the US equity market appears to be extended short-term and ripe for a pullback, but that was last week and about 1% lower (see Why the S&P 500 won’t get to 2400 (in this rally)). I stand by those remarks.

I could say that the Fear and Greed Index appears to be extended and historically stock prices have had difficulty advancing further with readings at these levels.
 

 

I could also say that Ned Davis Research Crowd Sentiment Poll is also extended. Historically, stock prices have exhibited a negative bias at these levels (via Tiho Brkan).
 

 

None of this matters much to short-term traders. That’s because sentiment and overbought/oversold indicators are less useful at tops than bottoms. While it may be timely for traders to tilt to the long side when panic starts to appear, market euphoria are not good trading signals of market tops. Savvy traders know to wait for a bearish break when the market gets overbought and giddy.

I am seeing some limited signs of a bearish break, but the trading sell signal is incomplete.

CBOE put/call sell signal

I recently highlighted the euphoric condition where the CBOE equity-only put/call ratio (CPCE) had fallen to below 0.60 for four consecutive days. A study showed that such overbought conditions resulted in subpar returns, but they were still positive.
 

 

The same study showed that when the market becomes overbought and mean reverts, CPCE rises above 0.60, forward returns tend to far more negative. That`s the bearish break that traders should be waiting for.
 

 

The signal appeared as of Tuesday’s close, when CPCE rose to 0.61 and Wednesday’s preliminary equity put/call ratio came in at 0.82. Those are sell signals.
 

 

Still waiting for other breaks

While the CPCE sell signal is encouraging for the bears, other short-term technical indicators have not flashed signals for my inner trader to commit funds to the short side. I am waiting for the SPX to fall below its 5 day moving average, which currently stands at about 2355. In addition, I am waiting for RSI-5 and RSI-14 to decline below 70 as signs of faltering momentum.
 

 

I would add that my cautiousness is tactical. Any pullback should be regarded as a correction within an uptrend unless proven otherwise.
 

 

My inner investor remains bullishly positioned. My inner trader is in cash, but he is waiting for a technical break to go short.

Negative real yields = Equity sell signal?

Posted by Cam Hui -

A reader asked me my opinion about this tweet by Nautilus Research. According to this study, equities have performed poorly once the inflation-adjusted 10-year Treasury yield turns negative. With real yields barely positive today, Nautilus went on to ask rhetorically if the Fed is behind the inflation fighting curve.
 

 

Since the publication of that study, The January YoY CPI came in at 2.5%, which was surprisingly high. The higher than expected inflation rate pushed the 10-year real yield into negative territory. So is this a sell signal for equities?
 

 

Well, it depends. The interpretation of investment models often depends a great deal on their inputs. In this case, the questions is how does we adjust for inflation? Do we use the headline Consumer Price Index (CPI), core CPI, which is CPI excluding volatile food and energy prices, or some other measure?

As I go on to show, how we adjust for inflation dramatically alters the investment conclusion for a variety of asset classes, like equities, gold, and the USD.

As is the case in the application any quantitative model, the devil is in the details.

Real yields and equity returns

Consider the evidence. As the FRED chart below shows, history shows real yields indeed either lead or are coincidental with equity returns. If we adjust for 10-year Treasury with headline CPI, the outlook is equity bearish. On the other hand, adjusting with core CPI leads to a bullish conclusion.
 

 

Which inflation measure should we use?

Real yields and the USD

There is a more direct empirical relationship between real yields and the level of the US Dollar. As real yields rise, it puts upward pressure on the USD. So which inflation rate should we use?
 

 

Real yields and gold

Historically, the price of gold has been inversely correlated with the USD. Since gold is thought of as an inflation hedge, it is therefore no surprise that low real yields are gold bullish and high real yields are bearish (note the inverse scale for the gold price, right axis).
 

 

Our intermediate term outlook for these asset classes therefore crucially depend on the correct interpretation of the inflation adjustment factor. Do we use headline CPI, or the less volatile core CPI?

A “hot” CPI print

The CPI print last week came in ahead of expectations. YoY CPI was 2.5% (vs. 2.4% expected), and core CPI was 2.3% (vs. 2.1% expected). As I showed in my previous post (see Watch what they do, not just what they say), most of the strength in CPI was attributable to rising Owners’ Equivalent Rent (OER), which comprises of 25% of the weight of CPI and 31% of core CPI, according to the latest BLS figures. (Note that the chart subtracts 2% from each CPI metric so that we can easily see whether each is above or below the Fed’s 2% inflation target.)
 

 

Much of the recent boost to headline CPI compared to core CPI is attributable to surging gasoline prices. As the chart below shows, YoY gasoline prices are due to peak and headline inflation should start to moderate in the months ahead.
 

 

After dissecting the components of CPI, my conclusion is that inflation remains tame after stripping out the more volatile components and OER, which can be ignored for the purposes of this analysis. I have also highlighted past analysis from George Pearkes that core PCE, which is the Fed’s preferred inflation metric, has been slowing.
 

