Page 71 – Humble Student of the Markets

A mid-year review of 2018 recession risk

Posted by Cam Hui - July 9, 2017

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

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

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

The latest signals of each model are as follows:

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

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

What is the risk of recession?

Over at A Dash of Insight, Jeff Miller criticized WSJ reporter Greg Ip for writing what Miller consider to be a doomster-like article about rising recession market risk. He went on to accuse Ip of cherry picking data to make his point about a heightened risk environment, and concluded:

The entire article reads like a laundry list of points that would make sense to investors with limited knowledge of economics. That is why I am disappointed. My hope is that top journalists would help explain reality rather than feed fears stoked by so many others. This article will frighten investors. Is that what the author intends?

The issue of recession risk is important to investors because every recession has been accompanied by an equity bear market. So let me put in my two cents worth in my own assessment of recession risk for the American economy.

Some time ago, I created a Recession Watch page on my website. The recession risk criteria on the page was based on the framework specified by New Deal democrat. NDD used the work of Geoffrey Moore, the founder of ECRI, to create seven long leading indicators designed to spot recessions a year in advance (click on links for the latest FRED charts):

Corporate bond yields (Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession)
Housing starts (Housing starts peaked at least one year before the next recession)
Real private residential fixed investment (Aside from the 1981 “double-dip,” and 1948, it has always peaked at least one year before the next recession)
Money supply (In addition to the 1981 “double dip,” on only 2 other occasions have these failed to turn negative at least 1 year before a recession)
Corporate profits and Proprietors` income, which can be a more timely proxy for corporate profits (Corporate profits have peaked at least one year before the next recession 8 of the last 11 times, one of the misses being the 1981 “double-dip.”)
Yield curve, which may not be relevant in the current interest rate environment (The yield curve inverted more than one year before the next recession about half the time)
Real retail sales (It has peaked 1 year or more before the next recession about half of the time)

A review of the seven indicators revealed both good news and bad news. Here are the details of each indicator, along with a discussion of the internals behind each indicator,

A healthy consumer (and jobs market)

Starting with the good news, the strongest indicator is real retail sales, which has been strong and shows no sign of turning down. It is difficult to see how the economy could collapse into recession if the consumer is still spending.

The key driver of retail sales is employment and wages. Friday`s June Jobs Report contained more good news than bad news. The good news is the headline Non-Farm Payroll (NFP) came in at 222K, which was well ahead of expectations. The closely watched participation rate edged up, indicating an expanding workforce, which raised the unemployment rate and reduced pressure on the Fed to raise rates. As well, average hourly earnings (AHE) came in at 0.2%, which was below expectations of 0.3%, indicating non-inflationary wage growth in the face of employment gains. Another positive that was buried in the report was the continuing gains in temporary jobs, whose peaks have tended to lead past NFP peaks.

It was a solid report, and we should see more details about the labor market next week when the Labor Market Conditions Index is released Monday and from the JOLTS report Tuesday. From the consumer`s viewpoint, however, there was one minor blemish that came in the form of AHE. As the chart below shows, AHE has been barely keeping pace with inflation. If real AHE does not show any progress, then how does real retail sales grow, unless the household takes extraordinary measures such as digging into savings or by borrowing?

Bottom line: The consumer is still healthy, but spending growth may be start to get pressured.

Whither corporate profits?

Corporate profits have had a record of peaking before past recessions, which makes it a good long leading indicator. As the chart below shows, corporate profits, whether normalized by unit labor costs or by inflation, have peaked for this cycle, which is an ominous sign.

The quarterly corporate profits data series is released with a significant lag, which lessens the utility of this indicator. However, proprietors’ income is a more timely proxy for corporate profits. Proprietors’ income has not peaked and remains strong.

Forward looking indicators such as Street estimates from FactSet remains strong. Early indicators of the results Q2 earnings season show that both earnings and sales beat rates are above historical averages.

As well, Ned Davis Research reported that forward EPS estimate revisions for the MSCI All-Country World Index are still rising.

Score corporate profits as a positive, for now.

Yield curve

The yield curve has historically been an uncanny signal of future recession. The 2/10 Treasury curve, or spread, has inverted before every recession since 1980. However, it is unclear how effective this indicator is likely to be in this era of near zero rates and quantitative easing.

The yield curve had been flattening for much of 2017, which is usually interpreted as the bond market discounting slower economic growth. It recently steepened dramatically. However, much of the steepening effect can be attributable to hawkish comments from the ECB about the prospects for the reduction of their QE program. In effect, an ECB induced “taper tantrum” has traveled across the Atlantic.

Rank the yield curve indicator as neutral, though the readings are confusing.

Money supply

One of the best known monetary equations in economics is PQ = MV, where P (price) X Q (quantity) = overall economy, or GDP, is equal to M (money supply) X V (monetary velocity). Theory holds that V is held constant over time, so the quantity of money determines how much liquidity is in the economy to power growth. Too much money sloshing around the economy will result in inflation. Too little, you get recession.

Here is the chart of real M1 and M2 growth over time. Real money supply growth has historically turned negative before past recessions. Current reading are still positive, but money growth is decelerating. The current expansion is unusual in that M1 velocity (dark blue line) has turned up in past cycles, but haven`t even risen once during this cycle and continues to fall.

The above chart uses a monthly M1 and M2 money supply data series to coincide with the monthly CPI data. Here are more timely weekly nominal money supply data series overlaid with monthly CPI. The story remains the same. Money growth is decelerating, though real growth is not negative yet.

Rank this indicator as neutral to negative, and deteriorating.

Is housing rolling over?

One of the key canaries in the coalmine of the American economy is the housing and construction sector. That’s because of the extreme cyclical nature of that industry. The latest data shows that both noisy housing starts and housing permits tends appear to have peaked for the cycle, which is a negative.

Another way to gauge the health of the housing and construction sector is real private residential investment, which amounts to spending on private housing as a percentage of GDP. This metric (black line) has not rolled over, but it is a quarterly data series that is reported with a delay, compared to the noisy monthly housing starts and permits data. Looking ahead, the recent rise in long bond yields is pushing up mortgage rates, and that will be another headwind for housing.

Bottom line: The housing sector looks wobbly. Rank this sector as a negative.

