Main Street bulls vs. Washington bears

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

Bifurcated opinions

Opinions are starting to split badly on the market and the economy. Main Street has become more upbeat on the economic outlook. The NFIB small business survey showed that optimism surged in December, though Renaissance Macro pointed out that optimism has not translated yet into a significant upswing in sales growth.

 

The preliminary January report of UMich consumer confidence shows that it is elevated, though opinions are reportedly split along political lines:

The post-election surge in optimism was accompanied by an unprecedented degree of both positive and negative concerns about the incoming administration spontaneously mentioned when asked about economic news. The importance of government policies and partisanship has sharply risen over the past half century. From 1960 to 2000, the combined average of positive and negative references to government policies was just 6%; during the past six years, this proportion averaged 20%, and rose to new peaks in early January, with positive and negative references totaling 44%.

Chart via Calculated Risk:

 

By contrast, I am seeing signs of doubt from political circles that Trump will be successful with his pro-growth agenda, even among Republicans. Traditional approaches to sentiment analysis states that the public tends to be slow. When the public finally latches onto an economic theme, it is indicative of a contrarian top (or bottom). On the other hand, the improvement in business and consumer confidence can be signals of broad based economic strength.

So who is right? Main Street, or Washington?

The stakes are high

Here is what’s at stake for equity investors. As we enter earnings season, Factset shows that forward EPS continues to rise, which is indicative of Street expectations of broad based cyclical strength.

 

However, broad based cyclical upturn can only get you so far. This Factset chart also shows that forward P/E ratio is elevated and expensive compared to its own history. Current forward P/E is based on bottom-up derived earnings based only analyst expectations of economic conditions without the Trump fiscal plan. That’s because you can’t make estimates when you don’t have the details of the proposals. A top-down analysis suggests that the Trump tax cuts could add roughly 10% to forward earnings, which would bring down the forward P/E ratio to more reasonable levels (annotations are mine).

 

To rephrase my previous question: Who is right about the expectations for the Trump tax cuts? Main Street or Washington?

Republican skepticism

When Donald Trump takes his oath of office, he will be entering the White House with an unusually high unfavorability rating for an incoming president. It is therefore no surprise that consumer confidence is bifurcated and there is skepticism from Democrats that he will be able to implement all of the policies that he promised on the campaign trail.

 

I was surprised that skepticism is also coming from die hard Republicans. Bloomberg report that Republican governor of Kansas, Sam Brownback, had words of caution for the incoming president:

The governor of Kansas has some wisdom for Donald Trump, from one Republican tax-cutter to another: The reductions may take longer than expected to give the economy a sustained lift.

Like President-elect Trump, who said on the campaign trail that slashing taxes would jump-start growth, Sam Brownback in 2012 said steep cuts to personal income and small-business taxes in the Midwest state would provide the economy a“shot of adrenaline.” What followed wasn’t the promised jolt. The shortfall in revenue has instead forced the government to curtail spending on everything from health care to higher education.

John Mauldin, market analyst and staunch Republican from Texas, described himself as “skeptically optimistic” about the new regime. Passing legislation is never easy. Seemingly straightforward proposals can get delayed, watered down, or simply fall apart:

I’m told the Republicans have a long list of relatively uncontroversial (at least on their side of the aisle) bills that they can pass very quickly. They want to show progress, and they think quick passage of some popular measures will buy them credibility to use later. I expect an initial burst of activity after January 20, probably followed by a lull as the Congress moves into more contentious issues like Social Security and healthcare reform. Things will keep happening, but we may not see as many votes.

The hard part is getting agreement on the big items like taxes and healthcare reform. I love seeing Trump and Pence and Ryan and McConnell and all the guys holding hands and acting as if they’re all ready to walk into the bright new future together, but the reality is that there are some quite different ideas in Washington about what serious reforms should look like, and a lot of congressmen want to put their personal stamp on the final bills.

The reform effort could fall apart for various reasons. The Senate majority is narrow enough that just a handful of GOP defectors will be able to stop any given bill, assuming Democrats stay united in opposition. I think Republicans should be on guard against hubris, as well. The decision last week to kick off the year by softening ethics rules was a terrible idea. They accomplished nothing and energized an opposition that was otherwise on its heels.

As an example, this pattern of debt to GDP could give GOP deficit hawks some pause as they consider Trump’s fiscal plan, which is expected to balloon the deficit.

 

Maudlin added that the new administration could get distracted by an unexpected crisis that weakens its ability to pass legislation.

Finally, as I cautioned last week, there is always the chance that some “bolt from the blue” could change everything. An international crisis, a large bank failure, terror attacks – any one of a long list of unforeseeable events could conceivably derail this train. Not to mention the endemic problems of Europe and China, which we will deal with below and which are entirely foreseeable. But if we can get through the first 100 days with this administration, then I think its agenda will have enough momentum to keep rolling.

The latest story that Russian intelligence had compromised Trump is just one of many tests that will face the new administration. The Lawfare blog had a the most balanced perspective that I had seen on this episode.

First, we have no idea if any of these allegations are true. Yes, they are explosive; they are also entirely unsubstantiated, at least to our knowledge, at this stage. For this reason, even now, we are not going to discuss the specific allegations within the document.

Second, while unproven, the allegations are being taken quite seriously. The President and President-elect do not get briefed on material that the intelligence community does not believe to be at least of some credibility. The individual who generated them is apparently a person whose work intelligence professionals take seriously. And at a personal level, we can attest that we have had a lot of conversations with a lot of different people about the material in this document. While nobody has confirmed any of the allegations, both inside government and in the press, it is clear to us that they are the subject of serious attention.

Third, precisely because it is being taken seriously, it is—despite being unproven and, in public anyway, undiscussed—pervasively affecting the broader discussion of Russian hacking of the election. CNN reported that Senator John McCain personally delivered a copy of the document to FBI Director James Comey on December 9th. Consider McCain’s comments about the gravity of the Russian hacking episode at last week’s Armed Services Committee hearing in light of that fact. Likewise, consider Senator Ron Wyden’s questioning of Comey at today’s Senate Intelligence Committee hearing, in which Wyden pushed the FBI Director to release a declassified assessment before January 20th regarding contact between the Trump campaign and the Russian government. (Comey refused to comment on an ongoing investigation.)

Politico reported that, on late Friday after the market close, the Senate Intelligence Committee has opened an investigation into this affair, Even before the Inauguration, this inquiry already has the potential to either distract the Trump team or weaken its apparent authority to pass legislation.

A Trumpian “animal spirits” revival?

Independent of what happens inside the Beltway, the latest NFIB survey represents a boost to economic confidence. Even though small business owners tend be conservative and therefore not reflective of views the general population, Ed Yardeni made some good points on why small business confidence matters:

(1) Small business is big employer. ADP, the payroll processing company, compiles data series on employment in the private sector of the U.S. labor market by company size. At the end of 2016, the shares of employment attributable to small, medium-sized, and large firms were 40.5%, 37.7%, and 21.8%.

(2) Small business drives jobless rate. There has been a very high correlation between “poor sales” reported by small business owners and the national unemployment rate. If Trump succeeds in boosting their sales by cutting personal income tax rates, the jobless rate should remain low.

There is also a high correlation between the earnings of small businesses and the inverse of the poor sales. Trump’s proposed tax cuts would boost their earnings, which are inversely correlated with the national unemployment rate.

Yardeni believes that rising small business confidence is a sign that the economy’s “animal spirits” are stirring, which will serve to drive further growth. Another manifestation of these “animal spirits” can also be found in the recovery in consumer confidence, despite the political bifurcation of opinions.

Investment implications

How should investors resolve this apparent contradiction? Should they be cautious, or bullish?

I interpret these conflicting signals in terms of differing time frames. It turns out that consumer confidence are coincidental indicators (via Bill McBride of Calculated Risk):

Consumer sentiment is a concurrent indicator (not a leading indicator). The survey shows some people are now much more positive than prior to the U.S. election – and others are much more negative.

Luke Kawa also observed that small business confidence is highly correlated with GDP growth, which makes it another coincidental indicator.

 

If you try to forecast a leading indicator, like stock prices, with coincidental indicators, it doesn’t work very well. In fact, Ned Davis Research found that extreme readings in consumer confidence can be used as contrarian indicators – and it’s flashing a sell signal right now (annotations are mine).

 

In the short term, the Trump rally looks overdone. Mark Hulbert reported that his sample of NASDAQ market timers is at a crowded long level, which is contrarian bearish.

 

The inverse of contrarian sentiment is insider activity. The latest update from Barron’s of insider trading is flashing a sell signal as this group of “smart investors” have stepped up their selling for a second consecutive week.

 

From a cross-asset viewpoint, the disappointing tone of Trump’s tone in his Wednesday press conference served to deflate the US Dollar and therefore also has bearish implications for equities. Instead of talking up tax cuts and deregulation, the president-elect chose to focus on protectionism (via CNBC):

The U.S. dollar index hit a one-month low Thursday after President-elect Donald Trump disappointed investors in a Wednesday press conference. Rather than discussing infrastructure spending, deregulation or tax cuts, Trump emphasized a tough position on trade and a border tax.

“The market had priced in a very positive scenario of Trump: fiscal policy without trade protectionism,” said Athanasios Vamvakidis, a European currency strategist in Europe for Bank of America Merrill Lynch.

“That’s why the press conference is a scare,” he said, noting that traders are now focused on the dollar and what the new administration does after next Friday’s inauguration.

This chart from Hedgopia shows that the USD Index is pulling back, but large speculators are still in crowded long position. That’s a recipe for further weakness.

 

Short term cautious, medium term bullish

My own views are well summarized by BCA Research‘s expectations for equity markets. In the short term, bullish sentiment is overdone and a period of consolidation or pullback can be expected. Longer term, growth expectations are still high and stock prices should rise after a corrective episode.

 

From a technical perspective, the MACD buy signal for the Wilshire 5000 based on monthly price data remains in force.

 

We can see a similar pattern from the relative performance of stocks (SPY) vs. Treasuries (TLT). The longer term trend remains bullish, but stocks have started to pull back against bonds. Further short-term weakness would be no surprise. As long as the long term trend remains intact, my inner investor is inclined to remain equity bullish.

 

Indeed, the sell-off in bonds appear to be overdone. Michael Hartnett at BAML demonstrated that the drawdown in UST prices are at levels where past major bottoms have occurred.

 

This chart from Hedgopia shows that even as 10-year yields have started to retreat, large speculator short positions continue to rise.

 

These conditions all suggest bond prices are poised for a powerful counter-trend rally for the next couple of months. From a cross-asset perspective, it also points to softer stock prices ahead.

 

There is an important caveat to this forecast. This scenario of near-term equity weakness and longer term strength falls apart if unexpected events, such as a trade war or even a shooting war, were to occur.

The week ahead

Looking to the week ahead, I expect volatility to rise as the market becomes subject to the event risk from Q4 earnings season. As well, Inauguration Day is Friday and who knows what kinds of fireworks and new initiatives will be announced.

Next week is also option expiry week. Jeff Hirsch at Almanac Trader observed that returns during January OpEx week tends to be a mixed bag and does not show the usual bullish seasonal bias of OpEx weeks.

 

The SPX has spent several weeks in a narrow range and it is testing a key uptrend line. For the reasons I outlined, I expect that the upside potential to be limited. Should the uptrend get violated, support exists at the 2180-2200 zone, which is roughly the level where the index staged its upside breakout to all-time highs.

 

Market internals also point to a bearish resolution of the sideways consolidation. Analysis from Trade Followers shows a negative divergence as bullish Twitter breadth has been deteriorating even as the market has rallied.

 

My inner investor remains constructive on stocks. My inner trade has taken a small short position in the SPX.

Disclosure: Long SPXU

A test for the markets

Posted by Cam Hui -

Mid-week market comment: Arthur Hill at stockcharts recently observed that the Russell 2000 was in a tight consolidation range, which is characterized by a narrowing Bollinger Band. Such conditions tend to resolve themselves with volatility expansions which represent breakouts from the trading range.

 

His remarks about the Russell 2000 could also be applicable to the current conditions of the SPX as well. The key question is which direction will the breakout occur?

Clues from inter-market analysis

We can get some clues from market internals and the performance of other asset classes. Kevin Muir, writing at The Macro Tourist, pointed out that the “Trump trade” of long Russell 2000 and US Dollar, short gold and bonds has started to roll over after a huge rally since the election. These conditions suggest an environment of falling risk appetite.

 

Indeed, the chart below of long Treasury prices shows that the 20+ year Treasury ETF (TLT) has started to turn up after experiencing a positive RSI divergence.

 

The chart of the USD Index is also telling a similar story. In this case, the USD Index is starting to roll over.

 

Independent of Muir’s analysis, Barry Ritholz constructed a POTUS Index, which consists of a basket of shares of companies that Trump has praised (grey line) and a basket of shares of companies that Trump has disparaged (blue line). As the chart below shows, this pair trade has been flat to down for the past month, which is indicative that the euphoria over the Trump election is fading (annotations are mine).

 

Despite these headwinds, stock prices have been surprising resilient. How will the Trump transition team deal with the challenges in the weeks ahead?

A test for the market and the Trump team

Early in the week, CNBC reported that the Trump team’s strategy ahead of the confirmation hearings scheduled this week was to “flood the headlines so that no bad news gets through”. The “bad news” was presumably any negative confirmation hearings headlines for the numerous nominees, such as Jeff Sessions, for Attorney General, John Kelly, for Homeland Security, Rex Tillerson, for Secretary of State, Betsy DeVos, for Education, and so on.

But the Trump team has a different strategy this week: They’re going to make a lot of news. So much, in fact, that the bet is no one piece of bad news will break through the media clutter. It’s all about safety in numbers.

That’s why you’ll see a wave of confirmation hearings all scheduled for the same day on Wednesday — even as Donald Trump himself provides cover with a long-awaited news conference in midtown Manhattan on the same day. The newser is bound to generate a wave of tweets, blog posts, cable TV hits and newspaper headlines that Republicans hope will wash over any poor performances by Trump’s nominees on Capitol Hill. The idea is to flood the zone.

