Page 72 – Humble Student of the Markets

When does the market top out?

Posted by Cam Hui - May 28, 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.

History rhymes

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

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

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

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

Recessions and bear markets

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

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

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

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

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

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

Passing the sanity test

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

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

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

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

And then there was this more hawkish possibility:

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

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

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

When does the market actually top?

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

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

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

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

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

How far down from here?

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

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

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

The risks from abroad

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

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

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

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

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

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

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

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

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

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

Intermediate term bullish

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

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

The week ahead

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

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

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

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

Disclosure: Long SPXL

The market`s hurdles to sustainable new highs

Posted by Cam Hui - May 24, 2017

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

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

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

A case of bad breadth

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

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

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

Narrow sector leadership

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

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

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

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

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

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

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

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

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

(Chinese) blood in the streets?

Posted by Cam Hui - May 22, 2017

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

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

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

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

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

Maximum pain

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

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

Investment implications

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

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

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

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

Disclosure: Long XIU.TO (TSX 60 ETF)

A market top checklist

Posted by Cam Hui - May 21, 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)

Late cycle = Market top?

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

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

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

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

Frothy sentiment

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

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

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

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

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

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

Few signs of breadth deterioration

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

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

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

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

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

Score market internals as still bullish.

Credit market are still healthy

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

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

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

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

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

Score credit conditions as still positive, for now.

Macro: Clear skies today but possible storms on horizon

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

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

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

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

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

No signs of a market top

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

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

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

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

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

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

Disclosure: Long SPXL

From alpha to actual returns: Why your mileage will vary

Posted by Cam Hui - May 18, 2017

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

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

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

What and when do you buy and sell?
How much do you buy and sell?
How do you time the trade?

The “arrows” in the above chart only answer question 1.

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

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

Execution timing

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

First, I should disclose that the “arrows” were placed on the Friday of each week, regardless of when the trading signal occurred. That’s because the signals were historically published on Fridays and therefore their placement was based on the date of publication. It also underlines the point that this model is meant to be a swing trading model with time horizons of weeks, not hours or days.

Here is where the process of return calculation gets noisy. From January 2, 1990 to today, the median swing from low to high on a daily basis was 1.04%. Assuming “typical” single point execution, that would introduce a return error of 0.52% (half of 1.04%). On top of that, add the variation of a few days from signal generation to the Friday publication date, and returns can change even more dramatically. Similarly, the median daily swing of the SPX on a closing basis during the same time period was 0.52%. Delay the signal by a few days, and it adds even more noise to the return calculations and assumptions.

With those caveats in mind, I have highlighted a number of past signals in the above chart that may prove to be problematical for a trader who is intolerant of drawdowns:

January to March 2013: The market continued to rise after the sell signal. Even after the market weakened, the buy signal occurred late after the bottom.

May 2013: The sell signal was early, and the market rose after the signal before falling dramatically. A risk averse trader could have been either discouraged or got stopped out of that trade.

February 2014: The market was flat and choppy after the sell signal. Depending on how the trader executed the original entry, he could have bounced around between slight breakeven and losses for several weeks before actually profiting. Does he have that kind of temperament?

March 2015: The market action after the sell signal was very similar to the February 2014 signal.

August 2015: Here, the trading model was simply wrong. The market fell and got oversold, which prompted the model to get long. Unfortunately, the market got even more oversold and this was one of the worst drawdowns suffered by the trading model.

June 2016 (Brexit whipsaw): The trading model got whipsawed badly. It flashed a sell signal after being long into the Brexit vote. It then reversed back into a buy signal the following trading day.

These are just some of the examples. In 2017, the trading model has been early in many of its signals, though the subsequent drawdowns have been relatively minor.

A lesson in portfolio dispersion

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

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

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

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

Teaching readers how to fish

I built Humble Student of the Markets as a forum to teach my readers how to fish. This is not a site with pre-packaged and pre-digested trading signals. There are trading chatrooms that offer those services (and with a much higher fee structure).

Your objectives and pain thresholds are different than mine. That’s why your mileage will vary.

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

The island at SPX 2400

Posted by Cam Hui - May 17, 2017

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

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

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

Market complacency

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

Dealer positioning: Watch the greeks

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

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

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

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

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

Rising political risk

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

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

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

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

Upbeat fundamentals

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

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

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

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

Disclosure: Long SPXU, TZA

How I learned to stop worrying and love the low VIX

Posted by Cam Hui - May 15, 2017

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

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

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

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

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

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

Look Ma, no vol!

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

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

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

Similarly, vol on other asset classes are also depressed.

Greater diversification effect

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

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

Cross asset correlations have fallen sharply

Vol regime clustering

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

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

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

What about the short VIX position?

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

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

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

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

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

The roots of a market demise

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

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

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

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

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

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

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

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

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

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

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

How I learned to stop worrying…

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

How the bull will die

Posted by Cam Hui - May 14, 2017

The latest signals of each model are as follows:

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

A maturing bull

This bull market that began with the SPX low of 666 in March 2009 has lasted over eight years. While that may seem like a long time, bull markets don’t just die of old age. Rather, they end as excesses build up and central bankers act to cool down the overheated economy.

Today, there are numerous signs that this bull market is in its late stages. Valuations are elevated by virtually all measures. The chart of forward P/E from FactSet shows that current forward 12-month P/E ratio is well above historical norms.

Sentiment is getting frothy. The TD-Ameritrade Investor Movement Index, or IMX, is designed to measure long-term retail investor sentiment. IMX hit an all-time high in March and pulled back in April. Readings are still very elevated by historical standards, indicating individual investor enthusiasm for stocks.

So when does the next shoe drop? The most likely catalyst for a market top is central bank action to cool down the economy. Will a 0.25% hike crash the market? How about 0.50% this year, or Fed action to reduce the size of its balance sheet?

We consider those questions this week.

Elevated valuations

There are many ways of measuring valuation. FT Alphaville recently highlighted analysis from Aswath Damodaran of NYU’s Stern School indicating that EV to EBITDA of the Russell 3000 is at levels last seen during the top of the NASDAQ Bubble. (For newbies, the EV/EBITDA ratio can be best explained as an unlevered P/E ratio, which substitutes equity + debt for P, and earnings plus + interest and taxes for E).

Arguably, EV/EBITDA is elevated because interest rates are so low, but there is an answer for that:

Some attribute these elevated valuations to low yields on government bonds. By this logic, investors should be willing to pay up for riskier assets because the alternatives are so unappealing. The problem, which has been addressed repeatedly elsewhere, is that the assumptions underlying low yields — weak demand, muted pricing power, depressed productivity — imply a challenging environment for businesses. Today’s interest rates could easily justify depressed earnings multiples, if you wanted to make that argument.

Besides, American interest rates more or less hit bottom in 2012. The Federal Reserve has switched from bond-buying to imminent balance sheet shrinkage and raised its policy band by 75 basis points. Real yields on long-term inflation-indexed bonds, which are a better comparison for earnings multiples, are significantly higher now than half a decade ago. None of this fits with the standard theory that companies have mechanically become more expensive in response to developments in the fixed income markets. The likelier explanation is just that US stocks are expensive and future returns will be lower than in the past.

As well, Callum Thomas found that when global markets get overvalued, equity prices tend to pull back. As the chart below shows, the percentage of countries with forward P/E ratios is elevated and at levels where past pullbacks have occurred.

However, valuation has shown itself to be an inexact market timing tool when applied to time horizons of less than 5-10 years. The bull market needs a catalyst for the bull to die.

A frothy market

Excessively bullish sentiment is another pre-condition for a major market top. When a market tops out, we can usually in hindsight point to some anecdotal event that marked a sentiment top. Some examples during the NASDAQ Bubble might be the get-rich-quick tone of online broker TV commercials, or the pets.com sock puppet, as well as evidence of lower and lower quality deals done at unreal valuations.

Today, we have several warning signs:

The launch of 4X leverage ETFs (via NASDAQ).
The actor playing J. Peterman from Seinfeld making a TV ad for a high risk IPO that is an aggregator for Uber and Lyft. The pitch is you could make millions like the investors who got in on Uber and Lyft (via Business Insider).

David Einhorn of Greenlight Capital comparing enthusiasm for Tesla to the heady days of the dot-com bubble: “For the time being, investors remain hypnotized by Tesla’s CEO. They’re skeptical that the company will be able to mass market its model 3 volumes and margins that justify the current valuation. The enthusiasm for Tesla and other bubble basket stocks is reminiscent of the March 2000 dot-com bubble as of the case then, the bulls have rejected conventional valuation methods for a handful of stocks that seemingly can only go up. While we don’t know exactly when the bubble will pop, it eventually will.” (via Avondale)

I could go on, but you get the idea. The party is certainly getting going, is it time for the Fed to come and take away the punch bowl?

The Fed’s change of tone

In response to the punch bowl metaphor, New York Fed president William Dudley recently stated that the Fed is not taking away the punch bowl, but “we’re just adding a bit more fruit juice”. Bloomberg also reported on a Janet Yellen April speech that indicated the Fed’s change of tone:

Federal Reserve Chair Janet Yellen said the U.S. central bank’s task has shifted from a post-crisis exercise of healing the economy to one aimed at holding on to progress made.

“Before, we had to press down on the gas pedal trying to give the economy all of the oomph that we possibly could,” Yellen said Monday in Ann Arbor, Michigan. The Fed is now trying to “give it some gas, but not so much that we’re pushing down hard on the accelerator.”

In other words, the Yellen Fed doesn’t believe that it’s in crisis mode anymore. It’s time to start normalizing monetary policy and not over-react to every hiccup in stock prices.

Indeed, pressure is building on the Fed to act. Deutsche Bank highlighted the rising number of “the Fed is behind the curve” stories on Bloomberg news as a measure of the market’s mood.

Variant Perception pointed out that NFIB (small business) compensation plans tend to lead average hourly earnings by about 18 months, indicating rising wage pressures, which is certain to push up inflation.

Bearish triggers

Market expectations of a June rate hike is almost a near certainty. But it’s unclear whether a 0.25% hike in June or an additional 0.25% hike later this year can derail this equity bull market.

However, there are a couple of likely bearish triggers that may bring the stock market advance to a screeching halt. The first is rising inflation. The Fed has embarked on a course of rate normalization even though inflation has been relatively tame. Last Friday’s April CPI release showed that the components of core CPI ex-shelter have been falling, not rising (via Matthew B). What happens if inflation were to actually tick up?

I wrote before that “late phase of the [market] cycle is characterized by tight capacity and rising inflation, which is an environment where asset plays and commodity extraction industries outperform” (see In the 3rd inning of a market cycle advance). I am therefore watching closely the relative performance of inflation hedge sectors such as energy, gold, and mining. Renewed leadership in these stocks will be a sign of rising inflationary expectations, which will be a signal for the Fed to become more aggressive in its monetary policy.

Wait for that signal, but now is not the time. As the chart below shows, the relative market performance of gold stocks is starting to base, but energy and mining stocks remain in relative downtrends.

Unwinding QE

Another possible bearish trigger may be the reduction in the size of the Fed’s balance sheet, which is expected to begin either late this year or early next year. Boston Fed president Eric Rosengren stated in a speech last week that he expects to start the balance sheet unwind after one more rate hike:

Looking ahead, the federal funds rate would obviously exceed 1 percent after one more 25 basis-point increase. In my view, that seems an appropriate point to consider beginning a very gradual normalization of the Federal Reserve’s balance sheet.

Bloomberg reported that William Dudley of the New York Fed echoed Rosengren’s views on the timing of balance sheet normalization:

“We are pretty close to full employment,” Dudley said Thursday while answering questions after a speech in Mumbai. “Inflation is just a little bit below our target of 2 percent if you look at the underlying inflation trend, so clearly if the economy continues to grow above trend we are going to want to gradually remove monetary policy accommodation.”