Corporate bond yields

Corporate bond yields have historically bottomed well before the onset of the next recession. Corporate yields bottomed a year ago, but this indicator has had a history of being extremely early in its recessionary warnings.

The midyear winner…

When I put it all together, the snapshot shows two positive, two negative, and three neutral indicators, with a negative direction of change. If this was a race and if were to end now, the verdict would call for low recession risk. Greg Ip would be declared an excessive worry wart and should be banished to write for Zero Hedge.

However, the race is no sprint but a marathon. Much of the future direction of recession risk depends on Fed policy, which is becoming increasing hawkish in tone.

The Fed policy wildcard

Even though the nowcast snapshot of recession risk remains relatively low, aggressive Fed policy to normalize monetary policy is likely to significantly raise the odds of a recession in 2018. Last Wednesday’s release of the FOMC minutes had the financial press interpreting the minutes as “deep divisions within the Fed”. Tim Duy cut through the BS and explained the “divisions” this way.

Recently Fedspeak from the important voices within the FOMC, such as Yellen and New York Fed President Dudley showed a determination to stay the course and normalize policy. Writing at Bloomberg, Duy thinks that the Yellen Fed is changing its focus towards financial stability as an objective:

Core leadership at the Federal Reserve appears determined to normalize policy via interest-rate hikes and balance-sheet reduction. But they have run up against a significant roadblock because the inflation data stubbornly refuse to cooperate with their forecast. Don’t expect that to deter leaders of the U.S. central bank just yet. They generally view the inflation weakness as transitory. A labor market circling around full employment serves as the justification they need to keep their foot on the brake.

And if that weren’t enough, they can pivot their focus toward financial stability. Indeed, that’s already under way. But be warned: That road will almost certainly lead to excessive tightening. In it you can see one path by which this expansion comes to an end.

Does that mean the return of the Yellen Put? Well, sort of. But Duy thinks such a shift brings enormous risks as the Fed does not have a roadmap that specifies a well-test reaction function. Consequently, they are more likely to fall behind the curve and react too late:

When central bankers lose focus on their primary mandates — inflation and unemployment — the odds of a policy mistake rise sharply. Remember that the most likely cause of a sustained drop in asset prices will be a recession and the associated fall in profits. That means that if central bankers wait until asset prices roll over before they stop tightening, they have almost certainly waited too long. I don’t think the Fed is in imminent danger of making such a mistake, but I can see the genesis of such a mistake if the bank turns rate decisions too much toward financial stability concerns.

If the Fed were to stay on this path, then expect the rate hike and balance sheet normalization path to be far more hawkish than the market expects. The hawks have plenty of ammunition to justify their course of action. The latest research from Goldman Sachs (via CNBC) which suggests that the opioid epidemic is affecting the employment eligibility of the labor force may provide the Fed a figleaf to justify ignoring feeble rise in the labor force participation rate and proceed with its normalization policy. As well, any likely Trump appointees to the Fed’s Board of Governors, as well as possible Fed chair replacement, are likely to lean towards a rules-based approaches to monetary policy and be even more hawkish than Janet Yellen (see A Fed preview: What happens in 2018?).

With the nowcast of recession risk reading in neutral, but deteriorating, how many much rate hikes and balance sheet reductions will recession risk rises into the danger zone?

Investment implications

Here is where the rubber meets the road. In light of these recession risk readings and likely path of Fed policy, what should an investor do?

Barry Ritholz recently wrote a Bloomberg article that castigated the doomsters, An Expert’s Guide to Calling Market Tops. To sidestep the problems that Ritholz hat identified, I prefer an approach of outlining an analytical framework ahead of time and then applying that framework to the current data.

Some time ago, I laid out a model for calling a market top for long term investors (see Building the ultimate market timing model). The technique calls for using a model to determine recession risk. If recession risk is high, or if it is evident that the economy is in a recession, use moving average techniques to take you out and back into the equity market. It is an extremely low turnover strategy that is useful for long-term investors who don’t want to trade a lot.

So where are we now? Despite the clouds on the horizon, the nowcasts of market and economic outlooks remain positive. FactSet‘s analysis of forward 12-month EPS revisions continue to be positive, which is bullish. As long as the Trump Administration doesn’t impose tariffs on steel and initiate a trade war, which could have unpredictable effects on the earnings outlook, the macro backdrop is bullish.

As well, Barron’s latest update of insider activity is constructive for further equity gains.

The sector rotation script based on a reflationary rebound that I wrote about is developing more or less as expected (see More evidence of a reflationary rebound). Capital-goods intensive industrial stocks are staging upside relative breakouts and assuming the market leadership mantle. The chart below depict the float weighted Industrial market performance in the top panel, and the equal weighted Industrial market performance in the bottom panel. The equal weighted relative breakout is of particular importance because of the dominance of heavyweight GE in the Industrial index.

The cyclically sensitive industrial metals are also holding up well, and they are staying above their 50 and 200 day moving averages.

The VIX Index rose above its upper Bollinger Band and mean reverted below over a week ago and flashed a SPX buy signal, which didn’t work. The same buy signal occurred last Friday, just as the index tested its 50 day moving average and exhibited a bullish divergence on RSI-5.

Even NASDAQ breadth is holding up relatively well despite the recent weakness.

As we proceed through Earnings Season in the upcoming weeks, expect the market to grind upwards in a choppy fashion as it reacts to the day-to-day earnings news from individual companies. My inner investor remains bullish on equities, and my inner trader got long the market last week.

Disclosure: Long SPXL

The things you don’t see at market bottoms, bullish bandwagon edition

Posted by Cam Hui - July 7, 2017

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

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

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

To summarize, Callum Thomas of Topdown Charts constructed a Euphoriameter, consisting of forward P/E, VIX (inverted), and bullish sentiment. Readings are highly elevated, though they have not reached the highs seen at the last cycle top.

Surging Street bullishness

In addition, the BAML Sell Side Indicator, which measures the asset allocation of Street strategists, has proven to be a good contrarian indicator. Currently, Street bullishness is surging, and BAML strategist Savita Subramanian wrote, “The recent inflection from skepticism to optimism could be the first step toward the market euphoria that we typically see at the end of bull markets and that has been glaringly absent so far in the cycle.”