Unfortunately, the Trump transition team did not count on the news about how Russian intelligence’s possession compromising material on Donald Trump caused the Trump advisers worked with Russian agents (see WSJ article and report from the Guardian). I’ll spare you the salacious details of the story, which have were seen by by various news organizations but not published because the details could not be confirmed.

The lurid details of how Trump may have been compromised should be of only minor concern to the markets. What really matters to investors is whether this story has the potential to distract and hamper the incoming administration’s ability to pass its package of fiscal programs.

In other words, will the tax cuts get delayed because the Trump team has to face Congressional investigations about Russian influence? That’s the first test for the Trump team, and for market psychology in the days and weeks ahead.

Disclosure: Long SPXU

Good news, bad news from the December Jobs Report

Posted by Cam Hui -

I had been meaning to write about the December Jobs Report, which was released last Friday, but I hadn’t gotten around to it. The report had elements of both good news and bad news.

The good news is the December report showed a solid market. True, the headline Non-Farm Payroll figure missed market expectations, but November was revised upwards, and the positive revision in November was bigger than the December miss.
 

 

In conjunction with the December Jobs Report, the Council of Economic Advisers released a report indicating that the American economy had added more jobs than other advanced economies in the last eight years (via Business Insider).
 

 

Notwithstanding the political victory lap nature of the CEA`s report, the December Jobs Report should keep the Fed on track with its expectations of three rate hikes in 2017.

Here is the bad news. There are worrisome signs that the economy is starting to overheat. The combination of Fed actions on interest rates and wage pressures on operating margins are likely to be unfriendly to the stock market. Unless the Trump administration comes through on their promised tax cuts in the near future, upside for equity prices will be limited in 2017.

The return of inflation

It was a solid jobs report. One of the more concerning features of the report was the return of wage pressures. YoY growth in average hourly earnings (AHE) rose to a new high for this economic cycle at 2.9%, which is well above the Fed’s 2% inflation target.
 

 

The surge in wage pressures is no surprise to the markets. The bond market’s inflationary expectations have been steadily rising for the last couple of months.
 

 

The reflationary trend has not just been isolated to American shores. Frederik Ducrozet constructed a global PMI price pressure index – and it has been surging.
 

 

These conditions give the Fed cover to stay on their path of interest rate normalization. Fed watcher Tim Duy analyzed the report and he believes that the risks to the growth outlook are weighted to the upside:

A solid report largely consistent with expectations among monetary policymakers. Hence it should have little impact on interest rate forecasts for the coming year. But watch out for upside risks to the outlook; the economy gained some traction in the final months of 2016. It is reasonable to believe that traction will hold in 2017.

Here comes margin pressure!

It’s not just the Fed that equity investors have to worry about. As the economy moves towards full employment, the upward pressure on wages from the labor shortage is likely to start to compress corporate operating margins. Variant Perception observed that rising real unit labor costs (note inverted right scale) tend to lead corporate profits by about two quarters.
 

 

In the absence of other factors, such as the Trump tax cuts, earnings growth is likely to come under pressure. For now, Factset reports that the Street has jumped on the global reflation theme and forward EPS is rising. In fact, the pace of downward earnings guidance has been lower than usual.
 

 

The risk of a negative surprise from falling operating margins should rise should labor market conditions stay tight.

The risk of a policy error

Even as the Fed prepares to raise rates, there is a risk that the Fed may mis-read the economy over-tighten a maturing expansion into recession. An area of concern is the loss of momentum in NFP growth. In the past, the deceleration of YoY NFP growth to 1.5% has been an ominous sign for both the economy and the stock market.
 

 

The evolution of temporary employment is telling a similar story. Temporary employment edged down in December. While the decline may be a data blip, temp jobs has led labor market growth in the last two cycles.
 

 

Indeed, New Deal democrat, who monitors high frequency economic releases, is starting to worry about weakness in his long leading indicators, though the short leading indicators and coincidental indicators remain healthy.

The interest rate components of the long leading indicators improved enough in the last two weeks to score neutral. The yield curve and money supply as well as real estate loans remain positive. The big news, however, is that both purchase and refinance mortgage applications have now turned negative.

Short leading indicators, including stock prices, jobless claims, industrial commodities, the regional Fed new orders indexes, spreads, and temp staffing are all positive. Oil and gas prices, and the US$ are neutral. Gas usage turned neutral.

The coincident indicators remain mixed. Steel, consumer spending, and tax withholding are positive, and rail mildly so. The BDI is neutral. The Harpex shipping index, the TED spread and LIBOR remain negative.

Seasonality will continue for one more week to be a huge factor in the volatility of the data. This week I am particularly discounting the strong staffing number. That being said, the shorter term 6 month forecast remains strongly positive (barring a trade war). The 12+ forecast is murkier now with mortgage applications finally turning negative. How long the post-Brexit strength in the monthly housing numbers continues will be important to watch.

If the Fed were to raise rates three, or maybe even four times, this year, it risks committing a policy error by looking in the rear view mirror of inflationary pressures and tightening just as the economy rolls over.

All eyes on the Trump administration

In short, market expectations for the Trump administration’s policies are high, even though Trump hasn’t even taken office. The bull case for equities rests on a combination of global reflation, Trump tax cuts, and deregulation. The bear case is based on the risks of a trade war (see How Trump/Navarro could spark a market crash), a hawkish Federal Reserve, and wage pressures on corporate margins.

David Kostin of Goldman Sachs (via Josh Brown) quantified the effects of these factors on earnings in the chart below, though he did not take into account the effects of high wage rates. As well, rising interest rates have a relatively minimal effect on earnings, but affect stock prices through changes in the P/E ratio. As the chart shows, the effects of tax policy is significantly higher than most of the other factors (annotations in red are mine).
 

 

In other words, Trump better come through on those tax cuts, or the stock market will see a very rough 2017.

How Trump/Navarro could spark a market crash

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

How the market could crash

At the end of 2016, WSJ reporter Greg Zuckerman made a tweet with ominous implications. Hmm…what happened in 1929?
 

 

Here is how a market crash can happen. Donald Trump’s appointment of Peter Navarro, the author of Death by China, represents the biggest source of policy tail-risk for the capital markets. Bashing China may be satisfying for Trump supporters, but the Chinese economy is increasingly fragile (see How much ‘runway’ does China have left?). Impose tariffs on Chinese goods, and you risk a Chinese economic slowdown that drags the world into a synchronized global recession.

While a crash is most definitely not my base case, the scenario of collapsing trade flows from a Chinese hard landing would first tank the Asian economies, followed by Europe, whose banking system are still over-levered and have not fully recovered from the Great Financial Crisis. Under such circumstances, an equity bear market would be a 100% certainty, and a market crash would be within the realm of possibility.

It’s hard to estimate the actual probability of a US induced China hard landing scenario. However, we should get better clarity as the Trump team moves into the West Wing of the White House in the coming weeks. In addition, President-Elect Trump may give us some clues on trade when he holds his press conference on Wednesday.

Fragile China

The chart below (via Stratfor) shows the trajectory of credit to GDP of countries that have experienced a strong rise in debt. It is only a matter of time that China’s debt capacity hits the wall, just like every country that has experienced a period of hyper-growth in the 20th and 21st Century.
 

 

I wrote a post last summer that highlighted analysis from China watcher Michael Pettis. Pettis made the case that China had a maximum of 2-3 years to resolve its growing debt problem (see How much ‘runway’ does China have left?). Fast forward to today, the time horizon is only 1-2 years.

Christopher Balding, writing in Bloomberg Views, explained the fragility of China’s financial system this way:

Rising asset prices in China have helped prop up everything from coal and steel firms to consumer sentiment. But with potential bubbles popping up everywhere, the government seems to be laying the groundwork for reform. That could mean raising interest rates, applying new restrictions on trading or tightening other regulations. Remember that such measures, however necessary, carry risks of their own. For example, given that China has some of the world’s most expensive housing relative to income, and extremely low turnover, withdrawing credit could result in a real-estate price shock. That might cause indebted developers to fail, or lead to much stronger government action to prevent a hard landing. As regulators try to rein in other asset prices, watch for similar turmoil in bonds and the yuan.

In short, it’s an accident waiting to happen:

Remember that risk is probabilistic and not mechanistic. As China’s known risks accumulate, the probability of some unexpected event having an outsized impact also increases. In such circumstances, the biggest mistake one can make is to rely on past assumptions to predict the future.

To be sure, most of the Chinese debt is denominated in RMB and therefore any blow-up is unlikely to resolve itself in a typical EM debt crisis fashion. Nevertheless, the cracks are starting to appear. A recent FT article warned of the risks in the Chinese financial system:

The dangerous nexus between shadow lenders and large, systemically important commercial banks. Trusts raise funds for their loans by selling high-yielding wealth management products [WMPs] to investors. For the riskiest trust products, banks typically serve only as sales agents but bear no legal responsibility for product payouts.

Yet investors often ignore these technicalities, assuming that state-owned banks — and by implication, the government — stand behind the products they distribute. Adding to the perception that defaults are impossible is a history of bailouts of WMPs by banks, even where no legal responsibility exists.

In December, the Chinese bond market tanked. It wasn’t just the prospect of the Fed raising interest rates, but shenanigans in the local shadow banking system (via Caixin):

It all started with a rumor that proved true. A midsize brokerage firm, Sealand Securities, was said to be reneging on a deal involving bonds worth originally 10 billion yuan ($1.44 billion) on Dec. 14. It soon turned out that it had made similar under-the-table repurchase agreements with more than 20 financial institutions to buy back bonds worth more than 20 billion yuan. Because those bonds were now trading at a loss, Sealand did not want to complete the agreements and buy them back. And what made it think it could do that? Because it said the seal used for all the repurchase agreements was forged. This had a far-reaching impact on the bond market, regardless whether a firm was directly involved in the troubled agreements or not. Sealand later said it had solved the disputes with the financial institutions after the direct intervention of high-level securities regulatory officials.

The possible default by a midsize brokerage firm sparked panic as it raised the possibility of a bank run in the shadow banking system:

To understand what this means, let’s first take a look at how funds flowed from banks to non-bank financial institutions and the bond market.

Typically, the process would start with a big bank purchasing the wealth management products offered by a smaller bank. The small bank then outsources the investment of the fund it received to a non-financial institution, such as a securities firm. The securities firm invests the money into bonds. But when bond prices kept falling, combined with the pressure of tightened liquidity that banks now need to grapple with, the flow of funds went into reverse as banks wanted cash.

This set in motion events that reinforced one another and increased the bond market volatility. As the securities firm sells off bonds to pay back the small bank, which itself may be facing increased pressure of returning funds to the large bank, bond prices fall further and more banks want their money back.

The December episode was only a hiccup, but where there’s smoke, there’s probably fire.

Enter Peter “Death by China” Navarro

Trump’s appointment of Peter Navarro as the director of the US National Trade Council and Robert Lightizer as US Trade Representative are ominous signs for the Sino-American trade relationship. While on the campaign trail, candidate Trump had shown an antipathy towards China and Mexico on trade. The appointment of Navarro, who authored Death by China, is especially unsettling. Lightizer has spent much of his career representing American steel producers in trade dispute litigation and he is unlikely to be any friend of China.

Despite the claims by Trump and Navarro, the Chinese yuan is not under-valued against the USD. As shown by this chart from Callum Thomas of Topdown Charts, the decline in CNYUSD is mostly attributable to USD strength (red line). CNY has been relatively steady against its CFETS currency basket (blue line).
 

 

If the US were to pressure China on trade, Beijing would react badly. Ian Bremmer of Eurasia Group believes that internal political pressures gives Xi Jinping little room to maneuver:

China’s scheduled leadership transition this fall will shape its political and economic trajectory for a decade or more. The scale of elite turnover before, during, and after the upcoming 19th Party Congress, combined with the divisive political environment that President Xi has fostered, will make this transition one of the most complex events since the beginning of China’s reform era.

Two risks flow from the upcoming power consolidation. First, because Xi will be extremely sensitive to external challenges to his country’s interests at a time when all eyes are on his leadership, the Chinese president will be more likely than ever to respond forcefully to foreign policy challenges. Spikes in US-China tensions are the likely outcome. Second, by prioritizing stability over difficult policy choices in the run-up to the party congress, Xi may unwittingly increase the chances of significant policy failures.

Xi cannot be seen to appear weak and therefore he will not tolerate any challenges. Notwithstanding issues like Taiwan and the South China Sea, which could be geopolitical flashpoints in 2017, expect economic challenges on trade to be met with resolve.

Xi’s sense that he will have to respond resolutely to any foreign challenge to national interests—in a year during which popular and elite perception of his leadership matter more than ever—means foreign policy tensions will escalate. At the least, Xi will view any external challenge as an unwelcome distraction from his focus on domestic political machinations. At worst, he will fear such threats could undermine his standing at home. Consequently, the president is likely to react more forcefully than his potential challengers expect. And unfortunately for global stability, the list of triggers that could rattle the president is long: a newly-empowered Trump and his China policy, Taiwan, Hong Kong, North Korea, as well as the East and South China Seas.

That’s how trade wars and hard landings can happen:

The intense focus on domestic stability means Xi may well overreact or stumble over any sign of economic trouble. This risk could take the form of a re-inflation of asset bubbles to boost domestic growth, or a substantial ramp-up in capital controls—either move would rattle foreign investors and international markets. Whatever form it takes, any misstep by Xi would provoke global economic volatility.

In case you didn’t get that, “global economic volatility” is code for “rising risk of a synchronized global recession”.

What happens in a trade war?

Should the Trump administration label China a currency manipulator and impose tariffs on Chinese exports, China will respond forcefully. The Petersen Institute modeled what would happen in a full-blown trade war. US GDP would be flat for two years – and those are just the first order effects.
 

 

The first shot in a trade war would also give the green light for the PBoC to weaken the CNY (what else do they have to lose?) in response. Already, China is struggling with capital flight. A collapsing CNYUSD exchange rate risks a disorderly hemorrhage of China’s foreign exchange reserves. In addition, China’s newly announced regulatory changes to stem capital flight does not exactly inspire confidence.
 