Dudley and his colleagues on the U.S. central bank’s rate-setting Federal Open Market Committee are on track to raise interest rates twice more in 2017 following a hike in March, marking a significant acceleration in the pace of tightening from the previous two years, as they prepare to start trimming their bloated balance sheet.

“I think if the economy continues to evolve in line with our expectations, sometime later this year or next year we will begin to gradually decide to normalize our balance sheet,” he said.

Currently, the Fed is reinvesting all of the coupons and maturing paper as part of their QE program. It is expected that the normalization process would begin with partial reinvestment, and then gradually move to a position where all of the maturing paper and coupons would not be reinvested. Assuming that the unwind program begins in January, the chart of the Fed’s balance sheet holdings below shows that an above average amount of paper begins maturing in early 2018, which could tighten monetary policy more than either the Fed or the market expects.

Raghuram Rajan, former governor of the Reserve Bank of India, spoke at an event sponsored by the Atlanta Fed in which he discussed the challenges of exiting from accommodative monetary policy (video here). Rajan outlined three issues that central bankers face, which I summarize below:

The reversal of QE effects may be asymmetric, meaning that it may be tougher to get out than to get in.
Banks may not be able to absorb riskier assets because of more stringent capital requirements.
Political constraints may force the central bank to unwind faster than may be prudent. Rajan cited the example where rising interest rates would create mark-to-market losses on the Fed’s balance sheet, which would raise uncomfortable questions in Congress. Under such circumstances, the Fed may feel political pressure to unwind the balance faster than originally planned.

In addition, Bloomberg reported that JP Morgan warned that medium sized banks may be forced to merge because of a disappearing deposit base as the Fed unwinds QE:

The company’s investment bankers are warning depository clients that they may begin feeling the crunch in December, thanks to a byproduct of how the U.S. Federal Reserve propped up the economy after the financial crisis, according to a copy of a confidential presentation obtained by Bloomberg News and confirmed by a JPMorgan spokesman…

JPMorgan’s presentation, titled “Core Deposits Strike Back” illustrates how this process will sap bank deposits using the example of a couple who pays off a mortgage that was bundled with other mortgages and sold to the Fed. Right now, when that couple takes that money out of their bank account for that payment, the Fed uses that cash to buy another mortgage bond, recycling it back into the banking system.

A “deposit is destroyed” if the “Fed does not reinvest,” the presentation states.
JPMorgan estimates that a quantitative easing-related deposit-drain could result in loan growth lagging deposit growth by $200 billion to $300 billion a year.

That could be particularly problematic for banks that rely on deposit products that tend to roll over swiftly, such as brokered accounts bought from third parties, large commercial banking accounts and high-interest savings accounts for wealthy customers.

QE flooded the banking system with liquidity, but part of the criticism of the program was much of the funds sat around in banks and wasn’t lent out, which diminished the intended effect of encouraging economic activity. Unwinding QE has a leveraged effect of draining liquidity from the banking system, but may hit medium sized banks hard as their deposit base vanishes. It has the potential to create a “bank run” of deposits because of leverage of the fractional reserve system.

There is nothing to worry about for now. Balance sheet normalization is not expected to occur until late 2017 or early 2018. Don’t get too excited until Fedspeak begins to signal its imminent implementation.

Political wildcards: Comey style

The last bearish trigger is a the possibility of political interference in the Fed by the Trump administration. These risks are particularly heightened in light of the Comey Affair.

The Federal Reserve’s independence isn’t unconditional. Pedro de Costa at Business Insider pointed out a provision in the Federal Reserve Act that would allow President Trump to fire Janet Yellen, just as he fired FBI director James Comey.

Political risk has been exacerbated by a number of unusual political statements by Fed officials indicating that the Fed may have gone to war with the White House. Vice chair Stanley Fischer recently pushed back on the Trump administration’s stated desire to “do a number on Dodd-Frank” and defended the Fed’s rationale for financial regulation. In addition, New York Fed president William Dudley made a speech last week extolling the virtues of trade and globalization, which is contrary to the Trump administration’s American First protectionist principles.

Here is what might is likely to spook the markets. Any Republican nominated to the Board of the Federal Reserve is likely to favor a rules based approach to monetary policy decisions. A fixed rule for determining interest rates, such as the Taylor Rule, is going to result in much higher interest rate than what the Fed Funds rate is today (see the Atlanta Fed’s Taylor Rule Utility).

Any new Republican Fed chair is therefore going to steer the Fed in a more hawkish direction. Even if Yellen and Fischer are not replaced, new Republican Fed governors on the Board are likely to favor a more aggressive monetary policy. As Janet Yellen’s term expires in February 2018, any decision to replace her will be announced in the fall.

The critical window will be in the fall, when the Trump administration is likely to announce its decision on the fate of the Fed chair and vice chair. The market could have a signal even earlier if a rules based advocate of monetary policy like John Taylor, who is known for the Taylor Rule, were to be nominated to one of the open seats on the Federal Reserve Board.

What now?

So far, what we have a “this will not end well” story with a number of bearish tripwires that have not been triggered. In the interim, market conditions are not very much changed from last week. The Rydex sentiment sell signal that I wrote about on Monday remains in force (see The right and wrong ways to use Rydex sentiment). Nine days after the sell signal, the SPX is +0.11%, which is ahead of historical experience.

The SPX remains range bound between 2400 as resistance and 2380 as support, with a couple gaps that could be filled below should the market weaken. As well, the chart below shows that the market is experiencing a number of minor negative breadth divergences with bearish implications.

The NASDAQ 100, which is rallied to fresh highs, is also exhibiting similar levels of negative divergences.

Schaeffers Research highlighted a contrarian sell signal last week. Equity only put/call volume fell to levels indicating high levels of complacency. If history is any guide, near term returns are likely to be subpar.

Specifically, the all-exchange equity-only put/call volume ratio fell to 0.67 on Wednesday, marking the third straight reading below 0.80 — something we haven’t seen since mid-December, according to Schaeffer’s Quantitative Analyst Chris Prybal. Further, it was the lowest daily reading since Dec. 15, 2016. “The giddiness of options traders is becoming apparent,” he said, with the 10-day average of this ratio hitting 0.84, marking the lowest point since Feb. 22.

On the other hand, the latest update from FactSet shows that the report card from Q1 Earnings Season has been solid. Both EPS and sales beat rates are well above historical averages. Forward 12-month EPS estimates continue to rise. These growth expectations should provide a floor on stock prices should the market correct.

Short term breadth metrics are not overly revealing of market direction. This chart of stocks above their 5 dma from Index Indicators indicates that the market is mildly oversold, which could lead to a one or two day bounce early in the week.

On the other hand, longer term breadth indicators are in neutral with a negative momentum bias, indicating that the market has the potential to pull back further over the next week.

I wrote last week that the stock market may be suffering from a bout of round number-itis, where the market advance stalls out as key major averages rise to round numbers (DJIA: 21,000, SPX: 2,400). I expect that consolidation and mild pullback will continue for another week or two before the rally can continue.

My inner investor remains bullish on equities. In the absence of a bearish trigger that signals a high risk environment or impending recession, he will be constructive on equities.

My inner trader put on a small short position last week, but it was not a high conviction trade. He is hoping for signs of either a short term bearish sentiment extreme or oversold conditions as a signal to cover his positions.

Disclosure: Long SPXU, TZA

Two elections, two questions for investors

Posted by Cam Hui - May 10, 2017

In the past week, two key elections have been held that have important geopolitical, economic, and investment implications. First, remember this Time magazine cover? I indicated on February 6, 2017 that the cover may have marked Peak populism.

I suggested at the time to buy France and sell Germany as a pairs trade. That trade has certainly worked out well. Now that Emmanuel Macron is destined to be the President of France, and Angela Merkel is the front runner to win another term as German Chancellor, challenges lie ahead for French-German cooperation in the eurozone. Macron has voiced his objective of greater European integration as part of his electoral platform, the question is, “How much integration is Germany willing to accept?”

As well, I wrote on April 17, 2017 that the US had few good options in dealing with North Korea (see The Art of the Deal, North Korean edition). Now a further political development is certain to cause both Trump and the American foreign policy establishment headaches, namely the election of Moon Jae In as the President of South Korea. The South Korean KOSPI Index has rallied in the wake of this electoral result, but the likely loser in any geopolitical settlement engineered by Moon is the United States.

Marketwatch recently featured a story indicating that investors should look to non-US equity markets for future gains, as valuations are far more compelling overseas. Not so fast! The story is more nuanced than that. The resolution of the situations in Europe and Korea have profound investment implications. As well, they have the potential to set the world on some very different paths for the next decade.

Time for Germany to choose

The various PIIGS eurozone crises of the last ten years have exposed the vulnerabilities of the euro. Monetary integration without political integration have created fault lines that could crack open the European Project (see The miracle of Europe). Simply put, monetary union without fiscal and political unions is a contradiction. The problem for Europe is implementation. The last time Europe had a political union was in 1941, when Hitler’s armies overran the continent. That experiment in forcible political integration didn’t work out so well .

Fast forward to the modern era. Angela Merkel made a speech in June 2012 calling for greater fiscal integration in the wake of the Greek debt crisis (via Credit Writedowns):

“We need more Europe; we need more cooperation,” said German Chancellor Angela Merkel. She is now calling for a joint budget policy and expanded political union for Europe.

-Deutsche Welle, June 2012

More recently, Emmanuel Macron called for eurozone fiscal transfers in 2015 (via FT):

Now it`s time to put up or shut up. In the wake of Macron’s victory, various commentators have raised the question of how far Germany is willing to down the fiscal integration road. Here is just a sample:

Angela Merkel should seize this chance to remake Europe (The Economist)
Wahl in Frankreich: Angela Merkels Moment (Süddeutsche Zeitung)
How will Germany respond to Emmanuel Macron? (Center for European Reform)

The main points of the commentaries are all the same. Germans are divided, but they have a golden opportunity to reform Europe in partnership with their main EU partner, France. Here is how The Economist summarized the issues:

German celebrations of Emmanuel Macron’s victory had barely begun last night when the first arguments about it broke out. The French president-elect’s longstanding calls for a “new deal” between his country and Germany were the impetus. In return for French structural reforms and fiscal restraint Mr Macron wants Berlin to support the closer integration of the euro zone, including joint investment projects, Eurobonds (common debt) and a finance minister, budget and parliament for the 19-state currency area. All of which drives a trench through the Berlin political landscape.

On the one side are most in the centre-right CDU/CSU, the liberal FDP and especially in the finance ministry under Wolfgang Schäuble, the CDU finance minister. This camp opposes all of Mr Macron’s most ambitious proposals. It is backed by the majority of public opinion and the Bild Zeitung, Germany’s most-read newspaper. And it tends to the belief that the country already pays disproportionately into the European project, that its current success was built on tough reforms in the last decade and that struggling Latin economies like France need to go through the same painful but necessary process. This outlook has deep cultural roots in Germany’s aversion to loose money; the word for “debt” in German is the same as the word for “guilt”.

On the other side are most of the centre-left SPD, the Greens and the foreign ministry under Sigmar Gabriel, the SPD politician who counts Mr Macron as a personal friend. On at least some points they are joined by internationally-minded CDU figures like Norbert Röttgen, the chair of the Bundestag’s foreign affairs committee who is close to Jean Pisani-Ferry, Mr Macron’s top economist. This camp, backed by the liberal and centre-left broadsheets, worldly think-tanks and much of German Brussels, tends to stress the advantages Germany has reaped from the euro and to argue that it should put its wagging finger away and acknowledge a responsibility towards weaker members of the club.

