Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities
Trend Model signal: Risk-on
Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
Great expectations
Bloomberg recently highlighted the huge gap between expectations and reality. As the chart below shows, soft (expectations) data has been surging, but hard (actual) data has risen, but it has not caught up with expectations.
The markets are pricing for perfection, which sets up a situation where minor disappointments could spark a market sell-off. BCA Research found that such divergences between “soft” expectations data and “hard” economic data has seen equity corrections in the past.
This week, I examine the details of how expectations have diverged from actual data on a number of dimensions.
Small business confidence
Corporate confidence
Consumer confidence
Federal reserve expectations
Wall Street’s tax reform expectations
Small business euphoria
Last week`s release of the NFIB January small business confidence survey showed another upside surprise. Small business optimism continued to surge and rose to multi-year highs. As small business owners tend to be small-c conservatives who tend to tilt Republican, the election of Donald Trump has undoubtedly sparked a resurgence in business optimism.
However, the outpouring of optimism has not been matched by actual sales results. Even though sales ticked up last month, their rise lagged expectations. Since 1974, there have been five other episodes where expectations have surged. In two of those cases, sales rose to match expectations; in two others, they did not; and in 2009-10, sales saw eventually rose, but the surge was delayed by about a year (chart annotations are mine).
Small business capital expenditure plans have been relatively muted despite the surge in small business optimism.
One reason for the cautiousness could be attributable to rising labor costs. While labor costs have risen, business owners have not been able to raise prices to pass through higher compensation rates, which results in a margin squeeze.
I am keeping an open mind as to whether small business optimism will translate into more hiring and capital expenditures. But watch what small business owners do, not just what they say.
Corporate optimism
It’s not just the mood of small business owners that has become more upbeat. A simple word count of the word “optimistic” in earnings calls has surged to all-time highs.
But if management is so optimistic, then why have insiders been selling so much of their company’s shares (via Barron’s)?
Watch what corporate insiders do, not just what they say.
Can the consumer MAGA?
If Donald Trump is to Make America Great Again, then one of the key ingredients is strength in consumer spending. As the chart below shows, the US economy is seeing a divergence between rising consumer confidence (black line) and real wage growth (blue line). How can the consumer spend when real wages are stagnant? More worrisome is the observation that falling real wages have been precursors to recessions in the past, not booms.
Even though January retail sales rose and beat expectations, consumer spending is likely to disappoint in the short-term. That’s because after adjusting for inflation, real retail sales actually fell from December to January. In addition, Bloomberg reported that this year’s IRS anti-fraud tax refund procedural changes are delaying the timing of refund payments. This is likely to depress current consumer spending and push it out by several months.
New Deal democrat is becoming concerned. He wrote about the ways consumers cope if real wages don’t grow. When the consumer runs out of coping mechanisms, the economy slides into recession:
The theory is that if real average wages are not increasing, which for a long time beginning in the 1970s they were not, average Americans use a variety of coping mechanisms. From the 1970s through the mid-1990s, spouses entered the workforce, adding to total household income. Other methods have included borrowing against appreciating assets, and refinancing as interest rates declined.
Borrowing against stock prices ended in 2000. Borrowing against home equity ended in 2006. When interest rates failed to make new lows, the consumer was tapped out, and began to curtail purchases. Thus in September 2007, with the stock market peaking, house prices falling, interest rates having not made new lows in over 3 years, and real wage growth having stalled, I wrote that a recession was about to begin: http://www.dailykos.com/story/2007/09/25/389903/-Why-American-consumers-are-signaling-recession
So far, mortgage rates have not made a new low for quite some time, so forget housing prices as an ATM to fuel consumer spending. Another way of maintaining consumer spending is to reduce savings. The savings rate is dropping, but it is not at levels that have signaled recessionary conditions in the past. As major stock indices reach all-time highs, another way of coping is by taking profits on their stock portfolios , but only a small minority of households are invested in the equity market.
NDD concluded:
So the consumer fundamentals nowcast indicates that the expansion should continue for awhile, but if inflation eats up wage gains and the savings rate this year, then all we will need for the consumer to signal a recession is for asset prices to peak. I do not think that will happen until at least next year.
Don’t panic just yet, but risks are rising. Watch what the consumers do, not just what they say.
A hawkish Fed
What’s going on at the Fed? George Pearkes recently observed core PCE, the Fed’s preferred inflation metric, has been slowing.
So why did Janet Yellen take on a decidedly more hawkish tone in her Congressional testimony last week? In fact, the WSJ reported that Fed officials have fanned out across the country to reinforce the message that to expect three rate hikes in 2017, which is more hawkish than the market expectations.
To be sure, the Consumer Price Index (CPI) came in a bit “hot”, or ahead of expectations, both in the headline number and core CPI. But as the chart below shows, much of the increase can be attributable to Owners’ Equivalent Rent (OER). Core sticky price CPI, ex-OER has remained below the Fed’s 2% target (note I have subtracted 2% from all CPI figures in order to better graphically show how far different inflation metrics are from the Fed’s 2% target).
What’s going on? What is the Fed seeing that the rest of us don’t see? Is the Fed reacting in anticipation of the Trump administration’s fiscal stimulus plan? Sure that can’t be the case. Ben Bernanke recently penned a thoughtful essay about the FOMC’s decision making process. He indicated that Fed officials focus on the medium term outlook. While the effects of fiscal policy plays a part in the Fed’s deliberations, they tend to take a wait-and-see attitude to see the full details of the legislative proposals before modeling the effects.
Watch what the Fed does, not just what they say.
Where’s my tax cut?
Over on Wall Street, they are still waiting for Trump’s “tremendous tax plan”, which will probably get unveiled in Trump’s joint address to Congress on February 28, 2017. Equity markets have rallied partly in anticipation of Candidate Trump’s tax cut and offshore tax repatriation proposals. It is not clear, however, whether any tax cuts would actually materialize this year, or what kind of bitter pill the economy would have to swallow in order for the tax cuts to get passed.
So far, it seems that the only way that Trump can pay for his proposed tax cut would be through the imposition of a border adjustment tax (BAT). Without a BAT, the Trump tax cuts could cost up to $7 trillion, according to the Tax Policy Center (via CNN Money). Bloomberg reported that the latest tax reform proposal has been stalled in Senate because a lack of Republican support:
Not long after House Speaker Paul Ryan offered a full-throated affirmation of his tax-overhaul plan, an influential conservative group announced a grassroots campaign against it and a Senate leader said a key part of the proposal is “on life support.”
Senate Majority Whip John Cornyn was diagnosing Ryan’s plan to replace the U.S. corporate income tax with a new, “border-adjusted” levy on U.S. companies’ domestic sales and imports. The proposal has stirred sharp divisions among businesses: Retailers, automakers and oil refiners that rely on imported goods and materials oppose it, while export-heavy manufacturers support it.
So far, the opponents are winning, interviews with lawmakers, lobbyists and tax specialists show. As Congress prepares to depart Washington for a one-week break, Cornyn said he didn’t see the votes lining up for the House leaders’ plan.
Even if a BAT were to pass, I highlighted analysis by Barclay’s last week (via Sam Ro) showing the net effects of a tax reform package. The sheet size of the BAT would, by necessity, be extremely protectionist and such an initiative would invite a debilitating global trade war.
Here is what’s at stake for equity investors. John Butters from Factset pointed out that the market’s forward P/E of 17.6 is at levels last seen in 2004, a 13-year high. Investors would have to include the dot-com bubble era to make the case that the current forward P/E looks reasonable on a historical basis. In short, market expectations for tax cuts and offshore cash repatriation are extremely high and prone to disappointment.
Watch what Trump administration and Congress do, not just what they say.
The week ahead: Be a patient bear
Looking to the week ahead, I don’t want to repeat what I’ve have written over the past week. The points I made in my last post (see Why the SP 500 won’t get to 2400 (in this rally)) still stands. Fundamentals still look wobbly, sentiment remains excessively bullish and short-term technical indicators are flashing overbought readings.
The latest update from Factset shows that forward 12-month EPS stopped falling and rose last week, which is a positive sign for stock prices. But the 2 and 4 weeks rates of change remain negative. In the past, stock prices have struggled whenever forward EPS has been flat to down.
The 10-year weekly SPX chart below illustrates how overbought the market is. I have marked past instances when RSI-5 has risen to similar levels. The red vertical lines when the market has declined, and the blue lines when the market has continued to advance. In the last 10 years, there were six red lines and three blue lines. We now have another overbought signal, play the odds.
On a shorter term time frame, this Index Indicators chart of stocks above their 10 dma is starting to roll over from overbought territory. That’s a classic technical trading sell signal.
As well, these market internals of risk appetite look very iffy.
Tactically, bearish traders may want to be patient. Helene Meisler observed that the CBOE equity only put/call ratio (CPCE) has spent four consecutive days under 0.60. The market is certainly overbought on this metric.
I conducted a study of past episodes, which indicates that such overbought markets don’t necessarily decline. Short term returns have been weak, but still positive.
Returns are tilted to the downside once CPCE mean reverts and breaks up above 0.60.
My inner investor remains bullishly positioned, though he is getting a little nervous. Should the market correct, he will be watching to see the nature of the bearish catalyst before making any further investment decisions.
My inner trader moved to cash a couple of weeks ago and he is standing aside from this market volatility.
Mid-week market update: As the major market averages make new all-time highs, I conducted an informal and unscientific Twitter poll. I was surprised to see how bullish respondents were.
Let’s just cut to the chase – forget it. Neither the fundamental nor the technical backdrop is ready for an advance of that magnitude. Even though the earnings and sales beat rates for Q4 earnings season is roughly in line with historical averages, Factset reports that the 12-month forward EPS growth is stalling. Past episodes has seen stock price struggle to make significant advances under such conditions.
In addition, the technical condition of the market shows that it is vulnerable to a pullback.
Breadth deterioration
This rally has raised a number of red flags. Schaeffer’s Research pointed out that the advance has been accomplished on deteriorating breadth, as measured by 52-week new highs.
If history is any guide, expect subpar returns pattern for the next couple of weeks.
Independent of the analysis from Schaeffer`s, this chart from Trade Followers shows that bullish Twitter breadth is also not advancing even as the market made new highs, indicating a different form of negative breadth divergence.
Sentiment too bullish
In addition, there are numerous instances of excessively bullish sentiment, which is contrarian bearish. The CNN Money Fear and Greed Index is at a level where stock prices have shown difficulty rising in the past.
The CBOE put/call ratio has fallen to levels that can only be described as giddy. Urban Carmel observed that short-term returns tend to be negative after such readings.
The option market is flashing other anomalous signals. Even as stocks rose today, both the VIX Index rose and the VIX term structure, as measured by the VIX/VXV ratio, flattened. Such behavior by the VIX are normally signs of rising caution. I did a study that went back to November 2007, when data for the VXV was first available. I found 117 non-overlapping similar instances. As the table below shows, historical returns were disappointing for the following week.
Overbought markets
As stock prices have risen, it is no surprise that most overbought/oversold models are showing overbought readings. Consider, for example, this chart from Index Indicators of the 5-day RSI above 70, which is a short-term (1-2 day) trading model
This chart of net stocks at 20 day highs-lows, which is a model with a longer term (1-2 week) time horizon, is also in overbought territory.
Overbought readings like those are to be expected as the market advances. There is nothing that says overbought markets can’t stay overbought. However, an alert reading sent me the following chart, which showed that the NASDAQ 100 is reaching overbought levels not seen since 1999, which was the top of the Tech Bubble.
Don’t get too bearish
Despite the combination of overbought and excessively bullish sentiment readings, my inner trader is not wildly bearish. Anecdotal evidence from independent sources of discussions with investment managers indicate that there is a lot of nervousness beneath the surface. This suggests to me that while stock prices may pull back in the near-term, any correction is likely to be shallow and should be bought.
Be cautious, but don’t go overboard on your short positions. My inner trader remains in cash and he is inclined to stay on the sidelines, for now.
The WSJ reported that the Trump administration is considering a new tactic in managing its trade relationship with China. Here is the Bloomberg recap for those without a WSJ subscription:
Under the plan, the commerce secretary would designate the practice of currency manipulation as an unfair subsidy when employed by any country, instead of singling out China, the newspaper reported. American companies could then bring anti-subsidy actions to the U.S. Commerce Department against China or other countries, it said.
The discussions are part of a strategy being pursued by the White House’s new National Trade Council to balance the goals of challenging China on certain policies while keeping broader relations on an even keel, the paper said. The Trump administration would avoid, at least for now, making claims about whether China is manipulating its currency, it said.
While such an approach may seem clever, it has the risk of sideswiping American relations with a whole host of other countries other than China. As well, the imposition of countervailing duties is subject to a challenge under WTO rules.
The Big Mac Index
One of the key questions is how you define an undervalued currency. There are many metrics, but consider the popular Big Mac Index, as compiled by The Economist.
If the idea of this initiative is to target China, then there are many other countries with undervalued currencies that will have to be targeted under this initiative. Starting from the bottom, the list includes the following countries before we get to China: Egypt, Ukraine, Malaysia, South Africa, Russia, Taiwan, Mexico, Poland, Indonesia, Sri Lanka, Hong Kong, India, Vietnam, the Philippines, and Turkey. A blanket rule that imposes countervailing duties on the exports from this list risks destabilizing a number of important geopolitical relationships, and it would signal the start of a global trade war.
To be sure, the Big Mac Index has a number of flaws and it is not the only measure of purchasing power parity (PPP). Bloomberg reported that Nomura compiled an iPhone index because the price of Big Macs in poor countries can be distorted by low labor costs.
For years, many traders have used the Big Mac index — which is based on the price of a McDonald’s Corp. hamburger — along with an OECD gauge and measures based on consumer and producer prices, to determine currencies’ relative value. All of these show the dollar as broadly overvalued.
The iPhone index is better than its traditional peers because it uses the “defining product of the digital era,” Hafeez said. “IPhone is high-end tech,” he said. “That’s going to be the bigger driver in the future.”
Nomura found a number of notable differences between iPhone and Big Mac prices (data as of July 2016).
In response to these criticisms, The Economist unveiled the Big Mac Adjusted Index, which adjusts for labor costs in each country. Suddenly, China`s currency doesn’t look that undervalued anymore. On the other hand, a whole host of other countries would get targeted using this methodology: Egypt, Hong Kong, Malaysia, Taiwan, South Africa, Russia, Poland, and Mexico. While having Mexico on both the unadjusted and adjusted lists may serve the Trump administrations political aims, what about the other countries?
A trade war brewing?
I recognize that the “currency manipulation as unfair subsidy” represents a trial balloon by the Trump administration as a way of fulfilling its campaign promise of addressing the damage from “unfair trade”. The fact that the White House is even thinking about such broad based solutions are raising the risks of a global trade war.