 

In conclusion, investors shouldn’t panic about negative real yields based on an erroneous interpretation of inflation. Unless conditions change dramatically, the intermediate term outlook for the USD and equities is bullish. Conversely, gold bulls will face headwinds from positive real yields.

Watch what they do, not just what they say

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.

Great expectations

Bloomberg recently highlighted the huge gap between expectations and reality. As the chart below shows, soft (expectations) data has been surging, but hard (actual) data has risen, but it has not caught up with expectations.
 

 

The markets are pricing for perfection, which sets up a situation where minor disappointments could spark a market sell-off. BCA Research found that such divergences between “soft” expectations data and “hard” economic data has seen equity corrections in the past.
 

 

This week, I examine the details of how expectations have diverged from actual data on a number of dimensions.

  • Small business confidence
  • Corporate confidence
  • Consumer confidence
  • Federal reserve expectations
  • Wall Street’s tax reform expectations

Small business euphoria

Last week`s release of the NFIB January small business confidence survey showed another upside surprise. Small business optimism continued to surge and rose to multi-year highs. As small business owners tend to be small-c conservatives who tend to tilt Republican, the election of Donald Trump has undoubtedly sparked a resurgence in business optimism.
 

 

However, the outpouring of optimism has not been matched by actual sales results. Even though sales ticked up last month, their rise lagged expectations. Since 1974, there have been five other episodes where expectations have surged. In two of those cases, sales rose to match expectations; in two others, they did not; and in 2009-10, sales saw eventually rose, but the surge was delayed by about a year (chart annotations are mine).
 

 

Small business capital expenditure plans have been relatively muted despite the surge in small business optimism.
 

 

One reason for the cautiousness could be attributable to rising labor costs. While labor costs have risen, business owners have not been able to raise prices to pass through higher compensation rates, which results in a margin squeeze.
 

 

I am keeping an open mind as to whether small business optimism will translate into more hiring and capital expenditures. But watch what small business owners do, not just what they say.

Corporate optimism

It’s not just the mood of small business owners that has become more upbeat. A simple word count of the word “optimistic” in earnings calls has surged to all-time highs.
 

 

But if management is so optimistic, then why have insiders been selling so much of their company’s shares (via Barron’s)?
 

 

Watch what corporate insiders do, not just what they say.

Can the consumer MAGA?

If Donald Trump is to Make America Great Again, then one of the key ingredients is strength in consumer spending. As the chart below shows, the US economy is seeing a divergence between rising consumer confidence (black line) and real wage growth (blue line). How can the consumer spend when real wages are stagnant? More worrisome is the observation that falling real wages have been precursors to recessions in the past, not booms.
 

 

Even though January retail sales rose and beat expectations, consumer spending is likely to disappoint in the short-term. That’s because after adjusting for inflation, real retail sales actually fell from December to January. In addition, Bloomberg reported that this year’s IRS anti-fraud tax refund procedural changes are delaying the timing of refund payments. This is likely to depress current consumer spending and push it out by several months.
 

 

New Deal democrat is becoming concerned. He wrote about the ways consumers cope if real wages don’t grow. When the consumer runs out of coping mechanisms, the economy slides into recession:

The theory is that if real average wages are not increasing, which for a long time beginning in the 1970s they were not, average Americans use a variety of coping mechanisms. From the 1970s through the mid-1990s, spouses entered the workforce, adding to total household income. Other methods have included borrowing against appreciating assets, and refinancing as interest rates declined.

Borrowing against stock prices ended in 2000. Borrowing against home equity ended in 2006. When interest rates failed to make new lows, the consumer was tapped out, and began to curtail purchases. Thus in September 2007, with the stock market peaking, house prices falling, interest rates having not made new lows in over 3 years, and real wage growth having stalled, I wrote that a recession was about to begin: http://www.dailykos.com/story/2007/09/25/389903/-Why-American-consumers-are-signaling-recession

So far, mortgage rates have not made a new low for quite some time, so forget housing prices as an ATM to fuel consumer spending. Another way of maintaining consumer spending is to reduce savings. The savings rate is dropping, but it is not at levels that have signaled recessionary conditions in the past. As major stock indices reach all-time highs, another way of coping is by taking profits on their stock portfolios , but only a small minority of households are invested in the equity market.
 

 

NDD concluded:

So the consumer fundamentals nowcast indicates that the expansion should continue for awhile, but if inflation eats up wage gains and the savings rate this year, then all we will need for the consumer to signal a recession is for asset prices to peak. I do not think that will happen until at least next year.

Don’t panic just yet, but risks are rising. Watch what the consumers do, not just what they say.

A hawkish Fed

What’s going on at the Fed? George Pearkes recently observed core PCE, the Fed’s preferred inflation metric, has been slowing.
 

 

So why did Janet Yellen take on a decidedly more hawkish tone in her Congressional testimony last week? In fact, the WSJ reported that Fed officials have fanned out across the country to reinforce the message that to expect three rate hikes in 2017, which is more hawkish than the market expectations.