 

If the Chinese economy were to tank, the collateral damage would first be felt among China’s major Asian trading partners, such as Hong Kong, Taiwan, South Korea, and Japan. The import of capital goods from Europe, most notably Germany, would fall. The failure of German exports, which has been the growth engine of the Europe, would weaken the already fragile eurozone financial system, whose leverage problems have not been solved since the last crisis. The problems of Banca Monte dei Paschi di Siena will be a tempest in a teapot compared to the problems that the European financial system will have to face.

Moderating influences on trade

At this point, the US induced China slowdown scenario is just a speculative scenario. It’s impossible to know how the Trump administration will actually act when it assumes power.

On one hand, Trump has flip-flopped on many issues over the years, but he has stuck to the assertion that China has been an unfair trader. The prospect of a protectionist US government will undoubtedly give the market jitters.

On the other hand, there are signs that there are moderating influences within the Trump administration on trade. Politico reported that Wilbur Ross was a Sinophile before he got the nomination to become Commerce Secretary. Ross could very well be a moderating influence on trade within the Trump administration.

I think the China-bashing is wildly overdone in this country,” said Ross in one CNBC interview, a statement that would have come across as a veiled swipe at Trump if he hadn’t made it in 2012. “The reality is that if something were to happen that cost China jobs, like if they upwardly revalued the currency a lot, those jobs aren’t going to come back to the U.S., they would go to Vietnam, they would go to Thailand, they would go to whatever country was the lowest cost, so it’s a fiction on both sides that those jobs will come back.”

Asked about outsourcing four years earlier by Profit Magazine, he said, “China has become the whipping boy in the U.S., just as Japan was some 15 years ago. This certainly is intellectually wrong.”

And in May, Ross, 79, explicitly departed from his future boss on a flashpoint in international trade, noting that China’s currency is in fact overvalued, not undervalued as Trump had been claiming on the campaign trail. “I disagree with my friend Mr. Trump in that particular regard,” he told Bloomberg.

More importantly, the New York Times reported that Trump`s son-in-law Jared Kushner has been pursuing a property development deal of a NYC building at 666 Fifth Avenue with Anbang Insurance, a Chinese financial conglomerate with uncertain ownership. Such relationships could color the administration`s views on trade with China as Kushner is expected to have an important unofficial voice in foreign affairs.

Indeed, despite a lack of foreign policy experience, Mr. Kushner is emerging as an important figure at a crucial moment for some of America’s most complicated diplomatic relationships. Such is his influence in the geopolitical realm that transition officials have told the Obama White House that foreign policy matters that need to be brought to Mr. Trump’s attention should be relayed through his son-in-law, according to a person close to the transition and a government official with direct knowledge of the arrangement.

So when the Chinese ambassador to the United States called the White House in early December to express what one official called China’s “deep displeasure” at Mr. Trump’s break with longstanding diplomatic tradition by speaking by phone with the president of Taiwan, the White House did not call the president-elect’s national security team. Instead, it relayed that information through Mr. Kushner, whose company was not only in the midst of discussions with Anbang but also has Chinese investors.

Notwithstanding how Trump and Kushner negotiate the delicate conflicts of interest issues, Trump himself has financial interests that are tied to Chinese state owned enterprises:

On China, Mr. Trump has talked a tough game, accusing Beijing of currency manipulation and raising the possibility of a trade war. But whether that is only a negotiating tactic remains to be seen. The president-elect has his own financial entanglements with China: He owns a 30 percent stake in a partnership that owes roughly $950 million to a group of lenders that includes the Bank of China, and one of his biggest tenants at Trump Tower is another state-owned bank, the Industrial and Commercial Bank of China.

The trade policy situation can only be described as fluid. I am watching how the Asian stock markets as my canaries in the coalmine. So far, they are behaving well as the stock indices of China’s major trading partners remain above their 50 day moving averages.
 

 

The week ahead: Watch for volatility

Looking to the week ahead, the Dow came within a hair of 20,000 at 19,999.63 and pulled back. Sentiment readings are overly bullish, which suggests a period of consolidation or pullback is ahead (via Urban Carmel).
 

 

Bloomberg reports that the latest readings from BAML’s funds flow analysis shows that nearly $70 billion have poured into equities since the election.
 

 

The BAML Sell Side Indicator, which measures the bullishness of Street strategists on stocks, has spiked from a contrarian buy signal into neutral territory.
 

 

Equally worrisome are the action of insiders. The latest update from Barron’s shows that this group of “smart investors” have moved into sell mode. Readings of insider activity tend to be noisy, but this latest data point represents another headwind for the bulls.
 

 

Measures of risk appetite are equally disturbing. Even as the market tested resistance at fresh highs on Friday, the chart below shows that risk appetite metrics were falling. The ratio of high beta to low volatility stocks (middle panel) was making a pattern of lower lows and lower highs. The relative performance of small caps to large caps (bottom panel) had violated its relative uptrend in addition to displaying a negative divergence condition.
 

 

When I put it all together, near-term upside potential is probably limited. A more likely outcome would be a period of sideways consolidation or pullback. My inner investor remains constructive on stocks, though he is nervously monitoring how the trade positions of the new Trump administration evolves.

My inner trader has taken a small short position in stocks. He waiting for the inevitable end of the Trump honeymoon. Wait for potential fireworks from the Trump press conference on Wednesday.

Disclosure: Long SPXU

Top-down meets bottom-up: How expensive are stocks?

Posted by Cam Hui -

Recently, I have seen several variations of market analysis concluding that stocks are expensive based on forward P/E ratios. Here is a tweet from Jeroen Blokland. David Rosenberg characterized the current equity environment as picking up pennies in front of a steamroller.
 

 

Blokland followed up the above tweet with an additional comment indicating that earnings growth is badly needed.
 

 

Does this mean it’s time to get cautious and sell your all stocks? Not so fast! A case can be made that the analysis of the forward P/E chart is based on a misread of how forward EPS expectations are formed. On an adjusted basis, stocks do not appear to be expensive at all.

Misreading forward P/E

Let’s consider how the process of how EPS estimates are formed. Individual analysts project earnings for the companies that they cover. Various data services compile and aggregate earnings estimates. From these estimates, forward EPS can be calculated for individual companies and for the market as a whole.

What happens when there is a macro shock to the system, such as the Asian Crisis, or the election of a new leader who promises business friendly policies? How do analysts react when the magnitude of the effect is unknown?

During my experience managing equity portfolios using bottom-up quantitative models, a sequence of events occur in approximately the following way after a macro shock. First, the best factors that work are the short-term technical analysis models, followed by estimate revision factors, as analysts revise their earnings upwards or downwards. Finally, the classic fundamentally driven value and growth factors then respond. After a macro shock, analysts know that things will be very good, or very bad, but they don’t know how much. They don’t actually revise their estimates until they can quantify the effect.

In the current environment, the market believes that the Trump tax proposals will be positive for earnings growth. We just don’t know how much. In effect, company analysts haven’t revised their earnings estimates to reflect the likely effects of the Trump tax cuts yet.

On the other hand, while bottom-up derived data of individual company analysts’ estimates don’t reflect the effects of the Trump tax cuts, Street strategists have taken a stab at projecting the likely tax cut effects on SP 500 earnings. As I pointed out before (see How Trumponomics can push the SP 500 to 2500+), the consensus forecast is about a 10% boost to earnings in FY2017.

The chart below from Factset (annotations in red are mine) depicts what happens if the E in the forward P/E ratio rose by 10%, as per the top-down strategists. The forward P/E falls from 16.9, which is near its historical highs, to 15.4, which is slightly above its 5-year average. Do stocks look expensive when viewed this way?
 

 

What about trailing P/E and earnings growth?

On a trailing P/E basis, the stock market does appear to be expensive at first glance. However, as the chart below shows, a trailing P/E ratio of 20.6 translates to an earnings yield of 4.9%. When you consider that the 10-year Treasury note yields 2.5%, do stocks look expensive?
 

 

The bull case for US equities have three earnings components:

  1. Organic cyclical growth;
  2. Tax cut effect; and
  3. One-time tax holiday boost from the repatriation of offshore cash.

Company analysts have not factored the last two effects into their earnings estimates. However, we can see from Factset that forward EPS continues to rise due to a cyclical recovery in economic growth.
 

 

Indeed, the latest Atlanta Fed’s nowcast of Q4 GDP has risen to 2.9%:
 

 

The growth revival component of the bull case is well supported by the evidence, both from a top-down (Atlanta Fed`s GDPNow) and bottom-up (Factset`s aggregated forward EPS) basis.

The bull and bear cases

In conclusion, we can make a bull case that the US equity market is fairly valued. The forward P/E ratio, adjusted for the Trump tax cuts, is not out of line with historical experience. The trailing earnings yield appears reasonable when compared to fixed income alternatives. The economy is undergoing a cyclical rebound, which would have happened no matter who had won the election.

Just because a market is fairly valued doesn’t meant that it can`t get overvalued. The bull case is also bolstered by a positive momentum in risk appetite. Josh Brown highlighted analysis from Ari Wald of Oppenheimer indicating that high beta stocks have rallied through a relative downtrend. While nothing goes up in a straight line, this development can be interpreted bullishly on an intermediate term basis.
 

 

The bear case is the market is pricing in the full effects the Trump tax cuts. If the incoming administration stumbles and cannot get its fiscal package through Congress, equity prices will adjust downwards in accordance with that disappointment. In addition, there are plenty of policy potholes in the road as the new team takes over the White House (see The bear case: How Trumponomics keeps me awake at night).

For the last word, we can get a clue from how corporate insiders are reacting. The latest update from Barron’s of insider activity shows that the behavior of this group of “smart investors” has been in neutral since the election.
 

 

So far, the insiders don’t appear terribly concerned about valuation, but they are sitting on the fence.

Pick your poison.

A 2016 report card

Posted by Cam Hui -

As 2016 has drawn to a close, it’s time to review the report card from my 2016 calls. My inner investor performed very well, though my inner trader suffered a number of hiccups. Overall, I had a solid year in 2016.

My inner investor: Steadfastly bullish

The chart below depicts the key highlights of my investment calls, which are based on a 6-24 month time horizon. I remained steadfastly bullish for most of 2016 even as others panicked. The jury is still out on my latest call for a correction in early 2017 (see A correction on the horizon?). My analysis has turned out to be largely correct.
 

 

Buy! Blood is in the streets! (January 2016)
Super Tuesday Special: How President Trump could spark a market blow-off (March 2016)
How the SPX could get to 2200 and beyond (June 2016)
A correction on the horizon? (December 2016, the jury is still out on that call)

My inner trader: The devil is in the details

The chart below depicts the calls of my trading model. While they appeared to be very good at first glance, I discovered a couple of problems in implementing the trades.
 

 

First, the model was a little slow and did not react to the slow deterioration in the market during the late summer. Even as the model remained long, the slow drip-drip-drip downtrend in prices (marked by the white arrow in the chart) was a little disconcerting. As the trading model is based on sensing changes in price trends, the lack of trade signals highlights a problem when the market moves sideways.

On the other hand, another problem arose when the model became overly sensitized to changes in prices. The trading model experienced whipsawing signals in the aftermath of the Brexit election (buy to sell to buy within a few days) and the US election (buy to sell to buy in the overnight futures market). These two issue highlight the need for further research in the future.

These problems highlight the problem with short-term trading and trading models. The chart above is a weekly chart and therefore does not show the actual price volatility experienced by traders.

Sometimes trading is like that. You think you have the perfect setup, followed by the perfect signal, then you miss on your execution, which results in an unfortunate outcome (click this link if the video is not visible).
 

 

I have no idea of what 2017 will bring, though I outlined my market views in my last post (see The cloudy side of Trump). In all likelihood, the incoming Trump administration will create a high degree of uncertainty and market volatility.

I hope that I can help you navigate it in the year to come.

The cloudy side of Trump

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

Is the Trump honeymoon over?

Bloomberg had a marvelous article that captures the market’s mood right now. It is entitled “The sunny side of Trump: There’s reason for short-term optimism. Then he has to deal with his policy contradictions”.
 

 

How long will this honeymoon last? For American business, the positive scenario is that Trump appoints sensible people, matures in office, and puts most of his considerable energy into the pro-growth parts of his agenda. The negative scenario is that he goes back to being the inciter who flew off the Twitter handle so much during the campaign that his people temporarily seized control of his account.

The bull case, which I laid out two weeks ago (see How Trumponomics can push the SP 500 to 2500+), is well known. Since the election, the stock market has embraced the prospect of a global cyclical upturn, anticipated fiscal stimulus, and buyback gains from a tax holiday fueled repatriation of offshore corporate cash. I went on to outline the bear case as the second part of my series the following week (see The bear case: How Trumponomics keeps me awake at night).

As Inauguration Day approaches, acts such as the appointment of Peter “Death by China” Navarro as trade czar has begun to unnerve the bulls. Market psychology is starting to turn from greed to fear. Concerns are rising that new Trump edicts may see parallels to this scene from Woody Allen`s 1971 comedy, Bananas (click this link if the video is not visible).
 

 

To be sure, bullish sentiment has surged in the short-term. Stock prices may have run ahead of themselves and a corrective period is likely. The bigger question is how will the bull and bear case resolve themselves in the longer term? I address that question this week with a scenario analysis that has some surprising results.

The bulls are back in town

There are numerous signs that the market sentiment has gotten too bullish too fast. Business Insider recently observed that Barron’s couldn’t find any strategists who thought that stock prices would fall in 2017. Bloomberg pointed out that range in Street strategists’ price targets have narrowed, as part of a herding effect.
 

 

Composite metrics of investor sentiment, like this one from Sentiment Trader, are at a bullish extreme. That’s contrarian bearish.
 

 

This analysis from Ned Davis Research came to a similar conclusion. It’s time for the market to pull back or consolidate its gains.
 

 

Finally, you can tell that market psychology has shifted by the tone of the tweets from a veteran WSJ reporter.
 

 

Hmmm, what happened after the Hoover election in 1929?

Assessing the bull and bear cases

I have already explained the bull case (see How Trumponomics can push the SP 500 to 2500+). The bear case rests mainly on disappointment in the implementation of Trump’s programs, or possible missteps by the new team on the geopolitical and trade fronts (see The bear case: How Trumponomics keeps me awake at night).