The idea of a eurozone finance ministry is precisely the sort of measure that Merkel proposed in 2012. On the other hand, eurobonds, or joint liability, is probably an overly ambitious objective (at least for the current round of negotiations). Nevertheless, there is probably a compromise solution to be had after all of the horse trading is done.

The outlines of a mutually acceptable “new deal” are clear. Closer defence and security co-operation (France is trying to cut spending, Germany has committed to spending billions more) will come easily. And even on the euro zone, argue Thorsten Benner of the Global Public Policy Institute in Berlin and Thomas Gomart of the Institut Français des Relations Internationales in Paris, there is a compromise to be forged. This would start with Mr Macron and Mrs Merkel promptly creating a Franco-German investment fund, committing jointly to a multi-speed Europe (an idea to which the chancellor has warmed in recent months) and forging a new front against authoritarianism in Poland and Hungary.

If Macron and Merkel can`t make a deal after the September election, then Germany may have to face President Marine Le Pen in five years’ time.

As Mr Gabriel has pointed out: “If [Mr Macron] should fail, Ms Le Pen will assume the presidency five years from now and the European project will be thrown to the wolves”. Amid the relief in Berlin, some here lose sight of the facts that almost half of French first-round voters backed candidates of the nationalist far-left or far-right, that just a few percentage points here and there prevented a run-off between those two extremes, and that Ms Le Pen could yet usurp Mr Macron in 2022.

If she does, and the euro zone falls, Berlin will feel the consequences. Its economy is built on supply chains that wend their unimpeded way around the continent. Its whole international vocation depends on its European identity. Germany cannot pretend France is just another country, just another line on the spreadsheet. As Willy Brandt said of his nation’s reunification: “Things grow together which belong together”. France and Germany are at once so foreign to one another, so temperamentally and historically different. Yet they are also natural allies and irredeemably interdependent. If Macron fails, Europe may fail. And if Europe fails, Germany fails.

Mrs Merkel can prevent this. German public opinion may not be favourable to Mr Macron’s sensible proposals. But the chancellor is powerful and popular. She looks set to win a fourth term in September and is not likely to seek a fifth one four years later. She has taken calculated gambles before: transforming Germany’s energy supply from 2011 and letting in hundreds of thousands of refugees from 2015. She has enough political capital in her account for at least one more splurge. Europe’s future is surely worth the outlay. “From September onwards it will be all about Merkel’s legacy,” Mr Benner tells me: “And letting the only plausible route to strengthening the German-French relationship for the greater good of Europe go to waste and preparing the ground for the extremes to take over France is nothing you want to be remembered for.” He has a point.

Here is what`s at stake for investors. The chart below shows the 10-year relative performance of FEZ (Euro STOXX 50) ETF against SPY. Both ETFs are USD denominated so the chart accounts for currency effects. Eurozone equities have been underperforming US equities for the entire period, but have shown several episodes where they seem to turn around on a relative basis. The big question is whether the latest turnaround is another fakeout, followed by more European underperformance.

The latest revival is attributable to two factors. The first is cyclical. The European Economic Surprise Index surged in late 2016 and readings remain elevated, indicating that macro-economic releases are coming in well ahead of expectations.

By contrast, the US ESI followed the same pattern of a reflationary rise in late 2016, but have tanked in the past few weeks.

The second reason is Macron’s electoral win, which took political tail-risk of European disintegration from a Le Pen victory off the table. If European equities are to continue to outperform, then Angela Merkel will have to spend the political capital “for at least one more splurge”.

Investment expectations are already high. The latest BAML Fund Manager Survey shows that institutional managers are in a crowded long in eurozone equities. Any political disappointment will see these stocks resume their downward slide against their US counterparts.

In the meantime, watch for the FEZ/SPY pair to either pull back or consolidate until the German election in September when these difficult questions will begin to get resolved.

Korea: Peace in our time?

On the other side of the world, the US faces a different dilemma on the Korean peninsula, and it has nothing to do with Kim Jong Un of North Korea. Jonathan Pollack at the Brookings Institution wrote this profile of newly elected South Korean President Moon Jae In. Moon wants to soft the hard line stance against North Korea. He has made it clear that his ultimate goal is peaceful Korean reunification.

On April 23, Moon disclosed his larger strategies in a thousand-word statement entitled “Strong Republic of Korea and the peaceful Korean Peninsula.” There is a Rip Van Winkle quality to the document, almost as if North Korea’s defiant, determined pursuit of nuclear weapons and missile delivery systems in the intervening decade had not occurred. At the precise moment when the international community has begun to grasp the fuller implications of North Korean nuclear and missile development and when the United States and China have moved closer to a coordinated strategy to inhibit Pyongyang’s advances, Moon seems intent on turning back the clock…

Moon foresees a Seoul-centered process whereby South Korea will lead and orchestrate a return to the six-party process, with South Korea creating a “new framework of inter-Korean relations.” But aspirational goals outlined in his policy document (including making Korea a nuclear-free zone, the signing of an inter-Korean peace treaty, and pursuit of a “mutual arms control agreement in stages”) are slogans contrary to ongoing efforts to curtail North Korea’s nuclear ambitions. Renewed engagement also plays on emotional sentiment favoring unconditional accommodation with the North and would enable Pyongyang to again influence South Korean domestic politics. This story did not end well under Roh Moo-hyun, and the risks with a nuclear-armed North are incalculably higher.

Moon openly advocates a return to the discredited “Sunshine Policy” first established under the late president Kim Dae-jung, and then pursued more vigorously under Roh Moo-hyun. Moon’s calls for the unconditional resumption of previous inter-Korean accords—to be ratified and enacted jointly by the South Korean National Assembly and North Korea’s nominally equivalent body, the Supreme People’s Assembly—and creation of a “common economic community” would presumably open the sluice gates of economic assistance to the North, which confronts growing economic pressures imposed by multilateral and national-level sanctions.

Moon wants to reunify the North and South. As part of that process, he wants to effectively Finlandize the Korean peninsula. A neutral Korea would not offend Chinese sensibilities of having unfriendly troops on their border.

Peace in our time, right?

The proposal, if implemented, have profound geopolitical implications for the region. Sure, the de-nuclearization of North Korea and a peaceful reunification of the North and South would rachet down the doomsday scenario of a regional war that could turn nuclear. But the big loser under such a scenario would be the United States. Finlandization of the Korean peninsula means a neutral Korea, and it would necessitate the withdrawal of American troops. As South Korea is already a major exporter to China, it would draw the reunified Korea closer into the Chinese political orbit.

The real wild card is how Donald Trump reacts to Moon’s initiatives? On one hand, he has balked at paying the $1 billion cost of deploying the THAAD missile system in South Korea and this would be consistent with his America First policy. Bloomberg reported that he had hit the roof when General McMaster indicated to his South Korean counterparts that the US would pay for the deployment of the missile system, for now:

Trump was livid, according to three White House officials, after reading in the Wall Street Journal that McMaster had called his South Korean counterpart to assure him that the president’s threat to make that country pay for a new missile defense system was not official policy. These officials say Trump screamed at McMaster on a phone call, accusing him of undercutting efforts to get South Korea to pay its fair share.

On the other hand, watch for rumblings from the American foreign policy and defense establishment about Moon’s softer policy on Pyongyang. Will future American historians be debating the question of “who lost Korea” in 10 or 20 years’ time?

Bloomberg recently documented how vulnerable the global economy is to a war in Korea because of the integration of Korean semiconductors in the global supply chain:

The country’s chipmakers produce almost two-thirds of the world’s memory semiconductors, thanks to the dominant role of SK Hynix and Samsung Electronics Co. Samsung also produces chips for customers like Qualcomm Inc., the world’s largest maker of semiconductors for phones. “If Korea is hit by a missile,” Soo Kyoum Kim, a vice president with IDC Research Inc., said in an email, “all electronics production will stop.”

About 12 percent of Apple Inc.’s suppliers are from South Korea, according to data on supply chains Bloomberg compiles. The U.S. company is LG Display’s biggest customer and may become even more reliant on Korean exports with the introduction of the iPhone 8, at least one version of which will likely have an OLED screen. Korean factories turn out about 40 percent of the world’s LCDs and almost all of its OLEDs, according to Alberto Moel, an analyst with Sanford C. Bernstein & Co. For high-end displays, he says, “it’s basically them or nothing.” The analyst pegs the cost of replacing the display manufacturing capacity of LG and its main rival, Samsung Electronics, at about $50 billion.

In light of this election, the wildcard is no longer just Comrade Kim, but the reaction of President Trump. How will he respond to the Moon election? How will he view his legacy? More importantly, what will the Sunday talk shows say about Korea that forces him to react?

These are all very good questions for both Europe and Korea. The answers to those questions are well beyond my pay grade. Stay tune for more developments.

The right and wrong ways to use Rydex sentiment

Posted by Cam Hui - May 8, 2017

Rydex funds (now Guggenheim) were early pioneers in offering bull and bear funds, as well as to encouraging switching between bull and bear funds. This innovation attracted short-term traders who had previously been shunned by other mutual fund families. Consequently, Rydex fund assets became an important measure of short-term trader sentiment.

Over the years, I have seen numerous analysts using Rydex data to support their investment conclusions. Most of it has been wrong. The latest came from Dana Lyons, whose conclusion I support, but it was based on the wrong methodology.

Measure cash flow, not assets!

Many analysts use Rydex asset levels as gauges of sentiment. That approach is problematical for a couple of reasons. As the stock market rises, bull asset levels rise and bear asset levels fall. Using asset levels to measure Rydex investor sentiment does not correct for this effect. I have made a number of studies that adjust Rydex funds assets for the rise and fall of market prices, but their results have been less than satisfying.

What matters more is cash flow. What matters the most in sentiment studies is not how much you hold, but what you are buying and selling. Stockcharts used have a have series showing cash flows into Rydex bull, bear, and money market funds, whose bull/bear ratio is shown in the bottom panel of the chart below. As the chart shows, this measure has been very good at flashing buy signals at bearish sentiment extremes (vertical blue lines). By contrast, sell signals using the same metric has been less effective.

Despite the minor market pullback, it was these off-the-charts model readings that contributed to my tactical buy signal on April 9, 2017 (see Buy the dip!).

A new Rydex sentiment model

Unfortunately, Stockcharts discontinued the Rydex cash flow data series as of March 31, 2017. However, they continue to report Rydex asset levels. I was able to reconstruct a Rydex sentiment model using asset level data. The trick is to watch for large spikes and drops in the bull/bear asset ratio data, which are reflective of either euphoria or panic, as a contrarian signal. The chart below shows the buy (in blue) and sell (in red) signals when the bull/bear asset ratio has either risen or fallen dramatically.

I conducted a study of the bull and bear asset data. Buy or sell signals were triggered if there was a two standard deviation move in the bull/bear asset ratio within a month. As the table below shows, returns were good, though the sample sizes were not that high for such a long backtest period (N=26 for buy signals, N=25 for sell signals). I would further observe that the signal peaks out after about 2-4 weeks.

I was also pleasantly surprised to see that this model worked well both on contrarian buy and sell signals. As the above Stockcharts chart based on Rydex cash flow measure showed, sell signals did not work well.

What does the model say now?

The chart below shows the record of this Rydex sentiment model in the past year. This model flashed a buy signal on March 29, which has worked out well. This was followed by a sell signal on May 1, 2017.

On the weekend, I had called for a period of market consolidation, or shallow pullback as the major stock indices are likely to encounter a bout of round number-itis, where their advance stalls out at round numbers (see Are the Fed and PBoC taking away the punch bowl?). These latest readings from the Rydex sentiment model are supportive of that view.