Edward Harrison at Credit Writedowns believes that Donald Trump’s entrepreneurial risk taking personality makes him far more likely to start a trade war:
Now when you look at Trump the Entrepreneur through this prism, it explains not just his behavior on the campaign trail and in using Twitter, it also explains his “grab them by the pussy” mode of operating. I think it also explains how Trump the entrepreneur saddled four different businesses with so much debt that they were forced into bankruptcy. in short, Donald Trump is a man of action, who often leaps before he looks. That can mean unexpected success. But it means he is prone to getting things very wrong, and then having to improvise to clean up the mess.
This isn’t how traditional politicians operate, by the way. First of all, most politicians are frightened to death by uncertainty and assiduously avoid it to prevent tail risk. If you think about it from a decision tree perspective, a politician that has a choice between guaranteed but moderately bad outcomes and uncertain but potentially catastrophically bad outcomes is going to feel a lot of loss aversion pressure. Even a supposed maverick like Greek Premier Alexis Tsipras caved in 2015 – and went with a bad outcome to prevent a catastrophic outcome when the ECB threw down the gauntlet and threatened to collapse the Greek banking system.
But Trump is not that kind of guy. His overarching strategy is just the opposite – create uncertainty, be as unpredictable as possible and hopefully profit from this. He has even said this himself – multiple times.
By floating this trial balloon, the Trump administration has in effect let “slip the dogs of (trade) war”. Once you accept the principle of imposing countervailing duties on currency manipulation, why not border adjust for other reasons? FT Alphaville outlined a number of other proposals that have been floated, such as a carbon tax border adjustment:
So it’s interesting to read a proposal from Republican eminences arguing the government should tax carbon dioxide emissions, including from imported goods, and rebate the revenues to the public:
Border adjustments for the carbon content of both imports and exports would protect American competitiveness and punish free-riding by other nations, encouraging them to adopt carbon pricing of their own. Exports to countries without comparable carbon pricing systems would receive rebates for carbon taxes paid, while imports from such countries would face fees on the carbon content of their products.
How about labor standards in the name of “fair trade”?
If “border adjustment” is appropriate for discouraging pollution, why shouldn’t it also be used to uphold labour standards? What’s the point of having minimum wages, protections for collective bargaining, and occupational safety requirements if the jobs are just going to be offshored to countries — often less-than-democratic ones — with different priorities?
Indeed, slip loose the dogs of trade war. The kennel door is opening, and that would be very, very bearish for the global economy.
The chart below depicts the yield curve, as measured by spread between the 10-year and 2-year Treasury yields, (blue line) and equity returns (grey line). The yield curve has been an uncanny recession forecaster. It has inverted ahead of every single recession, and warned of major equity bear markets.
Unfortunately, this indicator may not work this time.
Tim Duy’s doubts
Fed watcher Tim Duy recently expressed some doubts as to the Fed’s policy of separating the process of rate normalization and the normalization of its balance sheet “because it risks financial destabilization by flattening the yield curve”:
Having tipped their toes in the water with two interest-rate hikes — and more expected to come — the Federal Reserve officials have begun the discussion about reducing the size of the central bank’s $4.45 trillion balance sheet. To date, they have tended to look at interest rate-policy as separate from balance-sheet policy. Once the former is heading toward normalization, then they can begin the latter.
I tend to be skeptical of that strategy, largely because it risks financial destabilization by flattening the yield curve, or the difference between short- and long-term bond rates. I would prefer an explicit policy strategy that incorporates both interest-rate and balance-sheet tools acting jointly not with the goal of “normalizing” either of those components, but aimed at meeting the Fed’s dual mandates of full employment and stable prices. Under such a framework, for example, the Fed wouldn’t need to follow through with additional rate hikes before to balance-sheet reduction. There would be no preconceived notion of the “correct” order of operations.
If the Fed’s QE programs distorted the shape of the yield curve by intervening in the bond market, then the process of separating the process of rate normalization and balance sheet normalization will also create another distortion. Duy prefers the approach favored by St. Louis Fed president Bullard:
Bullard still sees the balance sheet as a mechanism to normalize policy even if policy rates remain low. The problem with the current policy stance is that the Fed is flattening the yield curve by raising expectations of higher short-term rates while a large balance sheet places downward pressure on long rates. Bullard doesn’t see a theoretical justification for maintaining this twist operation as the Fed responses to changing economic conditions.
As Janet Yellen faces Congress this week, she will likely face questions about her approach to the Fed’s balance sheet. This will be an important policy issue as it has wound down QE and begun raising interest rates.
The Fed vs. Trump
In addition, I pointed out in my last post that how pivots in monetary policy by new Trump appointees have the potential to send shock waves through the economy and the markets (see A blow-off top, or a wimpy top?).
Fed officials are just preparing for a possible battle over the future direction of Fed policy. Vice chair Stanley Fischer* pushed back against the idea of using a mechanical rule to set interest rates in a speech on February 11, 2017. In that speech, Fischer used the FOMC August 2011 decision as case study:
And what do I take from this episode? The interest rate decision taken in August 2011 was unusual in that a decision was made about the likely path of future interest rates. Most often, the FOMC is deciding what interest rate to set at its current meeting. Either way, in reaching its decision, the Committee will examine the prescriptions of different monetary rules and the implications of different model simulations. But it should never decide what to do until it has carefully discussed the economic logic that underlies its decision. A monetary rule, or a model simulation, or both, will likely be part of the economic case supporting a monetary policy decision, but they are rarely the full justification for the decision. Sometimes a monetary policy committee will make a decision that is not consistent with the prescriptions of standard monetary rules–and that may well be the right decision. Further, in modern times, the policy statement of the monetary policy committee will seek to explain why the committee is making the decision it is announcing. The quality of those explanations is a critical part of the policy process, for good decisions and good explanations of those decisions help build the credibility of the central bank–and a credible central bank is a more effective central bank.
The next few months could be an important turning point for the Fed. Watch this space!
* Fischer can be regarded as a highly respected and grizzled veteran of central banking. He was on the thesis committee for both Ben Bernanke and Mario Draghi. IMHO, he was a leading candidate for Fed chair ahead of Yellen, but he could not be appointed because his former position as the head of the Israeli central bank. Instead, he was invited to become vice chair to act as a congliere to Yellen.
Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities
Trend Model signal: Risk-on
Trading model: Bearish (downgrade)
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
So many questions, so few answers
Regular readers know that I have been calling for a cyclical market top in 2017 (see The roadmap to a 2017 market top). Outside of the risk of permanent loss from war or insurrection, severe bear markets have been mainly associated with economic recessions. My analysis has been based on the likely path of the US economy, and the timing of the next recession.
My base case, call it the “blow-off top” scenario, goes something like this:
The economy, which is in the late stages of an expansion, starts to overheat.
Investors and traders get enthusiastic about growth and bid stock prices up to unrealistic levels (hence the “blow-off”)
The Fed responds by raising rates to cool off the economy, but find it’s behind the curve…
Which results in a recession and bear market.
The blow-off top scenario would see the SPX reach the 2500-2600 level this year as it tops out.
I have been considering an alternative, call it the “wimpy top” scenario, where the market may have topped out already.
The economy, which is in the late stages of an expansion, starts to overheat.
Investors and traders get enthusiastic about the prospects for cuts cuts and deregulation under the Trump tax reform plan, which is what has happened so far.
Tax reform gets tied up in Congress and gets delayed until 2018.
Trump appoints hawks to the Federal Reserve board (now there are three vacancies with the resignation of Daniel Tarullo).
The new Trump appointed Fed governors, composed of hard-money advocates, becomes more aggressive, tightens monetary policy, and pushes the economy into recession.
An equity bear market is the result.
The wimpy top scenario is based on a double whammy of fiscal policy disappointment and a pivot to a more hawkish Fed policy. In that case, Current stock index price levels are roughly as good as they get.
The key differences between the two scenarios are the likely path of fiscal and monetary policy. Those are the big questions to which we have no answers. This week, I explain the risks and offer some suggestions of how to watch which scenario is the more likely one to unfold.
Geopolitical tail-risk
The risk of permanent loss from war or insurrection is the greatest toxic risk to an equity portfolio. The most likely potential US conflicts are with China, Iran, and North Korea. Reports such as this one from USA Today that indicated that Trump advisor Steve Bannon believes that the America and the western world are engaged in a war of civilizations against Islam, as well as the inevitability of war in the South China Sea are likely to spook markets.
Relax! Peter Lee (@chinahand on Twitter) reported that SecDef James Mattis signaled that the Trump administration is walking back much of its tough talk on China, North Korea, and Iran (use this link if the video is unavailable). At a minimum, any shooting war is unlikely in 2017.
There are also other hopeful signs that of a Sino-American thaw. Bloomberg reported that China has reached out the Trump administration through the Jared Kushner-Ivanka Trump back channel. Trump also sent a letter to Xi Jingping seeking “a constructive relationship” (via Bloomberg). What’s more, Trump told Xi in a phone call that the US would honor the “one-China policy”.
Tensions are being defused. The risk of war is off the table, at least for now.
A late cycle expansion
The economy is in the late stages of an economic expansion. The chart below depicts the latest initial jobless claims data normalized by population is at an all-time low. Further fiscal stimulus is likely to spark a round of wage driven cost-push inflation that forces the Fed to raise rates faster than market expectations.
The combination of a late cycle expansion that is starting to overhead, and rising interest rates from Fed policy are the key ingredients of a classical market top.
Doubts over Trump
I have also detected a rising level of anxiety over the Trump administration and the post election Trump rally. One prominent example was the New York Times profile of the legendary value investor, Seth Klarman:
In his letter, Mr. Klarman sets forth a countervailing view to the euphoria that has buoyed the stock market since Mr. Trump took office, describing “perilously high valuations.”
“Exuberant investors have focused on the potential benefits of stimulative tax cuts, while mostly ignoring the risks from America-first protectionism and the erection of new trade barriers,” he wrote.
“President Trump may be able to temporarily hold off the sweep of automation and globalization by cajoling companies to keep jobs at home, but bolstering inefficient and uncompetitive enterprises is likely to only temporarily stave off market forces,” he continued. “While they might be popular, the reason the U.S. long ago abandoned protectionist trade policies is because they not only don’t work, they actually leave society worse off.”
In particular, Mr. Klarman appears to believe that investors have become hypnotized by all the talk of pro-growth policies, without considering the full ramifications. He worries, for example, that Mr. Trump’s stimulus efforts “could prove quite inflationary, which would likely shock investors.”
These worries are nothing new, but concerns over protectionism, and the inflationary effects of fiscal policy are becoming more visible. Business Insider also outlined the reservations over Donald Trump voiced by well-known investors and analysts such as Ray Dalio, Nouriel Roubini, David Einhorn, and several others.
Don`t count Trump out
I would caution any Trump opponents and Never Trumpers not to allow their politics to get in the way of their investing. Even Paul Krugman, who styles himself as the “conscience of a liberal”, had a warning for investors who might be getting overly bearish.
Supposing that you thought that Donald Trump is destined to be another Adolf Hitler (not a view that I endorse), the historical record shows that the DAX actually performed well under much of Hitler’s reign. Investors just had to watch for the bearish trigger and to get out at the right time.
Tax reform: Bullish or bearish?
Even if we were to eliminate the tail-risk of a shooting war, investors need to consider a number of factors before taking either a bullish or bearish outlook on stocks.
Consider, for example, Trump’s headline program of tax cuts and tax reform. The economic effects of Trump’s proposed tax reform proposals are highly inter-connected and their effects are multi-dimensional. It is therefore difficult to forecast their effects without knowing all the program specifics.
Here is the bull case. Brian Gilmartin highlighted analysis from BCA and BAML which indicated that the combination of a Border Adjustment Tax and offshore cash repatriation would add roughly 10% to SP 500 earnings. Marketwatch reported that JPM’s estimates of BAT would add 6% to earnings, everything else being equal.
The key phrase here is “everything else being equal”. But everything else isn’t equal.
The bear case can be observed from the macro analysis from Barclay’s estimated fiscal effects of a likely tax reform package (via Sam Ro). Sure, there will be significant stimulus in the form of tax cuts, but most of it will be paid for by a Border Adjustment Tax. If enacted, the sheer size of the BAT indicates that these measures are hugely protectionist. Not would it bring the multi-decade globalization trend to a halt, it would play havoc with the global supply chains of American multi-nationals and likely devastate their operating margins. While brokerage firm analysts have modeled the first order effects of BAT, I have not seen anyone model those second and third order effects of protectionism and likely trade war.
Watch for the details of how the tax reform proposals might evolve. We will no doubt see lots of negotiations within the Republican Party before this process is complete.
What Wall Street wants
The reaction from Wall Street to the rising level of uncertainty is instructive. As an example, Goldman Sachs has become more cautious about the how the market has priced in Trump’s proposed tax cuts and deregulation (via CNBC):
In a note to clients on Friday, the investment bank noted President Donald Trump’s agenda was already running into bipartisan political resistance, with doubts growing about potential tax reform and a repeal of the Affordable Care Act, among other marquee Trump administration initiatives.
Just two weeks into his tenure, “risks are less positively tilted than they appeared shortly after the election ,” Goldman wrote. Growing resistance to Trump’s executive orders on immigration and financial reform has galvanized opposition while dividing members of the president’s own Republican Party.
In effect, Wall Street is asking Washington, “Where are my tax cuts?” Barry Ritholz wrote that, in order to succeed, Trump needs to focus on his economic agenda:
The disastrous roll out of President Donald Trump’s clampdown on refugees and visitors from majority-Muslim countries wasn’t how his supporters were expecting his administration to begin. While it was a cornerstone of his election campaign, it was poorly thought out, with little consideration given to the inevitable legal challenges, protests and political backlash.
If this seems somewhat familiar, you need only recall President Barack Obama’s disastrous launch of the Affordable Care Act, a piece of legislation the administration strained to get through Congress. The website was unusable and crashed constantly, and was widely recognized as a costly and avoidable error. It was obvious that the people in charge hadn’t thought this through and failed to stress test the site. It tarnished perceptions of both the program and the administration’s cherished reputation for competence…
By failing to act boldly on financial reform, the Obama team allowed a smoldering resentment to take hold and build among the public. The massive taxpayer wealth transfer to bankers who should have lost their jobs sowed the seeds of the backlash that fueled the rise of the Tea Party, and led to the huge electoral losses for the Democratic Party and Trump’s November victory.
Fast forward to 2017. It looks as if Trump is making a similar error by focusing on immigration first — and in an ill-considered and misguided way — instead of making tax reform his biggest priority.