Here is the bear case in some context. I put the following question to a number of Trump supporters who are bullish on stocks and the economy. If you are so convinced that Trump will make America great again, then at what interest rate would you lend him money? What would it take to turn you from an equity investor into a debt investor?

An unscientific Twitter poll gave me some clues. As much as Trump supporters like his approach, few are willing to lend him money at current market rates.
 

 

If rates have to rise by 1-2% under those circumstances, what does that mean for equity valuations? Let’s do some quick, back of the envelope calculations. Data from Factset shows that the SP 500 trailing 12-month P/E ratio to be 20.6, which translates into an earnings yield of 4.9%. When I compare that figure to the UST 10-year rate of 2.5%, stocks are still attractive, especially when a long-term equity holder can expect growth on top of the 4.9% earnings yield.
 

 

Now raise the UST 10-year rate by 1-2%. Would you own stocks at a 4.9% earnings yield when the 10-year Treasury yield is 4.5%?

Scenario analysis

I performed some simplistic scenario analysis, based on the assumption that the equity risk premium, defined as the spread between earnings yield and 10-year Treasury yield, remains unchanged. The scenarios are:

  • Full implementation of Trump’s program of tax cuts and offshore cash tax holiday
  • A delay in the fiscal program: It would be easy to envisage a scenario where the Trump team spends much of its initial legislative effort to repeal ACA, or Obamacare, and alienates the Democrats in Congress. Attempts to pass an ambitious program of tax cuts get blocked by GOP budget hawks and the new administration cannot cobble together sufficient support from Democrats across the aisle because of the bitter ACA fight. The fiscal stimulus program either gets watered down, or delayed into 2018-2019.
  • A disaster scenario involving trade wars, a global collapse in growth, or a simple 2% increase in Treasury yields without any commensurate rise in earnings.

The table below summarizes my findings. In a previous post (see How Trumponomics can push the SP 500 to 2500+), I had shown three components of equity gains. The first component is the global cyclical revival, which I estimated EPS growth at 6-8%. The second component comes from lower corporate tax rates, which could boost earnings growth by another 8-10%. To be conservative, I added the first two components together and modeled EPS growth at 15%. The third is the one-time buyback boost to stock prices from offshore cash repatriation, which I penciled in at a 5% price gain. In my scenario analysis, I also modeled what happens if rates were to remain the same, rise by 1%, or 2%. Further, I assigned probabilities to each of the outcomes. This table below shows a relatively optimistic case analysis as I assume that Trump has a 65% chance of getting his fiscal programs passed, with a 30% of a delay, and only a 5% of disaster.
 

 

Here are some observations from this analysis. First, the weighted increase in UST yields comes to 0.7%, which is consistent with “dot plot” expectations of three 2017 Fed rate hikes and a parallel shift in the yield curve.

Since the election, the market has mainly been focused on the best case scenario, whose benefits are known. Even with a relatively optimistic estimate of probabilities, the weighted 2017 target only represents a 3% price gain in the SP 500. As Inauguration Day approaches and the market starts to focus on downside risks, no wonder stocks are starting to trade a little heavy.

Here is some sensitivity analysis. A more bearish probability weighting where the probability of Trump’s fiscal program passage falls from 65% to 45%, the delay scenario odds rising to 45%, and the disaster scenario at 10% results a 0% price gain in 2017.
 

 

Some reasons for optimism

Does that mean equity market return expectations for 2017 are likely to be unexciting? Not necessarily. My conclusion of a relatively flat expected returns for the SP 500 in 2017 is based on an unsophisticated model with the simple assumption of a constant equity risk premium. There are a number of reasons for optimism .

Antonio Fatas, professor at INSEAD, recently outlined a more detailed model of the equity risk premium (ERP), where:

RP= E/P -RF + G

RP = Risk premium
E/P = Earnings to Price
RF = Risk-free rate
G = Growth

Fatas went on to plot the evolution of the ERP and observed that current readings are not out of line with historical averages. In fact, the risk premium has room to fall. An ERP compression would have either the effect of P/E expansion, or offset the negative effects of a rise in interest rates. Based on my observation of the chart below, ERP could easily fall by 1.0-1.5% before getting in the red zone seen at the height of the last bull market.
 

 

Here is another way of thinking about why the ERP has more room to fall. The market’s animal spirits haven’t totally revived yet. We need greater bullishness for a market top to form. This is consistent with sentiment readings from AAII bulls shown in the chart below. While short-term bullishness has risen, longer term metrics such as the 52-week moving average is still extremely low. Not every individual investor is glued to the screen 24/7. Most don’t check their portfolios on a hourly or daily basis. We need greater participation from the public for a top to form.
 

 

In addition, there may be some short-term goods news on interest rates. I have been waiting for Trump to make some comment on Fed policy since the December rate decision. Would he side with the hard-money audit-the-Fed crowd, who are his main supporters, who advocate for a rule-based Fed, which implies a tighter monetary policy? Or would he revert to his real estate developer’s persona and criticize the Fed for raising rates?

Last week, we saw part of an answer. Wilbur Ross, the nominee for Commerce Secretary, tweeted the following in support a weaker USD and therefore an easier monetary policy.
 

 

If Ross’ views does indeed represent the Trump administration’s position, then expect the new nominees to the two open positions on the Federal Reserve board of governors to have dovish tilts. In that case, it would ease any short-term concerns over interest rate pressures on stock prices. Longer term, however, there is a price to pay for stacking the board with too many doves. An overly accommodative Fed caught behind the inflation fighting curve will have to respond with a series of sharp rate hike that push the US and global economy into recession.

Here is where my scenario analysis gets a bit speculative, as there are so many moving parts. The combination of a falling ERP and a friendly Fed could push the expected price appreciation on the SPX to 6-7%. Add in another 2% of dividend yield, and equities would still look attractive in 2017 with a total return of 8-9%. The TINA (There Is No Alternative) scenario is still in play for stocks.

Looking ahead to Q1: A correction is likely

As I look ahead to Q1, some caution is warranted. The index of economic uncertainty has spiked…
 

 

…but VIX remains low, indicating market complacency. Any negative surprise has the potential to spark a market correction.
 

 

In addition, Callum Thomas observed that the Citigroup US Economic Surprise Index, which measures whether macro indicators are beating or missing expectations, tends to be seasonally weak in the first three months of the year. In other words, be prepared for some growth disappointment on the macro front.
 

 

Other cyclically sensitive indicators, such as industrial metal prices, have retreated and breached their 50 day moving averages.
 

 

The week ahead

When I put it all together, it points to a correction of unknown proportions. I sent an email alert last Thursday indicating that the trading model had turned negative. My inner trader liquidated all his long equity positions and went short the market. Subsequent to that email, the SPX decisively broke down out of its range. The next most likely support level can be found at the SPX breakout level of about 2200.
 

 

I am seeing confirming signals from other asset classes from an inter-market analytical perspective. Bond prices, which have been inversely correlated to equity prices, are starting to recover.
 

 

As well, gold prices have rallied out of a downtrend and they are turning up.
 

 

Barring any outlier surprises, such as a sneak attack on North Korean or Iranian nuclear facilities that upset the current geopolitical equilibrium, my inner investor remains constructive on equities and he is inclined to buy the dips. His base case scenario is a correction to test the breakout level at 2200, followed by a rally later in the year to fresh highs. The Dow will exceed 20,000 in 2017.
 

 

In addition, the monthly MACD buy signal on the Wiltshire 5000 remains intact.
 

 

There will be fireworks, and volatility. I will be with you every step of the way.

Have a happy and prosperous 2017.

Disclosure: Long SPXU

A correction on the horizon?

Posted by Cam Hui -

Mid-week market update: It’s always nice to take a few days off during the holidays, except all that I got for Christmas was a cold. The stock market doesn’t seem to be doing too much better as it tests the bottom of a narrow trading range during what should be a period of positive seasonality.
 

 

None of the other major indices, such as the DJIA, NASDAQ, or Russell 2000, have broken support. The one exception is the Dow Jones Transports.
 

 

My inner trader has a number of tactical concerns as we look ahead into January.

Weak Twitter breadth

As the chart from Trade Followers shows, Twitter bullish breadth is weakening. Such a condition is bad news for the bulls.
 

 

Complacency from option market

As stock prices have rallied since the election, the level of anxiety fall significantly. The chart below depicts the spread between 3-month VIX and 9-day VIX. Usually, the spread is positive, which is called a contango in the VIX term structure. However, when the contango gets too high, defined as the spread as 6 points or more, the stock market has generally undergone a period of sideways consolidation or correction (blue dotted lines).
 

 

The term structure spread went above 6 on Friday, December 23, 2016.

Where’s Santa Claus?

The combination of weak-ish market action, deteriorating breadth, and excessively bullish sentiment does not bode well for the Santa Claus rally. Ryan Detrick of LPL Financial studied the relationship between the Santa Claus rally, which he defines as the period for the last five days of the year and the first two days of the new year. Detrick found that the lack of a Santa Claus rally is not a good sign for January.
 

 

The jury is still out for this year’s Santa rally, but the signs are not looking good.

I am not willing to throw in the towel on the bull case just yet. However, if we see a definitive downside break in the trading range, the trading model will flip from bullish to bearish and my inner trader will act accordingly.

Disclosure: Long SPXL, TNA

The bear case: How Trumponomics keeps me awake at night

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

Trumponomics: The bear case

In last week’s post (see How Trumponomics could push the SPX to 2500 and beyond), I laid out the bull case for stocks under a Trump administration and how stock prices could appreciate 20% in 2017, assuming everything goes right. This week, I outline the bear case, or how Trumponomics keeps me awake at night.

Candidate Trump has said many things on the campaign trail, some of which are contradictory. President-elect Trump’s cabinet is taking shape and we are now getting some hints about policy direction. Nevertheless, there are a number of contradictions in his stated positions whose unexpected side-effects that could turn out to be equity bearish:

  • Legislative tax cut disappointment
  • A contradiction in fiscal policy vs. trade policy
  • Geopolitical friction with China
  • Rising geopolitical risk
  • Loss of market confidence
  • A possible collision course with the Federal Reserve

In this post, I will discuss each of these points, and I will end on how I believe these contradictions are likely to be resolved by the market.

Will Congress pass the Trump tax cuts?

My last weekend’s post (see How Trumponomics could push the SPX to 2500 and beyond) assumes that Candidate Trump’s fiscal stimulus plans of tax cuts and corporate offshore cash repatriation tax incentives will be passed by Congress. However, there may be significant resistance from Republican budget hawks.

The appointment of Mick Mulvaney as the head of OMB makes the passage of wholesale tax cuts less likely, as Mulvaney is known as a balanced budget advocate during his term in Congress (via Business Insider):

Trump has promised large tax cuts for both individuals and corporations, which would make increasing revenue difficult. He has also said he wants to invest heavily in the military, so cutting spending elsewhere may be difficult.

Debt always seemed to make sense given cheaper debt-servicing costs enabled by low interest rates, but now with Mulvaney at the helm of the OMB, this option may not be as likely.

“This significantly lowers the probability of big unfinanced tax cuts and big unfinanced infrastructure spending,” Torsten Sløk, the chief international economist at Deutsche Bank, said in a note to clients after the announcement.

This does not mean stimulus won’t happen; ultimately, Trump is still in charge and can push Mulvaney to include the spending in the budget or make the math work to get an infrastructure plan going. Mulvaney may be able to provide some pushback, however, Mills said.

“President-elect Trump’s statement announcing the nomination highlighted Rep. Mulvaney’s conviction to address the federal debt and pledged ‘accountability’ in federal spending in his Administration,” Mills concluded. “This leads us to believe that Mulvaney could push back against the significant stimulus spending.”

In effect, the stock market is priced for the perfection of Trump’s promised tax cuts. What happens if they don’t materialize as expected?

Fiscal policy vs. trade policy

Even if Trump gets his tax cut package passed, BAML foreign currency strategist David Woo recently appeared on Bloomberg and outlined a dilemma for the Trump team. Candidate Trump has made fiscal policy and trade policy the centerpieces of his campaign. But there is an inherent contradiction between the two.

His fiscal policy of tax cuts and incentives for offshore tax repatriation is very bullish, both for the US equities, the American economy, and the US Dollar. However, his trade policy of slowing or reversing the offshoring effect and enhancing trade requires a weaker USD. So what does he want? A strong Dollar or weak Dollar?

Mohamed El-Arian agrees with David Woo’s assessment of the strong vs. weak Dollar dilemma:

Though the US economy is doing much better than most of the other advanced economies, it is not yet on sound enough footing to withstand a prolonged period of a substantially stronger dollar, which would undermine its international competitiveness – and thus its broader economic prospects. Augmenting the risk is the prospect that such a development could spur the Trump administration to follow through on protectionist rhetoric, potentially undermining market and business confidence and, if things went far enough, even triggering a response from major trade partners.

Central to the dilemma is Trump`s view of China`s competitive position. One of Candidate Trump’s principal targets has been the trade behavior of China. The PBoC has been taking active steps to strengthen the CNYUSD exchange rate, which weakens their trade position. However, if a Trump administration were to label China as a currency manipulator, it would give cover for Beijing to actually devalue their currency in line with market forces, which sets the stage for a trade war that no one wants.

Even worse, Business Insider pointed out that a weakened yuan isn’t helping Chinese exports, which may be a signal that the China export engine is losing its competitive edge.

The yuan has been reaching multi-year lows, and the dollar’s recent strength after Donald Trump won the U.S. presidential election isn’t helping either. What’s even more worrisome is that October export numbers show that a weak yuan isn’t helping the Chinese economy.

“Stripping out the impact of yuan depreciation, exports in dollar terms fell 7.3% year on year in October after a 10% drop in September,” wrote Bloomberg’s Tom Orlik in a recent note. “Imports slipped 1.4% after a 1.9% decline. China’s trade surplus in dollar terms was $49 billion, up from $42 billion. The surplus is in contrast to a larger-than-expected $45.7 billion decline in China’s foreign reserves in October, indicating quicker capital outflows in the month.”