I agree. Just like the “Euphoriameter”, readings are rising and highly elevated, but it is too early to declare this a contrarian sell signal just yet.

Bob Shiller gets really, really bullish

Bob Shiller, who developed the CAPE valuation metric that shows stock markets to be richly priced, stated in a CNBC interview that upside potential is up to 50% from current levels. He did, however, qualify that remark:

Stocks are “highly priced now, which means I don’t expect them to outperform so much,” he said. “But for a long-term investor and most people are, I think there should be a place for stocks in the portfolio and they could go up a lot from where they are now … they could also go down.”

Retail investors jump on the bandwagon
There are other indications that the retail investor is jumping on the bullish bandwagon. The latest AAII asset allocation survey shows that equity allocations are at levels not seen since 2005. The asset allocation survey is not to be confused with the weekly AAII opinion survey. The former asks what people are actually doing with their money, compared to their opinion of the markets, whose survey results can be volatile and move around from week to week.

Equity allocations among individual investors rose to their highest level in more than a decade last month. The June AAII Asset Allocation Survey also shows fixed-income holdings at a multi-year low.

Stock and stock fund allocations rose by 1.4 percentage points to 68.8%. This is the largest allocation to equities since April 2005 (70.3%). June was the 51st consecutive month that equity allocations were above their historical average of 60.5%.

Bond and bond fund allocations declined 0.5 percentage points to 15.0%. Fixed-income allocations were last lower in May 2009 (14.2%). The historical average is 16.0%.

T-D Ameritrade does a similar survey of their client accounts to determine the level of retail investor optimism about the stock market. The June survey results have not been released yet, but the latest May readings show that bullishness is highly elevated, though they are not a record levels.

And finally, there is this tweet from Ben Carlson.

Need I say more?

More evidence of an emerging reflationary rebound

Posted by Cam Hui - July 5, 2017

Mid-week market update: Further to my last post (see Nearing the terminal phase of this equity bull), There are numerous signs that the market’s animal spirits are getting set for a reflationary stock market rally. First of all, the BAML Fund Manager Survey shows that a predominant majority of institutional managers believe that we are in the late cycle phase of an expansion.

Poised for a reflationary rebound

Monday`s print of ISM blew past market expectations. Nordea Markets pointed out that an ISM reading of 57.8 has historically corresponded with a YoY SPX return of 26%, compared to a current YoY return of 14%.

Johnny Bo Jakobsen at Nordea Markets also observed that the Citigroup Economic Surprise Index, which measures whether economic releases are beating or missing expectations, follows a seasonal pattern of Spring weakness, following by a recovery that begins about now.

Should ESI start to rise, the yield curve has significant room to steepen.

Sector rotation = More growth

A review of equity sector leadership shows that the stock market is also setting up for the return of more growth and inflation.

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

Here is the RRG chart for US sectors.

There are a number of observations to make. We can see that Technology leadership has rolled over. Sectors such as Consumer Discretionary, Utilities, and Consumer Staples are also losing relative strength, and therefore should be avoided or tactically underweight in portfolios.

Emerging leadership can be see in the capital-goods heavy Industrial stocks, which I discussed in Nearing the terminal phase of this equity bull. The chart below shows that this sector has staged a relative upside breakout through initial resistance, though further overhead relative resistance is ahead. The macro backdrop for capital goods appears to be international in scope, as Bloomberg reported that “Euro Area faces capital bottlenecks as recovery gathers pace”.

The relative performance of Financial stocks have been correlated with the shape of the yield curve. A steepening yield curve, which is the bond market’s signal of better growth expectations, should be positive for this sector.

Mining stocks appear to have bottomed out against the market and they are poised to turn up. This as another sign of a nascent reflationary bias in sector leadership.

Equally intriguing for the inflation trade are the Energy stocks. Energy is in the process of testing a key relative downtrend line.

The monthly chart of the Energy stock ETF (XLE) is also displaying a constructive pattern of a doji candle in June, which indicates indecision, with a possible turnaround in the first few days of July.

Gold stocks are currently testing a relative support within the context of a relative downtrend. For a full surge of inflationary expectations to occur, the relative performance of gold stocks need to turn up, which hasn’t happened yet.

Finally, I would like to add a word about the Healthcare sector. The relative strength turnaround in Biotech and Healthcare is a function of the Obamacare repeal (and possible replacement) that is winding its way through Congress. While these stocks have bottomed and rallied, their future performance is dependent on legislation. Your guess is as good as mine as to the fate of that legislation.

Setup for a blow-off top

In addition, Ryan Detrick at LPL Research pointed out that July tends to be seasonally bullish.

As well, the market tends to perform better when returns in the first six months exceed 8%, which it has.

In short, the stars are lining up for a reflationary rally and blow-off top. Fasten your seat belts!

Disclosure: Long SPXL

Nearing the terminal phase of this equity bull

Posted by Cam Hui - July 2, 2017

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities
Trend Model signal: Risk-on
Trading model: Bullish (upgrade)

Charting the pain trade

Even as the recent SPX stays in a narrow trading range, there was plenty of pain to go around beneath the surface. The drubbing taken by NASDAQ stocks were largely offset by rallies in Financials and Healthcare.

So what are the next pain trades, and what are the implications?

Hedgopia documented how large speculators (read: hedge funds) have moved from a crowded short in the 10-year Treasury Note to a crowded long.

Similarly, large speculators are also in a crowded long in the T-Bond futures.

Bond yields began to rise, and the yield curve steepened dramatically.

Those are the first major pain points for traders. These dramatic reversals have further implications for the equity market.

Here comes the reflation trade

Two weeks ago, I highlighted a scenario for how an equity bear market may begin (see Risks are rising, but THE TOP is still ahead). It called for one last reflationary blow-off, led first by capital-goods intensive industries, and then spreading to the late cycle inflation hedge and hard asset sectors such as energy and mining. One important sign of this reflation theme taking hold would see bond yields starting to back up and the yield curve steepening.

It appears that the developments that I had outlined are coming to pass. There are signs of a turnaround in both the Citigroup US Economic Surprise Index, which measures whether economic statistics are beating or missing expectations, and bond yields.