Edward Harrison echoed Ritholz’s remarks and he believes that Trump is likely to fail in his first term if he stays a “cultural warrior”:
Early on in President Trump’s new administration, too much of his energy is being placed on divisive ‘cultural’ issues and not enough attention is being paid to economic policies. To the degree Trump has turned to the economy, much of his policy has been focused on issues that will not yield long-term economic benefits but contain considerable risk, like trade with Mexico and China. And so, while Donald Trump is only a few weeks into his presidency, I think we can begin to take stock of what his presidency will mean for the US economy…
“A successful Trump who keeps his campaign promises would work with McConnell, Ryan, Sanders, and Pelosi to get an infrastructure bill through Congress. Meanwhile he would force US allies to increase their military spending and purchase of US weaponry while the US pares back its own defense spending. And finally, a successful Trump would cut the FICA tax that supposedly ‘funds’ social security, something that is both a cost for employers and for employees and therefore a highly regressive tax. Cutting business taxes or lowering the top tax bracket won’t get that job done. But those kinds of tax cuts will increase income inequality…
“A failed Trump who bought lock, stock and barrel into Republican orthodoxy would go back on his pledge to leave social security and medicare alone and focus on privatizing or cutting social security as a way of lowering the deficit. And he would focus on killing TTIP and TPP or extracting the US from NAFTA. You could make ideological arguments on these issues after robust growth and lower broad unemployment have returned. But, by then we would see whether economic and job growth had changed the path of debt and deficits and unemployment demonstrably. Moreover, none of these goals would immediately stimulate growth in the short term. They could mean recession and doom his presidency, if they became his signature economic goals.”
The latest political developments yield a mixed picture. On one hand, Reuters reported that Trump promised a “tremendous tax plan” in the next 2-3 weeks. On the other hand, the WSJ reported that Trump downgraded the position of chair of the Council of Economic Advisers (CEA) as he won’t be part of the cabinet. This development is a worrisome sign over the medium term for the health of the economy.
Assume a Clinton presidency
What if there is no Trump tax reform, or the legislation gets stalled until 2018? CNBC reported that Goldman Sachs had fretted about the possibility that Trump’s tax reform package might get stalled in Congress:
In a note to clients on Friday, the investment bank noted President Donald Trump’s agenda was already running into bipartisan political resistance, with doubts growing about potential tax reform and a repeal of the Affordable Care Act, among other marquee Trump administration initiatives…
“While bipartisan cooperation looked possible on some issues following the election, the political environment appears to be as polarized as ever, suggesting that issues that require bipartisan support may be difficult to address,” the bank added.
The balance of risks “are less positively tilted than they appeared shortly after the election,” Goldman said, which may blunt the force of future growth.
Amid reports that top GOP members are reportedly becoming nervous about the impact of a full-fledged repeal of health care, that political pushback “does not bode well for reaching a quick agreement on tax reform or infrastructure funding, and reinforces our view that a fiscal boost, if it happens, is mostly a 2018 story.”
To model the effects of a stalled tax reform plan, imagine that the status quo candidate, Hillary Clinton, had won the election. The world would still have undergone a global reflationary recovery, which was in place regardless of who had won. Market fundamentals on a backward looking basis would not be very different today in a Clinton victory scenario.
We observe today`s market’s forward P/E ratio from Factset is 17.3, which is quite elevated when compared to its own history. US equities would be regarded as expensive, especially in light of the lack of the promise of tax cuts and deregulation in the near future. Deflate prices by about 12%, and valuations fall to its 5-year historical average.
Now return from your alternative universe of a Clinton victory to today’s Trump presidency, should you freak out about a correction potential of about 12% if tax reform is delayed by a year? In all likelihood, the decline would be less as the market will still look ahead to the potential benefits from future tax cuts.
Changes at the Fed?
Friday’s news of the resignation of Fed governor Daniel Tarullo was a surprise. There are now three vacant seats on the Fed board, which gives the Trump administration an opening to dramatically shape the course of monetary policy.
Here is the big question: Who will Donald Trump appoint? Will the low interest loving Trump seek out doves to accommodate his expansionary fiscal policy, or will he stick with Republican supply-side orthodoxy and appoint hard-money hawks? Names like John Taylor and Kevin Warsh have been floated as possible future Fed chairs to replace Janet Yellen. If so, then watch for their names to be appointed to the board as a first step. Both Taylor and Warsh can be considered to be more hawkish than Yellen.
To illustrate my point about Taylor, here is a chart of the interest rates under the Taylor Rule, proposed by John Taylor. Taylor has been an advocate of a rules based approach to setting monetary policy. Taylor Rule rate assumptions are based on a 2% real rate and 2% target rate. As the chart shows, the target rate is considerably higher than current Fed Funds rate, which imply a tighter monetary policy under a Taylor Fed.
Kevin Warsh was a hawk when he was a Fed governor. In a speech he made on September 25, 2009, about a year after the Lehman collapse, he made it clear that he was itching to tighten monetary policy.
Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative…
In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal–and the economy has returned to self-sustaining trend growth–they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.
Here is what’s at stake. The chart below shows the US federal debt, which has exploded in the past decade.
How will the federal budget handle those payments if interest rates were to rise? In the chart below, debt service is estimated as the total debt times the 10-year Treasury yield as an approximation (black line). To estimate the impact of a tighter monetary policy, I added the differential between the Taylor Rule rate and the Fed Funds rate (see above chart) to the 10-year rate. I assumed that rates either rise by one-half of the differential (blue line), or the full differential (red line). For added perspective, the purple line shows total tax receipts as a percentage of GDP. If we were to accept the Republican supply-side orthodoxy that tax rates are too high, the dotted line represents the linear regression of tax receipts, which I defined as “normalized” tax receipts. (All data was downloaded from FRED, calculations are mine).
As the above chart shows, if rates were to rise to even half of the Taylor Rule adjustment, debt service costs would surge dramatically. A full Taylor Rule adjustment would raise debt service charges to 2.6 times the current rate. The federal deficit would explode in the absence of offsetting revenues.
The chart below depicts debt service costs as a percentage of normalized federal tax receipts (dotted line in the previous chart). If rates were to rise to between 50% and 100% of the Taylor Rule adjustment, debt service costs would become 30-40% of total tax revenues. Yikes!
I recognize that there are a number mitigating factors to this study. Firstly, interest rates would not adjust immediately and rise to a Taylor Rule rate, but would occur over a longer period. As well, tax revenues could increase under the Trump fiscal stimulus plan because of increased tax receipts from better economic growth. On the other hand, the history of Republican tax cuts have not turned out to be revenue neutral but ballooned the debt (see total debt chart above).
In summary, a hawkish pivot of Federal Reserve monetary policy would result in a surging federal deficit, and make a 2018 recession a virtual certainty. I am not sure if Trump fully grasps the implications of his Fed appointments just yet. His actions to downgrade the chair of CEA from a cabinet post indicates that he has little respect for economists. Has anyone pulled him aside and explained the implications of Fed governor appointments? If he opts to steer the Fed toward a dovish course, can he find enough governors who are as dovish as the current board?
Watch this space!
Where we stand today
I wrote at the beginning of this post that there are more questions than answers. The market faces a number of key policy uncertainties. What is this “tremendous tax plan” that Trump promised, and will it pass muster with the deficit hawks in the Republican caucus?
Who will he appoint to the board of the Federal Reserve? So far, none of the three vacant posts at the CEA have been filled. Even some CEA appointments could give some hint as to possible policy direction.
So many questions, so few answers.
Here is what I am watching. First, the direction of fiscal policy by way of the reception of the Trump team’s tax reform proposals is important. Equally important, but more ignored, are hints about who might be appointed to the Fed board.
Fortunately, the probability of a recession in 2017 is low to nonexistent. On the other hand, a recession in 2018 is still an open question. New Deal democrat is starting to see a few dark clouds on the horizon in his monitor of high frequency economic indicators, and that’s before all of the possible policy effects that I discussed:
The interest rate components of the long leading indicators have improved enough to be neutral. The yield curve and money supply remain positive (but with the positivity in real M2 decelerating). Purchase mortgage applications are neutral. Refinance mortgage applications remain quite negative. The important change this week is that growth in real estate loans has decelerated enough to turn from positive to neutral…
While the shorter term 6 month forecast remains strongly positive (barring a trade war), The 12 month + forecast is shading even more neutral to negative, with money supply, the yield curve, and spreads being the remaining positives.
The markets are forward looking discounting machines. Market trends can therefore provide clues as to whether the cyclical top is in. My approach of applying trend following techniques to a variety of asset classes across different geographic regions gives a holistic picture of global macro conditions, as well as investor risk appetite. To be sure, trend following models are always late and they will never get you out at the exact top. They are, however, designed to avoid the worst of any bear market and allow investors to take appropriate action to protect themselves.
Still, I am hopeful that the market will follow the blow-off top path. The wimpy top scenario just doesn’t “feel right”. While every market cycle is different, we are not seeing the kind of investor and trader giddiness that accompanies a typical cyclical top. The more likely scenario calls for a benign resolution of these tax reform proposals, followed by a rally where market participants pile into stocks and move into a crowded long position on risky assets. That’s when I will signal “sell” and be derided for being an idiot, a Never Trumper, or something worse.
Near-term risks
In the interim, the market faces a number of near-term risks. The uncertainty over the tax reform proposals and the risk of rising protectionism are factors that will spook the markets.
In addition, Jeff Hirsch at Almanac Trader observed that we are entering the most bearish part of the first 100 days of a new presidential administration. In particular, Republican presidents have had a tougher time that Democrats.
The latest update from John Butters of Factset shows that Wall Street is pulling back on the earnings growth outlook. While earnings and sales beat rates for Q4 are roughly in line with historical averages, the negative guidance rate edged up from last week. More importantly, forward 12-month EPS deflated by 0.12% in the week. These are all signs for traders and investors to brace for some near-term turbulence.
Another warning comes from a combination of mild overvaluation and insider activity. The charts below shows a mild overvaluation of stock prices of 3%, from Morningstar’s fair value estimate, and several weeks of consistent insider selling (via Barron’s). Under these conditions, stock prices are likely to face headwinds until the details of the fiscal stimulus proposals are not clear.
Still, there is no reason to panic. All of these factors are only mildly bearish. They can be resolved with a shallow pullback. Bear markets are caused by either by growth disappointments or rising interest rates. Unless we see evidence of full scale protectionism, or if the Fed stomps on the monetary brakes, the equity outlook remains benign.
So don’t freak out.
The week ahead: Brace for turbulence
Looking to the week ahead, I stand by my tactically bearish trading view in my last post (see What’s wrong with the VIX?). Even though major market averages all achieved all-time highs on Friday, the move may be interpreted as exhaustive.
The lack of confirmation of the new high by the junk bond market is worrisome from a cross-asset basis, as junk bonds is a key metric of the market’s risk appetite.
This Index Indicators chart of stocks above their 5 dma (1-2 day time horizon) is flashing an overbought reading, which suggests that a near-term pause is in order.
This Index Indicators chart of net 20 day highs-lows (1-2 week time horizon) is showing a near overbought reading, indicating that upside potential is limited at current levels.
My inner investor remains bullish on equities. He is unlikely to turn bearish in the absence of a recession warning, which is not present, or significant technical deterioration in the major market indices.
My inner trader moved to cash last week. Even though the trading model flashed a “sell” signal, it is not a high conviction call. He is therefore staying on the sidelines for now.
Mid-week market update: Increasingly, I have seen cases being made for an equity market correction. This Bloomberg article, “Five charts that say not all is well in the markets” summarizes the bear case well.
Uncertainty is at a record high: The number of news stories using the word “uncertainty” is surging.
Wall Street vs. Washington: While the Global Economic Uncertainty Index is elevated, the VIX Index remains low by historical standards.
The price of hedging tail-risk is rising: Even as the VIX remains low, the CBOE SKEW Index, which measures the price of hedging extreme events, is high. Which is right?
Gold is rising: Gold is often thought of as a safe haven in times of stress and the gold price has recently been inversely correlated with equity prices.
Watch for gold and bond yields to rising together: “Gold may prove the “tell,” according to Chris Flanagan, also at Bank of America. He advises investors to watch “for the combo of rising yields and rising gold prices to signal impending market volatility.” Three consecutive quarters of rising benchmark bond yields and gold prices preceded previous market falls including the 1973-1974 bond market crash and Black Monday in 1987, he says. The yield on the benchmark 10-year U.S. Treasury has risen to 2.44 percent from 1.77 percent since Trump’s election win. Gold has moved sideways.”
Much of the anxiety can be summarized as, “What’s wrong with the low level of the VIX Index? Isn’t the VIX supposed to be a fear gauge?”
Why aren’t stock prices falling if actual fear is so high?
The VIX explained
To answer those questions, let’s start with the definition of the VIX Index. The VIX Index measures the at-the-money implied volatility of SP 500 options. Now remember the diversification effect. An index of stocks is less volatile than the aggregate volatility of its individual components because the returns of the components don’t all move together. In other words, they are diversifying.
Joe Wiesenthal showed how correlations of stocks within the index have been falling. As correlation falls, the diversification effect gets magnified and therefore puts downward pressure on index volatility, or VIX.
If you are convinced that stock prices are destined to drop dramatically, one way for institutional investors to capitalize on this is to trade correlation (see this GSAM presentation). Kids – don’t try this at home. Unless you fully understand the math, the subtleties of trading correlation can be highly detrimental to your net worth.
A rolling correction
Here is a a far simpler explanation of why stock prices aren’t falling. The market has been moving sideways since December and it is undergoing a rolling correction. The chart below shows the RRG chart by sector. Cyclical sectors such as energy, material, and industrials have been correcting. Financial stocks, which had been market leaders, have retreated from a leadership position to the weakening category. By contrast, formerly weak sectors, such as consumer staples, healthcare, and utilities, are rising. More importantly, the heavyweight technology sector, which comprises 21.3% of the weight of the index, has been strengthening as well.
In order for the index to weaken significantly, we would have to see some evidence of stalling by technology stocks. So far, that’s not happening.
The top panel of the chart below shows that the high beta vs. low volatility ratio falling through its relative uptrend, which is a sign of falling risk appetite. However, the bottom panel shows that the relative performance of momentum stocks, which are mostly the glamour FANG names, have taken the baton of leadership.
In addition, I am watching whether the financial stocks can stabilize at these levels in light of the Trump administration to backtrack on Dodd-Frank. As well, the relative performance of this sector has historically been correlated to the shape of the yield curve. Will the yield curve steepen (bullish for financials) or flatten (bearish)?
If these two heavyweight sectors hold up, then it would be difficult to see how stock prices could correct significantly given the relative strength support of emerging sectors such as consumer staples, healthcare, and utilities.
More sideways consolidation
Having said all this, the recent technical violation of the SPX uptrend is not good news for the bulls. On the other hand, I find it difficult to make a case for a significant market correction under the current circumstances. There seems to be significant support at the 2260-2270 level. Until that zone is breached, the most likely scenario is a period of choppy sideways market action
My inner investor remains bullish on stocks. I outlined my intermediate term bull case in my weekend post (see Still bullish after my chartist’s round-the-world trip). My inner trade sold all of his long position and moved to cash today. The trading model has flashed a weak sell signal, but he is staying in cash due to the low conviction nature of the signal.
Technical analysts often use the magazine cover indicator as a contrarian indicator. When an idea has become so commonplace that it becomes the cover of a major magazine, the public is all-in and it’s time to sell.