While diminishing growth in Chinese exports may sound like good news for the America First crowd, it also has the potential to set off a trade war through the devaluation channel if Trump were to label China a currency manipulator. Holger Zschaepitz at Die Welt observed that a cratering CNYUSD exchange rate could have global repercussions.

 

A weaker yuan would be the first shot in a possible trade war, followed by retaliation for possible US tariffs. Trump’s appointment of Peter Navarro, the author of Death by China, to head the newly created National Trade Council is particularly disconcerting.  The chart below from Bloomberg shows the portion of sales that selected major American companies derive from China.

 

Consider, for example, Boeing (BA) which is the least exposed company on the list. In a trade war, The company claims that Chinese orders support 150,000 American jobs per year.  (Who cares, that’s just a single month’s of Non-Farm Payroll job increases, right?) In addition, the WSJ reported that China is preparing a retaliatory response whose list includes Boeing, General Motors, and 30 million tons of soybeans imports from over 30 US states.

Geopolitical friction with China

It is unclear whether Trump’s belligerent attitude towards China is real, or if it represents an “art of the deal” posturing for bargaining purposes. Trump’s controversial telephone call with the Taiwan’s president Tsai Ing-wen crossed a red-line for the Chinese. Trump defended the call by stating that Taiwan could be used as a bargaining chip in US negotiations with China. In response, China flew a nuclear-capable bomber over the South China Sea as a signal that it is not to be intimidated.

If the Trump team does go down the China confrontation road, then it must be prepared to bear the consequences. You want help controlling North Korea’s nuclear ambitions? Forget it! You want the Chinese to refrain from using its UN Security Counsel veto in a vote against Iran? You’ve got to be kidding!

You get the idea.

In general, taking steps to batter an already fragile Chinese economy is in no one’s interest. China’s debt excesses are well known. Crash the Chinese economy, and it will push most of Asia and resource based economies, such as Brazil, Australia, New Zealand, and Canada, into recession. Tanking Chinese capital goods demand would depress German exports and possibly topple the equally fragile eurozone economy. This domino effect of cascading economic crashes is not the kind of outcome anyone wants (see Why the next recession will be very ugly and How much “runway” does China have?).

 

Here is just one simple example of China`s economic fragility. In response to the Fed’s rate hike, the WSJ reported that Chinese bond market cratered. The South China Morning Post outlined four reasons why China is afraid of US interest rate increases:

  1. Yuan depreciation against US dollar deepened
  2. China forex reserves shrank quickly
  3. China’s stock market plunged
  4. Beijing started to reverse capital account opening process

The world is highly connected. You can’t just alter policy in one place without unexpected consequences showing up somewhere else. A China hard-landing could crash the global economy. The ensuing carnage has the potential to be another Lehman Crisis, or worse. Already, China is on the verge of implementing a tighter monetary policy, which raises the risks of an accident (via Bloomberg):

China’s leaders are pledging a harder push to rein in risk next year and emphasizing prudent and neutral monetary policy. With the Federal Reserve flagging a steeper interest-rate path, that sets the scene for the first U.S.-China tightening since 2006.

President Xi Jinping and his top economic policy lieutenants adjourned their annual planning conference Friday with a vow to safeguard the financial system and deflate asset bubbles. Maintaining stability and making progress on supply-side reform will be key 2017 themes, they said in a statement issued after the three-day Central Economic Work Conference.

“Policy makers are making clear that they’re determined to clamp down on speculation and will keep doing so next year,” said Wen Bin, chief research analyst at China Minsheng Banking Corp. in Beijing. “It’s very important to deflate the property bubble.”

To be sure, China is holding its 19th Party Congress in the autumn of 2017 and its timing will keep economic risk low for most of the year. The Party will do everything in its power to maintain the facade that growth is strong. Any hard landing, should it occur, won`t happen until Q4 2017 at the earliest.

Rising geopolitical risk

Another bearish factor for the market is rising geopolitical risk. A recent CNN Money post-election interview with Warren Buffett found the legendary investor to be bullish on America. However, he expressed reservations about the “temperament and judgment” of president-elect Trump when it came to WMDs.

 

More worrisome was Trump’s remarks about encouraging an arms race in nuclear weapons (via Reuters):

Trump had alarmed non-proliferation experts on Thursday with a Twitter post that said the United States “must greatly strengthen and expand its nuclear capability until such time as the world comes to its senses regarding nukes.”

MSNBC’s Mika Brzezinski spoke with Trump on the phone and asked him to expand on his tweet. She said he responded: “Let it be an arms race. We will outmatch them at every pass and outlast them all.”

In many ways, Americans have been spoiled by the history of their capital market returns. Many analysts have espoused a buy-and-hold discipline to equities, as long as the investor can bear the risk. That`s because the historical record shows that everything has turned out fine in the end, as evidenced by this chart from the Credit Suisse Global Investment Yearbook 2016 (annotations are mine).

 

But the hidden risk to capital returns has always been war and rebellion. Such episodes can turn the above US return pattern to the one below, even if you are a victor but the wars leave you exhausted and depleted.

 

Worst still, they can become like this, even for an economic and technology powerhouse like Germany. The real terminal value for German equities at $42 after 116 years may sound good, but they are dwarfed by the American results at $1271.

 

Or worst still, like this, when investors were far more concerned about personal survival than the value of their portfolios after cataclysmic events like revolution.

 

It would be overly simplistic to assert that Trump’s foreign policy by spur-of-the-moment Twitter is erratic and creates geopolitical instability. Thomas Wright explained in a thoughtful Foreign Policy article that the actual source of that instability comes from the tension between three distinct factions within the Trump administration. The three factions consist of America First, who counts Trump as its leader and is isolationist in outlook, the Religious Warriors, who sees America as locked in an existential conflict against the Islamic threat, and the Traditionalists from the foreign policy establishment. It is the tension between these three groups that create uncertainty about the direction of foreign policy:

These three factions—the America Firsters, the religious warriors, and the traditionalists—are mutually suspicious. But each also needs the others to check the third. Trump needs the religious warriors to prevent a mainstream takeover, but he fears they will drag him into a war against Iran. The religious warriors need Trump to achieve their objectives, but they also have no desire to collapse the U.S. alliance system. The traditionalists need both to check the radical impulses of the other.

The America that Trump inherits faces many geopolitical challenges. Former Swedish PM and diplomat Carl Bildt, writing in Project Syndicate, outlined the threats to the global order with a warning from Henry Kissinger, who has been a master practitioner of realpoltik:

Nearly two years ago, former US National Security Adviser and Secretary of State Henry Kissinger warned the Senate Armed Services Committee that, “as we look around the world, we encounter upheaval and conflict.” As Kissinger observed at the time, “the United States has not faced a more diverse and complex array of crises since the end of the Second World War.”

Bildt went on to fret about how the Trump administration might handle such a vast array of threats:

Against this volatile backdrop, the new Trump administration could very well embrace vastly different policies from what we have seen so far. Judging by the last few weeks, it seems as though we are going to have to live with a routine spectacle of international destabilization via Twitter…

Still, after years of rising turmoil and uncertainty, we have no choice but to assume that more “black swan” events are around the corner. From Donbas to North Korea to the Gulf region, there is no shortage of places where developments could take a shocking turn.

In normal times, the web of international relations affords enough predictability, experience, and stability that even unexpected events are manageable, and do not precipitate major-power confrontations. There have been close calls in recent decades, but there have not been any unmitigated disasters.

But those times may be over. We are entering a period of geopolitical flux: less stable alliances and increasing uncertainty. One should not exaggerate the risk of things spiraling out of control; but it is undeniable that the next crisis could be far larger than what we are used to, if only because it would be less manageable. And that is unsettling in itself.

The combination of Brexit, the Trump election, and anti-establishment threats in Europe has prompted Standard and Poor’s to issue an assessment concluding that political risk in developed markets is no different from the emerging markets (via Bloomberg):

“We believe it may no longer be possible to separate advanced economies from emerging markets by describing their political systems as displaying superior levels of stability, effectiveness, and predictability of policy making and political institutions,” wrote Moritz Kraemer, chief sovereign ratings officer, in a 2017 outlook report entitled “A Spotlight On Rising Political Risks.”

We have all become banana republics.

Loss of business confidence

Speaking of banana republics, Trump’s America is bearing an increasing resemblance to Indonesia under Suharto, or the Philippines under Marcos. Trump’s deals with Carrier to retain jobs in America, where he threatened retribution against any company offshoring jobs, or his tweets against Boeing (complaining about the cost of Air Force One) or against Lockheed Martin (complaining about the cost of the F-35) are examples of one-man rule by edict, rather than by a rules-based institutional system. My concern isn’t just about Trump’s policy by late night tweets, but whether individual decisions represent systematic policy initiatives with thoughtful consideration of policy consequences. Consider, for example, the above discussion about the conflict between fiscal policy and trade policy.

A country that is ruled by edict is a country subject to the whims of a single person. A country ruled by institutions have systems where property rights are upheld and there is high degree of regulatory certainty. Here is Tim Duy‘s reaction to the Trump threat of a tax on companies offshoring jobs:

President-Donald Trump’s renewed call for a 35% import tax on firms that ship jobs out of the United States triggered the expected round of derision from an array of critics, both on the left and the right. The critics are correct. It is indeed a terrible idea. One sure way to discourage job creation in the US is to guarantee that firms will be punished if they need to layoff employees in the future. It is just bad policy, plain and simple.

It`s not just bad policy, Trump has in essence accused American companies of treason and promised to punished offenders. In addition, his proposed initiative of a 35 % import tax sounds distinctly French and exemplifies the worst aspects of eurosclerosis. In France, employers cannot just arbitrarily hire someone. They have to prove that the company has sufficient resources to pay that employee and keep him around for a specific period. While employment law is very employee friendly, it creates a chilling effect for anyone who wants to expand into that jurisdiction. Moreover, such laws inhibit the natural process of creative destruction. In addition, Trump’s recent characterization of the “free market” as a “dumb market” in a Fox News interview does not exactly inspire business confidence (via Business Insider):

President-elect Donald Trump suggested that his administration would have to put a major tax on companies that relocate to other countries and then sell their goods in the US like “we’re a bunch of jerks.”

“What about the free market,” Wallace asked.

“It’s the dumb market,” he responded.

Why would anyone want to invest in France, Indonesia, or the Philippines America under those circumstances?

A collision course with the Fed?

Finally, the most recent hawkish interest rate raise by the Federal Reserve puts it on a potential collision course with the Trump administration. Not only did the Fed raise the Fed Funds target by a quarter point, it signaled that it is likely to raise rates three times, instead of two before the election. This would run counter to the stimulative effects of Trump’s tax cuts.

If Trump were to fill the two open seats on the Federal Reserve board with his hard-money cronies, they would likely favor a Taylor Rule like approach to setting interest rates, which would make the Fed even more hawkish. I recently wrote that my estimate of Taylor Rule target was 2.8%:

 

A more recent estimate of a neutral Taylor Rule target on a Bloomberg terminal turns out to be 4% (see Some perspectives on the new dot plot). A hard-money dominated FOMC would likely see interest rates faster than under a Yellen Fed.

 

I have no idea how this possible confrontation turns out, but the markets could freak out if the White House is on a collision course with the Fed. For some perspective, I conducted an unscientific Twitter poll early in the week asking Trump voters at what rate they would lend money to a government led by Donald Trump.

 

One respondent wrote:

hahahaha…. I would lend Trump money ONLY if secured by COLLATERAL WORTH MUCH MORE than the amount loaned.

That collateral would have to be something I could hold in my possession. Gold, for example.

Those poll results speak for themselves. If you voted for Trump and you are now equity bullish, and you are in the 3% or more camp, then ask yourself, “How much of an increase in earnings growth do you need in order to justify a 1% or more rise in bond yields?”

Bull vs. bear: What to do?

To summarize, my bull case for stocks has SPX earnings rising about 15-18% in 2017. If the P/E multiple stays the same, it would translate to a 15-18% boost to stock prices. On top of that, we have a potential buyback effect amounting to about 5% of index market cap to further raise the upside. If nothing goes wrong, it is easy to make a case that stock prices rise by 20% or more.

By contrast, the bear case consists a mainly of series of possible negative shocks, such as rising geopolitical risk, that raise the risk premium and depress the P/E multiple. There is no way to quantify how much the P/E multiple compresses in a bearish scenario, as much depends on the nature of the bearish trigger.

Here is how I would approach the equity market as 2017 unfolds. Historically, the seasonal pattern remains bullish until just after Inauguration Day. Until then, the market is focused on the positive effects of the Trump tax cuts. Stay bullish until then.

 

As the new Trump team takes over, risks will start to appear and the market is likely to experience some downside volatility. Right now, we have no idea of what the bearish trigger might be, so don’t ask me what the downside target is.

As the year progresses, I will be monitoring the precarious balance of the bull case of cyclical growth, tax cuts, and offshore cash repatriation tax holidays, against the bear case of mainly political and geopolitical risk of the Trump administration. In addition, I will be watching how recession risk develops (see Going on recession watch, but don’t panic!).

Under these circumstances, a blend of both fundamental and technical analysis is useful for guiding where stock prices are likely to go.  From a fundamental and intermediate term perspective, as long as the global cyclical upturn remains intact, my inner investor is inclined to give the bull case the benefit of the doubt. At a tactical level, technical and sentiment analysis will be more useful for determining short-term peaks, bottoms, and other turning points.

The week ahead

Looking to the week ahead, the jury is out on market direction (see Santa Claus rally, or round number-itis). On one hand, next week is one of the most seasonally positive weeks for equities, and for small caps in particular.

 

On the other hand, Helene Meisler observed that a Bradley date, which is an estimate cyclical turning point in a market (not necessarily equities), occurs next week on December 28. In addition, Alex Rosenberg, writing at CNBC, pointed out that there may be a natural huhe man tendency for traders to book a gain as the stock market has had a good year. The selling from the “book a gain” behavior would serve to counteract next week’s positive seasonal effects.

Finally, Ryan Detrick at LPL Research found that the success of the Santa Claus may be a window into the market’s January returns. Simply put, weak Santa Claus rallies tend to see weak January returns:

We’d put it like this; not all red Januaries have had a weak Santa Claus Rally during this period, but all weak Santa Claus Rallies have led to a red January. Over the past 20 years, stock market performance during the Santa Claus Rally has been negative five times and the following January was also red all five of those times.