Another bullish development that was largely ignored by the market was the better than expected Manufacturers’ New Orders, which is an indication of a capex revival.

The market relative chart of the capital-goods heavy Industrial stock sector looks constructive as it nears another relative upside breakout after a pullback test after the initial breakout.

Is an inflation blow-off around the corner?

Hot on the heels of a capital-goods revival is the rise of inflation and inflationary expectations. I had highlighted analysis from New River Investments manager Conor Sen who postulated an oil spike would signal the end of the economic expansion:

Every boom in the U.S. economy is different, but over the past several decades, each has ended the same way. First you get full employment. Then you get a spike in the price of oil. And then there’s a recession.

When Sen wrote those words, I was skeptical that the current cycle would necessarily be marked by a surge in oil prices. Instead, I generalized the analysis to rising commodity prices would be the signal for rising inflationary expectations, to which the Fed would have to respond with more aggressive tightening.

Indeed, the prices of industrial metals have staged an upside breakout from a downtrend. By contrast, the energy heavy CRB Index is still struggling to test a key technical resistance line.

The relative market performance of mining stocks in the US and Basic Material companies in Europe are also tracing out constructive bottoming and recovery patterns, indicating the global nature of the upturn.

By contrast, both American and European Energy sectors remain in relative downtrends.

Even though the above chart shows that Energy stocks are staging a relative strength rally, there are no definitive signs that their relative strength is anything more than just a blip in relative downtrends – until now.

The energy pain trade

Short energy stocks is another potential pain trade. Sentiment in the energy sector is getting washed out. Should oil and commodity prices turn up, that would be the setup for a second pain trade that could rip the faces of the shorts. Sentiment Trader recently documented how Rydex assets in energy is at all-time lows.

Here is another way of thinking about this sector, the weight of Energy in SPX hasn’t been this low since 2004.

Tiho Brkan pointed out that Google searches for “bear market” and “oil” have spiked, an levels are consistent with readings at past market bottoms in oil prices.

Washed out sentiment aside, it is unclear what the exact catalyst is for an oil price revival, but there are two possible fundamental candidates. Marketwatch recently reported that energy analyst Phil Flynn’s forecast of a shale oil production crash. Low prices have prompted wildcatters to cut back on their exploration budgets. Consequently, the discovery of new fields have plummeted. While rig counts remain steady, their productivity is starting to fall, which led to Flynn`s conclusion of a shale oil production crash.

As well, the elevation of Mohammed bin Salman (MbS) as the new Crown Prince raises the risk of geopolitical disruption in oil prices. MbS has been the architect of Saudi Arabia’s more aggressive foreign policy, such as its military adventure in Yemen, which has turned into a quagmire, and the isolation of Qatar. These foreign policy initiatives have been aimed at curbing Iranian influence in the Gulf. Therefore the risk of either a Saudi-led diplomatic or military confrontation with Iran in the near future has risen considerably. Such an event has the potential to disrupt oil supply from the region and spike prices.

Here is why the price of crude matters. Johnny Bo Jakobsen documented a long-term relationship between oil prices and inflationary expectations.

Scott Grannis found a similar relationship between gold prices and 5-year inflation-indexed bond yields.

If commodity prices were to start rising again, it will lead to rising inflationary expectations. The Fed, which is already intent on rate normalization, will have no choice but to respond with a more hawkish monetary policy. The combination of more rate hikes and balance sheet reduction will, at some point, choke off growth enough to push the economy into recession.

It is said that no one rings a bell at market tops, but a recovery in commodity prices is as close to a signal as investors are likely to get. I would caution, however, that a definitive turnaround in oil and other commodity prices hasn’t occurred yet.

The trade war wildcard

Last week, I wrote that policy was likely to be a bigger driver of market returns than economic data in a data light week (see All eyes on policy makers). That is especially true today, as Axios reported that the US is on the verge of imposing broad tariffs on steel:

One official estimated the sentiment in the room as 22 against and 3 in favor — but since one of the three is named Donald Trump, it was case closed.

No decision has been made, but the President is leaning towards imposing tariffs, despite opposition from nearly all his Cabinet.

As the imposition of tariffs has the potential to set off a trade war, such a development could freak out the markets. Business Insider reported that the estimated effects of a trade war could cut 0.5% to 1.0% from GDP growth next year:

Michael Gapen, a chief US economist at Barclays, in December estimated the economic drag that broader tariffs on imports from China and Mexico, two of Trump’s favorite targets, may have on US GDP growth.

One idea floated by the Trump team previously was a 15% tariff on Chinese imports and a 7% tariff on Mexican imports — modestly above their current levels of 2% to 10%, depending on the good. In this scenario, Gapen estimated that the US would see a 0.5% reduction in annual GDP growth in the year after implementation.

Meanwhile, Buiter said Citi estimates trade and other policy uncertainties could be a 1% drag on US GDP over the next year.

A decision to impose tariffs on steel has a geopolitical dimension as well. Among countries that are likely targets of sanctions are China and South Korea. Such a move would setback American efforts to contain North Korea’s nuclear and missile development ambitions, and would have the effect of raising tensions in North Asia.

Under more “normal” circumstances, late cycle expansion accompanied by inflationary pressures from rising commodity prices would see an inflationary driven equity market blow-off, led at first by Industrials, followed by Energy and Materials. All bets are off if the Trump Administration’s steel tariffs spark a trade war.

Under those conditions, we may see a choppy market top develop characterized by sector rotation. Winners would include Energy and Materials, especially the steel producers. Losers would be concentrated in Consumer Discretionary and Industrials as cost of inputs rise, which would squeeze margins.

In short, market conditions are setting up for a last gasp market blow-off. However, we have to allow for the possibility that the market may have already made its high for this cycle, and the major averages will consolidate in a choppy sideways pattern before the bearish fundamental fully assert themselves. My inner investors remains constructive on equities, but he is inclined to replace his long equity positions with buy-write ETFs such as PBP as a way of controlling his equity risk.

The week ahead: Another pain trade setup

In the short-term, there is another possible pain trade setup. The SPX tested its 50 day moving average on Thursday and recovered Friday. In the course of that test, the VIX Index closed marginally above its upper Bollinger Band (by 0.01), and mean reverted.