Disclosure: Long SPXU, TZA

Are the Fed and PBoC taking away the punch bowl?

Posted by Cam Hui - May 7, 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)

Tightening into an approaching storm?

William McChesney Martin Jr., who was the longest serving Fed chair, famously said that the job of the Federal Reserve was to take away the punch bowl just as the party gets going. In the past week, there has been rising angst over two separate central bank actions that may indicate that the “punch bowl” is leaving the global party.

The first set of actions belong to the Federal Reserve. The tone of the May FOMC statement and the strength of the April Employment Report makes a June rate hike a virtual certainty. Barring further “data sensitivity”, the Fed is well on its way to raise rates three times in 2017, and to begin reducing its balance sheet either late this year or early next year. At the same time, the Citigroup US Economic Surprise Index, which measures whether macro releases are beating or missing expectations, has been tanking. These readings, along with the weak Q1 GDP growth figures, raise the risk of a Fed policy error as it tightens into a weakening economy.

At about the same time, Beijing has been taking dramatic steps to contain credit growth and reduce leverage in China’s shadow financial system. These liquidity tightening measures have caused commodity prices to collapse and create heightened market anxiety.

The combination of a newly hawkish Federal Reserve and a PBoC intent on reining in excesses in the Chinese financial system have raised fears that the global economy may come crashing down as a result. Ambrose Evans-Pritchard summarized these fears in a recent Telegraph article:

Equity investors across the world are positioned for the nirvana of synchronised and accelerating global expansion led by China and the US.

What they may instead get is a synchronised Sino-American slap in the face. Analysts at UBS say the international credit impulse has already “collapsed”. The two interlocking economic superpowers are both tightening policy into an approaching storm.

The US bond market has been signalling for two months that the US economy remains uncomfortably close to a deflationary relapse, an implicit judgment that the US Federal Reserve is about to commit a policy error…

Meanwhile, the Fed is in “another galaxy”, to borrow an expression in vogue this week.

It shrugged off signs of weakness as “transitory” at this week’s meeting and seems determined to pack in a clutch of interest rate rises while the coast looks clear…

There must be a risk that they will do exactly what they did at the tail end of the pre-Lehman boom, when monetary indicators had already turned down. Bureaucratic over-tightening caused a manageable downturn to morph into a banking crash.

In addition, China is raising the risk of a global crash with its shift in with a credit restrictive policy:

Beijing began stealth tightening six months ago. This is turning into a full-fledged effort to rein in the $US8 trillion shadow banking nexus.

“The Chinese economy peaked in the first quarter and is set to lose steam for the rest of 2017,” said Danske Bank. Caixin’s manufacturing index is the weakest in seven months. Steel output has dropped to 2015 levels. Planned investment is even lower. Housing curbs are biting with a delay. China’s credit impulse has turned negative.

Saxo Bank says the contractionary forces are so powerful that the Chinese economy may slide towards a “full stop” later this year, with tremors through the commodity nexus and with risk of outright falls in world GDP.

“The markets are pricing in a 20 per cent chance of a recession, but after returning from China, we think it is more like 60 per cent,” said Saxo’s Steen Jakobsen.

Are the US and China tightening into a synchronized global recession? Let’s examine the bull and bear cases.

The bear case

The key underpinnings of the bear case is the fragility of both the American economy. Indeed, three of my seven recession indicators are starting look a little wobbly.

Corporate bond yields tend to bottom out before recessions. Even though this indicator tends to be very early, they made a cycle low in August 2016.

Real money supply growth has also turned negative before recessions. While real M1 and M2 growth have not turned negative just yet, they are showing signs of deceleration, which are signs of a late cycle expansion.

While real M1 and M2 growth have been less reliable recession indicators, real M3 growth has turned negative just before, or coincidentally with past recessions.

The Federal Reserve stopped publishing an M3 money supply series in 2006. However, Now and Futures has reconstructed an M3 estimate. The latest reading of nominal M3 growth as of January 1, 2017 shows YoY M3 growth to be barely positive. Once we subtract an inflation adjustment, real M3 growth would be either negative or very close to negative – which is a recessionary red flag.

The yield curve has been an uncanny recession indicator. The 2/10 Treasury spread has turned negative, or inverted, ahead of every recession. Today, the yield curve is flattening, indicating slowing economic growth expectations, and has been bouncing around between 100bp and 105bp for the past few weeks.

While UST 2/10 yield curve is not in the danger zone, the Chinese yield curve is plunging, indicating market fears of an economic slowdown.

These concerns about the reversal of the global reflation trade are not new. The latest BAML Fund Manager Survey, which was done about a month ago, reveals that institutional managers were already concerned about a global growth slowdown.

While many Chinese economic statistics cannot be fully trusted, we can rely on market prices as real-time proxies of Chinese growth expectations. One of the most commonly used indicators are commodity prices because China has been such a voracious consumer of raw materials. As the chart below shows, the CRB Index has been falling for most of 2017 and it is now testing a key support zone.

The cyclically sensitive industrial metals are faring better than the CRB Index, which is heavily weighted in the energy complex. Even then, industrial metals have weakened this year to test a key uptrend line, which is raising doubts about the global reflation scenario.

Even if you think that the Fed is charting the right course on monetary policy, there is a significant risk that Fed policy could become even more hawkish next year. The terms of Fed chair Janet Yellen and vice chair Stanley Fischer expire in 2018, and the Trump administration has not indicated whether they would be replaced. Most Republican candidates for the Fed chair are said to favor rules based approaches to monetary policy, where interest rates targets are higher than they are today. Chances are, any replacement to Janet Yellen will steer the Fed on a more hawkish course.

In addition, vice chair Fischer did not endear himself with the Trump White House when he rebuked them for their intention to “do a number” on Dodd-Frank in a CNBC interview:

“We seem to have forgotten that we had a financial crisis which was caused by behavior in the banking and other parts of the financial system and it did enormous damage to this economy,” Fischer told CNBC in a live interview. “Millions of people lost their jobs, millions of people lost their houses.”

“The strength of the financial system is absolutely essential to the ability of the economy to continue to grow at a reasonable rate, and taking actions which remove the changes that were made to strengthen the structure of the financial system is very dangerous,” he added.

In summary, there is merit to the concerns that the tightening efforts by the Fed and the PBoC risks policy errors of tightening even as their respective economies are showing increasing signs of fragility. These actions could then plunge the world into a global recession.

The bull case

By contrast, the bull case consist of, “What economic weakness?”

Sure, long leading indicators of the American economy, which are designed to spot recessions a year in advance, are starting to turn down. On the other hand, other long leading indicators show that the US economy is nowhere near the recessionary danger zone.

As an example, housing and construction is one of the most cyclically sensitive sectors of the US economy. If the economy is starting to weaken, then housing would be rolling over. As the chart below shows, there are no signs of a peak in housing starts.

In addition, recessions are characterized by a slowdown in consumer spending. American consumer spending continues to be healthy.

Employment is also a key factor in driving consumer spending. As the April Employment Report shows, the jobs market remains strong. In addition, leading indicators of employment, such as temp jobs, are not peaking.

There is also lots of good news from Wall Street. The latest report card from Q1 Earnings Season remains a solid one The latest update from Factset shows that both the EPS and sales beat rates are above average. Forward 12-month EPS estimates are continuing to rise.

Barron’s report of insider activity shows that insiders are back buying again.

In short, these are not the kind of readings normally found when the US economy is at high risk of recession.

China concerns overblown

As for China, Bloomberg’s Asian economist Tom Orlik thinks that fears over a China credit crunch are overblown, “Credit is down but land sales and profits are up – businesses and local governments still have funds to work with.”

If the market is worried about the contagion effects from a Chinese credit slowdown, then the first place these concerns should show up is in the markets of China’s major Asian trading partners. As the chart below shows, the Shanghai Composite has declined dramatically and violated its 200 dma. On the other hand, the stock indices of other major Asian markets remain healthy. All are above their 50 dma, and several, such as South Korea and Singapore, have rallied to new recovery highs. Chinese induced global slowdowns don’t look like this.

In addition, my monitor of two New (consumer) China vs. Old (finance and infrastructure) China pairs trades shows the ascendancy of consumer sensitive industries in China. Beijing’s policies of credit controls while targeting consumer oriented growth seems to be working. Isn’t economic balancing supposed to look like this?

Finally, Beijing still has lots of tools available should the latest round of credit controls tank the economy. Overshadowing these policies is the 19th Party Congress in the fall, where Xi Jinping is expected to consolidate power. Any government official who get overzealous in curbing growth and embarrasses Xi by tanking the economy as the Party Congress opens can expect a detailed corruption investigation into his affairs, as well as those of his extended family and close associates.

Investment implications

When I put it all together, resolving the bull and bear cases is a matter of differing time horizons. Current conditions are nowhere near recessionary levels and fears of an imminent downturn are overblown. Still there are a number of longer term concerns that investors should be aware of.

Jan Hatzius at Goldman Sachs recently indicated that their models show US recession risk is rising, but readings are not at danger levels. That sounds about right. My own Recession Watch indicators show that risk is rising, but there is no slowdown in sight. Should the Fed continue on its tightening path, however, it would be no surprise to see risk levels significantly higher six months from now. The economic outlook would further deteriorate should Yellen and Fischer be replaced by Trump nominees, who are likely to be even more hawkish.

Looking into 2018, both corporate and household balance sheets will come under great stress as rates rise. While the megacaps are in strong financial shape, smaller companies face far more financial pressures. What happens when rates are 50bp to 100bp than they are today?

In addition, analysis from Pimco shows that credit leads industrial production by about six months. The current round of credit tightening suggests that manufacturing could be peaking soon. If so, then watch for weakness in the stock indices of major Asian partners, which hasn’t occurred yet.

At a tactical level, Sentiment Trader observed that the market flashed a dual Hindenburg Omen for both the NYSE and NASDAQ on Thursday, which is a short-term cautionary signal for the stock market.

I interpret these conditions as the intermediate term bull trend remains intact. Don’t expect a Fed or China induced downturn to be realized between now and year-end. However, those concerns are not without merit and could materialize in 2018, but those are problem for next year, not now.

The week ahead: Round number-itis?

Looking to the week ahead, the stock market may be subject to a case of round number-itis, where stock indices pause or pull back as they rally to round numbers. The major US indices all closed at or around round numbers on Friday: Dow (21,006.94), SPX (2,399.29) and NASDAQ (6,100.76).

Round number-itis can be a contributing factor to a market pause as short-term worries over policy induced slowdowns to play themselves out. The SPX could either consolidate while remaining overbought on RSI-5, as it did last July, or pull back and test initial support at its 50 dma.

As well, data-mined fears are coming out of the woodwork. While the analysis below looks like a spurious correlation from torturing the data until it talks, sentiment readings are at neutral levels and have room to get more bearish. Tactically, the bears may need to take temporary control of the tape and spike fear levels before an uptrend can resume.

Under the current circumstances, long-term investors may be best served by holding sectors that exhibit market leadership, such as Technology and Consumer Discretionary stocks.

In the short term, I will be watching the market reaction to electoral results on Monday as a test of market psychology. Emmanuel Macron is likely to win the French Presidency on Sunday, which is positive news but largely discounted by the market. As well, I will be also watching the Schleswig-Holstein state election in Germany, where Angela Merkel’s CDU is leading Martin Schulz’s SPD in the polls. A CDU win would therefore be an expected result and solidify Merkel’s campaign for another term as chancellor. Will the market rally on the electoral news from Europe, or will traders sell the news?

My inner investor is constructive on stocks and he remains overweight equities. My inner trader took profits on his long positions on Friday. Even though the trading model flashed a sell signal, he did not go short. He preferred to adopt a wait and see attitude and wait for a break of the SPX trading range before making a commitment.