To be sure, the Consumer Price Index (CPI) came in a bit “hot”, or ahead of expectations, both in the headline number and core CPI. But as the chart below shows, much of the increase can be attributable to Owners’ Equivalent Rent (OER). Core sticky price CPI, ex-OER has remained below the Fed’s 2% target (note I have subtracted 2% from all CPI figures in order to better graphically show how far different inflation metrics are from the Fed’s 2% target).
 

 

What’s going on? What is the Fed seeing that the rest of us don’t see? Is the Fed reacting in anticipation of the Trump administration’s fiscal stimulus plan? Sure that can’t be the case. Ben Bernanke recently penned a thoughtful essay about the FOMC’s decision making process. He indicated that Fed officials focus on the medium term outlook. While the effects of fiscal policy plays a part in the Fed’s deliberations, they tend to take a wait-and-see attitude to see the full details of the legislative proposals before modeling the effects.

Watch what the Fed does, not just what they say.

Where’s my tax cut?

Over on Wall Street, they are still waiting for Trump’s “tremendous tax plan”, which will probably get unveiled in Trump’s joint address to Congress on February 28, 2017. Equity markets have rallied partly in anticipation of Candidate Trump’s tax cut and offshore tax repatriation proposals. It is not clear, however, whether any tax cuts would actually materialize this year, or what kind of bitter pill the economy would have to swallow in order for the tax cuts to get passed.

So far, it seems that the only way that Trump can pay for his proposed tax cut would be through the imposition of a border adjustment tax (BAT). Without a BAT, the Trump tax cuts could cost up to $7 trillion, according to the Tax Policy Center (via CNN Money). Bloomberg reported that the latest tax reform proposal has been stalled in Senate because a lack of Republican support:

Not long after House Speaker Paul Ryan offered a full-throated affirmation of his tax-overhaul plan, an influential conservative group announced a grassroots campaign against it and a Senate leader said a key part of the proposal is “on life support.”

Senate Majority Whip John Cornyn was diagnosing Ryan’s plan to replace the U.S. corporate income tax with a new, “border-adjusted” levy on U.S. companies’ domestic sales and imports. The proposal has stirred sharp divisions among businesses: Retailers, automakers and oil refiners that rely on imported goods and materials oppose it, while export-heavy manufacturers support it.

So far, the opponents are winning, interviews with lawmakers, lobbyists and tax specialists show. As Congress prepares to depart Washington for a one-week break, Cornyn said he didn’t see the votes lining up for the House leaders’ plan.

Even if a BAT were to pass, I highlighted analysis by Barclay’s last week (via Sam Ro) showing the net effects of a tax reform package. The sheet size of the BAT would, by necessity, be extremely protectionist and such an initiative would invite a debilitating global trade war.
 

 

Here is what’s at stake for equity investors. John Butters from Factset pointed out that the market’s forward P/E of 17.6 is at levels last seen in 2004, a 13-year high. Investors would have to include the dot-com bubble era to make the case that the current forward P/E looks reasonable on a historical basis. In short, market expectations for tax cuts and offshore cash repatriation are extremely high and prone to disappointment.
 

 

Watch what Trump administration and Congress do, not just what they say.

The week ahead: Be a patient bear

Looking to the week ahead, I don’t want to repeat what I’ve have written over the past week. The points I made in my last post (see Why the SP 500 won’t get to 2400 (in this rally)) still stands. Fundamentals still look wobbly, sentiment remains excessively bullish and short-term technical indicators are flashing overbought readings.

The latest update from Factset shows that forward 12-month EPS stopped falling and rose last week, which is a positive sign for stock prices. But the 2 and 4 weeks rates of change remain negative. In the past, stock prices have struggled whenever forward EPS has been flat to down.
 

 

The 10-year weekly SPX chart below illustrates how overbought the market is. I have marked past instances when RSI-5 has risen to similar levels. The red vertical lines when the market has declined, and the blue lines when the market has continued to advance. In the last 10 years, there were six red lines and three blue lines. We now have another overbought signal, play the odds.
 

 

On a shorter term time frame, this Index Indicators chart of stocks above their 10 dma is starting to roll over from overbought territory. That’s a classic technical trading sell signal.
 

 

As well, these market internals of risk appetite look very iffy.
 

 

Tactically, bearish traders may want to be patient. Helene Meisler observed that the CBOE equity only put/call ratio (CPCE) has spent four consecutive days under 0.60. The market is certainly overbought on this metric.
 

 

I conducted a study of past episodes, which indicates that such overbought markets don’t necessarily decline. Short term returns have been weak, but still positive.
 

 

Returns are tilted to the downside once CPCE mean reverts and breaks up above 0.60.
 

 

My inner investor remains bullishly positioned, though he is getting a little nervous. Should the market correct, he will be watching to see the nature of the bearish catalyst before making any further investment decisions.

My inner trader moved to cash a couple of weeks ago and he is standing aside from this market volatility.