The Economist reported on an ad hoc study by Greg Marks and Brent Donnelly at Citigroup using covers from The Economist and did find contrarianism works, even though The Economist is not really a popular mainstream magazine:
Interestingly, their analysis finds that after 180 days only about 53.3% of Economist covers are contrarian; little better than tossing a coin. After 360 days, the signal is a lot more reliable—68.2% are contrarian. Buying the asset if the cover is very bearish results in an 18% return over the following year; shorting the asset when the cover is bullish generates a return of 7.5%.
Now consider the following Time magazine cover and accompanying story on Steve Bannon, who is said to be the man behind the Donald Trump presidential throne.
There is also this cover from The Economist within the same week.
Still not convinced? How about this cover from Der Spiegel. You don’t even have to read German to understand the idea.
It isn’t just me, Helene Meisler raised the same question about magazine covers, which was answered by Liz Ann Sonders at Schwab.
Here at Humble Student of the Markets, our mission to focus on investing and try to remain apolitical. Like most on Wall Street, we don’t protest political developments, we trade them.
Rather than interpreting these magazine covers as just peak Trump, as he will be POTUS for the next four years, the contrarian message may be “peak populism”. Nate Silver recently wrote an article called “14 versions of Trump’s presidency, from #MAGA to impeachment”, where he laid out a variety of scenarios of how Trump’s presidency might proceed.
I would like to offer some details of how the reversal of peak populism might work. As well, there is a possible trade for contrarian investors who are willing to bet on the “peak populism” theme.
Yes, Minister
Back in the early 80s, the BBC aired a satirical series called Yes, Minister which told the story of a government minister’s struggles against the civil service, and vice versa. New political initiatives that upset the status quo would be met with, “Yes, Minister. But…”
Why did limited government and ‘constitutionalism’ (the rule of law, constitutional rules, and political representation) evolve in some societies but not others? Guided by history, this paper examines why this evolution reflects dependence on administrators to implement policy choices including those affecting them. Limited government and constitutionalism are manifestations of equilibria in which the administrators have the power to influence choices. The thesis that constitutionalism reflects an equilibrium among the powerful differs from the prevailing one, which asserts that it reflects gains to the weak from constraining the powerful. Analyzing the determinants and implications of administrative power reveals its impact on trajectories of economic development. Distinct administrative-power equilibria have different impacts on the security of the non-elite’s property rights; intra-state and inter-state violence (e.g. civil wars and wars, respectively); policies; entry barriers to new technologies and economic sectors; the nature of political conflicts; and the means to resolve conflicts concerning political rights.
Happily ever after?
This post isn’t just about the unconventional approach of the Trump administration, but how the rise of populism has upset the status quo in developed economies. This is also the story of how new governments with revolutionary ideas fall down in implementation. Just because you won an election doesn’t mean that you will necessarily live happily ever after.
Consider the problems of the myriad of details surrounding the Brexit process, which is another political initiative that upset the status quo. Here is FT Alphaville on the latest UK government Brexit white paper:
The UK government’s white paper on exiting the European Union was published on Thursday. Unfortunately, it doesn’t have much detail — or at least nothing like the sort of detail that might provide a picture of how Britain will actually end 43 years of EU membership, replace the entire body of adopted EU legislation, and re-build a trading regime with its biggest overseas market…
Malcolm Barr, an economist at JP Morgan, is simply aghast:
Resources in many government departments have been focused on the Brexit issue since the referendum result back in June. That should be generating a repository of granular, sector level detail that was available to be drawn on for this publication. As a distillation of the state of knowledge within the UK government six months after the vote, and with the beginnings of a time-compressed negotiation just weeks away, the shallowness of the analysis and absence of detail are matters of great concern, in our view.
There’s no discussion of continued EEA membership, no discussion of Britain’s share of EU liabilities, no list of what new regulatory authorities Britain will need, and no real detail on how migrant flows might work.
Call it what you want. Maybe the civil service is resisting change. On the other hand, the government may not simply be prepared for all the operational details of its political initiatives.
Over on this side of the Atlantic, the implementation of Trump’s travel ban is also instructive of how a neophyte government is learning the ropes of administration. Sure, there were protests, which were to be expected given the radical nature of the announcement. What was more disturbing were the reports of confusion by Homeland Security over the details of the directive, which is a sign that the lack of preparation by the civil service, and the courts upholding the legal challenges, which is a sign that the directive was not well written. These are all indications that the government was unprepared for the nitty-gritty of implementation.
Struggles of the political leadership against the bureaucracy is nothing new. In China, Beijing’s stated goal of re-balancing the economy towards consumer spending and away from credit driven infrastructure growth represents a direct attack on the wealth and power of many Party cadres. That’s one of the reasons behind Xi Jingping’s anti-corruption campaign. He wants to control the bureaucracy and eliminate opposition to the policy goals of economic re-balancing.
Politico featured an insightful interview with James Baker, who served in the Reagan and Bush I administrations, about how to manage the bureaucracy. Much of it is about getting the right management structure in place:
When he reigned in the Washington of the 1980s as its premier backstage power broker, Baker took as his personal motto the saying, “prior preparation prevents poor performance.” Clearly, the Trump White House is not yet delivering on the prior preparation part, a problem that Baker says may well be because Trump comes from decades of running his own company exactly as he wished. “Running a business and running the government are two entirely different functions, quite frankly, and process matters,” says Baker, who tells me he has also given his advice directly to Trump, Tillerson and Trump’s new chief of staff Reince Priebus. And presumably also Vice President Mike Pence, who was seated next to Baker at last night’s Super Bowl in Houston. “Process matters a lot in order to avoid mistakes, controversy.”
Already, he is struck by a White House that he worries is set up for internal conflict, division and miscommunication. “The White House that they have constructed has a lot of chiefs,” he says. “In this White House, it seems to me, you’ve got at least four, maybe five, different power centers, so we are just going to have to wait and see how it works in practice.”
Baker believes that you have to understand the process of governing involves dotting the i’s and dotting the t’s. That is a lesson that the neophyte Trump administration, which is mainly composed of outsider, is still learning.
Jim Baker was so invaluable to the Reagan Revolution not because he helped the Gipper blow up Washington but because he knew how to work its institutions. And that included first and foremost the White House, where Baker as chief of staff quickly figured out how to gain control despite being a newcomer to the president’s inner circle who was viewed suspiciously by Reagan’s longtime aides and ideologists like Ed Meese.
In our conversation, Baker makes a point of drawing a distinction between Trump and Reagan on just this point.
“In fact, Ronald Reagan’s administration had a lot of people in it who had been there before,” he says. “And we knew how Washington worked and what didn’t work. Consultation and not surprising people is important if you want them to support the policy and Ronald Reagan was very good at understanding that. He was ideological, there’s no doubt about it… but in terms of how you got there and what you did, he wanted to do it in a way that made it work, so that you could accomplish it. And that’s what he did,” Baker says. “He was to some extent an ideologue but people don’t appreciate the extent to which he was really pragmatic. If he told me once he told me a thousand times sitting there in the Oval Office with him… he would say, ‘Jim, I’d rather get 80 percent of what I want than go over a cliff with my flag flying.’”
Big Bold Ideas are great, especially if you have the political mandate. It’s perfectly ok to want to implement political initiatives, such as “keep the country safe from terrorists”, “leave the European Union and chart our own course”, or “re-balance the economy to a more sustainable growth path”. What is not acceptable a government fumbling their implementation of a Big Bold Idea. Repeat those mistakes enough times, and you will lose credibility and result in the slow death of your populist movement.
Buy the French panic
If you believe that the populism is at or near its high tide mark, a trading opportunity can be found in Europe. In France, support for the socially and fiscally conservative presidential candidate François Fillon is slipping quickly in light of “Penelopegate”, where Fillon put his wife and children on the government payroll without any apparent work performed. The spread between French OAT and German 10-year Bunds are blowing out. This presents an opportunity for contrarians to buy the “French panic”.
Fillon’s failings leaves a clear shot for upstart centrist Emmanuel Macron, who appears to have the best shot to win the election against Marine Le Pen, the populist anti-establishment candidate. Macron was a minister in the Hollande’s socialist government, but as this Guardian profile shows, he’s not very “socialist” at all. He is best characterized as a left-winger in the Tony Blair centrist mold.
He says he is “of the left”, but keen to unite people from across the spectrum, including the right. Economically liberal and pro-business, Macron was tasked by Hollande with opening up France’s sclerotic economy; the loi Macron reforms that bear his name were so unpopular they had to be forced through by decree. But he is also fiercely progressive on social issues – eager to stimulate growth and free up business while protecting the country’s strong social safety net.
The latest polling averages show that Marine Le Pen ahead in the first round, but Macron would beat her 64-36 in the second round (via Macro Monitor). Moreover, he outperforms all of the other candidates. If Macron were to win, he would go to the Elysée Palace without Fillon`s Moscow friendly tilt. A Macron victory would be bullish for French and European assets.
For investors who want to play the contrarian “peak populism” trade, buy French OATs. In the alternative, there is also the long France/short Germany equity ETF pair.
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 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.
Confusing macro cross-currents
Last week, I wrote that investors should tune out the political noise and focus on the fundamentals of growth (see A focus on growth). Still, the markets appear to be confused.
On one hand, Friday’s positive surprise from the January Jobs Report told the story of an American economy that is on a solid non-inflationary growth path. Indeed, the latest update from ECRI shows their Weekly Leading Indicator has surged to an all-time-high.
Urban Carmel pointed out that the macro outlook is strong in virtually all respects, and I agree. Moreover, the upturn is global in scope, which suggests that this recovery has staying power because of the breadth and scope of the advance.
On the other hand, the new Trump administration is starting to give Wall Street the jitters. Josh Brown summarized the anxiety well this way:
All the investment guys want the tax cuts and repatriation to happen. They want the 4% GDP growth. They want the infrastructure push to actually work. But, they’re definitely afraid. They don’t like the tweets, the executive orders, the daily mass protests or the shady people who seem to be accumulating power and influence.
I know of no conventional way to resolve the interplay between the bullish macro backdrop and bearishness from policy uncertainty. One approach to cut through the noise is to just ignore it. Instead, use technical analysis to understand what the markets are discounting.
This week, I will dispense with my usual macro and fundamental analysis and take a chartist’s tour around the world. Let’s see what the markets are telling us.
A chartist’s world tour
We begin with a chartist’s tour around the world using an intermediate term framework. Starting in the US, we can see that the SPX is in a solid uptrend, defined as trading above its upward sloping 50 dma and 200 dma, and testing overhead resistance.
Crossing the Atlantic, we can see that UK FTSE 100 is also in a uptrend, though it has pulled back just above its 50 dma.
Across the English Channel, the Euro STOXX 50 shows a similar picture of a pullback within an uptrend.
So far, so good. All of these markets are in uptrends. Each of the indices are above their 50 dma, which is above their 200 dma. In addition, the 50 and 200 dma lines are all sloping upwards.
I found an exception in Asia. The Shanghai Composite is trading below its 50 dma, but above its 200 dma. However, the stock indices of all of China’s major Asian trading partners are all above their 50 dma.
The weakness in Shanghai Composite can be somewhat discounted because the Chinese stock market functions more as a casino rather than a serious capital market. The trends seen in the other regional exchanges can be better measures of market expectations of Chinese growth.
Commodity prices are also good indicators of Chinese growth, largely because China is such a voracious consumer of raw materials. Callum Thomas of Topdown Charts found a high degree of correlation between copper prices and Chinese PMI.
With that in mind, the chart of industrial metals, which is a broader measure of cyclical metals than just copper, shows a solid uptrend.
Similarly, the CRB Index is also trading above its 50 and 200 dma. The CRB is less reliable global cyclical indicator as it has a heavy energy weight and therefore subject to the specifics of the supply-demand dynamics of the oil market.
Healthy risk appetite
In addition, my measures of risk appetite remains bullish. As the chart below shows, equity risk appetite, as measured by high beta stocks vs. low volatility stocks, and small vs. large cap stocks, are in solid relative uptrends.
The bond market is also telling a similar story of rising risk appetite. The price performance of junk bonds against their duration equivalent Treasuries are confirming the equity uptrend.
When I put it all together, global equity and commodity markets, as well as US market internals, are telling a story of reflationary rebound. The nascent strength was indicated by last year’s MACD buy signal on the Wilshire 5000, which should be respected.
Mixed breadth reading
While the intermediate term investment outlook for equities looks solid, the picture is less clear for traders with a shorter term perspective. In particular, market breadth is presenting a mixed picture.
The top panel of the chart below shows the SP 500 Advance-Decline Line, which is not showing any negative divergence against the index. I prefer using this indicator over the more popular NYSE A-D Line as the former has the same components as the index and it is therefore an apples-to-apples breadth comparison. However, other breadth metrics, such as % bullish and % above their 50 dma, are exhibiting negative divergences against the index. On the other hand, the longer term % above their 200 dma is range bound. I interpret these readings as the intermediate term bull trend being intact, but the market may need to pause and consolidate its gains.
The chart below of the NYSE common-stock McClellan Summation Index (middle panel) is also flashing a cautionary signal. The index is exhibiting a negative divergence against the SPX, though that is not necessarily very worrisome as past negative divergences have not resolved bearishly. More problematical is its stochastic (top panel) not oversold enough to signal a bottom. The NYSE McClellan Summation Index (bottom panel, which includes all NYSE issues such as closed-end funds) is only starting to top out, indicating possible weakness ahead. These readings suggest that the markets are not ready to stage a sustainable rally to new highs just yet.
In addition, the latest update from Barron’s of insider activity shows that this group of “smart investors” has been selling heavily. The last episode of insider selling resolved itself with a period of sideways consolidation and minor pullback.
Arguably, the negative data point from insider activity is offset by the news that Warren Buffett, another “smart investor”, had bought $12b of equities since the election.
Measuring the Trump factor
Another concern I have is the fading effects of the so-called “Trump rally”. While I believe that the main reason behind the recent equity market strength is a global reflationary rebound, there is nevertheless a Trump enthusiasm effect.
One way of measuring this “Trump factor” would be through a paired trade of long Russia, which is enjoying friendlier relationship with Washington, and short Mexico, which is being pressured by Trump on trade and immigration. As the chart below shows, this pair has strengthened since the election, but it has started to roll over in early 2017.
One of the drawbacks of using a long Russia/short Mexico pair to measure the “Trump factor” is the large differences in sector weights between the stock markets of the two countries. The Russian market is heavily tilted towards energy and mining, while the Mexican market is far more diverse. Therefore any performance difference between the Russia/Mexico pair could be attributable to sector effects, in addition to the “Trump factor”.
A better paired trade might be a long Russia/short Australia position. Like Russia, Australian market is more exposed to resource extraction industries, which mitigates much of the sector effects found in the Russia/Mexico pair. In addition, Australia is highly sensitive to the Chinese economy, which is another country that is likely to come under pressure from the Trump administration. As the chart below shows, the Russia/Australia pair does not have the upward sloping bias of the Russia/Mexico pair, which may be indicative of a partial neutralization of sector effects. The pairs trade did rally in the aftermath of Trump’s electoral win, but it has steadied and it began to trade sideways starting in December.
Bottom line, the Trump rally is fading.