What’s next for gold?

Posted by Cam Hui - May 3, 2017

Mid-week market update: My recent sector review was well received, especially when it was framed in the context of how a market cycle rotation works (see In the 3rd inning of a market cycle advance). As I don’t have much to update about the technical condition of the stock market, especially in light of the non-reaction to the FOMC meeting. The SPX remains in a tight trading range between 2380 and 2400.

Under those circumstancees, I thought that I would focus on a popular topic with a number of readers, gold. In particular, gold is important in a market cycle analytical framework. That’s because inflation hedge leadership tends to mark the terminal phase of equity bull cycle.

The gold outlook

Technically, gold prices may be nearing an inflection point. As the chart below shows, gold violated its 50 and 200 day moving averages (dma) and it is now testing an uptrend line. Further weakness would be bad news for the bulls.

However, keep a close eye on the RSI reading (top panel). Charlie Bilello pointed out that gold is oversold, as defined by its RSI below 30, gold prices has historically performed well.

Callum Thomas of Topdown Charts observed that gold prices tend to be inversely correlated with the shadow Fed Funds rate. The Fed continuing tightening cycle should be bearish for gold.

Indeed, the historical record shows that gold prices (blue lines) are inversely correlated with real interest rates (red line, inverted scale). Gold is an inflation hedge, and rising real interest rates would tend to depress the price of gold.

Should investors and traders be bullish or bearish on gold? Rather than try and debate the likely path of inflation and interest rates, an analysis of the technical conditions of other inflation hedge vehicles such as energy and mining represents a more pragmatic approach to the problem.

The message from the markets

The Relative Rotation Graph (RRG, click link for full explanation of RRG) of US sectors depict how sectors rotate in a clockwise fashion in RRG charts. The late cycle inflation hedge groups, namely Energy, Mining, Materials, and Gold, are either in the bottom left or nearing bottom left quadrant, which indicates their lagging status.

As shown in the chart below, the relative performance of Energy and Mining in both the US (in black) and Europe (in green) show the poor relative returns of these groups. The top panel shows the USD Index on an inverted scale. As the USD tends to be inversely correlated with commodity prices, a weakening USD should be bullish for these stocks. The weak relative returns shown by these groups even with a tailwind of a falling USD is testament to the fact that these stocks are not ready for market leadership.

Based on this analysis, I can only conclude that gold and other inflation hedge stocks need time to find a bottom, base, before they can exhibit sustained price strength.

From a big picture viewpoint, this analysis is constructive for equity bulls. If inflation hedge vehicles are still laggards, then that means inflationary expectations remain dormant. The Fed is therefore unlikely to believe that it is behind the inflation fighting curve and will not become overly aggressive in its pace of monetary tightening.

Once inflation hedge stocks start to run, then that will be a signal for the Fed to stomp on the monetary brakes. Such actions would likely lead to a series of staccato rate hikes to cool the economy into a recession, and a bear market.

That day hasn’t arrived yet.

Finding risk and opportunities from the BAML and Barron’s Big Money polls

Posted by Cam Hui - May 1, 2017

You may think that institutional money managers run in herds, but that is not necessarily true. Different managers have different mandates that color their views. As well, their geographical base can also create differences in opinions in how their view their world and markets.

Barron’s published its quarterly Big Money poll of institutional money managers on the weekend. The Barron’s survey sample consists of US based managers. Another well known poll, the BAML Fund Manager Survey, is published monthly and surveys global institutions. A comparison of these two polls gives us a chance to find some opportunities and risks in the market.

The US equity market comprise roughly half the weight of global equity indices, and the opinions of American managers are undoubtedly important. By contrast, the BAML sample also survey shows the views of non-US managers whose opinions can, on occasion, reveal key differences. By analyzing the degree of agreement, astute investors can find opportunities, as well as understand the blind spots of each group.

A remarkable consensus

First of all, there was some remarkable agreement in the opinions of both groups. Both are bullish on equities. The Big Money poll showed a clear progression on equity bullishness.

Similarly, the BAML sample showed a similar rising level of bullishness. Normally, a bullish stampede would set off contrarian warnings of caution. However, as the chart below shows, sentiment rose in the last year from relatively low levels and they are not excessively high. Therefore it is probably too early to get cautious just yet.

Here is another reason not to panic over institutional bullishness. Both American and global managers believed that US equities are overvalued.

They therefore underweighted the US, and found better opportunities in Europe and emerging markets.

There was another consensus on sector allocation. On the whole, both are bullish on Technology and Financials (or banks), and bearish on Utilities.

Here is the BAML survey of global managers on their US sector weights.

What’s the risk?

There was, however, a difference of opinion on the sources of risk. One possible explanation is how the questions were asked on the surveys. Barron’s asked about the threat to US equities, as the survey was America-centric in scope.

By contrast, BAML asked about the sources of tail-risk, which is a more open and generalized question. The categories “a delay in US corporate tax reform” and “the risk of a trade war” are in broad agreement with the answers from Barron’s of “US political turmoil or policy error”. However, there seems to be broad disagreement about the other sources of risk between US and global managers.

Opportunities and risks

Based on the comparison of the two surveys, I have identified several opportunities and risks for investors in US equities.

Let’s start with the consensus trades. Bullish on equities. Overweight Europe and emerging markets, underweight US equities. In the US, overweight Technology and Financials, and underweight Utilities.

One of the contrarian trades that stands out is an overweight position in the Consumer Discretionary sector. Both US and global managers are underweight US consumer discretionary stocks. As the chart below shows, the sector has begun to turn up on a relative basis. As well, the outperformance is broad based across different industries within the sector (except for Media). Should this trend continue, the sector should rise further as managers stampede into these stocks.

On the other hand, the crowded long in the Financial sector is a concern for me. I have demonstrated before that the relative performance of this sector has been highly correlated with the shape of the yield curve. Should the yield curve continue to flatten, it will drag down the relative strength of these stocks. Please note that I am not advocating a short position in these stocks but a neutral or underweight position in this sector because of the risks.

A bond market Apocalypse?

Related to the discussion about the shape of the yield curve, the differences in opinion on the sources of risk reveals some possible ways that institutional managers could get blindsided. One of the key tail risks identified by global managers is a crash in the global bond market. The most likely cause of such an event would be the combination of an overly hawkish Fed and the ECB shifting from an accommodative policy to a more restrictive one. Should such a development occur, the timing is likely to be in late 2017 or some time in 2018.

Under such a scenario, the crowded trade of overweight Europe and emerging markets and underweight US amounts to a high beta beta and it would reverse as managers scramble to de-risk their portfolios. A crashing bond market would expose the fragility of the eurozone banking system, which has not repaired the damage from the Great Financial Crisis, as well as that of the EM economies. Even though equity prices are likely to suffer, the US market and USD assets would likely become a safe haven on a relative basis in the event of another global financial crisis.

Investment conclusions

In conclusion, the analysis of the Barron’s Big Money poll and the latest BAML Fund Manager Survey yielded some remarkable insights.

In the short term, US consumer discretionary stocks represent an opportunity for better performance for long portfolios. On the other hand, the crowded long in financial and bank stocks is a bet on a steepening yield curve which may not necessarily pay off.

Looking longer term, investors need to recognize that the overweight position in Europe and EM, as well as the underweight in US equities, represent a high beta bet. While that may pay off in the short run, portfolios that are long that trade also need to recognize the macro risks should the global economy start to slow from a coordinated central bank shift from easy to more restrictive monetary policy.

Should you sell in May and go away?

Posted by Cam Hui - April 30, 2017

The latest signals of each model are as follows:

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

Sell in May?

The adage “sell in May and go away” has been well known to traders for many years. Indeed, the chart below shows that the stock market is entering a period of weak seasonality.

Should investors heed the cautious seasonal signal and avoid stocks? Let’s consider the bull and bear cases before making a decision.

A solid earnings growth outlook

Earnings and earnings growth is one of the key drivers of stock prices. Q1 Earnings Season has shown solid results so far. The latest update from Factset shows that both the EPS and sales beat rates are well above average. As well, forward 12-month EPS estimates continue to rise, which reflect continued Wall Street optimism about the earnings outlook (chart annotations are mine).

Additional analysis from Ed Yardeni shows that forward EPS is rising across the board for large, medium, and small cap companies in a broad-based advance in fundamental outlook.

What about the Q1 GDP miss last Friday? How can we resolve a picture of upbeat Wall Street earnings expectations with the disappointment in Q1 GDP growth?

Don’t be so sure about economic weakness. 1Q real GDP rose 1.9% YoY. 1Q final sales, which is GDP growth after stripping out inventory adjustments, grew 2.1%, indicating few signs of growth deceleration and little deviation from trend.

Q1 GDP has shown a history of missing expectations. The problem is “residual seasonality”, which is an issue that the BEA is aware of and addressing.

Possible fiscal tailwinds

Another possible tailwind for equity prices come from the long awaited tax cuts promised by Candidate Trump during his election campaign. The Trump White House presented an outline of its plan for tax reform last week. While Wall Street largely scoffed at the likelihood of its enactment, I regard the equity risk/reward from the tax plan as one-sided. At worse, it won’t get enacted and the effects will be neutral. At best, its implementation will show some upside for equity prices.

Evercore/ISI ran the plan through the Fed’s macro model and found that the plan would boost economic growth by about 0.5% in the early years but the effects gradually decline and go negative as time goes on.

To be sure, the Trump administration’s record of enacting legislation has been less than stellar. The latest “tax reform” proposal should therefore be regarded as nothing more than the opening offer in multiple rounds of bargaining with the GOP caucus. Should a tax reform be enacted, the most likely case would be some form of standard Republican tax cut package with little or minimal levels of tax increases.

With that scenario in mind, this analysis from Citi Research of the GOP House and Trump proposals puts the negotiations into some context. Notwithstanding the inevitable horse trading that will occur, the easiest and most likely proposal to be enacted will be an offshore cash repatriation tax holiday (annotations in red are mine).

The most obvious beneficiary of such a proposal are Technology stocks. The two biggest stocks in the NASDAQ 100 account for 20% of index weight are APPL and MSFT, both of which are cash rich and would benefit from an offshore cash repatriation tax holiday. As another example of the possible benefit from this tax provision, CNBC reported that Credit Suisse double upgraded CSCO from underperform to outperform and raised the price target from $27 to $40 based on the offshore cash repatriation proposal.

As the chart below shows, the technology sector has been outperforming the market. While the relative advance appears to be a little extended in the short run, the sector should continue to be market leaders as the Trump tax reform proposals evolve.

The bear case

While the bull case consists mainly of an upbeat growth outlook and possible fiscal tailwinds, investors should not ignore possible bearish catalysts:

A China deleveraging slowdown
Hawkish monetary policy

Chinese curbs on financial risk

Regular readers know that my analytical approach has been global in nature. I use a framework of analyzing the health of the three major trade blocs, namely the US, Europe, and China. As I have already outlined, the US growth outlook remains upbeat. The results of the first round of the French election has taken much of the political tail-risk off the table in Europe. The one possible growth blemish comes from China.

The Chinese stock market has been weakening as a result of Beijing’s curbs on financial risk. Bloomberg reported that Beijing is employing a multi-dimension approach of regulatory oversight and heightened corruption scrutiny:

Maintaining financial safety is “strategically important” to the country’s economic and social development, Xi said at a meeting of the Communist Party Politburo Tuesday, according to the official Xinhua News Agency. It was a rare occasion for the top policy making body to discuss a specific topic. Officials who attended the group study included the central bank governor and chiefs of the nation’s market watchdogs.