I had outlined a VIX upper Bollinger Band study several weeks ago (see A market top checklist). The market action on Thursday and Friday constituted a buy signal for this model whose past returns are shown below. Consequently, the trading model has flipped from a “sell” to a “buy” signal, and the “arrow” now points upwards.

The latest readings from Index Indicators show that the market reached a minor oversold reading and recovered. A rally from these levels to test and possibly break out from all-time highs is well within the realm of possibility.

I took a few days off with my family late last week after the end of the school year and my inner trader did not recognize the signal until after the close on Friday. Barring any surprise announcements on the steel tariff front, he expects to enter into a small long position in the SPX on Monday.

Things you don’t see at market bottoms, 29-Jun-2017

Posted by Cam Hui - June 29, 2017

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

As a result, this is another post in an occasional series of lists of “things you don’t see at market bottoms”. This week, I focus on the theme of “subprime is the new black”:

How cov-lite loans have become the norm
The popularity of subprime auto loan ABS
A start-up for customers with no money but want to buy things

Subprime is the new black
Just when you thought that subprime lending was dead and buried, it has come back to life. The Argentina 100-year bond deal showed how yield starved the market is.

Indeed, the stretch for yield has prompted issuers to take advantage of the easier credit environment. As the chart below shows, the percentage of covenant light loans has been rising steadily since 2010 and cov-lite loans are now the norm.

Here is another sign that investors are stretching to get more yield, JP Morgan observed that Santader Consumer USA priced a deep subprime auto loans ABS deal where 84% of the loans are to borrowers with unverified income (via Tracy Alloway).

In case you were wondering, the AALYA deal on the first line is another Santander issue.

A start-up for customers with no money
If “irrational exuberance” is defined as equity investors throwing caution to the winds, what do you call the excessive consumer risk-taking behavior? The following news item recently came across my desk (via Tech Crunch):

If you’re looking to buy something, but don’t want to pay for it yet, Blispay thinks it has the solution for you. The start-up works with small and mid-sized businesses to help retail customers defer payments for six months…

If someone walks into a participating store and wants to make a purchase of at least $199 without paying anything upfront, they can sign up on the Blispay app in 2–3 minutes and once they submit the form they will find out if their credit is approved within 15–20 seconds. They can then take the item home without any payments or any interest for six months, while also getting 2% cash back. Blispay makes money off customers who don’t end up paying for the item when the six months comes around and then they are subject to 19.99% interest.

But as far as the businesses are concerned, it costs them nothing more than the roughly 3% credit card processing fee that they would be paying Visa anyway. Blispay allows businesses “to leverage technology in a way that makes it efficient and affordable to service a far broader swath of a merchant base,” said Lisiewski.

File this as another item under “things you don’t see at market bottoms”.

Time for the Fed to get “unpredictable”?
Alan Greenspan biographer Sebastian Mallaby recently penned an Op-Ed in the WSJ to address the problem of excessive risk taking by staying unpredictable and ambushing the markets once in a while:

With every passing month, the U.S. economy feels, ominously, more like it did in 1999 and in the mid-2000s. Both were times when a promising mix of full employment, low inflation and buoyant spirits gave way to a financial convulsion that triggered a recession. Unfortunately, the Federal Reserve under Janet Yellen is ignoring a relatively painless policy that would reduce the danger of a sequel…

A different debate could help the Fed out of this bind. Even if Ms. Yellen’s current, rather gradual pace is appropriate, the Fed can reduce the odds of a financial bust by tweaking the manner of its tightening.

To do so, the Fed should examine a tenet of the central-banking faith: that transparency is always virtuous. By being less transparent—and reserving the option of deliberately ambushing investors with a shock move—the Fed could discourage them from taking too much risk.

Such an ambush would unsettle markets, to be sure; but that would be the point. The painfully learned lesson from the late 1990s and mid-2000s is that excess financial serenity leads to excess risk-taking, which in turn increases the chances of a blow-up. In the first case, that meant the tech bust of 2000; in the second case, it meant the planet-shaking subprime-mortgage meltdown. Since market convulsions caused the last two recessions, reducing the probability of the next one must be a Fed priority.

In effect, Mallaby was echoing what Mark Carney said at Jackson Hole in 2009 about policy transparency at central banks:

How central banks communicate can influence the degree to which low, stable, and predictable inflation fosters excess credit growth. It is important that markets understand how a central bank formulates policy, but that does not equate to perfect foresight. Differences in judgment and the fundamental uncertainties surrounding the economic outlook should mean occasional differences in view. These should be particularly marked during turning points in the economic cycle. As the review of liquidity cycles suggests, wider “markets” in expected economic outcomes (which would mean greater short-term volatility) could promote long-term financial stability.

The alternative would be to generate price instability to prevent financial instability. That is, the price objective might have to become less stable in order to disrupt the endogenous liquidity creation that comes from relatively stable, predictable rate paths.16 This, rather than a higher inflation rate (if reliably achieved), would appear necessary to disrupt the dynamics described earlier.

Instability can be a source of stability.

All eyes on policy makers

Posted by Cam Hui - June 28, 2017

Mid-week market update: As we wait to see if the stock market can break either up or down out of this narrow trading range, this week has been a light week for major market moving economic data, However, there are a number of political and non-economic developments to keep an eye on.

The Fed gets hawkish

Early in the week, we heard hawkish Fedspeak from a number of officials. San Francisco Fed president John Williams reiterated his “docking the boat” metaphor to emphasize that the effects of monetary policy operates with a lag, and therefore the Fed is unlikely to alter its course of rate normalization:

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

New York Fed president Bill Dudley, who is a member of the FOMC triumvirate of Yellen, Fischer, and Dudley, cited loose financial conditions as a reason for the Fed’s continued tightening path despite tame inflation and inflationary expectations:

As I see it, financial conditions are a key transmission channel of monetary policy because they affect households’ and firms’ saving and investment plans and thus influence economic activity and the economic outlook. If the response of financial conditions to changes in short-term interest rates were rigid and predictable, then there would be no need to pay such close attention to financial conditions. But, as we all know, the linkage is in fact quite loose and variable.