 

Barring significant market developments, my plan is to start to lighten up on my long equity positions as Inauguration Day approaches. If I were to buy back into the market after a post-inauguration correction, my preference would be to own a buy-write index. The long position in the underlying index provides capital gains upside, and the probable higher level of market volatility will provide juicy premiums from call option writing.

Disclosure: Long SPXL, TNA

Santa Claus rally, or round number-itis?

Posted by Cam Hui -

Mid-week market update: As the Dow approaches the magic 20,000 mark, the question for traders is: Will Santa Claus be coming to town this year, or will the market advance stall as it catches “round number-itis”?
 

 

Here is what I am watching.

Risk appetite

Risk appetite metrics are mixed. Fixed income risk appetite, as measured by junk bond performance (top panel), remains in an uptrend with a series of higher highs and lower lows. On the other hand, the relative performance of small caps (middle panel) and high beta vs. low volatility (bottom panel) have not achieved new highs, though they have not turned down to form a negative divergence. Score this indicator as positive to neutral.
 

 

Seasonality

I am much indebted to Callum Thomas for his analysis that showed that the stock market is tracking its bullish seasonal pattern. If history is any guide, the market will see a final price thrust into year-end.
 

 

For another perspective on seasonality, Jeff Hirsch observed that the DJIA has historically risen 66.7% of the time between option expiration (last Friday) and the December year end for an average gain of 0.83%. The corresponding statistics for SPX are 61.9% success rate and 0.84% gain; for NASDAQ 66.7% success rate and 0.86% gain; and 81.0% success rate and 1.82% gain.

Sentiment

In addition, sentiment readings remain supportive based on Callum Thomas’ Europhiameter:

Another weird and innovative indicator, the “Euphoriameter” attempts to capture the level of euphoria (or otherwise) in the market. It looks at forward PE ratios (higher = more euphoric), the VIX (lower = more euphoric), and bullish sentiment (self explanatory!). The VIX and bullish sentiment measures are 12-month smoothed to give a clearer signal and capture the key trends over the longer term. The main point is that it’s starting to surge after a dive down last year, but is not quite at levels of euphoria that would be considered irrational exuberance as such.

 

Bullish sentiment is rising within a positive momentum backdrop, but readings are not at a crowded long yet. There is more room for stocks to run.

The message from gold

As confirmation of my equity bullish outlook, here is another from an intermarket, or cross-asset, perspective. Gold has been one of the asset classes that has shown an inverse correlation with stocks. I have written in the past that gold and gold stocks did not appear to be ready to rally (see Too early to buy gold and gold stocks), which would be a signal of likely equity weakness. Sentiment analysis from Mark Hulbert confirms this view, Hulbert observed that gold timers have been turning bullish in the face of bullion weakness. In short, gold bulls have yet to throw in the towel on bullion, which is contrarian gold bearish and therefore equity bullish.
 

 

VIX Index

Finally, the market has been experiencing a momentum surge that has been accompanied by a series of “good overbought” RSI readings. One cautionary signal that these advances may stall occurs when the VIX Index falls below its lower Bollinger Band. While that hasn’t happened yet, this is something I am monitoring closely.
 

 

When I put it all together, I have to give the bull case the benefit of the doubt for now. My inner investor remains bullish on equities. My inner trader is cautiously positioned for a year-end rally with long positions in SPX and RUT.

Disclosure: Long SPXL, TNA

How Trumponomics could push the S&P 500 to 2500+

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

Trumponomics: The bull case

It’s nearing year-end and prognostication season. Rather than just gaze into my crystal ball and make a forecast for 2017, I will write a two-part series on the likely effects of the new president on the stock market. This week, I focus on the bull case.

Since the recent upside breakout, point and figure charting is pointing to a SPX upside target of 2523, which represents a gain of 11.7% from Friday`s close. I show how that figure is easily achievable under the Trump proposals – and more.
 

 

Earnings, earnings, earnings!

The bull case for stocks rests mainly on earnings growth. There are three components of earnings growth that investors should focus on:

  1. Organic growth, in the absence of Trumponomics
  2. Tax cut effects
  3. One-time offshore cash repatriation effects

If we start with organic EPS growth, the November 4 pre-election bottom-up Street estimates from Factset showed a forecast of $119.47 for FY2016 SPX and $113.68 for FY2017, which comes to an earnings growth rate of 11.8%. The latest Factset consensus estimates in the post-Trump era also shows an identical EPS growth of 11.8%, which indicates that company analysts have not incorporated the unknown effects of Trump’s fiscal proposals into their earnings estimates.
 

 

However, I would caution that these EPS growth estimates need to be taken with a grain of salt. Ed Yardeni showed that bottom-up derived Street EPS forecasts tend to start high and fall. That`s why I focus on the evolution of forward 12-month EPS, which is more stable.
 

 

So let`s be conservative and cut that growth figure by somewhere between one-third and one-half. We arrive at an organic EPS growth rate of about 6-8%.

On top of that, we can add the tax cut effect of the Trump fiscal proposals.  Bloomberg recently summarized the tax cut earnings effect of different Street strategists. The growth projections vary, but come to about 10%:

  • Deutsche: $10 (8.4% EPS growth), based on a tax cut to a rate of 25%
  • JPM: $15 (12.6% growth), based on a 15% tax rate
  • Citi $12 (9.3% growth), based on a 20% tax rate (via CNBC)

Add the 10% tax cut effect to the organic EPS 6-8% growth rate, we get to a 2017 EPS growth rate of 15-18%. In the absence of changes in P/E multiples, the SPX could therefore rise 15-18%, in line with earnings growth. That gives us a 2017 year-end projection in the 2600-2650 range, which is above the point and figure chart target of 2523.

That’s not all, Brian Gilmartin recently took a stab at estimating the offshore cash repatriation effect:

Yesterday, 12/6/16, at the CFA Chicago luncheon, Dan Clifton of Strategas Partners gave a great presentation on the coming fiscal stimulus and what it might look like and what it might mean for the US economy in 2017.

The inevitable question about cash repatriation came up and Dan gave a lengthy and thoughtful response, but he eventually got down to the numbers: Dan thought that as much as $1 trillion could be brought back to the US as repatriated cash, and granted investors will hear the standard hue-and-cry about using the repatriated cash to repurchase stock, Clifton thought that $300 – $400 billion of the repatriated cash could be spent directly on buybacks.

Looking at the numbers:

  • The current market cap of the SP 500 is roughly $19 trillion, so roughly 5% of the SP 500 market cap could be repatriated;
  • In terms of the “index divisor” (per Thomson Reuters data) there are 8.6386 billion shares used in the SP 500 EPS calculation.
  • Using Clifton’s numbers, if $300 – $400 billion of the $1 trillion is used directly on shares repurchases, then roughly 1.5%, 2%, 2.5% of the SP 500’s market cap could be repurchased JUST from overseas cash repatriation in 2017.

This obviously doesn’t include any cash generated from a reduction in effective tax rates, faster revenue growth or cash generated normally from operations, resulting in free-cash-flow.

Let`s summarize the results. Start with a 15-18% increase in stock prices, which assumes no changes in P/E multiples. Add to that an estimated buyback demand amounting to roughly 5% of total market cap, you have the bull case for stocks. As Brian Gilmartin put it:

In year-end meetings with clients, I’m telling clients from both sides of the aisle that the SP 500 could be up 20% next year. Prior to the election and since last Spring ’16, the SP 500 was already looking at its best year of expected earnings growth in 5 years. The proposed President-elect and Congressional fiscal policy could be another level of earnings growth above what was already built into the numbers, before November 8th.

Any way you slice it, the upside potential for US equities in 2017 easily comes in at 15-20%.

The big money stampede

While the fundamental outlook appears to be positive, no equity rally is sustainable without the participation of the big money institutions. The latest BAML Fund Manager Survey shows that the institutional risk appetite is rising in a big way.

They believe that global growth is returning. Growth expectations have spiked significantly in the last few months.
 

 

As a consequence, earnings expectations have also risen dramatically too.
 

 

In response to this newly upbeat assessment, institutions are taking more risk with their portfolios. Readings are rising, but nowhere near crowded long levels.
 

 

They are buying equities.
 

 

US equity exposure is rising, but they are not over-owned.
 

 

Similarly, the AAII sentiment survey of individual investors can hardly be described as being all-in on stocks.
 

 

In summary, sentiment models show that investors are piling into risky assets, but the stampede is just in its early stages. There is still time to jump on the bandwagon.

Valuation not excessive

What about valuation? Stock prices appear to be highly overvalued on CAPE, but Michael Batnick pointed out that the CAPE is a terrible metric for short-term market timing: “Over the past 25 years, the CAPE ratio has been above its historical average 95% of the time. Stocks have been below their historical average just 16 out of the last 309 months. Since that time, the total return on the SP 500 is over 925%”.
 

 

By contrast, the Morningstar fair value estimate shows that stock prices are mildly overvalued by 4%, but that’s not excessive compared to its own history.
 

 

I would be far more worried if insiders were consistently selling in an overvalued market. The latest update from Barron’s of insider activity shows that insider activity at a neutral level, despite the proximity of all-time highs in stock prices.
 

 

The week ahead: Will Santa show up?

Looking to the week ahead, the Santa Claus rally may be just getting ready to get rolling. Now that the equity market has successfully navigated the hawkish FOMC rate hike, the seasonal pattern is highly favorable. Rob Hanna at Quantifiable Edges observed that stock prices tend to rise and continue rising starting December option expiry (OpEx) week, which began last Monday.
 

 

In addition, the electoral pattern shows that stock prices tend to have an upward bias and peaks out just after Inauguration Day.
 

 

My inner investor remains bullish on stocks. My inner trader is positioning himself for the seasonal rally. Subscribers received an email notice last Thursday indicating that my inner trader had added to his long equity exposure with a purchase of small cap stocks.

Unless something earth shattering happens in the markets next week, postings will be light or nonexistent as I take a week off during the holidays. The next scheduled update will be on Monday, December 26 when I outline my Trumponomics bear case for stocks, and how I resolve the bull and bear scenarios.

Disclosure: Long SPXL, TNA

Some perspective on the new dot plot

Posted by Cam Hui -

In my post written last weekend (see Watch the reaction, not just the Fed), I suggested that the key to future stock market trajectory was not just the FOMC statement, but the reaction to the statement and subsequent press conference:

  • What happens to the dot plot?
  • How will the market react to the Fed’s message? Will the current market expectations of about two more rate hikes in 2017 change?
  • How will Donald Trump react to the likely quarter-point rate hike?

I had expected a stand pat Summary of Economic Projections (SEP), otherwise known as the “dot plot”. Instead, the FOMC shaded up the dot plot, which suggests that 2017 will see three quarter point rate hikes instead of two (chart via Business Insider).
 

 

The market reaction was understandably negative. Stock prices fell. Rates rose across the board, but the 2/10 yield curve steepened, which indicated market expectations of better growth.

Here is my perspective on the new dot plot and subsequent market reaction.

Bernanke on the “dot plot”

Former Fed chair Ben Bernanke recently wrote about how to use the “dot plot”, or SEP. Here is how not to use the SEP.

  • It is not a policy commitment by the FOMC
  • It is not an unconditional economic forecast

More revealing was his comment that investors should think of the SEP as a straw poll:

The FOMC is not a simple democracy but a consensus-driven organization, with the agenda set by the chair. Only twelve of nineteen participants have a vote at each meeting. Consequently, it is not straightforward to infer FOMC policy by looking at the median SEP projection of rates or other variables, without benefit of other information. Still, in conjunction with speeches and other public comments, the SEP does provide timely quantitative information about the range of views on the committee and how the thinking of participants is evolving. I think of the SEP as a straw vote, a reflection of the range of sentiment going into the full committee debate.

Does the SEP straw vote predict actual FOMC decisions? Interest-rate projections in particular are still a relatively recent innovation, so the data seem insufficient at this point to give a clear answer to that question. The SEP released after the September FOMC meeting showed a strong majority of committee participants (all but three) expecting another rate increase this year, and an increase does seem likely for December. On the other hand, recently, SEP rate projections over longer horizons have been too optimistic about the ability of the economy to sustain rate increases (for example, as of a year ago many participants saw four rate increases in 2016). As discussed further below, however, I believe that discrepancy is explained by systematic changes in participants’ outlooks in light of new economic information, not by the failure of the SEP to capture the range of views at a particular moment in time.

In other words, the dot plot represents individual FOMC members’ views of interest rate projections given all of each person’s view of how the economy is likely to develop. So what are we to make of the new development where the “dot plot” now expects three 2017 rate hikes instead of two?

From the market’s perspective, the combination of rising yields and a steepening yield curve indicates that bond market continues to focus on higher growth expectations. The steepening yield curve is directly contradictory to the reflex sell-off in stock prices. If the bond market’s verdict is to be believed, then this development should be interpreted as equity bullish.

What about Trump?

The one missing ingredient to the FOMC announcement was the reaction from PEOTUS Donald Trump. On one hand, the change in the “dot plot” from two 2017 rate hikes at the pre-election September meeting to three rate hikes could be seen as a challenge to the incoming president’s agenda. Not only did the Fed raise rates in December, it went on to signal a faster pace of rate normalization in 2017.

On the other hand, if Trump were to appoint any of his hard-money supporters to the two open positions to the Federal Reserve board, they are likely to be more hawkish than the current FOMC. Potential board members from the “audit the Fed” and hard-money school are likely to support a rule-based approach to monetary policy, such as the use of the Taylor Rule to set interest rates. I indicated in my weekend post (see Watch the reaction, not just the Fed) that my Taylor Rule estimate puts the target Fed Funds rate at 2.8%, which is significantly above the even raised Fed Funds target.
 

 

Further analysis by Holger Zschaepitz of Die Welt using his Bloomberg terminal showed that the Taylor Rule target is even higher at 4%: Everything else being equal, the adoption of an equilibrium Fed Funds rate of between 2.8% and 4.0% is likely to accelerate the pace of rate hikes, which would largely negate the pro-growth effects of Trump’s fiscal policy stimulus.
 