The statement came just as the country’s top leaders said at a separate meeting on Tuesday that they will improve financial support for the real economy, while also stressing preventing financial risks. Chinese banks are pulling back $1.7 trillion source of inflows in response to a series of regulatory guidelines over the past three weeks that put a spotlight on the risks, helping erasing stock market value and sending bond yields to the highest level in near two years.

The government is seeking to reduce financial-system risk by tightening the screws on leverage. The banking regulator said late last week it will intensify steps against irregularities in the financial sector, echoing comments by the securities watchdog just days earlier, while the top insurance official is being investigated on suspicion of “severe” disciplinary violations.

So far, the fallout from the regulatory crackdown appears to be contained within China itself. The chart below of the Chinese stock market and the stock markets of China’s major Asian trading partners tell the story. While the Shanghai Composite (top panel) has been falling and it is now testing its 200 day moving average (dma), the stock indices of the other Asian market look healthy. All are trading above their 50 dma. Hong Kong’s Hang Seng Index has rallied to test new highs. Of particular note is the South Korean KOSPI, which has been strengthening and reflects minimal anxiety over geopolitical tensions with North Korea.

In addition, Chinese economic growth is going like gangbusters. The Li Keqiang Index is 11.6%, which is the greatest level of strength since Li became the Premier of China. For readers unfamiliar with the index, Wikipedia explained it this way: “According to a State Department memo (released by WikiLeaks), Li Keqiang (then the Party Committee Secretary of Liaoning) told a US ambassador in 2007 that the GDP figures in Liaoning were unreliable and that he himself used three other indicators: the railway cargo volume, electricity consumption and loans disbursed by banks.”

Staff economists at the New York Fed confirmed the story of Chinese economic strength in an unusual way. It conducted a study of Chinese economic growth based on the brightness of night lights using satellite data. They concluded that Chinese growth has not been overstated, but understated.

Bottom line: Investors should relax, China is not crashing. The authorities will take every step to minimize tail-risk ahead of the Party Congress this fall.

What about the Fed?

Recently, the perennially cautious John Mauldin featured analysis from the equally cautious Lacy Hunt and Van Hoisington about the risks posed by the Fed’s tightening cycle. Hunt and Hoisington warned that the “last ten cycles of tightening all triggered financial crises”:

Four important considerations exist today that were not present in past cycles and that may magnify the current restraining actions of the Federal Reserve:

1. The Fed has initiated a tightening cycle at a time when significant differences exist in the initial conditions compared to the initial conditions in prior cycles. Additionally, the Fed is tightening into a deteriorating economy with last year’s growth in nominal GDP worse than in any of the prior fourteen cases.

2. Business and government balance sheets are burdened with record amounts of debt. This means that small changes in interest rates may have an outsized impact on investment and spending decisions.

3. Previous Federal Reserve experiments, primarily the periods of quantitative easings, have led to an unprecedented balance sheet (an action of “grand design”) to which the economy has grown accustomed. The resulting reduction in that balance sheet (reduction in the monetary base) may have a more profound impact on growth than anticipated.

4. The monetary base reduction and the impact of the changing regulatory landscape, both in the U.S. and globally, has meant a significant increase in the amount of liquid reserves that banks are required to hold. Liquidity may have already been sharply restrained by the lowering of the monetary base, despite its massive $3.8 trillion size. This is evident as the monetary and credit aggregates are following the expected deteriorating pattern resulting from monetary restraint, suggesting recessionary conditions may lie ahead.

The Fed seems dead set on tightening monetary policy. In a past post, I had pointed out that Fed watcher Tim Duy and award winning economic forecaster Jim O’Sullivan believe that the Fed is likely to look through any Q1 weakness and continue on its tightening path (see Will the real Q1 GDP please stand up?).

Indeed, as the FOMC prepares meets next week, the market expects the Fed to stand pat. The latest markets expectations from the CME shows only a 5% of a May rate hike and an about two-thirds chance of a June hike.

More revealing will be the tone of the language in the FOMC statement. Despite the soft Q1 GDP figure, one of the key indicators to watch will be core PCE inflation which is due for release on Monday. Core PCE is the Fed’s preferred inflation metric and its progress will be an important input into monetary policy. Last Friday’s GDP release also saw the Employment Cost Index rise 0.8% in the quarter, which was ahead of expectations and shows growing wage pressure. As well, the Employment Report due Friday, which is after the FOMC meeting, will also play a key role in the determination of interest rate policy.

For the time being, I agree with Tim Duy when he wrote in Bloomberg that both the stock and bond markets can be right:

Equities have renewed their rally — and so have bonds, and that is creating much alarm among some investors. Whereas the former suggests the stage is set for solid growth, the latter and the accompanying narrowing of the yield curve raises red flags about the health of the economy. I am not sure there is much of a puzzle here. This dichotomy is fairly typical of a monetary tightening cycle and can exist for a long time. How long? Until the Federal Reserve finally snuffs out the expansion with excessively tight monetary policy.

For investors, the trick is to spot the inflection point when the Fed “snuffs out the expansion with excessively tight monetary policy”. One indicator that can be used to proxy the degree of accommodation in monetary policy is real M1 growth, which has tended to turn down before recessions. As the chart below shows, real M1 growth is decelerating, but it is far from the overly restrictive danger zone (for now).

If the Fed were to stay on its current course of two more rate hikes this year, recession risk is unlikely to rise significantly until late 2017. Since the markets are forward looking, that implies a cyclical market top at about the same time, with the caveat that this forecast is “data dependent”.

Until then, the equity party is still going. Enjoy!

A breadth thrust failure?

Turning to the technical outlook, I identified a possible bullish setup in my last post in the form of a breadth thrust that had until a deadline of last Friday’s close to flash a buy signal (see Just overbought, or a “good overbought”?). Unfortunately for the bulls, the buy signal did not materialize, but that failure does not necessarily instantly translate into a sell signal.

Market internals remain supportive of higher prices. Jeff Hirsch of the Stock Trader’s Almanac has gone against this year’s “sell in May” seasonal bias by issuing a buy signal based on improving breadth:

Well, patience with our Best Six Months Seasonal MACD Sell Signal has sure proved to be a virtue thus far. Both MACD indicators for both the S&P 500 and DJIA went negative in early March and did not all turn positive until the past Monday’s big gains. Now we are getting some bullish confirmation from market breadth. The cumulative Advance/Declines in several major market indices are trending higher and on the brink of more new highs.

This weekly chart of the NYSE McClellan Summation Index (NYSI) shows that it bottomed five weeks ago after flashing an oversold reading. The NYSI is rising again and it is far from overbought, which indicates further room for an intermediate term advance.

As well, Sentiment Trader pointed out that small option traders (the “dumb money”) has been buying put options at levels consistent with past market bottoms.

Lastly, analysis from Eric Parnell shows that a “sell in May” strategy would have given the trader little or no edge in the post-crisis era.

Instead of wondering whether to sell in May and go away, I would prefer to stay long in May and play.

The week ahead

Looking to the week ahead, there is plenty of potential from event driven volatility. In addition to the key macro releases like PCE inflation and ISM on Monday, the FOMC meeting announcement on Wednesday, and the Jobs Report on Friday, a number of index heavyweights will be reporting earnings results. These include trading favorites like AAPL (Tuesday) and FB (Wednesday). As well, the second round of the French election is scheduled for May 7.

From a technical perspective, the failure of the SPX to punch through technical resistance was a setback for the bulls. However, breadth charts from Index Indicators show that the market has already retreated from overbought levels to neutral, which suggests that either the pullback has already occurred, or further corrections are likely to be shallow.

This chart of net 20 day highs-lows, which tends to have a 1-2 week trading time horizon, tells a similar story of a pullback from overbought conditions to a neutral reading.

If the SPX were to weaken, look for the gaps to be filled. Initial support can be found at the 50 dma at about the 2360 level, which represents downside risk of less than 2%.

My inner investor remains bullishly positioned. The intermediate term outlook remains positive and he is not worried about minor downside blips of 2% or less.

My inner trader remains long the market, with a tilt towards the technology heavy NASDAQ stocks.

Disclosure: Long SPXL, TQQQ

Just overbought, or a “good overbought” signal?

Posted by Cam Hui - April 26, 2017

Mid-week market update: In the past two weeks, I have become progressively more bullish on stocks (see A capitulation bottom? and Buy signals everywhere), based on the belief that the risk/reward trade-off was tilted in favor of the bulls. Even as the market bottomed with sentiment at crowded short levels, the rebound had been unusually weak with little bullish follow-through. That pattern was broken this week when the stock market finally put together two consecutive up days.

In order for this rebound to turn into an uptrend, the market has to show some positive momentum, with a series of “good overbought” conditions. Such episode tend to be characterized by RSI-5 (top panel) getting overbought and staying overbought, as well as the SPX riding the top of the Bollinger Band (BB). The chart below shows some past examples of bullish impulses in the last two years.

Can the market continue upwards, or will it stall as it tests resistance at its all-time highs? Will the market focus on the bullish message of the Trump tax proposals, or news reports indicating that the Trump administration is giving notice that it is getting ready to withdraw from NAFTA? Here is what I am watching.

A possible bullish breadth thrust

There is some reason for bullish optimism as there are signs of a possible broadly based upside breadth and momentum thrust. Some encouraging signs come from the other major US indices as both the NASDAQ Composite and the Russell 2000 made new all-time highs this week. In addition, Chris Ciovacco pointed out that the market is experiencing a bullish breadth divergence, based on net NYSE new highs vs. lows.

Another constructive sign came in the form of a possible breadth thrust. I had written about the Zweig Breadth Thrust before (see A possible, but rare bull market indicator). Steven Achelis at Metastock explained the indicator this way:

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

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

Currently, we don’t have the setup for a classic Zweig Breadth Thrust (ZBT). However, the ZBT calculation is based on NYSE breadth. As good traders are well aware, NYSE breadth statistics are distorted by the presence of a number of closed-end funds and REITs, which do not necessarily reflect market action of common stocks.

To remedy this problem, I developed a ZBT indicator based strictly on SP 500 breadth as an apples to apples comparison of market breadth. As the chart below shows, the SPX ZBT Indicator is nearing a buy signal, but not yet. It has until the market close on Friday to exceed the top line and signal a momentum thrust.

Readers who would like to follow along at home can use this link to get updates.

Look for confirmation

If a breadth thrust were to continue, then one of the secondary signs that I would be watching for as confirmation is the continued outperformance of the price momentum factor. The chart below depicts the relative return of momentum stocks against the market. A definitive rollover in this factor would be a warning sign that to turn more cautious.

For now, my inner trader is enjoying this bull run, but he is keeping an open mind as to whether it can continue.

Disclosure: Long SPXL, TQQQ

Will the real Q1 GDP please stand up?

Posted by Cam Hui - April 25, 2017

The US Q1 GDP report is scheduled to be released Friday morning. Current expectations call for a Q/Q growth rate of 1.1%, but there are wide disparities in nowcasts. The Atlanta Fed GDPNow nowcast of Q1 GDP growth has been declining since late February and stands at a meager 0.5%.

By contrast, the New York Fed’s nowcast has been relatively steady, with an estimate of 2.7%.

What’s going on? Who is right? The evolution of GDP growth in 2017 will have a large impact on Fed policy.

Seasonal Q1 weakness?

High frequency economic releases have been disappointing. The Citigroup US Economic Surprise Index (ESI) has been plunging, as a reflection of the recent weakness. However, ESI has shown a seasonal pattern of declining into mid-May and then rising into September.