For example, during the mid-2000s, financial conditions failed to tighten even as the Federal Reserve pushed its federal funds rate target up from 1 percent to 5¼ percent. Conversely, at the height of the crisis, financial conditions tightened sharply even as the Federal Reserve aggressively pushed its federal funds rate target down toward zero. As a result, monetary policymakers need to take the evolution of financial conditions into consideration. For example, when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease—as has been the case recently—this can provide additional impetus for the decision to continue to remove monetary policy accommodation.

As the New York Fed operates the desk that trades with the market, Dudley’s views of market conditions undoubtedly has a high degree of influence on the discussions within the FOMC.

Did Draghi say “reflationary forces”?

Across the Atlantic, ECB President Mario Draghi spoke at Sintra and stated “the threat of deflation is gone and reflationary forces are at play”. That remark was interpreted as a hawkish signal that the ECB is getting ready to begin normalizing monetary policy sooner than expected.

After the markets convulsed on Draghi’s remarks and the surge in the EURUSD exchange rate, ECB officials walked back Draghi’s comments and announced that they had been misinterpreted (via Bloomberg):

Draghi’s speech at the ECB Forum in Sintra, Portugal, was intended to strike a balance between recognizing the currency bloc’s economic strength and warning that monetary support is still needed, said the officials, who spoke separately and who asked not to be named as internal discussions are confidential. Vice President Vitor Constancio scrambled to set the record straight, saying the remarks were “totally” in line with existing policy and the response by investors was hard to understand.

Notwithstanding the short-term path of the ECB`s path for monetary policy, global central banks are slowly removing accommodation. The big question for investors is how the markets are likely to react in 2018 when it becomes clear that both the Fed and ECB are tightening.

Brussels vs. Google

Another piece of non-economic news hit the tape on Tuesday when the EU hit Google with a €2.4 billion for anti-competitive practices in search (see details of the case from Business Insider). GOOG, GOOGL, and QQQ cratered as a result of the ruling and tested its 50 dma, but it was not enough to push the SPX out of its trading band.

Waiting for Washington

Currency strategist Marc Chandler also cited a couple of important non-economic market drivers this week coming out of Washington:

The first is the expected Senate vote on its version of national healthcare to replace the Affordable Care Act (“Obamacare). This is not the space to discuss the merits or demerits of the plan. The point is that the Republicans have little room to maneuver with a razor-thin majority of 52-48. There are already 4-5 Republican senators are have publicly indicated their lack of satisfaction. A couple may be able to be peeled back with a tweak to the bill, but some opposition appears fundamental and principled. The nonpartisan CBO is expected to publish their evaluation, which includes a forecast of the impact on the deficit.

If the Senate cannot pass a healthcare reform bill, it will raise more doubts about the broader economic legislative agenda. In addition to the agenda, there are important maintenance measures that need to be taken by the end of Q3, namely the debt ceiling needs to be lifted (or abolished) and spending authorization (budget) needs to be granted before the start of the new fiscal year (October 1). Skepticism that tax reform and infrastructure spending measures can be adopted that will boost growth in the way the was previously suggested is a weight on medium and long-term US yields (while the short-end remains anchored by Fed policy). Lower US yields, in turn, are a drag on the dollar.

At the time of this writing, it is unclear whether the Senate’s healthcare bill will get passed as Senator Majority Leader Mitch McConnell delayed a vote on the bill, indicating a lack of support. FiveThirtyEight interpreted the intent of the bill not so much just an Obamacare repeal bill, but as a tax cut bill with an underlying conforming with the conservative policy of less government:

I’d posit a simpler idea: This bill is exactly what McConnell wants because it’s right in line with his long-term goals. As Bloomberg’s Francis Wilkinson points out, the BCRA “will transfer hundreds of millions of dollars from poor and middle-class people, in the form of health care, to rich people in the form of tax cuts.” To be more specific, the bill would cut Medicaid spending by $772 billion over 10 years, according to the CBO, and reduce health care tax credits by about $408 billion. It would also reduce taxes and penalties by more than $700 billion, mostly in the form of “repealing or modifying tax provisions in the ACA that are not directly related to health insurance coverage, including repealing a surtax on net investment income and repealing annual fees imposed on health insurers.”

To put it another way, the BCRA is less a health care bill than a tax cut (that will mostly benefit the wealthy), coupled with a trillion-dollar-plus reduction in federal government spending on health care (that mostly benefited the poor and the sick). Those goals — lowering taxes on the wealthy, trimming the welfare state, and reducing the size of government — are at the core of Ronald Reagan’s philosophy of movement conservatism, and they’ve been the primary axis of political conflict between Democrats and Republicans for most of the past several decades.

Here is a chart that simplifies the fiscal effects in graphical form (via Diogenes).

There are two issues for the markets. First, will the promised Trump tax cuts will ever see the light of day? This bill is the first test. For now, the market remains skeptical as the basket of high tax companies are underperforming the SPX.

As well, the decline in NASDAQ stocks had been partially offset by strength in Healthcare and Biotech. As hopes for a rapid resolution of BRCA fades, what happens to this sector and what happens to market leadership?

In addition, Marc Chandler also cited the threat of protectionism as a potential negative for the equity market:

The other important event that will not be on economic calendars is the expected announcement of the results of the investigation begun in April of the threat to US national security by steel imports. It seems there is a foregone conclusion to the investigation. Commerce Secretary Ross, who led the investigation, recognized that the law gave him 270 days for the investigation, but insisted all he needed was 90 days, which brings us to the end of June. The political dynamics warn that the more that the Trump Administration feels frustrated by Congress and the judiciary, the more that it may feel compelled to act forcefully where it has discretion.

The risk is the Trump Administration’s protectionist policies that could lead to a trade war. The environment is turning dark, as the Commerce Department slapped additional duties on Canadian softwood lumber (see CNBC report). The next shoe to drop is steel. These developments stand in stark contrast to Politico’s report of an imminent EU-Japan free trade agreement.

So far, the market remains on edge as a result of this uncertainty. However, I am still waiting for some definitive verdict of a technical break before making a definitive trading decision on possible market direction.

Long live the reflation trade!

Posted by Cam Hui - June 25, 2017

The latest signals of each model are as follows:

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

The global bull keeps on charging

Despite my recent negativity (see Risks are rising, but THE TOP is still ahead and Things you don’t see at market bottoms, 23-Jun-2017 edition), I am not ready to throw in the towel on this equity bull market.