 

So we are left waiting for the next shoe to drop. What will Trump say? Will he go on Twitter and criticize the Fed for adopting a more hawkish outlook, or will he acquiesce to hard-money supporters and prefer an even aggressive pace of monetary tightening?

Watch this space.

FOMC preview, part II

Posted by Cam Hui -

Further to my last post (see Watch the reaction, not just the Fed), I got a number of questions that asked if there are any factors or nuances from the FOMC statement or subsequent press conference to watch for.

Firstly, I reiterate my point that the reaction to the Fed is far more important to the future direction of stock prices than the Fed statement itself. I expect that the Fed will try very hard to remain apolitical and refuse to react to any possible changes in fiscal policy until they are actually announced. Nevertheless, I will be watching if the committee makes any references to:

  • The strength of the US Dollar; and
  • Any possible changes in the projected path of inflation.

How the Fed views these factors will influence affect the pace of interest rate normalization in 2017.

What about the USD?

A rising currency has a natural deflationary effect, because imports become cheaper, which puts downward pressure on inflation. The recent bout of USD strength has a similar effect of tightening monetary policy.
 

 

If the FOMC statement makes a reference to the strength in the greenback, interpret it as dovish.

Wither inflation?

The chart below shows the number of instances in a trailing 12-month window when the annualized monthly increase in core PCE exceeds the Fed’s inflation target of 2%. In the past, the Fed has embarked on a tightening cycle when the number of instances has reached 6. The current reading is 5, which is close, but not yet.
 

 

How the Fed views the development of inflation develops will be a critical input in the future path of monetary policy. Here, the picture is mixed. As the chart below shows, market based inflationary expectations metrics have been rising, but survey based data has remained steady.
 

 

Higher inflationary expectations will put more pressure on the Fed to have a hawkish tilt, while steady inflationary expectations can give the Fed cover to remain dovish and adopt a wait and see attitude.

Watch the reaction, not just the Fed

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

All eyes on the Fed

As market activity starts to wind down for the holiday season, the major event next week will be the FOMC meeting. The Fed’s policy move has been well telegraphed and a quarter-point rate hike will be a foregone conclusion. Bond yields have been rising, and so have inflationary expectations, but that’s not a surprise. Sometimes the best part of watching a play where you already know the plot is to watch the audience`s reaction.
 

 

Even as bond prices got clobbered, equities have soared. Major US indices achieved new record highs last week. At this rate, the SPX may achieve its point and figure target of over 2500 in the not too distant future.
 

 

To stay ahead of the markets, here is what I will be watching next week in the wake of the FOMC announcement:

  • What happens to the dot plot?
  • How will the market react to the Fed’s message? Will the current market expectations of about two more rate hikes in 2017 change?
  • How will Donald Trump react to the likely quarter-point rate hike?

Watch the audience, not just the show.

A well telegraphed rate hike

There are plenty of reasons why the Fed should start a rate hike cycle. The unemployment rate is falling, and the normalized initial claims to population metric is at an all-time low. The combination of these factors is pointing to cost-push inflationary pressure because of rising wages.
 

 

Economic conditions today are typical of a late cycle expansion. The combination of rising wages and rising core PCE generally lead to tighter monetary policy. It’s time for the Fed to tap on the brakes.
 

 

Global reflation is here

Economic growth is robust again after the mid-cycle slowdown early this year. The good news is that the economic expansion is global in scope. PMIs (Purchasing Managers’ Index) are rising and tell a story of global reflation.
 

 

Bloomberg reported that Citigroup’s Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations, are positive in all of the big regions.
 

 

Is the upturn sustainable? Gavyn Davies is hopeful. The improvement in growth is widespread and it’s coming from both EM (emerging markets) and AE (advanced economies):

[T]he main reason for the recent uptick in global growth has stemmed from the EMs, notably from the major easing in fiscal policy in China, and the flattening in deep recessions in Russia and Brazil. The main downside risks to growth prospects in the EMs are a return to tighter credit control in China and an outflow of capital as an aggressive tightening in Fed policy pushes the dollar higher. These risks need to be watched, but do not seem imminent.

In the AEs, fiscal policy is being eased, monetary policy is still accommodative and the manufacturing sector is gaining from firmer corporate investment as the energy shock dissipates. These developments may lead to an upgrade to growth forecasts in the AEs for the first time in many years, provided that a major shock to confidence can be avoided from a shift towards populism in elections in the Eurozone next year.

Overall, we can perhaps be hopeful, though certainly not yet confident, that the global economy will begin to overcome the powerful forces of secular stagnation next year.

Is it any surprise that the Fed is getting ready to raise rates?

Equity market reaction

What about the stock market? Won’t rising interest rates tank stock prices?

Under “normal” circumstances, the initial phase of a rate hike cycle tends to be equity bullish. That’s because the positive effects of better growth expectations overcome the negative effects of higher rates. As this chart from the JPM Asset Management shows (annotations are mine), stock prices tend to be correlated with changes in bond yields when yields are low.
 

 

As this chart from Factset shows, the trailing P/E ratio for the market is 20.5, which translates to an earnings yield of 4.9%. Factset also reported that the forward 12-month P/E ratio is 17.1, which corresponds to an earnings yield of 5.8%. I arrive at a ballpark earnings yield estimate of somewhere between 4.9% and 5.8%. That still compares favorably to a 10-year Treasury yield of 2.4%. TINA (There Is No Alternative) is still at play today (for now).
 

 

Moreover, earnings growth expectations are still rising. Factset’s analysis shows that forward 12-month EPS has been trending upwards for several months.
 

 

What could derail this rally?

Under “normal” circumstances, the market “should” focus on the rising growth outlook and bid up stock prices. But do the words “normal” and “should” apply to today’s market environment?

There are a few factors that could derail a potential stock market rally into 2017. First, the Fed could spook the market with a more aggressive path of rate normalization. New York Fed President William Dudley created some uncertainty in a speech last week. First, he stated that he supports starting a rate hike cycle:

If the economy grows at a pace slightly above its sustainable long-term rate, as I expect, the labor market should gradually tighten further, and the resulting pressure on resources should help push inflation toward our 2 percent objective over the next year or two. Assuming the economy stays on this trajectory, I would favor making monetary policy somewhat less accommodative over time by gradually pushing up the level of short-term interest rates.

But the election of Donald Trump creates “considerable uncertainty” for fiscal and monetary policy:

Obviously, there is still considerable uncertainty about how fiscal policy will evolve over the next few years. At this juncture, it is premature to reach firm conclusions about what will likely occur. As we get greater clarity over the coming year, I will update my assessment of the economic outlook and, with that, my views about the appropriate stance of monetary policy.

Does that mean a more aggressive dot plot? Probably not, but Janet Yellen’s body language in the subsequent press conference might signal a more hawkish tilt, depending on how the FOMC interprets the new administration fiscal policy proposals.

What about The Donald? How will Trump react? Will he tweet and express his displeasure with the FOMC decision? Will he view a rate hike as a personal challenge to his plan to revive the economy and Make America Great Again?

Already, we have sensational headlines from the likes of Zero Hedge. The market will not react well if war erupts between Trump and Yellen.
 

 

I am still struggling with a contradiction about Trump’s view of monetary policy. I understand that Trump may like a more dovish interest policy, but much of the criticism of the Fed voiced by ZH and many Trump proxies are contrary to that preference. As an example, CNBC reported that Trump advisor and transition team member Judy Shelton criticized the Fed for undue meddling in the economy:

The Federal Reserve shouldn’t be driving the United States economy because monetary stimulus is quite limited, Trump economic advisor Judy Shelton told CNBC on Wednesday.

“What you want is productive growth and the kind of growth that is truly stimulated by tax reform, by regulatory reform, trade reform and important infrastructure projects to upgrade our ability to be more productive as a nation,” she said in an interview with CNBC’s “Closing Bell.”

Similarly, ZH touted the likes of Jim Grant, David Stockman, Jim Rogers, and Ron Paul for the two open positions of governors on the Federal Reserve Board:

If it is indeed Yellen’s plan to tank the Trump presidency on her way out by raising interest rates, the Donald should fight back. He should take to his best medium, the TV, and begin making the public aware of the sabotage going on. When Yellen abandons her throne, Trump should appoint someone who is concerned about the dollar’s long-term stability. A few choices off the top of my head: finance writer and all-around mensch Jim Grant, former Director of the Office of Management and Budget David Stockman, commodity guru Jim Rogers, or former congressional representative and arch-Fed-critic Ron Paul.

Either would do nicely in turning the Fed from a politically-driven economy-destroying machine into something far less dangerous. And each could do their part in making King Dollar great again.

These potential candidates to the Federal Reserve board, which includes Shelton, all share one characteristic. They all hated the Fed’s quantitative easing programs and easy monetary policy. They would prefer to hold Fed policy to some fixed rule, such as a Taylor Rule, for determining interest rates.

Here is my problem. The chart below shows a projected Taylor Rule rate that assumes a 2% constant real rate and 2% inflation target. The Fed Funds rate be roughly 2.8% today, which would kill any recovery and choke off economic growth. Is this what Trump really wants to Make America Great Again?
 

 

Notwithstanding any potential war of words between the Yellen Fed and the incoming Trump administration, Business Insider reported that Deutsche Bank modeled the possible paths of monetary policy in light of Candidate Trump’s fiscal policy proposals.
 

 

Depending on how fiscal policy evolves, we could see a heightened pace of rate hikes in the last half of 2017 compared to the current market expectations. Just remember the trader’s adage, three steps and a stumble, where three consecutive rate hikes tend to signal the start of a bear market.

That’s why it’s important to monitor Trump’s reaction to any rate hike.

The week ahead

Looking to the week ahead, there is no shortage of seasonality studies with bullish conclusions. Dana Lyons pointed out that December stock markets tend to tilt bullishly if the VIX Index makes a 3-month low in the first half of the month.
 

 

Equity options expire on Friday. Rob Hanna at Quantifiable Edges observed that December OpEx is one of the most bullish OpEx weeks of the year.
 

 

However, positive seasonal effects go out the window in light of the possible volatility from next week’s FOMC meeting. As we stand now, the stock market is dramatically overbought as major equity indices have surged to record highs.
 

 

This chart from IndexIndicators of stocks above their 10 dma is a short-term (1-3 day time horizon) is flashing warnings of near-term downside risk.
 

 

This net 20-day highs-lows is a longer term (1-2 week time horizon) indicator that is also signaling caution for the bulls.
 

 

In addition, the CNN Money Fear and Greed Index is also overbought. Its own history shows that its signals can be several weeks early and this is not a precise contrarian indicator.
 

 

With those conditions in mind, I believe that any market consolidation or correction next week represents a great opportunity to buy stocks and to get positioned for a year-end rally. The trend in rising risk appetite is a signal of significant FOMO (Fear Of Missing Out) buying momentum.
 

 

My inner investor remains bullish on equities. My inner trader took an initial long SPX position. He is enjoying the rally but he is waiting for a pullback to put more money to work on the long side.

Disclosure: Long SPXL

A tale of two markets

Posted by Cam Hui -

Mid-week market update: It was the best of times, it was the worst of times. Stock prices continue to surge ahead, while the bond market *ahem* is having its difficulties.

The Dow Jones Industrials Average made another record high, followed by the Transportation Average. The combination of the dual all-time highs constitutes a Dow Theory buy signal.
 

 

By contrast, investors are fleeing the bond market. Moreover, the yield curve is steepening, which means two things. First, long dated yields are rising higher than short yields, which means that investors at the long end of the maturity curve got hurt more. In addition, a steepening yield curve has historically been the bond market’s signal of better growth expectations.
 

 

How are we to interpret these differing patterns in stocks and bonds? Have stocks gone too far? Are bonds ready for a comeback?

Stocks: A “good” overbought reading

You can tell a lot about the character of a market when you watch how it responds to news. On the weekend, Italy overwhelming voted “no” to change its constitution. That outcome caused prime minister Matteo Renzi to resign, which raised the risk of more instability in the eurozone.

So what happened next? Stocks rallied. What’s more, the yield spread between Italian BTPs and German Bunds narrowed.

Stock prices continue to grind upwards. As the chart below shows, the SPX has flashed a series of overbought readings on RSI-5, only to pull back when RSI-14 hit 70, which is an overbought level. These is a classic example of what my former Merrill Lynch colleague Walter Murphy called a series of “good overbought” readings.
 

 

In the short-term, equities prices may pause and pull back a little here. Short-term breadth metrics are not at extreme levels. As this chart from IndexIndicators shows, % of stocks above their 5 dma is getting a little stretched.
 

 

However, these timing models tend to have a very short-term (1-2 day) time horizon and any pullback is likely to be shallow given the powerful momentum that underlies this rally.

Bonds: A “bad”oversold condition?

By contrast, consider this chart of TLT, which is the long Treasury ETF. Prices appear to be trying to find a bottom. It is experiencing a series of positive divergences on RSI-5 and RSI-14 even as it sees a number of “bad oversold” RSI readings, indicating negative price momentum.
 

 

The latest Commitment of Traders data shows that large speculators, or hedge funds, have moved to a short position in the 10-year note (charts via Hedgopia):
 

 

…and in the long Treasury bond. These readings are indicative of crowded short positions.
 

 

Is the bond market flashing a series of “bad oversold” conditions? Should you try to catch falling knives?

To be sure, a longer term perspective of the 10-year Treasury yield shows that the downtrend is still intact.
 

 

Bond bulls shouldn’t worry – just yet.

The inter-market analysis interpretation

Have stock prices risen too far, too fast? Are bond prices poised to bounce? Here is my interpretation based on inter-market, or cross-asset, analysis.

The relative performance of SPY to TLT just staged an upside breakout from multi-year resistance level stretching back to 2007. While the price break is not definitive, it potentially signals a sea-change in risk appetite and the relative performance of stocks vs. bonds.
 

 

We can get more clues form other underperforming assets, such as gold and gold stocks. As the chart below shows, gold stocks (GDX) are showing a similar bottoming technical pattern as bond prices. As I indicated before, the % bullish metric (bottom panel, also see Why it’s too early to buy gold and gold stocks) tend to form double or multiple bottoms before a sustainable bottom is made. Gold and bond prices could bounce here, but any strength is likely to be short-lived.
 