Fed watcher Tim Duy believes that the Fed is likely to look through any Q1 weakness and maintain their stated policy of three rate hikes in 2017 because of a history of weak Q1 seasonality:

Federal Reserve officials continue to anticipate additional monetary policy tightening this year on the order of another two interest-rate increases. They have no reason to back down just yet. The weakness seen in “hard” economic data based on actual performance relative to “soft” data, such as surveys, is enough to temper concerns that they are falling behind the curve and keeps a May move off the table. That means they can be patient and adjust their forecasts, if necessary, before the June 14 meeting…

It should not come as a surprise that the Fed would be looking through these weak numbers. They recognize that residual seasonality issues — the tendency for first-quarter growth to be unusually low — may be holding down estimates. Policy makers also know that net exports and inventories account for much of the weakness. The Fed will thus seek guidance from real private final sales, which the Atlanta Fed currently estimates growing at a 2.6 percent pace. Hence, the underlying economy looks to be growing at a rate that might exceed their forecasts. Also, the soft data represent upside risks to their forecasts.

Jim O’Sullivan of High Frequency Economics, who was named Marketwatch’s top economic forecaster for six years in a row and won the award for nine years out of the last 13, concurs with Duy’s assessment. O’Sullivan stated in a Bloomberg interview that he also sees another two Fed rate hikes in 2017, which represent a more hawkish shift in Fed policy.

One of the key signs of Fed policy will be the Q1 GDP report. Who will be right, the Atlanta or New York Fed? Even if Duy and O’Sullivan are correct about the Fed looking through Q1 weakness, a strong GDP report that is closer to the New York Fed estimate will be a confirmation that the economy is strengthening sufficiently for the Fed to stay on its projected tightening path.

Stay tuned.

In the 3rd inning of a market cycle advance

Posted by Cam Hui - April 23, 2017

The latest signals of each model are as follows:

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

Market cycles explained

When I first got interested in the stock market (back in the day when we programmed computers with punched cards), I learned the principles of market cycle analysis from a grizzled veteran of technical analysis. Markets are said to move in cycles.

Here is how an idealized cycle works. In the initial phase of an expansion, central banks lower rates to boost the economy, and the market leaders are the interest sensitive stocks. As the cycle matures, leadership rotates into consumer stocks, followed by capacity expansion, which leads to capital goods sector leadership. The late phase of the cycle is characterized by tight capacity and rising inflation, which is an environment where asset plays and commodity extraction industries outperform.

I never forgot that lesson. I also learned that while the market cycles thematically parallel economic cycles, they are different. Market undergo mini-cycles of changes in sentiment whose length are much shorter than economic cycles. Nevertheless, the broad principles of market cycle analysis remain valid today.

In the past few weeks, I have been repeating the message that the intermediate term equity market outlook appears bullish (see Buy the dip! and Buy! The party is still going strongly). There is a growth surge, not only in the US, but around the world. This chart from Callum Thomas of Topdown Charts summarizes the growth outlook perfectly.

In addition, the recent 2-3% pullback saw sentiment tank to bearish extremes, which is contrarian bullish. Last week, oversold markets began to bounce, which is an indication of an inflection point (see Buy signals everywhere). As well, Tom McClellan observed that the 10-day Open ARMS index was also signaling a bottom.

Rather than repeat the same bullish message for another week, I thought that a sector review from a market cycle analytical framework would be a good change of pace. Interestingly, the broad message from this analysis tells the story of a global upturn, and we are roughly only in the third inning of an intermediate term bull phase.

Synchronized US and Europe

One of the tools of any sector review is the Relative Rotation Graph (RRG, click link for full explanation), Market leaders tend to rotate in a clockwise direction in an RRG chart, from lagging (bottom left), to improving (top left), to leading (top right), to weakening (bottom right), and then finally reverting to lagging again.

Here is the RRG chart of US sectors. It shows the revival of “animal spirits”, in the form of enthusiasm for high beta, high octane stocks, and the rising leadership of interest sensitive stocks. The laggards are mainly the late cycle plays, namely as energy and materials. Gold stocks, which are also inflation hedge stocks, appear to be rolling over while in the emerging quadrant before it can take over the leadership mantle.

Interestingly, the RRG chart of Europe tells a similar story. Technology stocks are leading the way, followed by interest sensitive sectors. Energy and Basic Material stocks are lagging.

The combination of these two RRG charts indicate that the dynamics of the market cycle are global in nature. The combination of the current picture of sector leadership, and the idealized template of sector rotation that I described above, suggests that we are only in the third inning of an intermediate term cycle which can carry the SPX to the 2500-2600 region before it’s all over.

A detailed look at sectors and industries

Here is a more detailed look at sectors, starting with the relative performance of the interest sensitive groups. The top panel below shows the relative returns of Utilities and REITs against the market. As the chart shows, these sectors are tracing out a rounding bottom relative to the market. The bottom panel shows the relative returns of Financials compared to the market. There has been much discussion in the blogosphere and social media about these stocks. As the chart shows, their relative returns have been highly correlated to the shape of the yield curve. A flattening yield curve has been detrimental to relative strength of Financial stocks.

Here is a chart of some mid-cycle sectors. Consumer Discretionary stocks are bottoming. Late cycle industrial stocks are struggling, and it’s too early to be overweight this sector. Health Care is starting to trace out a relative bottom. Biotech, which is the high beta “canaries in the coalmine” of this sector, remains range-bound compared to the market.

The emergence of Consumer Discretionary stocks as a leadership sector was a bit of a surprise. Here are the relative performance charts of selected industries within the sector. Most of the industries within the sector, with the exception of Media, are starting to turn around. Even the much maligned Retailers look washed out and they are starting to bottom.

Technology was another surprising leadership sector, especially in light of the pattern exhibited by the other sectors in a market cycle analytical framework. As the chart below shows, enthusiasm for high beta FANG and FANG-like stocks are rising again, except for biotech stocks.

Finally, here is the relative return chart of late cycle inflation hedge sectors. Energy and mining stocks (top panel) have broken out of relative downtrends. They need some time to consolidate and bottom before they can become market leaders. The same goes for gold stocks (bottom panel).

In addition, there are signs that gold is reaching a bullish sentiment extreme, which is contrarian bearish. A recent Bloomberg survey found a similar reading of excessive bullishness.

Mark Hulbert also found that gold market timers were in a crowded long:

Consider the average recommended gold market exposure level among a subset of short-term gold market timers that I monitor (as measured by the Hulbert Gold Newsletter Sentiment Index, or HGNSI). This average earlier this week rose to as high as 57.7%, the highest level in nearly 12 months.

As recently as mid-March, in contrast, the HGNSI stood at minus 27.7%. So in six weeks’ time the average gold timer increased his recommended exposure level by more than 85 percentage points. No wonder gold’s rally ran out of steam earlier this week.

In summary, bullish enthusiasm has returned to the market, in the form of FANG leadership. In addition, the emergence of leadership of interest sensitive and consumer discretionary stocks suggests that the market is still in the early phase of an intermediate term bull move.

The week ahead: Still anxious

Last Wednesday, I wrote that the VIX Index was flashing buy signals (see Buy signals everywhere). While fear levels have receded, short-term fear levels spiked again on Friday. The chart below depicts the VXST (9-day) to VIX (1-month) ratio, which has spiked indicating fear.

Past buy signals where an indicator has become oversold and mean reverted to neutral has resulted in powerful bullish thrust. The current episode is unusual as the bullish follow through has not materialized. The VXST/VIX spike is probably indicative of rising fear over the French election, whose first round is occurring this weekend.

For a different perspective, the chart below shows the spike in VSTOXX (via Callum Thomas). In all likelihood, any outcome other than where Le Pen/Mélenchon, or Fillon/Mélenchon victories will spark a relief risk-on rally.

In the meantime, eurozone PMI has risen to a six year high and Bloomberg reported that French companies are adding staff and shrugging off election uncertainty. The view from the ground in France doesn’t sound too bearish to me.

In addition, President Trump has announced that he will be unveiling his tax reform and reduction proposals next Wednesday. Even though the announcement is expected to be heavy on broad principles and light on details, the announcement has the potential to be the bullish catalyst that the stock market has been waiting for.

My inner investor remains bullishly positioned and overweight equities. My inner trader is nervously long. At a minimum, he would not want to be short in light of all of these potential

Disclosure: Long SPXL, TQQQ

Buy signals everywhere

Posted by Cam Hui - April 19, 2017

Mid-week market update: One of the most reliable trading signals occur when an indicator becomes oversold and mean reverts to neutral (buy signal), or if it gets overbought and mean reverts to neutral (sell signal). We saw numerous versions of buy signals of that variety from the VIX Index this week.

Consider, for example, the VIX/VXV ratio as a measure of the VIX term structure. When this ratio rises above 1, that is an inverted term structure indicating market fear. As the chart below shows, the VIX/VXV ratio inverted last week and returned to a normal upward sloping curve on Monday.

I went back to November 2007 and studied past instances of this buy signal. Historically, such episodes have resolved themselves bullishly.

That’s not all! There is more good news from the VIX for the bulls.

VIX Bollinger Band reversal

I have written before about the VIX Index rising above its upper Bollinger Band (BB) as a setup for a buy signal (see A capitulation bottom?). Last week, we saw the VIX rise above its upper BB. On Monday, it mean reverted to neutral.

Historical studies show that the odds are with the bulls when the market flashes this buy signal.

In addition, we are also seeing the rare condition of not only the VIX Index rising above its daily BB, but the weekly VIX above its BB (see Buy! The party is still going strongly). Should the VIX close at or near current levels, we will have a buy signal based on a weekly time horizon. The chart below shows that there were 8 signals in the last 5 years. This has been unabashedly bullish. With the exception of the double dip to test the lows in 2015, the market went straight up in all of the other cases.

VIX spikes in a market uptrend

Finally, CNBC reported that Ari Wald of Oppenheimer found that VIX spikes while the market is in an uptrend, defined as the index above its 200 dma, it tends to foretell a period of turbocharged equity returns:

“We think you have to use these market pullbacks to add to your exposure; we think the bull market is intact,” Wald said Monday in an interview on CNBC’s “Trading Nation.”

Since 1990, when this signal between the VIX and the market is triggered as it was last Thursday, the average gain over the next six months has been 8 percent, versus 4 percent for any six-month period.

Key risk

In summary, differing interpretations of the VIX Index are all telling the story that we are seeing the start of a relief rally. What is puzzling about the current market environment is the lack of bullish follow through. Past bounces off oversold conditions have seen powerful upside momentum, which is not currently in evidence.

However, different measures of risk appetite continue to look positive, which is constructive for the bullish outlook. I will be keeping an eye on these metrics and would become more defensive if these internals were to deteriorate.

Disclosure: Long SPXL, TQQQ

The Art of the Deal, North Korean edition

Posted by Cam Hui - April 17, 2017

Can we stop freaking out over the prospect of an imminent war over North Korean nuclear tests? After the hoopla over the North Korean announcement to expect a major event on or before their “Day of the Sun” on April 15, there was much speculation that they would conduct another nuclear test. Trump responded with the assertion that if China wouldn’t help, he would deal with North Korea by himself. The aircraft carrier USS Carl Vinson was re-routed from a planned exercise with Australia to the North Pacific.

The geopolitical tensions is fizzling out like a wet firecracker. The biggest splash was the display of some submarine launched ballistic missiles that were mounted on trucks in the annual parade. Afterwards, North Korea tried a missile test, but it blew up shortly after launch. Even Zero Hedge sounded disappointed.