From a long-term perspective, the reflation trade is still alive, and growth is global in scope. As the 20-year monthly chart below of the Dow Jones Global Index (DJW) shows, the last two tops were preceded by negative RSI divergences. So far, DJW is barely overbought and has not even had the opportunity to exhibit a negative RSI divergence. This suggests that global equities can continue to grind higher, and the ultimate top is, at a minimum, several months away.

The tactical outlooks suggests that there may be some near-term weakness ahead. Drilling down to the weekly chart, DJW has shown a pattern of flashing double RSI overbought sell signals. In the past, the index has achieved a first RSI peak overbought reading (dark vertical line) which was followed by a second RSI peak (red vertical line). DJW has recently shown the same double overbought peak pattern, and, if history is any guide, the market is likely to stage a minor pullback.

I interpret these technical conditions as being in favor of the global reflation trade, though some minor pause may be necessary. This scenario is consistent with current macro and fundamental readings that are supportive of a reflationary driven equity advance..

Global reflation still lives

Last week, Business Insider featured a number of charts from market strategists that confirm my reflationary view.

Starting with the US, Neil Dutta of Renaissance Macro observed that a simple but rarely used leading indicator is pointing to improving growth.

Joe LaVorga at Deutsche Bank noted that employee withholding tax receipts are trending upwards, which implies a healthy employment and consumer spending outlook.

From a bottom-up perspective, the latest update of earnings estimates from FactSet shows that forward EPS continues to rise. Fundamental momentum of rising estimates should act to support higher stock prices in the near future.

Last week, I wrote that the next stage of the market cycle typically sees leadership from capital-goods intensive stocks (see Risks are rising, but THE TOP is still ahead). The market relative breakout of the Industrial sector that I observed last week proved to be premature. Nevertheless, the technical pattern remains constructive.

Sean Darby of Jefferies observed that the Philly Fed’s expected capex outlook leads non-residential fixed investment, indicating that capex revival is likely ahead.

Across the Atlantic, Chris Williamson of IHS Markit commented that Friday’s Eurozone Flash PMI is still signaling better GDP growth.

Moreover, Williamson also noted that employment in the eurozone is likely to be strong.

The recent record of better than expected growth has propelled the Euro STOXX 50 to break out of its relative downtrend against the MSCI All-Country World Index.

Over in Asia, the market signal from the performance of the stock indices of China’s major Asian trade is positive. Beijing’s crackdown on credit and the shadow banking system has shown little or no effect on Asian stock markets. The Shanghai Composite has managed to recover above its 50 and 200 dma, and only the resource heavy Australian market is struggling below its 50 dma.

The Chinese authorities appear to have engineered the perfect economic re-balancing even as they tightened credit. My two pair trades of long new “consumer” China and short old “finance and infrastructure” China shows that new China is winning.

In short, the global reflation trade remains on track, with few impediments in sight.

How the Fed could take away the punch bowl

The biggest risk to the global reflation trade is a Fed policy that is more hawkish than market expectations. This chart from Albert Edwards (via Business Insider) tells the story of how the market doesn’t believe that the Fed`s dot plot rate hike projections. As the Fed announced its latest rate increase, 2-year Treasury yields barely budged, indicating market disbelief of further tightening because of tame inflation statistics.

That’s where the market may be in for a big surprise. Tim Duy agrees. He is turning to the hypothesis that the Fed is working backwards in order to justify its rate normalization policy. It first specifies the interest rate target, and works backwards to arrive at projected inputs afterwards:

What I don’t like is the feeling that the Fed’s unemployment rate forecast is essentially being reverse-engineered. They have a rate forecast that delivers policy normalization in a time frame they think appropriate. And they have a reaction function. If policy makers forecast lower unemployment then they need to either adjust the reaction function or lower their estimate of the natural rate of unemployment more aggressively. They don’t want to do either. So to keep their rate forecast intact, they need to set a matching unemployment rate forecast. And that produces a flat unemployment rate for this year.

While this approach of calculating the answer first and massaging model inputs is inherently objectionable, Duy thinks that Yellen believes the risks of the Fed falling behind the curve is rising quickly:

Yellen must feel there is a substantial risk of undershooting the natural rate of unemployment. It’s implied by the Fed’s growth forecast and Yellen’s view of the labor markets. This explains the Fed’s hawkishness in the face of low inflation. Indeed, despite years of below target inflation, officials continue to attribute the weak numbers to transitory factors. Yellen’s “idiosyncratic factors” has become a defense mechanism in response to fears that if unemployment drifts too low they can stave off inflation only by triggering a recession.

Ultimately, the Fed sees the risks associated with undershooting the natural rate of unemployment as greater than those of low inflation.

What this means is that the Fed will not turn dovish easily. Officials will not take their rate hike plans and go quietly into the night, even in the face of low inflation. Expect their baseline case to remain another rate hike and balance sheet reduction this year, plus another three 25 basis point hikes next year.

If Duy’s interpretation of Fed policy is correct, then the risk of a central bank engineered economic slowdown is substantially higher than expected. At a minimum, the market is going to be in for a big surprise.

Let’s consider how the market might react to this “new reality”. Currently, the 2/10 yield curve stands at about 0.80%. Supposing the Fed were to hike again in September and signals that it will pause in December, but begin to reduce its balance sheet then, which is another form of tightening. 2-year yields adjust upwards by 50bp (25bp for the September hike and 25bp for a delayed effect from the June hike), while 10-year yields compress by 20-30bp. The result is a yield curve that gets very close to inversion. As the chart below shows, equity market tops have either coincided or shortly followed yield curve inversions in the past.

On top of that, we haven`t even considered the additional risk that the FOMC becomes more hawkish with the addition of Trump appointees to the Board of Governors (see More surprises from the Fed?), New governors are likely to adhere to the Republican audit-the-Fed orthodoxy of rules-based monetary policy.

That day of reckoning is not here yet, and such a scenario is purely speculative. Meanwhile, enjoy the reflation party.

The week ahead

Looking to the week ahead, the short-term technical direction is less clear-cut than it has in the past. Both the bull and bear cases are equally compelling.