Rolling corrections = Consolidation?
In light of the above analysis, a case could be made for the stock market to consolidate and trade sideways as it digests its post-election gains. Under such a scenario, a rolling correction is the most likely outcome. As leadership sectors weaken, other sectors rise and take up the baton of market strength. Under these circumstances, the key to market direction would be the weights and performance of weakening sectors and emerging sectors within the index.
In a previous post, I highlighted the phenomena of the rolling sector correction (see The contrarian message from rotation analysis). As the RRG chart below shows, emerging sectors (Consumer Staples, Healthcare, and Utilities) comprise 26.2% of the weight in the index. Weakening sectors (Energy, Financials, and Industrials) comprise 32.0%. On a net basis, the index weight of the weakening sectors beat the emerging sectors by 5.8%, which argues for a bout of limited market weakness.
However, if the Technology sector, which is in the “lagging quadrant” and a heavyweight at 21.3% of the index, were to be re-defined as an “emerging sector”, the relative weight of rising sectors would overwhelm the relative weight of weakening sectors. In that case, the market could rally to new highs. Indeed, the relative performance of this sector appears to be highly constructive and supportive of such an outcome.
The week ahead
I have no idea what the stock market will do in the short-term. The above intermediate term analysis indicates that, barring any major White House policy or geopolitical surprises, any correction is likely to be shallow.
Here are some questions to ponder in the days ahead:
The SPX briefly violated an uptrend line last week. Further violations will likely signal a period of sideways action or mild correction.
The absolute level of the VIX Index (bottom panel) is low. Watch for rallies of the VIX above its upper Bollinger Band (BB) as potential short-term buy signals (see my VIX study in Watching the USD for clues to equity market direction).
Also watch for expansion of the VIX BB. That could also be a signal of rising uncertainty and sideways choppy market action.
Can a major sector like Technology strengthen sufficiently to take the mantle of market leadership? Can Financials turn around in light of Trump’s dismantling of the Dodd-Frank regulatory regime, or both? These heavyweight sectors have the potential to push the major market averages to new highs.
My inner investor remains bullishly positioned and he is overweight equities. My inner trader is also long the market, but he has some dry powder to buy any possible dips.
Wikipedia explained the island reversal formation this way:
In stock trading and technical analysis, an island reversal is a candlestick pattern with compact trading activity within a range of prices, separated from the move preceding it. This separation is said to be caused by an exhaustion gap and the subsequent move in the opposite direction occurs as a result of a breakaway gap.
I had grown up with trading aphorisms and folklore like this, so I decided to test out whether the island reversal formation had any trading information. The results were surprising, and it was another lesson in how asymmetric signals were at tops and bottoms (see The ways your trading model could be leading you astray).
Asymmetry strikes again
My study used the daily open, high, low and close data of the SPX going back to January 1, 1990. I looked for instances of island reversals and calculated the returns of each episode. There were, on average, 1.5 reversals per year. As the table below shows, the results were surprising.
Bullish reversals, where the island reversed upwards, did not perform very well. The index saw a one day bounce and went on to underperform going out about a week. Bearish reversals performed a lot better than expected. Absolute returns were positive whatever time horizon you chose, though the index underperformed on a 2-3 day time horizon.
This gave me another lesson in the asymmetry of trading models. In the current instance, we are ending the three day underperformance window. If history is any guide, then stock prices should see better returns in the days ahead.
Mid-week market update: With stock prices pulling back to test its technical breakout to record highs, it is perhaps appropriate to watch other asset classes for clues to equity market direction, especially on a day when the FOMC made its monetary policy announcement.
From a cross-asset perspective, there is much riding on the direction of the USD. As the chart below shows, the USD Index has weakened after making a high in December. It is now testing a key support zone, as well as a Fibonacci retracement level. Despite the pullback, the uptrend remains intact.
The other panels of the chart shows the UST 2-year yield and its rolling 52-week correlation with the USD. As well, I show the price of gold and its rolling correlation to the USD. The correlation charts show that the relationship between the USD and these two assets have been remarkably stable. The USD has been positively correlated to interest rates, as measured by the 2-year UST yield, and inversely correlated to gold prices.
As well, please be reminded that gold and equity prices have recently shown a negative correlation. In the past few months, stock prices have risen when gold fell, and vice versa.
With these cross-asset, or inter-market, relationships in mind, what happened to the USD in the wake of the Fed announcement?
Nothing. Sure, the greenback weakened a bit in response to the FOMC decision, but soon bounced back. The same could be said of interest rates, and stock prices.
That leaves investors and traders waiting for a decisive break for clues to stock market direction. Equities are mildly oversold, but my metrics of risk appetite remains in an uptrend. I am inclined to give the bull case the benefit of the doubt, but with reservations.
A mildly oversold condition
Regular readers know that I watch the VIX Index closely for clues of short-term market direction. As the chart below shows, past instances when the VIX Index has risen above its upper Bollinger Band (blue lines) have been reasonably good buy signals. Interestingly, the opposite condition, when the VIX has fallen below its lower BB (red lines), have been less useful as sell signals (see my past comment about asymmetric signals in How your trading model could lead you astray). The market got close to a buy signal on this indicator on Tuesday when it traded above its upper BB, but did not close there.
I conducted a study of this signal going back to 1990 shows that the market tends to see an oversold bounce under these conditions.
Even relaxing the rule to the VIX rising above 1.5 standard deviations, instead of the usual 2 standard deviations in BB analysis, showed positive results. Call this a mild oversold condition, which is what happened on Tuesday.
Indeed, analysis from Index Indicators confirm my assessment of the market’s mild oversold condition. This chart of stocks above their 5 day moving average (1-2 day time horizon) shows a mild oversold reading, with the caveat that oversold markets can get more oversold.
This chart of net 20-day highs-lows, which is a trading indicator with a 1-2 week time horizon, also shows a mild oversold condition where stock prices have bounced in the past.
In addition, measures of risk aversion shows that their uptrends remain intact.
In conclusion, the SPX mildly oversold, risk appetite still bullish, and testing a key support zone centered at 2270. I am therefore inclined to give the bull case the benefit of the doubt.
However, my inner trader will be carefully watching these bearish tripwires over the next few days.
This is the second in an occasional series of posts on how to build a robust investment process. Part 1 was addressed to the individual investor and trader (see The ways your trading system could lead you astray). This posts explores the issues that face the professional and institutional investor.
I had illustrated in the past why managers closet index. That`s because even a single misstep in an individual position could sink portfolio performance (see How Valeant revealed the dirty little secret of fund management). In this post, I would like to focus on how style and factor exposures affect business risk.
I recently came upon a study by Research Associates, which showed the tradeoffs between investment returns and business risk. The authors modeled a series of hypothetical portfolios with different styles, namely value, growth, momentum, quality, and random selection, which they called the “4 Orlandos”, for the period 1967-2016. As it turns out, the styles that showed the best performance also had the highest chance of getting a manager fired.
The termination criteria for a manager (which they called an “agent”) is detailed below and roughly reflects the patience level of institutional sponsors:
We select two highly stylized rules for a hypothetical investment board to use in evaluating the agent’s performance:
1) Fire the agent if more than 50% of funds selected by the agent underperform the benchmark in a given period.
2) Fire the agent if the equally weighted portfolio aggregated from the selected funds underperforms the benchmark by more than 1%.
In the light of these results, the big question for institutional investors is, “We all want good performance, but how far do you want to stick your neck out?”
When should you fire a manager?
Imagine that you are a hypothetical board member of a pension or endowment fund. You are reviewing the performance of a value manager, which is shown in the chart below. As the top panel of the chart shows, the manager underperformed the index for three years since 2009 and returns have been roughly flat ever since. Is there any reason to be patient with this manager? The initial knee-jerk reaction to this analysis is the board has been far too patient with this manager and it’s time for a new one.
The manager’s name is Warren Buffett.
The bottom panel of the chart shows a better picture, as Buffett has been steadily beating his style benchmark, the Russell 1000 Value Index. Nevertheless, the bottom chart begs the question of whether the board should be patient with this particular investment style.
Your pain threshold isn’t your client’s pain threshold
Take the example of the value manager. According to the Research Associates study, long-term returns have been stellar over the study period, but the manager is taking a 30% chance of getting fired over any single three-year horizon. I have met a number of dyed-in-the-wool managers of various styles who steadfastly refuses to change their stripes, arguing that “our clients hire us for style X”. But time horizons are shortening very quickly in this business, and the investment risks that the manager takes in his portfolio may not be compatible with the goal of business survivability.
In other words, your pain threshold is different from your client’s pain threshold. A CIO may choose to construct a portfolio with certain style and factor tilts in order to maximize the returns to his style and investment approach, but he also has a responsibility to the employees of the firm. Do the employees want to take the same level of business risks that the CIO wants to take? During the difficult periods of performance, the firm may have to downsize and people will lose their jobs (as an example, see Grantham’s GMO cuts 10% of workforce as assets shrink). Are the employees’ pain thresholds the same as the CIO’s?
The rush into passive funds
In addition, the investment industry faces a challenge as investors re-allocate their cash flows into index funds and ETFs. This chart from the Investment Company Institute’s 2016 Investment Company Fact Book tells the story.
Equity Fund cash flows
This trend of a wholesale re-allocation from active to passive funds raises a few questions, with my thoughts in brackets:
Much of the allocations are based on robo, or robo-like algorithms. Will investors be disciplined enough to buy back into equities in the next bear market? [Knowing human nature, probably not]
If not, then will the next bear market be the acid test for active management? [Best guess: Yes]
If your answer to the above question is “yes”, will you survive long enough in the profession to see that turn?
Controlling business risk
Investment fads go in cycles. There is no doubt that if you have the combination of a successful investment discipline and enough patience from investors, you will prosper as an investment professional.
Stop me if you’ve heard a story like this. In my youth, I met a successful investment manager. Let’s call him M. M began working as a trust officer, and over the course of time, cultivated a lot of relationships and gathered many clients. He eventually struck out on his own and founded his own investment firm. Returns were good, and success followed. When I met him, M was the “it” manager and assets were rushing in the door as people clamored to become his clients. Then events started to spiral downwards. M made a big bet on the bond market and performance suffered. He was so sure of his conviction that he doubled down on his exposure. It didn’t work. Clients left and the firm eventually shut its doors. A number of years later, I spoke to one of his former partners who ruefully told me, “Our biggest mistake was we were out past the 90th percentile in bond allocation when compared to the SEI median”.
In other words, M showed the courage of his conviction and the firm went over a cliff. For us mortals not named Buffett, we have to manage business risk in order to survive into the next cycle.
There are a number of ways that I can suggest to control business risk and enhance returns, all without changing your alpha generation secret sauce:
Set an investment benchmark that reflects your business risk: For example, if you are a manager of a certain style that is also evaluated against the market benchmark, why not set your neutral weight between your median competitor’s weight and the market benchmark weight? That way, you will beat either your competitor or the market.
Distill and control your bets: Identify what you are good at and maximize your intended bets to a specified risk level. Then minimize or eliminate your unintended bets.
Optimize your trading to fit your style: Trading is often relegated as an afterthought in many investment firms, but it is an essential part of the investment process. Optimize the way you trade based on the reasons why you are trading. Sample reasons include alpha generation (information trading), risk control and cash re-allocation (information-less trading). Treat each trade differently. The spread between a top quartile and median manager for a large cap US equity mandate over a 10-year time horizon comes to about 1%. A good trading desk that can squeeze 50bp out of trading can mean the difference between below median and above median performance.
Portfolio implementation and shortfall analysis: I find that an organization learns the most when it encounters subpar performance. That’s when the investment team pores over its analytics and finds the places where it fell short.
Process integration: Ask yourself if all parts of the investment process work together like a well-engineered Deming Process, or did they clash with each other? Did the portfolio construction process undo many of the intended bets that came out of alpha generation? Was the trading desk not properly incentivized, or did it mis-understand the reasons for trading and left performance on the table?
This is just a basic outline, but it should be enough to get anyone started.
For anyone who is interested, I am also part of a consulting practice that conducts investment process tuneups that optimizes investment performance without any changes in the formulation of the “secret alpha generation sauce”. We also offer other services, such as estimating the macro exposure of your competitors in real-time so that managers can better control the business risks in their portfolios. For more information, please contact Ed Pennock at Pennock Idea Hub.
I had been meaning to write about a preview of the upcoming FOMC meeting. Here are the elements of the Yellen Labor Market Dashboard, courtesy of Bloomberg.
As you can see, many of the components have either fully or nearly recovered from the depths of the GFC, with the glaring exception of a subpar labor force participation rate. These factors put pressure on the Fed to start normalizing rates.
However, there is one important exception that may cause the Fed to have a slightly more dovish tilt than the market expects.
Stalling PCE inflation?
The chart below depicts Fed Funds rate, along with the number of times in the last 12 months that the annualized monthly core PCE, the Fed`s preferred inflation metric, is above the inflation target of 2%. Historically, the Fed has tended to start rate hike cycles when the count hits six.
I have been watching this chart for some time, and the count has been stalled at 5 for five months. December`s annualized monthly core PCE came in at 1.4%. November was 0.2%. In fact, most of the clusters of high readings occurred about a year ago, in January and February 2016. If the January 2017 rate comes in at below 2%, then the count will drop from 5 to 4; and from 4 to 3 if the February figure is tame.
Even if core PCE inflation were to start to come in “hot” in the next few months, these readings suggests that we may have to wait until the May-June meetings before seeing the next rate hike.
Wow, Trump’s political honeymoon didn’t last very long! In the past few days, there have been numerous objections of Trump’s Executive Orders. I’ll spare you the details of the protests and demonstrations, particularly from the Left. What stood out were the objections from the Right and within the GOP. As an example, Eliot Cohen, who served under Condeleeza Rice, fretted about the threats that Trump posed to the American Republic:
I am not surprised by President Donald Trump’s antics this week. Not by the big splashy pronouncements such as announcing a wall that he would force Mexico to pay for, even as the Mexican foreign minister held talks with American officials in Washington. Not by the quiet, but no less dangerous bureaucratic orders, such as kicking the chairman of the Joint Chiefs of Staff out of meetings of the Principals’ Committee, the senior foreign-policy decision-making group below the president, while inserting his chief ideologist, Steve Bannon, into them. Many conservative foreign-policy and national-security experts saw the dangers last spring and summer, which is why we signed letters denouncing not Trump’s policies but his temperament; not his program but his character.
Precisely because the problem is one of temperament and character, it will not get better. It will get worse, as power intoxicates Trump and those around him. It will probably end in calamity—substantial domestic protest and violence, a breakdown of international economic relationships, the collapse of major alliances, or perhaps one or more new wars (even with China) on top of the ones we already have. It will not be surprising in the slightest if his term ends not in four or in eight years, but sooner, with impeachment or removal under the 25th Amendment. The sooner Americans get used to these likelihoods, the better.