As it turns out, this account from South Korean media shows that even the re-deployment of the USS Carl Vinson was mostly for show:

Japanese analysts believe that the USS Carl Vinson’s change of course is designed to fill a strategic vacuum in US forces at the present moment. “Since the nuclear aircraft carrier USS Ronald Reagan, which is based at Yokosuka Naval Base [in Japan], is inactive from January to April because of inspections and repairs, [the USS Carl Vinson] was deployed to fill a gap [in the West Pacific region],” wrote Tetsuro Kosaka, a staff writer for the Nihon Keizai Shinbun and an expert on Japanese security, in a column for the newspaper on Apr. 11. Though the USS Carl Vinson is in charge of the East Pacific, the fact that it is heading toward the Korean Peninsula (located in the West Pacific) cannot be regarded as an increased American military presence in the region, he argued.

In addition, the announcement that VP Mike Pence was to begin on the weekend a 10-day Asian tour with stops in South Korea, Japan, Indonesia, and Australia, it was evident that the US was unlikely to start unilateral military action without consulting regional allies. On Sunday, Donald Trump also tweeted that China was cooperating to defuse the North Korean problem.

Indeed, Beijing is showing signs of cooperation. State controlled media Global Times just published an Op-Ed warning to North Korea:

Preventing Pyongyang from carrying out its sixth nuclear test is the top priority at the moment. North Korea should not think that it has once again broken through the pressure from the global community. If it continues to go its own way, sanctions from the international community will become more stringent and the US will seriously consider launching military strikes against it. If conflict does break out, Pyongyang will suffer the most.

As geopolitical risk premiums recede and the South Korean KOSPI rose 0.51% on Monday, it is well worth considering how Donald Trump, who considers himself to be a master dealmaker, can find an accommodation with North Korea. Unfortunately, there aren’t any good deals to be found.

Consider the options that the current and past American presidents have faced in neutralizing the North Korean nuclear threat.

Attacking North Korea

National Security Adviser McMaster said on Sunday that “this problem is coming to a head” and “all options are on the table”. The phrase “all options are on the table” is just the warning of a possible attack.

Oh, PUH-LEEZ! McMaster is intelligent enough to recognize the tactical and strategic hurdles in the way of an attack.

Remember the calls to bomb Iran so that they couldn’t build nukes? Bombing Iran would not just be a pinprick raid, but a massive and concerted air campaign that would have lasted a week or more. A North Korean strike would roughly be on the same scale, but in a much compressed time frame. That’s because North Korean troops have massed artillery within range of Seoul. The onset of hostility would see an artillery barrage that would leave horrific South Korean civilian casualties. Does the US have sufficient air assets to suppress all of the artillery and hit the nuclear and missile launch sites all at the same time? I don’t know, but it would not be easy.

Last week, I had privately voiced my skepticism that the rising tensions from the deployment of a carrier task force would lead to a shooting war. One measly carrier group was not enough to start an attack. In addition to the B-52s based in Guam, the US needed an armada, which was nowhere in evidence.

US and South Korean commanders would also have to consider the Chinese reaction. China considers North Korea as a buffer state, and she would treat the presence of unfriendly troops on her border seriously. The most recent bout of tensions saw the deployment of 150,000 Chinese troops on the North Korean border and the entire military region was put on a state of high alert (via Huffington Post).

Notwithstanding the tactical issues of an attack on North Korea, the bigger strategic question would be the geopolitical endgame. Supposing an attack successfully took down the North Korean regime, what happens next? The Chinese would totally freak out over the prospect of unfriendly troops on their border. An attack therefore risks another Korean War and a confrontation with China, which is a real nuclear power with real ICBMs aimed at the United States.

Given sufficient warning, China could even opt to station troops in North Korea as a tripwire, or human shields. Such a tactic would mirror American actions at the beginning of the Cold War. US troops were stationed in Europe as a warning to the Soviet Union. Invade, and risk a nuclear confrontation with America.

Korean re-unification

Another long-term strategic option is Korean re-unification. Even if such a dream were to be achieved, in reality it would be the economic takeover of the North by South Korea. Bloomberg recently provided analysis showing the vast economic gap between the two countries.

From an economic viewpoint, the new Korea would be plunged into instant recession. German re-unification took a huge toll on the German economy. In that case, the economic gap was more narrow, and Germany had the support of her EU partners in that undertaking.

As well, China would not react well to the presence of South Korean troops, along with those of her American allies, on her border (see above). Therefore any effort to re-unify the two Koreas faces serious geopolitical constraints.

The Finlandization of South Korea

Since China seeks a buffer state on her border, one solution to Korean re-unification would be the Finlandization of either South Korea or the re-unified Korea.

For readers who are unfamiliar the term “Finlandization”, Finland fought a brutal Winter War with the Soviets in 1939-40. Today, even though Finland is part of the EU and eurozone, it is neutral and it has never been a member of NATO. This way, Helsinki avoided antagonizing the Soviet Union, and, today, Russia.

While the Finlandization process may make sense from an economic viewpoint, the biggest geopolitical loser of such a development would be the United States. If South Korea were to become neutral, it would have to sever current military alliances. American troops would have to be withdrawn from Korean soil. As China is South Korea’s biggest trading partner, a neutral South Korea or re-unified Korea would naturally be drawn into the Chinese orbit. Years from now, American historians might ask the question, “Who lost Korea?”

The answer would be Donald Trump. It’s highly unlikely that Trump the dealmaker would acquiesce to that deal.

The Finlandization of North Korea

Another solution might be a Chinese directed replacement of the current North Korean regime with a technocratic government. The new North Korea could then proceed down the Deng Xiaopeng “it is glorious to be rich” road of economic transformation. North Korea could disarm and become neutral, in the manner of Finland, which would also prompt South Korea to dial down its military strength and possibly lead to the withdrawal of American troops.

Ummm, who bells the cat?

Kim Jong-un is unlikely to go quietly into the night. He has consolidated power and built a political apparatus that has suppressed all dissent. There is no political opposition in North Korea, not even Chinese leaning ones. The prospect of the Finlandization of North Korea is highly unlikely.

No good options

In conclusion, I have outlined the major endgames for the North Korean problem. Donald Trump, the self-fashioned master dealmaker, is faced with an unpalatable choice of options. If he could disarm North Korea with a creative solution, then he would be deserving of a Nobel Peace Prize,

There is, of course, the outside-the-box solution of North Korea to take the capitalist road to revitalize their economy. When the Soviet Union fell apart, Dean LeBaron, the founder of my former employer Batterymarch Financial Management, quipped that the government of the day should embrace the free market by selling off their nuclear arsenal. Kim JongUn could do the same thing. Maybe he could get help from those free market economists at the University of Chicago on how to conduct auctions without the interference of heavy handed government regulations.

Now that would be the “deal” that Donald Trump could not resist participating in.

Buy! The party is still going strongly

Posted by Cam Hui - April 16, 2017

The latest signals of each model are as follows:

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

Measuring the Trump effect

Stock prices have been on a tear since the US election last November. While analysts have attributed the rally to a Trump effect, the chart below shows the SPX and international stocks, as measured by MSCI EAFE, during that period. Both asset classes have performed roughly in line with each other. This indicates the lack of a pronounced Trump effect as the outlook for non-US stocks should not be affected by the prospect of Trump tax cuts and deregulation. The main reason for equity strength was a broad based global growth recovery.

Since taking office, the Trump White House has been seized by legislative paralysis. Consider Exhibit A, the repeal failure of ACA, which was a major goal of candidate Trump. The new administration has struggled to find its footing in the business of governing. The Washington Post reported that, of the 553 positions requiring Senate confirmation, 478 have not even been chosen, such as the three vacant board seats at the Federal Reserve. CNN reported that Trump still has about 2000 vacancies to fill – and that includes the ones that do not require Senate confirmation.

To be sure, Trump stated in a recent interview with Fox News that he does not intend to fill “unnecessary” posts in an effort to cut down on government. For now, many parts of the US federal government is running on autopilot. However, with no ambassadors in place in South Korea, China, or Japan, and an unfilled post of the Assistant Secretary of State for East Asia, the recent crisis, or near-crisis, over North Korea highlights the vulnerabilities of a slimmed down government.

Still, a government on autopilot makes market analysis an easier task. You just have to focus on the fundamentals. For now, the fundamentals remain positive.

Global growth is alive and well

One of the principal drivers of stock prices is the earnings outlook, and the early indications from Q1 Earnings Season looks upbeat. The latest update from Factset shows that only 6% of SPX components have reported, but both the EPS and sales beat rates are above their 5-year historical averages (and that was before Thursday’s beats from major banks). More importantly, forward 12-month EPS continue to get revised upwards, which is reflective of Wall Street’s optimism (chart annotations are mine, data from Factset).

The upgrades in earnings estimates are not just restricted to the US. Bloomberg highlighted a report from JP Morgan that earnings estimates are being revised upwards globally. This is unusual situation as analysts tend to estimate EPS for a fiscal year high, and then revise downwards as time progresses. This time, 2017 EPS estimates are rising on a global basis.

Here is further evidence of the global growth resurgence. Analysis from Factset shows that companies with more foreign exposure are expected to show better sales and earnings growth.

Marketwatch also reported last week that Morgan Stanley is forecasting another 15% upside potential in SPX from renewed growth. Morgan Stanley analysts, led by Michael Wilson, observed that the Philly Fed Survey tends to lead GDP growth. Current readings are pointing to a growth surge later this year.

Growth is alive and well. The party is still going strongly.

Widespread signs of fear

If I told you that earnings estimates were rising, not just in the US but globally, and bond yields fell, what would you expect stock prices to do? Instead of rising, equity prices have been weakening. Even though the SPX is less than 3% off its all-time high, widespread fear has crept into the market.

The Trifecta Bottom Spotting Model flashed an exacta buy signal on Thursday, which is indicative of market panic. The chart below shows the signals from this model in the last three years, with exacta signals shown in blue and trifecta signals shown in red. In the past, such occurrences have generally marked low risk entry points on the long side.

Last week, I wrote about the VIX Index rising above its upper Bollinger Band (BB), which indicated an oversold condition (see A capitulation bottom?).

In fact, we have the unusual condition where the VIX Index has risen above its weekly upper BB. The chart below shows past episodes trading setups where VIX has risen above its upper BB (red line), and when mean reversion occurred (blue line). All buy signals have seen positive returns.

Thursday also saw a relatively rare condition where the CBOE equity-only put/call ratio spike to 0.96, which is indicative of high fear.

I went back to October 2003, which is when the CPCE data series began in my database. Past episodes of high CPCE levels and the daily VIX Index above its upper BB (N=18) have tended to resolve bullishly.

Seasonal tailwinds

If evidence of excessive fear isn’t enough for the bulls, the market is entering a period of positive seasonality. Ryan Detrick pointed out that the second half of April tends to be favorable for stock prices and the market just reached the seasonal nadir on April 14.

In addition, next week is option expiry week. Rob Hanna at Quantifiable Edges observed that April OpEx tends to be highly favorable for stock prices.

The week ahead: BTFD

Looking to the week ahead, the market is obviously very oversold and due for a relief rally. Breadth metrics from Index Indicators are showing oversold conditions consistent with trading bottoms.

However, oversold markets can get more oversold. There are hints that there may be further short-term downside early in the week before a durable bottom is reached. Firstly, past episodes of CPCE spikes have seen 1-2 days of downside follow through before the actual trading bottom (see above CPCE chart). As well, the Fear and Greed Index has not fallen to sub-20 levels where the market has bottomed in the past. The current reading of 25 is close, but the market may need a final flush.

Market nervousness may not necessarily subside next week because of the uncertainties posed by the upcoming first round of French elections on April 24. As the chart below shows, hedging costs for the Euro STOXX 50 has recently spiked.

My inner investor remains bullishly positioned. He is inwardly smiling at the silliness of the emotional extremes when the market has only corrected by 3%.

My inner trader remains long equities. Should the market fall further, he is prepared to take the unusual step of going all-in on the long side.

Disclosure: Long SPXL, TQQQ