The short-term bull case can be summarized by this breadth chart from Index Indicators. The market is starting to rebound after a mild oversold reading, indicating a possible change in direction.

The correction that I have been calling for seems to have been accomplished in time rather than in price. As the chart below shows, the recent Tech correction appears to have been nothing more than just performance mean reversion and internal rotation.

On the other hand, there are negative divergences everywhere that haven’t been resolved. I had cited the negative divergences that overhang the market (see A market breadth model that works) and the negative divergence seen in DJW at the beginning of this post. The chart below also shows a minor divergence between credit market risk appetite and the equity market.

As well, option sentiment flashed an unusual contrarian signal on Thursday, when the CBOE Equity Put/Call Ratio (CPCE) fell to 0.50, which is a historically low reading. Thursday’s low CPCE was followed by an equally low 0.58 on Friday. What is unusual is this was accomplished when the stock market was flat to down. CPCE is normally low when the market is rallying, and a low put/call ratio is reflective of the growing bullishness momentum traders. The only instance in the last two years of CPCE at 0.50 or less on flat returns resolved itself with a minor pullback.

A longer term study of CPCE below 0.50 revealed a definite momentum effect. Forward equity returns tended to be strong when CPCE was low but past returns were rising, but forward returns were weak when CPCE was low but past returns were weak. However, that effect was short-lived and only last two days.

These cross-currents in the market has left my inner trader utterly confused. He is inclined to believe that the market is likely to trade sideways in a choppy fashion until either and upside breakout or downside breakdown is accomplished.

My inner investor remains constructive on equities. My inner trader is hanging on to his short position, though he may opportunistically cover his position on weakness and move to the sidelines.

Disclosure: Long TZA

Things you don’t see at market bottoms, 23-Jun-2017 edition

Posted by Cam Hui - June 23, 2017

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

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

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

Argentina’s 100-year bond

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

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

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

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

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

Irrational exuberance

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

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

The E*Trade Indicator

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

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

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

The China debt time bomb

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

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

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

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

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

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

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

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

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

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

A market breadth model that works

Posted by Cam Hui - June 21, 2017

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

That’s the theory.

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

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

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

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

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

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

An apples-to-apples breadth indicator

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

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

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

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

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

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

Negative divergences everywhere

What is the SPXEW Breadth Model telling us now?

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

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

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

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

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

Disclosure: Long TZA

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

Posted by Cam Hui - June 19, 2017

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

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

Naive or pure value?

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

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

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

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

That’s where the difference in value investing lies.

Sizing up the macro bets

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

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

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

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

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

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

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

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

A contrarian setup

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

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

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

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

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

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

Risks are rising, but THE TOP is still ahead

Posted by Cam Hui - June 18, 2017

The latest signals of each model are as follows:

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

Four steps, where’s the stumble?

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

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

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

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

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

A weakening economy?

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

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

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

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

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

Edward Harrison at Credit Writedowns Pro sounded a similar warning:

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

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

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

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

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

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

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

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

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

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

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

Slowdown fears premature

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

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

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

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

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

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

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

Timing the market top

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

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

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

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

The week ahead: Seasonal headwinds for stocks

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

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

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

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

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

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

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

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

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

Disclosure: Long TZA

More surprises from the Fed?

Posted by Cam Hui - June 15, 2017

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

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

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

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

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

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

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

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

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

Waiting for Marvin

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

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

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

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

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

A dovish or hawkish rate hike?

Posted by Cam Hui - June 13, 2017

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

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

The case for a hawkish hike

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

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

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

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

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

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

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

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

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

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

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

What to watch for

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

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

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

The risk to growth and growth stocks

Posted by Cam Hui - June 12, 2017

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

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

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

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

Are expectations too high?

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

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

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

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

A Fed preview: What happens in 2018?

Posted by Cam Hui - June 11, 2017

The latest signals of each model are as follows:

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

Marvin Goodfriend for Fed chair?

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

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

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

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

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

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

The Fed’s current analytical framework

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

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

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

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

Transitory weakness?

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

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

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

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

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

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

Here comes the new Fed governors

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

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

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

Who is Marvin Goodfriend?

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

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

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

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

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

Unanticipated shocks to inflation lead to corrective action when the price is the target.

Under inflation targeting, past mistakes and shocks are treated as ‘bygones’.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A more hawkish and activist Fed: What dual mandate?

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

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

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

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

Market potholes in late 2017?

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

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

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

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

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

Interpreting the NASDAQ break

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

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

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

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

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

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

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

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

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

The week ahead

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

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

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

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

Disclosure: Long TZA

A possible volatility spike ahead

Posted by Cam Hui - June 7, 2017

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

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

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

Tame VIX, but rising anxiety

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

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

What`s the trigger?

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

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

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

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

Disclosure: Long TZA

Peak smart beta?

Posted by Cam Hui - June 5, 2017

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

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

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

Smart beta a crowded trade?

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

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

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

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

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

How did she create her factor?

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

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

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

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

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

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

The perils of data mining

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

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

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

Thrust and bust, or lower for longer?

Posted by Cam Hui - June 4, 2017

The latest signals of each model are as follows:

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

A Fed pause ahead?

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

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

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

The official Federal Reserve view

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

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

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

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

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

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

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

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

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

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

What’s the Fed’s reaction function?

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

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

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

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

Political wildcards

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

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

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

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

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

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

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

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

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

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

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

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

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

The message from the market

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

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

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

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

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

The message from the stock market

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

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

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

The risks to stock prices

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

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

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

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

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

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

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

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

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

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

Contrarian alarm bells

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

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

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

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

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

The week ahead

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

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

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

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

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

A matter of time horizon

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

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

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

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

Disclosure: Long TZA

Possible market turbulence ahead

Posted by Cam Hui - May 31, 2017

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

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

Let me explain.

Breadth divergences

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

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

Hedge funds all-in on risk

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

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

Faltering Twitter breadth

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

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

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

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

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

Disclosure: Long TZA

Thinking Straight 101

Posted by Cam Hui - May 30, 2017

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

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

Each of the stated positions have their own inherent contradictions.

The drumbeats of war

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Buy signal on small cap Tech

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

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

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

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

Invincible China

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

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

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

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

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

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

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

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

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

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