Cass Sunstein objected to Trump’s economic approach by invoking Fredrich Hayek:
If American conservatives have an intellectual hero, it might well be Friedrich Hayek — and rightly so. More clearly than anyone else, Hayek elaborated the case against government planning and collectivism, and mounted a vigorous argument for free markets. As it turns out, Hayek simultaneously identified a serious problem with the political creed of President-elect Donald Trump.
Sunstein worried aloud about Trump’s conservative credentials and autocratic tendencies:
In “The Road to Serfdom” and (at greater length) in “The Constitution of Liberty,” Hayek distinguished between formal rules, which are indispensable, and mere “commands,” which create a world of trouble, because they are a recipe for arbitrariness. When formal rules are in place, “the coercive power of the state can be used only for cases defined in advance by law and in such a way that it can be foreseen how it will be used.”
Like the rules of the road, formal rules do not name names. They are useful to people who are not and cannot be known by the rule-makers — and they apply in situations that public officials cannot foresee.
Commands are altogether different. They target particular people and tell them what to do. (Think Hitler’s Germany, Stalin’s Soviet Union, Mao’s China, Castro’s Cuba.) They require the exercise of discretion on the spot. As examples, Hayek pointed to official decisions about “how many buses are to be run, which coal mines are to operate, or at what prices shoes are to be sold.”
Forgive me for being cynical, but blah blah blah…None of this matters very much.
The main objective of these pages is to make money for my readers. I try very hard to divorce my investment views from my political views. As the chart below shows, the stock market can prosper under both Democratic and Republican presidents.
With that preface in mind, here are some key metrics to watch that Donald Trump needs to achieve in order to politically prosper in his first term.
The Newt Gingrich criteria
Newt Gingrich laid it all out in a recent New York Times interview:
“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”
“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”
Bloomberg Intelligence economic criteria
Assuming that Trump can “keep America safe” (see the reactions from this recent BBC report), Bloomberg Intelligence chief economist Carl Riccadonna compiled a list of five economic metrics to watch as signs of American prosperity, all without resorting to “phony” statistics like GDP and the unemployment rate.
Prime age labor force participation rate: If prime age discouraged workers can return to the labor force in size, then score a win for Trump (if you want to follow along at home as the data updates, see this FRED chart).
Full time workers as a % of the labor force: Trump promised good jobs. That means full-time jobs (FRED chart).
Manufacturing workers in the economy: The point behind bashing Mexico and China on trade was the disappearance of manufacturing jobs, which tend to be well paying. As the chart below shows, these jobs have been in secular decline. Can they come back? (FRED chart)
Capital expenditures: One of the puzzles of this economic expansion has been the tepid pace of capital expenditures. Trump’s proposal of a one-time tax holiday for the repatriation of offshore corporate cash is intended to address this problem. (FRED chart)
Net business births: Net business births is a useful bottom-up derived of economic confidence and business dynamism. Unfortunately, I can’t find any regularly reported statistics of business formation, but I have substituted the NBIB small business confidence index as a proxy (link to NFIB). Small business confidence has soared in the wake of Trump’s electoral win.
However, the rise in optimism has not been matched by any observable increase in small business sales yet. I discussed this disconnect extensively in a previous post (see Main Street bulls vs. Washington bears).
For investors, the question is slightly different. Incidents like the most recent one over objections to the ban on entry of foreign nationals from seven selected Middle East countries can serve to weaken Trump’s Congressional support among Republicans. In that case, it would either make more difficult the task of passing his promised fiscal package of tax cuts, which is a boost that Wall Street desperately wants. In the past, parties with control of the White House and both houses of Congress have struggled with passing legislation.
In conclusion, I urge my readers to cut through the political noise and watch the aforementioned five key indicators of whether Donald Trump can keep his promises to his political base. As well, keep an eye the reaction from Republican members in Congress as a measure of whether the new administration can successfully pass legislation. Then you can either go back to being jubilant (if you are a Trump supporter), or get into a rage (if you are a never-Trumper).
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 direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities
Trend Model signal: Risk-on
Trading model: Bullish (upgrade)
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
It’s not all about Trump
In the past few weeks, market analysis in these pages have been all Trump, all the time. As America`s 45th president assumed his first full week in office, his administration made a number of rookie mistakes that gave the impression of a government in disarray.
Politico reported that many of presidential executive orders were drafted by Trump aides Stephen Miller and Steve Bannon without consultation with the relevant departments or Congress. These actions made the implementation of some aspects of the executive orders difficult, impractical, or possibly illegal. CNBC reported that the Trump aides were leaking stories as a sign of infighting between different factions. Not only that, the Washington Post reported that most of the senior bureaucrats at the State Department, most of whom had served both Democrat and Republican administrations, had resigned en masse, which deprived the department of years of experience in the nuts-and-bolts of foreign policy.
So how did the stock market react to these events? The Dow proceeded to rally above 20,000 to make an all-time high, as did the SPX. This kind of market reaction in the face of negative political news is bullish. Moreover, it showed that investors and traders had turned their focus to the most important metric of equity performance, namely the growth outlook.
Indeed, analysis from Deutsche Bank showed that macro growth surprises have been the biggest driver of equity prices for the last 15 months (via Bloomberg).
The reflation trade continues
It’s earnings season, and the market is turning its focus to the earnings growth outlook. I had an inkling that Q4 earnings season was going to come in reasonably well when Thomson-Reuters observed that there were an unusually low number of negative Q4 pre-announcements:
The more positive outlook by analysts is also supported by Q4 guidance with a negative to positive ratio of 2.0, which is more positive than the long-term (since 1995) historical average of 2.7.
The latest update from John Butters of Factset shows that, with 34% of the SP 500 having reported, the earnings and sales beat rates were roughly in line with their 5-year historical averages. Despite these slightly below par beat rate readings , they improved substantially from last week’s reports. More importantly for future stock performance, the Q1 guidance rate has been upbeat when compared to its history, and forward 12-month EPS continued to rise.
Other cyclical indicators, such as the Chemical Activity Barometer that is a leading indicator of industrial production, were showing signs of strength (via Calculated Risk).
Even the Q4 GDP report turned out to be a solid result despite missing Street expectations. Much of the shortfall could be attributed to the rising USD during that period.
New Deal democrat was particularly impressed with the trend in proprietors’ income (blue line), which is a more timely proxy for corporate profits (red line):
This tells us that domestic US businesses with little exposure to foreign exchange issues continue to improve their top lines. Now that the strong 2015 US$ has disspiated, he likelihood is that corporate profits will follow. Needless to say, this is a positive for the next 12 months.
I wrote last week that I was seeing signs of a global reflationary rebound from equity and commodity prices (see Global market rally = Dow 20K). Jurrien Timmer at Fidelity Investments also saw a similar trend of a synchronized global recovery.
Is it any wonder the markets adopted a risk-on stance? The New York Fed found that there was a dramatic turnaround in Republican voters as to their outlook for the economy and stock prices. The chart below shows the net change in expectations that stock prices would be higher after the election, sorted by political leaning. While the Republicans show much greater optimism, expectations from Democrats are lower but still positive.
This evidence of the reawakening of “animal spirits” raises the odds of a market melt-up in 2017 (see my post last week Could “animal spirits” spark a market blow-off?). This chart from Jeffrey Kleintop at Charles Schwab shows that individual investors have shown a habit of chasing returns. As equity returns start to improve, watch for the equity stampede to begin.
Breakout or fake out?
Still, I have this nagging feeling that we may be seeing a false upside breakout and what we are seeing is a bull trap. Jeff Hirsch of Almanac Trader found that stock prices tend to make a short term peak in early February in the first year of a new presidential term, followed by a correction into March. This seasonal analysis suggests that the market high window will occur some time next week.
This chart from Dwaine van Vuuren of Recession Alert (via Jeff Miller) shows that the readings of weekly leading indicators are at extreme level. Could these signs of macro improvements be as good as they get?
The same could be said of the Citigroup US Economic Surprise Index, which measures whether economic releases are beating or missing expectations (annotations are mine).
In addition, the wildly bullish tone of Barron’s front page and lead story flashed a contrarian sell signal.
As well, the latest update of insider activity from Barron’s shows that this group of informed investors were not showing confidence in the market. To be sure, the last episode of high insider selling resolved itself in a sideways market with little upside.
By contrast, Mark Hulbert highlighted an insider study by Nejat Seyhun, which eliminates trading activity by large holders of stock, that came to a bullish conclusion.
What are to make of these conflicting conditions? Are we seeing an honest to goodness upside breakout that will take stock prices to further new highs, or is this a fake out, which will be followed by a February correction? I have no idea. Sometimes you are faced with two contrary scenarios, they defy analysis, and you have to be open to all outcomes.
Who knows, maybe mommy really is a superhero.
The week ahead
Here are some of the signs that I am monitoring in the week ahead. Market internals of risk appetite are holding up well so far. Any breaches of these relative uptrends would be a signal of the start of a correction.
The behavior of high yield, or junk, bonds is also confirming the narrative of a rising risk appetite. Similarly, I am watching for negative divergences, which have not occurred so far.
The SPX broke out to new highs early last week and the index has consolidated sideways. It would be no surprise to see it pull back to test the breakout level at 2280. Should stock prices race ahead and melt up, I am watching if the VIX Index (bottom panel) breaks down through its lower Bollinger Band. Such episodes have typically marked overbought conditions and short-term tops.
I am also monitoring the copper/gold ratio for signs of faltering macro momentum. This ratio is important as copper has both cyclical and hard asset characteristics, compared to gold, which is mostly a hard asset play. Should this ratio roll over, then it will be a real-time signal of faltering macro growth momentum.
My inner investor remains bullishly positioned. My inner trader covered his short SPX position last week and nervously went long the market.
I have had a number of discussions with subscribers asking for more “how to” posts (see Teaching my readers how to fish). This will be one of a series of occasional posts on how to build a robust investment process.
For traders and investors, one of the challenges is how to build a robust discipline that works well through different market regimes. As a case study, consider this study from Simple Stock Model that generates signals based on the cash flows in and out of the SPY ETF as a sentiment signal. The trading rule is: “If the 4-week average of the 3-month change in SPY’s percentage of shares outstanding is greater than +5%, be out of the market.”
The chart below shows the equity curve from this trading system (white line = buy and hold, blue line = trading system). The results look pretty good, especially for a relatively low turnover model. (Incidentally, it’s on a sell signal right now).
SPY shares outstanding trading system
Not so fast! Don’t jump to conclusions before digging into the data and reading the fine print.
One big call
If you look at the details of the equity curve, you will see that the trading system made its money by avoiding the devastating bear market of 2008-09, but the market kept rising when it flash its other “sell” signals. If we were to restart the equity curve from the time this trading system flashed the all-clear buy signal after the 2008-09 bear market, it underperformed its buy-and-hold benchmark.
This is the first lesson. Evaluate the success rate, or batting average, of any trading system to see if the results are acceptable. In some cases, you may decide that a system with a low success rate with outsized gains is acceptable – just be aware of its characteristics and manage your risk properly.
Asymmetric signals
This trading model is a sentiment model and I used it as an example to illustrate another point. The market response to model readings don’t always behave the same way at buy and sell extremes. Model signals can be asymmetric, especially for sentiment models.
Consider this chart of NAAIM exposure, which measures the sentiment of professional RIAs. In this example, I have arbitrarily set the trading rule to buy when the NAAIM exposure falls below 20 and to sell when it rises above 95. The “buy” signals are marked with blue vertical lines and the “sell” signals are marked with red lines. As the chart shows, the “buy” signals have tended to be pretty good, as they have tended to mark panic market bottoms. On the other hand, “sell” signals, which indicate complacency, have been less than effective.
As these are backtested results, it could be argued that when I set the buy and sell signals at 20 and 95 respectively, I was torturing the data until it talked. As an alternative, I set the buy and sell signals when the NAAIM exposure reading penetrated its 2 standard deviation Bollinger Band with a one-year moving average. The conclusions are similar. Buy signals work much better than sell signals.
That is the second lesson. Measure the effectiveness of both your buy and sell signals. They may not be the same.
In a post next week, I will address some the issues that face the professional and institutional investor.
Mid-week market update: Since the time I issued a correction warning in late December (see A correction on the horizon?), the US equity market has traded sideways in a narrow range. Moreover, the SPX has alternated between a seesaw up-and-down pattern since early January – until today.
As the SPX breaks upwards to a new all-time high, and the DJIA breaches the psychologically important 20,000 mark, it’s hard to argue with price and momentum.
Overbought and vulnerable markets can correct in two ways. It can correct through price, with lower prices, or through time, with a sideways consolidation. The latter scenario is often accompanied by an internal rolling correction characterized by weakness in market leaders and nascent strength from laggards, which seems to be what has happened (see The contrarian message from rotation analysis).
The turmoil beneath the surface
Even as the stock market traded sideways for most of January, an anomaly began to develop in the option market. The VIX Index, which is a measure of index volatility, fell as expected, but SKEW rise dramatically (chart via Bloomberg). In other words, the cost of hedging a tail-risk event such as a market crash rose dramatically even as stock prices flattened and volatility fell. In fact, tail-risk fear is at levels not see since the correction last June, which stock prices actually fell.
What gives? Has the market been that nervous about the Trump administration? If so, shouldn’t the VIX Index be rising in anticipation of heightened market volatility? Who is right? The VIX or the SKEW Index?
It turns out that there are perfectly reasonable explanations for the low level of the VIX Index. As this chart of implied (orange line) and historical (blue line) volatility from iVolatility shows, historical, or realized, vol has been falling and therefore it is no surprise that implied vols have followed suit.
In addition, Julian Emanuel of UBS pointed out that the correlation between stocks have been falling since the election. Lower correlations between stocks create a greater diversification effect, which leads to lower index volatility and lower realized historical volatility. In addition, lower correlations can create the sorts of conditions where rolling corrections can occur, which is precisely what seems to have happened.
I have been wrong before and I am wrong now, as Mrs. Humble Student of the Markets have pointed out to me on numerous occasions. I mis-interpreted the rolling corrections, where cyclical sectors weakened and defensive sectors began to outperform as signs of weakening internals (see The contrarian message from rotation analysis). Instead, they turned out to be a healthy rolling correction.
Markets are breaking out
In the meantime, the markets have staged a broad based rally. The chart below shows that the DJ World Index has risen to new highs, just like the SPX. Even though the European averages have not rallied to new highs, they are displaying signs of strength.
Similarly, the Asian markets of China and her major trading partners are all well above their 50 day moving averages.
The cyclically sensitive industrial metals are also in a healthy uptrend.
What’s not to like?
Key risks
One of the key risks is this rally could turn out to be a bull trap. Ryan Detrick of LPL Financial observed that the market tends to rally after Inauguration Day, with a peak in early February. Could history repeat itself?
In addition, this chart from Trade Followers shows that Twitter breadth remains weak, which does not exactly inspire a great deal of confidence in the current upside breakout.
My inner trader has changed from a small SPX short position to a small long SPX position with a tight stop (don’t ask me how tight, because my pain threshold will be different from yours). Should the market rally further and VIX Index breach its lower Bollinger Band, that will be an overbought signal to realize profits and take some chips off the table.
Now that the Trump team has moved into the West Wing of the White House, investors still one big Trump policy question mark that overhang the market. Who will Trump appoint to the two vacant governor seats at the Federal Reserve?
CNBC reported that David Nason is a leading contender for a board seat, but he is rumored to be considered for a regulatory role. Such an appointment gives us no hints about the likely future direction of monetary policy and who might replace Janet Yellen, should Trump choose not to re-appoint her as Fed chair in 2018.
Bloomberg reported that the latest rumor mill has the leading candidates for Fed chair, namely Glenn Hubbard, John Taylor, and Kevin Warsh, advocating a tighter monetary policy than the current Fed:
Potential candidates to head the Federal Reserve in 2018 suggested that monetary policy would be tighter if they were in charge.
Speaking at the annual American Economic Association meeting that ended Sunday, Glenn Hubbard of Columbia University, along with Stanford University’s John Taylor and Kevin Warsh, criticized the central bank for trying to do too much to help an economy struggling with problems that monetary policy can’t solve.
“The Federal Reserve is a little behind the curve” in raising interest rates, Taylor, a Treasury undersecretary for international affairs under the last Republican president, said Saturday during a panel discussion in Chicago.
Hubbard, who headed the Council of Economic Advisers under Bush, said he agreed with what he perceives as Trump’s stance that the U.S. has depended too much on the Fed to support the economy in recent years.
Is that what Trump really wants? There is a battle going on for the hearts and minds of the Federal Reserve. The outcome will have profound implications for the direction of monetary policy, the likely trajectory of economic growth for President Trump’s next four years, and the stock market.
War at the Fed
Current members of the FOMC have pushed back against proposals by the hard money crowd to impose a rules based approach to setting interest rates. Neel Kashkari, president of the Minneapolis Fed, shot back that using a Taylor Rule to set interest rates would have kept millions out of work:
In December, I wrote an op-ed in the Wall Street Journal explaining that forcing the Federal Open Market Committee (FOMC) to mechanically follow a rule, such as the Taylor rule, to set interest rates can cause tremendous harm to the economy and the American people. My staff at the Minneapolis Fed estimates that if the FOMC had followed the Taylor rule over the past five years, 2.5 million more Americans would be out of work today. That’s enough to fill the seats at all 31 NFL stadiums simultaneously, almost 6,000 more people out of work in every congressional district.
To sum up, simple policy rules can serve as useful benchmarks to help assess how monetary policy should be adjusted over time. However, their prescriptions must be interpreted carefully, both because estimates of some of their key inputs can vary significantly and because the rules often do not take into account important considerations and information pertaining to the outlook. For these reasons, the rules should not be followed mechanically, since doing so could have adverse consequences for the economy.
Hawkish Fed = USD bullish
Everything else being equal, a hawkish Fed would tend to put greater upward pressure on the US Dollar, which would be contrary to Trump’s trade policy objectives. I pointed out that Trump had already expressed his preference for a weak USD (see Weaken the USD to Make America Great Again). Therefore it makes no sense for him to appoint a hard money economist to be Fed chair and steer monetary policy.
If the Trump administration were to turn away from the likes of John Taylor, who would be a more likely Fed chair? For this exercise, let`s peg the Yellen Fed`s monetary policy as the neutral position. Janet Yellen has said that she expects to continue raising rates in 2017. In a January 18, 2017 speech, Janet Yellen made it clear that her dovish tilt has limits.
In a nutshell, the Fed’s goal is to promote financial conditions conducive to maximum employment and price stability. And I have offered broad-brush definitions of each of those objectives. So where is the economy now, in relationship to them? The short answer is, we think it’s close…
Nevertheless, as the economy approaches our objectives, it makes sense to gradually reduce the level of monetary policy support. Changes in monetary policy take time to work their way into the economy. Waiting too long to begin moving toward the neutral rate could risk a nasty surprise down the road–either too much inflation, financial instability, or both. In that scenario, we could be forced to raise interest rates rapidly, which in turn could push the economy into a new recession.
She expects to raise rates “a few times a year” until the end of 2019, when Fed Funds gets to the neutral rate of 3%:
Now, many of you would love to know exactly when the next rate increase is coming and how high rates will rise. The simple truth is, I can’t tell you because it will depend on how the economy actually evolves over coming months. The economy is vast and vastly complex, and its path can take surprising twists and turns. What I can tell you is what we expect–along with a very large caveat that our interest rate expectations will change as our outlook for the economy changes. That said, as of last month, I and most of my colleagues–the other members of the Fed Board in Washington and the presidents of the 12 regional Federal Reserve Banks–were expecting to increase our federal funds rate target a few times a year until, by the end of 2019, it is close to our estimate of its longer-run neutral rate of 3 percent.
Forgive me if I am parsing this incorrectly, but if “a couple” is two, then doesn’t “a few” mean more than two? It sounds like Yellen is signaling that she expects at least three rate hikes in 2017. Indeed, Bloomberg reported that former Fed governor Laurence Meyers deduced that Yellen is forecasting three rate hikes on the “dot plot” for 2017:
Meyer is playing a game of elimination popular among investors and economists that revolves around the so-called dot plot. That’s a graphic layout that the Fed publishes every three months to show where policy makers think interest rates should go if their forecasts for the economy prove accurate. The quarterly rate projections don’t identify the author of each forecast, which is represented by a dot on a chart…
Atlanta Fed President Dennis Lockhart told reporters on Jan. 9 that he had forecast two hikes this year. His Chicago counterpart Charles Evans suggested he’s also looking at two, saying on Jan. 6 that a couple of moves were “not an unreasonable expectation.” Next, Governor Daniel Tarullo, who in the past has advocated a decidedly cautious approach to raising rates, also got ranked at two hikes by several economists.
With a single two-hiker remaining, there is one more firm clue: In December, in the run-up to the FOMC meeting, the board of directors at the Minneapolis Fed was alone among the regional banks when it voted against increasing the so-called discount rate, which establishes interest rates for direct loans from the Fed. They did so to support the labor market and allow inflation to rise, according to minutes published on Jan. 10.
A reserve bank’s position on the discount rate typically reflects its president’s view with respect to the benchmark federal funds rate, suggesting Minneapolis Fed President Neel Kashkari isn’t hawkish enough to forecast more than two hikes this year on the dot plot.
If that’s correct, Yellen and New York Fed President William Dudley are among the six policy makers forecasting three hikes in 2017.
Wow! Three 2017 rate hikes for a reputed dove like Janet Yellen. Trump won’t like that!
Even doves have limits
What about Lael Brainard? Even though Brainard supported Hillary Clinton in the election and was rumored to be in the running for the post of Treasury Secretary in a Clinton administration, could the ȕber-dove Lael Brainard be a candidate for Fed chair?
In a recent speech made on January 17, 2017, Brainard made it clear that even doves have limits when faced with an expansionary fiscal policy. Fiscal policy that provide only a temporary boost to demand (read: tax cuts) spur inflation, especially when the economy is running near capacity, as it is now:
Focusing first on policies that affect only aggregate demand, temporary demand-based fiscal expansions can speed recovery when the economy is some distance from full employment and target inflation, particularly if conventional monetary policy is constrained by the effective lower bound. But when the economy is either close to or at full employment and inflation is converging to or at its target, additional fiscal demand will more likely result in inflationary pressures. Thus, fiscal expansions that affect only aggregate demand and are enacted when the economy is near full employment and 2 percent inflation are relatively less likely to sustainably boost economic activity and relatively more likely to be accompanied by increases in interest rates.
These kinds of fiscal policies are actually counterproductive, as the government has to incur debt without a corresponding boost to long-term growth. In addition, the Fed is weakened because it has little ammunition to fight the next downturn:
Policies that persistently raise aggregate demand alone can lift the neutral rate, but that may come at substantial cost. Because these policies do not affect the economy’s long-term growth potential but do result in persistent fiscal deficits, they can lead to substantial increases in the debt-to-GDP ratio. The greater space for monetary policy to respond to adverse shocks provided by a higher neutral rate comes at the expense of reducing the space for fiscal policy to stabilize the economy in the event of future adverse shocks.
At the end of her speech, she did sound a dovish tone by giving a nod to her thesis that the Fed has to consider the global implications of its policy:
Against this uncertain backdrop, monetary policy will continue to be guided by actual and expected progress toward our goals, the level of the neutral rate, and the balance of risks. A gradual approach will remain appropriate as long as inflationary pressures remain muted, the economy remains short of our objectives, the neutral rate remains low, and downside risks from abroad remain, although this will depend on the fiscal trajectory, as it evolves, and its uncertain effects on the economy and financial markets.
Will that be enough for Trump looking for a dovish Fed chair? Probably not.
The rise of inflation
Regardless of who Trump appoints to the Federal Reserve’s board of governors, or to next Fed chair, the inescapable fact is inflation is rising. As one of the Federal Reserve’s mandate is to fight inflation, monetary policy will become tighter. This chart from Callum Thomas of Top Down Charts shows that not only are the inflationary pressures building, they are global in nature.
Indeed, BIS recently put out a paper entitled The globalisation of inflation: the growing importance of global value chains. The authors concluded that the globalization of manufacturing has also globalized inflation dynamics, which makes it more difficult for central banks to control inflation locally. The conclusions of this paper is supportive of Lael Brainard’s thesis that the Fed needs to pay greater attention to the global effects of US monetary policy. Here is the abstract of the BIS paper:
Greater international economic interconnectedness over recent decades has been changing inflation dynamics. This paper presents evidence that the expansion of global value chains (GVCs), ie cross-border trade in intermediate goods and services, is an important channel through which global economic slack influences domestic inflation. In particular, we document the extent to which the growth in GVCs explains the established empirical correlation between global economic slack and national inflation rates, both across countries and over time. Accounting for the role of GVCs, we also find that the conventional trade-based measures of openness used in previous studies are poor proxies for this transmission channel. The results support the hypothesis that as GVCs expand, direct and indirect competition among economies increases, making domestic inflation more sensitive to the global output gap. This can affect the trade-offs that central banks face when managing inflation.
Kyle Bass believes that financial markets are at the beginning of a major tectonic shift towards inflation from deflation:
Texan hedge fund manager J. Kyle Bass, the founder of Hayman Capital, says that global markets are at the “beginning of a tectonic shift.”
“Today, global markets are at the beginning of a tectonic shift from deflationary expectations to reflationary expectations. What happens to economies at maximum leverage when interest rates begin to rise? Reconciling the potent strengths of the world’s largest economies with their inherent weaknesses has revealed various investable anomalies. The enormity of the apparent disequilibrium is breathtaking, making today a tremendous time to invest,” Bass wrote in a year-end letter to investors seen by Yahoo Finance.
If Trump wants a dovish Fed, and if he decides to pack the board with like minded appointees who are willing to tilt towards an easier monetary policy (and therefore a weaker USD), a major war will likely erupt within the FOMC on policy, especially when well-known doves like Brainard and Yellen have become more hawkish.
Three steps and a stumble?
Under the scenario I outlined, the three steps and a stumble rule, where the market tops or corrects after three consecutive rate hikes, will inevitably come into play. But it’s probably too early too panic. Jim Paulsen of Wells Capital Management observed that equity markets typically don’t pull back in the face of rising yields until market psychology changes from disinflation to inflation:
Charts 5 and 6 illustrate how important the relationship portrayed by this correlation has been for stocks in recent years and when the recent rise in bond yields might finally cause a correction in the stock market. Specifically, it suggest the stock market may continue to rise despite higher yields until the correlation switches from positive to negative. That is, higher interest rates may not restrain the stock market until the primary investor anxiety shifts from deflation to inflation.
As shown, since the late-1990s, the stock market has suffered either a correction or a bear market each time the stock-bond correlation has declined below zero (i.e., each time investor mindsets have switched from deflation to inflation concerns). The 2000 collapse occurred after the correlation turned negative in late-1999, the 2007-2008 collapse happened after the correlation dropped below zero in the second half of 2006 and the correlation again fell below zero at the end of 2013 followed by two separate 10% corrections and an essentially flat stock market during the ensuing couple years.
The risk stock investors face in 2017 from rising bond yields may have less to do with how much they rise or how high they are, as it does with the surrounding attitude of investors concerning inflation/deflation as yields rise. Currently, the consensus investor mindset is viewing the recent rise in yields as a positive for the economy and the stock market (as suggested by a strong positive correlation in the last year from Chart 5). Fears of deflation and anxieties surrounding another potential crisis are diminishing as commodity prices recover, as U.S. and global economic growth improve, as the Federal Reserve finally begins to normalize monetary policy and as the interest rate structure around the globe moves back above zero.
It sounds like that “three steps and a stumble” is a late 2017 investment story. Tactically, I would hesitate about getting overly defensive just yet. The bond market is currently poised for a counter-trend rally as large speculator, or hedge funds, remain in a crowded short in both the 10-year note and the long bond (chart via Hedgopia).
Bloomberg also pointed out that while the fast money, or hedge funds, are in a crowded long in the bond market, the patient and big money institutions are extremely long. In the end, big money fund flows have tended to overwhelm the fast money.
Leveraged funds that use borrowed money to boost returns see even more losses ahead. As of Jan. 10, their short positions — futures that pay off if five-year notes lose value — exceeded longs by a record 1.1 million contracts, data compiled by the U.S. Commodity Futures Trading Commission show.
While it’s been the winning strategy over the past several months, institutional buyers are undaunted. Not only did they boost their long positions for five-year notes to an all-time high this month, but they’ve also stepped up bullish bets on 10- and 30-year Treasuries as well. (Most recent data as of Jan. 17 showed a slight pullback in both institutional net longs and leveraged net shorts.)
When real-money investors do go all-in, they tend to overwhelm the fast-money crowd because of their sheer size.
In the end, “real money always wins,” said Tom di Galoma, the managing director of government trading and strategy at Seaport Global Holdings. “Speculators tend to get taken out. We’ve seen this occur several times in the last 10 to 15 years, where everybody thinks rates are too low.”
By all means and enjoy the party, but don’t go overboard and be selective with your risk appetite.
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 direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
Ultimate market timing model: Buy equities
Trend Model signal: Risk-on
Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
Trump’s challenge
Now that Donald Trump is the President of the United States, the real work of his administration begins. In inauguration speech, he invoked the spirit of Horatio Alger as a way to take America to new heights:
Finally, we must think big and dream even bigger. In America, we understand that a nation is only living as long as it is striving…
Do not allow anyone to tell you that it cannot be done. No challenge can match the heart and fight and spirit of America. We will not fail. Our country will thrive and prosper again.
Ray Dalio of Bridgewater Associates was optimistic about this “can-do” attitude of Americans:
This new administration hates weak, unproductive, socialist people and policies, and it admires strong, can-do, profit makers. It wants to, and probably will, shift the environment from one that makes profit makers villains with limited power to one that makes them heroes with significant power.
Despite inheriting an economy that is in the late stages of an expansion, Dalio believes that the incoming president can spark a second wind of growth by reviving the economy’s “animal spirits”:
This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge.
Bob Shiller went further and postulated a speculative stock market blow-off, followed by a crash (via The Telegraph):
America should brace for a final blow-off surge in stock markets akin to the last phase of the dotcom boom or the “Gatsby” years of the Roaring Twenties, followed by a cathartic crash and day of moral judgment, according to a Nobel prize-winning economist.
Prof Robert Shiller said the psychological “narrative” behind Donald Trump is powerful and likely to carry Wall Street to giddy heights before the aging business cycle finally rolls over.
“I think there will be a Trump boom for a while. Stocks look high, but they are not yet super-high. In 2000 the (Cape Shiller) price-earnings ratio was over 45 and we may see a repeat of that,” he told The Daily Telegraph.
For investors, the stakes are high. Under this scenario, a Trump inspired “animal spirits” revival could spur the SPX to its point and figure target of 2523 or more.
The question is, can Trump spark the “animal spirits” to Make America Great Again?
A mature expansion
Despite Trump’s rhetoric about a revival of an America that’s on its knees, he inherits an economy that is growing and in the late stages of an expansion. This chart of initial jobless claims, normalized by population, shows that initial claims are at or near all-time lows.
Unemployment has been falling in the wake of the crisis of 2008, and it is at levels consistent with rising wages and rising inflationary pressures. These are further signs of a late cycle expansion, which is usually followed by the start of a Fed tightening cycle that ends in recession.
In addition, retail sales are robust, but decelerating, which is another indication of a late cycle expansion.
A second wind?
The counterfactual to these rosy economic statistics is the discontent that elected Donald Trump. True, the job picture has improved considerably since 2008, but the quality of jobs haven’t returned. For much of Main Street America, the “animal spirits” in the form of business dynamism has been missing. Economic Innovation Group found that most of the counties that swung from Obama to Trump in the election experienced a decline in business dynamism:
It appears that business closures helped the president-elect poach counties that had voted for President Obama twice before. Of these 209 counties, roughly 75% saw more businesses close than open from 2010 to 2014. It’s important to note that these counties ran the gamut from affluent to distressed; highly educated to below average; overwhelmingly white to majority-minority. In spite of their many differences, a decline in business dynamism is where the vast majority found common ground.
In the wake of Trump’s electoral win, Small business confidence has soared, though we have yet to see the revival in actual sales (see last week’s post Main Street bulls vs. Washington bears).
View through Main Street’s prism, Trump`s triumph has woken the economy’s dormant “animal spirits” out of hibernation.
Economic “animal spirits”
There are other ways of defining “animal spirits”. If we were to think about the idea of “animal spirits” like an economist, we might think of it in the monetary framework of:
MV = PQ
Where M = money supply, V = velocity, P = price, and Q = quantity
In other words, GDP (= Price x Quantity of goods and services) is a function of money supply growth and monetary velocity. While monetary theory held that V is constant over time, that hasn’t been true in practice. As the chart below shows, M1 money supply growth has been positive, which indicates that Fed policy remains acccommodative. However, monetary velocity has been falling dramatically, which has offset the Fed’s stimulus efforts through lower interest rates and several rounds of quantitative easing.
If the economy’s “animal spirits” were to revive, then one sign would be a rise in monetary policy. That hasn’t happened yet, though monetary velocity is a quarterly data series that is slow to update and therefore that data set is reported with a lag.
Investment’ “animal spirits”
If we were to think about “animal spirits” from an investor’s viewpoint, it would be in the form of investor sentiment. As the chart of AAII sentiment shows, weekly readings are volatile and noisy. The 52-week moving average of the bull-bear spread (blue line) shows that long-term investor sentiment remains at depressed levels.
Indeed, this chart of the relative performance of high beta stocks against low-volatility stocks, which were the investment darlings of last year, shows that risk appetite is starting to revive. However, sentiment is nowhere near levels that could be described as frothy or a crowded long.
Recently, Mark Hulbert warned about valuation headwinds for stock prices and argued that stock prices were overvalued on a variety of metrics.
While I don’t necessarily agree with Hulbert’s assessment (see Top-down meets bottom-up: How expensive are stocks?), the one element that has been missing in this market cycle is the presence of excessive bullishness as one of the prerequisites of a market top. If investor “animal spirits” were to revive and we see a blow-off top, then that requirement would be complete.
Animal spirits: The bull case
So where does that leave us? The bull case is based on preliminary evidence of the revival of “animal spirits”. Ed Yardeni is optimistic:
A week after his election victory, I concluded that incoming President Donald Trump could succeed in stimulating economic growth, so I raised my real GDP forecast for 2017 from 2.5% to 3.0%. Since then, I’ve been keeping track of all the signs showing a revival of “animal spirits” in surveys of consumer and business confidence.
His YRI Weekly Leading Index, as well as the ECRI Weekly Index, have been surging.
Jim Paulsen of Wells Capital Management is showing a similar level of cautious optimism. The chart below depicts a composite of investor, small business, and consumer confidence, all of which have surged to new cycle highs.
Paulsen went on to ask if investors are positioned for the next possible upleg:
Indeed, both investor and business confidence have probably spurted to unsustainable levels recently. Although both may decline somewhat again, given the impressive confluence of factors (shown above) which have recently formed to provide a foundation for this renewed optimism, it seems possible that overall private player confidence might remain much stronger during the balance of this recovery.
Investors may want to ruminate a bit on whether they are prepared and positioned for a potential second “confidence driven leg” to this economic and financial market recovery?
Animal spirits: The bear case
The bear case is based on the assertion that much of the factors behind the “animal spirits” consist of mostly smoke and mirrors.
Consider, for example, Ed Yardeni’s observation of a rise in growth expectations. As the chart below of forward 12-month EPS from Factset shows, investors need to distinguish between the cyclical effect of a growth revival, and the “animal spirits” effect. Forward EPS had already been rising well before the election, so what we are observing might be a cyclical effect, rather than a second wind of growth based on improving business dynamism.
As for Trump’s claims of bringing jobs back to America, Josh Brown observed that corporate executives have learned to play the game:
Either before or after the tweet is sent about your company, you make a trip to Trump Tower on Fifth Avenue or to Mar-a-Lago (which will be the new combination White House / Camp David, by the way) and you parade ostentatiously before the bank of TV cameras. “Look at me! I’m down with the President’s agenda!”
Then a half hour later, you come down the golden elevator with the man himself, who holds an impromptu Q&A with you, as part of his end of the deal. Announcements of new jobs are made. New factories. New initiatives that will be undertaken, ASAP. Then he goes back up in his golden elevator for the next meeting and you get another 10 minutes of face time with the news crews. You grin optimistically, knowing that you and your company are off the Twitter shit list for awhile.
Mission accomplished.
It’s an old playbook, imported from the east. More on that in a moment.
One of the obvious things going on here, at least to the business world, is that much of this is just another reality show. There’s truth to these corporate pronouncements, but there’s plenty of artifice as well. It’s a pageant of sorts, designed for the consumption of the masses. To which I’d say, so what? If it gets the job done, let the man put on his show. Just don’t get overly excited about any sort of national transformation.
Business goes on as before. It really is all smoke and mirrors.
Resolving the bull and bear cases
So what’s the answer? Can Donald Trump spark the “animal spirits” in the economy? The jury is still out. Here are some observations from Avondale’s company notes:
The optimism is palpable
“The optimism for positive change here at Bank of America and among our customers is palpable and has driven bank stock prices higher. We will have to see how these topics play out, but we are optimistic.” —Bank of America CEO Brian Moynihan (Bank)
There’s a lot of optimism but not a lot of action
“there’s more optimism and positive commentary for a lot of our business customers. But we haven’t seen a significant change in utilization or actually take down of credit yet. So while the talk is there, the actual action is not yet shown itself.” —US Bank COO Andy Cecere (Bank)
“What I’m cautious about is nothing has actually happened yet, other than there has been a move in rates, right, and it changes sentiment. And I think we need to start seeing some of confirmations get through. We need to see real progress on tax reform. We need to see real progress on infrastructure, spending bills of state and local, and then all of a sudden, this thing takes flight, but right now, it’s just people talking about it.” —PNC CFO Rob Reilly (Bank)
For the last word, I conclude with a CNBC interview with Ray Dalio. Notwithstanding his tremendous optimism about the “can-do” attitude of Americans, Dalio believes that the market had largely discounted the obvious changes, such as the Trump tax cuts. Now there are more questions than answers with regards to policy implementation, such as how Trump’s fiscal plan gets turned into legislation, as well as geopolitical questions like as Sino-American relations.
In the coming weeks, we will undoubtedly see some of the bumps in the road that will create uncertainty, raise the risk premium, and spook the markets. The latest BAML Fund Managers Survey shows that fund managers are deathly afraid of a protectionist backlash, or US policy error (annotations in red are mine).
Indeed, assertive language like this on trade on the White House website will undoubtedly unnerve investors:
President Trump is committed to renegotiating NAFTA. If our partners refuse a renegotiation that gives American workers a fair deal, then the President will give notice of the United States’ intent to withdraw from NAFTA.
In addition to rejecting and reworking failed trade deals, the United States will crack down on those nations that violate trade agreements and harm American workers in the process. The President will direct the Commerce Secretary to identify all trade violations and to use every tool at the federal government’s disposal to end these abuses.
We will see next week how much of these fears have been discounted by the market.
The week ahead
Looking to the week ahead, the stock market will face its first test under a Trump administration. At a minimum, can it at least conform to the inauguration pattern as outlined by Alpha Hat (via Business Insider)? Historically, the market typically rallies for about two weeks after inauguration, followed by a February correction. Longer term, however, Republicans president markets have tended to underperform.
The market action on Friday did not give any strong clues. The hourly chart of the SPY shows that the market broke down through and uptrend on Thursday, but rallied to (barely) regain the trend line. At this point, it’s unclear whether the breakdown below the trend line was a false break.
My inner investor remains long the market. His base case scenario calls for a shallow correction in Q1, followed by a rally later in the year. Market internals appear to be setting up for a period of sideways consolidation or pullback (see The contrarian message from rotation analysis).
My inner trader still has a small short position in the market, but he will close that short should the market break out to new highs.
About a month ago (see The bear case: How Trumponomics keeps me awake at night), I highlighted a Bloomberg interview with BAML currency strategist David Woo. Woo pointed that there is an inherent contradiction in a couple of Trump’s policies. His fiscal policy of tax cuts is pro-growth and therefore USD bullish, but his “America first” trade policy needs a weaker dollar. So what does he really want, a strong dollar, or a weak dollar?
We may have an answer. In a recent WSJ interview, Trump said that the dollar is “too strong”, especially considering the China’s yuan is “dropping like a rock.” While those remarks were made in the context of Sino-American trade relations, Trump signaled that, if he had to choose, he would prioritize a weaker currency over fiscal stimulus.
Trump`s priorities of trade policy over fiscal policy is consistent with his criticism of the House Republican border tax adjustment plan as “too complicated“ (via WSJ). Already, the spectacle of passing a fiscal budget, even with Republican control of the White House, the Senate, and the House, is turning into a public “sausage making“ exercise.
A strategy of USD weakness makes more sense for Trump if he wants to achieve his trade policy objectives. As Larry Summers pointed out, Trump’s populist message of attacking trading partners like Mexico has the unintended effect of depressing the Mexican Peso. A lower MXNUSD exchange rate paradoxically incentivizes companies to move production south of the Rio Grande (via AP and Business Insider):
Summers told a panel at the World Economic Forum on Wednesday that the president-elect’s “rhetoric and announced policies” over Mexico have led to a big fall in the value of the Mexican peso against the dollar.
That, he said, is a “dagger at Ohio,” as it will make it even more attractive for firms to move to Mexico.
How to weaken the USD
Bloomberg featured an article that outlined several options that the US government could employ to weaken its currency, along with the pros and cons of each approach.
A couple of previous notable Republican Presidents have been responsible for currency intervention, as seen in this handy chart.
Should the Trump administration want to go down this path, I believe that the Plaza Accord may be the best template for crafting an agreement to weaken the USD. Trump`s threats of protectionist measures may be enough for other major trade blocs to agree to weaken the USD in the manner of the Plaza Accord of 1985.
USD bear = Gold bull
That brings me to another point. Should the Trump administration succeed in crafting another Plaza Accord, a weak greenback would be gold bullish. The chart below depicts the price of gold (blue line) and the trade weighted USD (red line, inverted scale), along with the major interventions shown in the previous chart. Should an agreement be reached to weaken the dollar, then historically that has marked the beginning of a major gold bull.
At this point, such a scenario is highly speculative. However, investors should be prepared for such an eventuality and its investment consequences, should it ever occur.
Mid-week market update: Occasionally, it is useful to step back and view the market through a different prism. I was reviewing the RRG charts of sector, region, and factor, and I found that they are all telling a similar story.
First, let’s start with a primer. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
The latest sector rotation chart shows that financial stocks and cyclical stocks (energy, industrials, materials) are the leading groups, but they are weakening. By contrast, defensive sectors are starting to improve from the lagging quadrant to improving. In particular, the upgrade of interest sensitive utilities from lagging to improving quadrant is consistent with the nascent counter-trend rally seen in the bond market.
In short, high beta is faltering and defensive sectors are starting to turn up.
Confirmation from Europe
The trend of waning risk appetite appears to be global in nature. We can see a similar pattern in the RRG chart of European sectors. The main difference between the US and European RRG charts is the behavior of the materials sector. The European basic materials sector has already deteriorated into the weakening quadrant, whereas US materials remain in the top right leading category.
Style rotation: Too far too fast?
The message from style rotation of US equities also tells a similar story. High beta groups are ascendant, but starting to weaken. The value style, which had been on a tear, is also starting to roll over in relative strength. By contrast, out of favor styles such as dividend payers, as well as growth and momentum (think FANG), are starting to turn up.
Global regions: Buy Europe and Asia
A glance at regional and country rotation tells a story of cyclical factors starting to roll over. The leadership countries are Russia and Canada (oil), and the US. Europe appears to be a source of emerging strength, while Asian markets are lagging, but starting to improve. Tactically, traders may wish to consider selling their cyclical exposure and start to add exposure to Europe and Asia.
From a top-down macro perspective, even though Citigroup’s Economic Surprise Index have been surging, the market believes that the pace of improvement is probably unsustainable (h/t Topdown Charts).
Be contrarian
From an absolute return viewpoint, the de-risking pattern from the RRG charts suggests that US equities are likely to undergo a period of sideways action, or mild pullback for the remainder of Q1.
In addition, the message from group rotation analysis is a cyclical rally that is starting to stall. Better performance may be found in some of the laggards, such as emerging leadership groups like interest sensitives (utilities, bond market), or European equities (in the face of anxieties over Brexit and upcoming elections in France and Germany). As well, traders may also want to consider beaten up and out of favor groups, such as growth and momentum stocks, as well as Asian equities.
In other words, be contrarian. This view is confirmed by the latest results in the BAML Fund Manager Survey (annotations in red are mine).
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