 

One clue to the timing of any turnaround in stock, bond, and gold prices is the US Dollar (top panel). The USD Index has pulled back to test support at its last breakout. The success of any bounce in gold and bonds, as well as a pullback in stock prices, can be found in the behavior of the greenback.

In conclusion, the stock market is experiencing strong price momentum from a FOMO (Fear Of Missing Out) risk-on stampede in the wake of the election. Expect stock prices to pause or pull back for 1-2 days, but continue advancing for the remainder of December as underperforming managers pile into the career risk trade in order to chase returns. Any pullbacks should be regarded as buying opportunities. Conversely, any turnarounds in gold or bond prices in the month of December will probably be fleeting. Better opportunities in those asset classes are likely to emerge in 2017.

Disclosure: Long SPXL

Do you have what it takes to succeed in finance? (Dani Rodrik trilemma edition)

Posted by Cam Hui -

Dani Rodrik of the Harvard Kennedy School has outlined a trilemma of the global economy.
 

 

The Economist explained the trilemma this way:

Dani Rodrik of Harvard University is the author of the best-known such critique. In the late 1990s he pointed out that deeper economic integration required harmonisation of laws and regulations across countries. Differences in rules on employment contracts or product-safety requirements, for instance, act as barriers to trade. Indeed, trade agreements like the Trans-Pacific Partnership focus more on “non-tariff barriers” than they do on tariff reduction. But the consequences often run counter to popular preferences: the French might find themselves barred from supporting a French-language film industry, for example.

Deeper integration, Mr Rodrik reckoned, will therefore lead either to an erosion of democracy, as national leaders disregard the will of the public, or will cause the dissolution of the nation state, as authority moves to supranational bodies elected to create harmonised rules for everyone to follow. These trade-offs create a “trilemma”, in Mr Rodrik’s view: societies cannot be globally integrated, completely sovereign and democratic—they can opt for only two of the three. In the late 1990s Mr Rodrik speculated that the sovereignty of nation states would be the item societies chose to discard. Yet it now seems that economic integration may be more vulnerable.

In practice, it is difficult to integrate global trade without the harmonization of standards and business practices. While that sounds fine in theory, here is an example of what happens when the rubber meets the road.

Ogden vs. CIBC

Consider the case, and this was literally a court case in the Canadian province of British Columbia, of Ogden vs. Canadian Imperial Bank of Commerce, 2014 BCSC 285. The case involved the litigation of Guiyun (Han) Ogden against her former employer CIBC. Guiyun Ogden comes from an ethnic Chinese background and she acted as a licensed financial advisor. Her employer fired her for cause and the ensuring legal dispute revolved around whether the act of termination for cause was overly harsh.

Without regard for the merits of the case, the business practice that Ogden used raised a number of eyebrows. (Note that this summary was written by a Canadian judge):

[162] This incident occurred on September 9, 2010, when Ms. Ogden received two wire transfers from third parties in China and had the funds immediately transferred into the account of Ms. Xuelan Xu.

[163] Ms. Xu was a client of Ms. Ogden’s. She emigrated from China in 2009 and lived in Richmond. Ms. Xu had found a $5.7 million home in Vancouver that she wanted to buy. She was approved for a $3.45 million personal line of credit through Ms. Ogden to finance, in part, the purchase of this home. Ms. Xu testified that she needed to bring just over $500,000 into Canada from China for the deposit.

[164] As a result of Chinese regulations at the time, each individual was restricted to transferring no more than $50,000 USD abroad annually out of China. Working around these regulations was a challenge and a complicated process, but it was a practice CIBC supported. There is no issue about this. If, for example, a CIBC client wanted to send $150,000 from China to Canada, the money had to come from three accounts belonging to three different account holders in China and be transferred to three separate accounts belonging to three separate account holders in Canada. As long as all the appropriate accounts were set up, the money could be moved.

[165] In order to work around the Chinese transfer limits in this case, Ms. Xu needed 10 different account holders in China to send wire transfers to 10 different accounts in Canada. And she ran into a problem.

[166] On September 9, 2010, in the middle of the night, Ms. Ogden received a phone call from Ms. Xu. She was in a panic. She was short two accounts to bring in two wire transfers of $50,000 USD. Ms. Xu was calling from Vancouver, but she had two people at a bank in China at that very moment – with the 16 hour time difference it was business hours in China – ready to wire the funds from their respective accounts. The urgency was that the deal on Ms. Xu’s $5.7 million home would collapse if the funds weren’t transferred immediately as the deposit funds had to be in Canada the following day to secure the offer.

[167] Ms. Xu asked Ms. Ogden to provide her with two of Ms. Ogden’s own account numbers so that the funds could be transferred from China and then into Ms. Xu’s accounts the following day. It was the middle of the night. Ms. Ogden had no one to consult.

[168] Ms. Ogden sat up in bed and quickly thought about it. A third party didn’t need her authorization to deposit funds into an account. Anyone could deposit funds into an account by wire transfer or at the counter. So that part seemed fine. The next part – money leaving Ms. Ogden’s account – that required her authorization. But of course she would give her authorization and transfer the funds. She was not borrowing money from the client. She was not lending money to the client. She was not using client money.

[169] In the unique context of the wire transfer limits out of China, she was trying to facilitate the client’s need to bring the necessary family funds to Canada so that she could close the deal on the home. Ms. Ogden concluded there was no problem with the transaction and gave Ms. Xu two of her own personal account numbers.

I can see a few problems here. First, there is the compliance issues of accepting wire transfers of US$50,000 from 10 different sources (how do you know it’s not drug money, or funding terrorism? Also see my previous post How China’s Great Ball of Money rolled into Canada), As well, Ogden`s practice of co-mingling client funds with her own got her in trouble with her employer.

This is where Rodrik`s trilemma comes in. Trade globalization requires the harmonization of practices. But whose practice do you adopt?

[170] The cultural aspect of how business is conducted in China is an important overlay to this case. It explains why Ms. Ogden was so successful at her job. And it explains – in part – why she held the view that how she facilitated the transfer of funds for her client from China was a reasonable course of action. Ms. Ogden testified that in China you form a relationship first, as friends and then you do business. Thus, business is conducted as friends helping friends.

[171] Rose Wang is a current CIBC client and was on Ms. Ogden’s portfolio. Ms. Wang testified that, in China, “it is quite normal for money to go back and forth between account manager and client”. If Ms. Wang was out of the country, for example, her account manager in China would pay $20,000 for Ms. Wang’s insurance premiums “using the account manager’s own funds”. Ms. Wang testified she would pay her account manager back by transferring funds between their accounts.

[172] Ms. Xu echoed this sentiment and testified that in China it was “very common” for her bank account manager to make various payments on her mortgage or credit card using “the account manager’s own funds” if Ms. Xu was out of the country. Ms. Xu would simply pay the account manager back when she returned.

[173] The practice in China does not impact the fact that a Canadian bank policy governed Ms. Ogden’s conduct in this case, but it does help to understand why Ms. Xu did not think her request was unusual. This was not the case of a client saying “I know you probably shouldn’t do this but… ”. The conflict of interest was certainly not apparent to Ms. Xu.

It is trite to say that business in China is based on relationships. But how far will you go to get business in China based on these “relationships”? If you were a bank manager, or bank executive, would you pay your client’s expenses out of your own pocket with the understanding that the client would reimburse upon her return?

Where do you draw the line in a client-adviser relationship? How do you define fiduciary duty in such an instance?

Guiyun Ogden operated according to Chinese business practices in Canada. Because of that, she was very successful at her job of cultivating Chinese clients. For that, she was fired by her employer for violating the bank’s standards against co-mingling client funds with her funds. (The fact that the bank turned a blind eye to numerous US$50,000 wire transfers into a single account is a different issue that needs to be addressed elsewhere.)

It depends on what you mean by “ethics”?

The bank’s view was Ogden violated bank policy by creating a conflict of interest when she co-mingled client funds with her own. What she did opens the door to embezzlement, which is a liability that no bank wants. Her employer therefore created policies and procedures to guard against that kind of behavior.

On the other hand, Ogden operated according to Chinese relationship business practices, where transactions like these were not unusual at all. After all, relationships are based on trust. As long as there is trust, there is profit potential from additional banking business.

How far would you go?

This becomes a Rorsbach test of how far you are willing to go in order to succeed in finance. How far would you go to bend the rules, especially if what you are doing is considered to be normal business practice in the country or culture that you are catering to.

Before you answer that question, Ben Carlson at A Wealth of Common Sense recently outline some important research from John Bowman of the CFA Institute, who conducted a survey of investment professionals:

  • Only 28% of respondents said they remain in the investment industry to help clients achieve their goals. This one is depressing but not surprising. 
  • Nearly two-thirds (62%) of investment professionals believe that their organization is acting in its own best interest rather than the client’s. Also depressing.

If only 28% of investment advisers are there to serve their clients and 62% believe that their employer is acting in its own best interest, what does that say about the incentive system (Exhibit A: Wells Fargo)?

Now tell me how far you would go to succeed in finance (in the face of differing business practice standards)?

Trump makes stocks great again (for now)

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in 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.

Remember the Audacity of Hope?

Does anyone remember Obama’s “Audacity of Hope” campaign that won him the White House? As a reminder, here is a video clip from eight years ago which depicted an Obama supporter who believed that the new administration would pay for her gas and mortgage. Fast forward to today, Obama’s legislative legacy is far less impressive than what his enthusiastic supporters expected from St. Barack of Chicago.

 

While the jury is still out on what the political expectations are for Donald Trump’s win, market expectations are getting positively giddy, which may be setting itself up for disappointment. Here is what Ed Hyman of ISI Evercore observed from his survey of institutional clients:
 

 

Will the legacy of Trump’s “Make America Great Again” be similar to Obama’s “Audacity of Hope”? While it’s far too early to make any kind of judgment, I made the point last week that the fundamentals for the current market rally have been in place before the election (see The start of a new Trump bull?), the electoral results seemed to have awakened the market`s animal spirits.

There is much to get enthusiastic about. Evidence of a reflationary turnaround had been brewing since the summer. Many of the stated business friendly policies of the Trump administration are also reasons to get bullish on stocks. However, excess bullishness can carry the risk of the bulls’ demise. Jeffrey Gundlach recently warned that the rally was losing steam:

The strong U.S. stock market rally, surge in Treasury yields and strength in the U.S. dollar since Trump’s surprising Nov. 8 presidential victory look to be “losing steam,” Gundlach, who oversees more than $106 billion at the Los Angeles-based investment management firm, said in a telephone interview.

“The bar was so low on Trump to the point people were expecting markets will go down 80 percent and global depression – and now this guy is the Wizard of Oz and so expectations are high,” Gundlach said. “There’s no magic here.”

Gundlach had warned last month that federal programs take time to implement, rising mortgage rates and monthly payments are not positive for the “psyche of the middle class and broadly,” and supporters of defeated White House candidate Hillary Clinton are not in a mood to spend money.

“There is going to be a buyer’s remorse period,” said Gundlach, who voted for Trump and accurately predicted in January the winner of the presidential election.

Has Trump made stocks great again? Should you get cautious? Here is how I would play the market as I peer into 2017.

No shortage of good news

Notwithstanding the Trump Effect, there is plenty of good news to get excited about. The reflationary trend is not just isolated to the US, but it is global in scope. Bloomberg recently featured an article about 10 good pieces of economic data from around the world:

  1. China’s manufacturing purchasing managers index rose to 51.7 in November, above market expectations.
  2. Manufacturing in the U.S. expanded in November at the fastest pace in five months, underscoring the healthy outlook for domestic consumer demand.
  3. Sentiment among U.S. consumers has held close to the highest level of the year, a boon for spending prospects.
  4. In the euro-area, joblessness fell to 9.8 percent in October from a revised 9.9 percent the month prior, the lowest level since July 2009.
  5. Industrial output in the euro-zone accelerated at its strongest pace in almost three years last month.
  6. In Canada, third-quarter growth surprised to the upside at 3.5 percent.
  7. In South Korea, exports rose 2.7 percent year-on-year in November, after a 3.2 percent decline in October.
  8. In Japan, corporate profits have rebounded by over 11 percent year-on-year, underscoring “a broad pattern around the world (U.S., China, other countries as well) that has seen the ‘earnings recession’ driven by higher dollar and lower oil/commodities start to roll off without an economic recession,” according to a note by Bespoke Investment Group.
  9. PMI readings by IHS Markit for Austria, the Netherlands, and Russia are both at the highest levels since the financial crisis. Meanwhile, purchasing managers indexes for Spain, Italy, France, and Germany are slowly, though, unevenly improving.
  10. Even in Russia, a rebound may be nigh: In the third quarter, the manufacturing PMI rose above the 50 threshold for the first time since 2014.

Last but not least, the November Non-Farm Payroll report came in slightly ahead of expectations. Unemployment fell to a cycle low of 4.6%. The best news of all came from temporary employment (blue line), whose growth has led Non-Farm Payroll (red line). Temporary employment continues to rise and made a new cycle high, indicating that employment has not yet peaked this cycle.
 

 

Wall Street analysts are getting on board the Trumpflation train. The latest update from John Butters of Factset shows that forward 12-month EPS rose 0.30% in the week.
 

 

What’s more, the latest Trump nominees for Treasury and Commerce went on CNBC and told the market what wanted to hear. Tax cuts is the #1 priority and Yellen is “doing a good job at the Fed”. More importantly, they walked back the much of the tough protectionist rhetoric of Candidate Trump (see Avondale CNBC interview notes). Tariffs are said to be a “last resort” and Mexico/NAFTA is about a “better trade deal”.

What is there for the stock market not to like?

Market psychology turns bullish

As a result, Bloomberg reported that Wall Street strategists have been falling all over themselves to raise their stock market targets for 2017 (also see Ed Hyman’s institutional survey results above). The enthusiasm isn’t just restricted to strategists and institutional investors, but it has spread to individual and corporate investors as well:

It’s not just Wall Street that has changed its mind. Charles Schwab Corp. surveyed clients in October, and found 34 percent reporting that Trump would have a “major negative impact” on the U.S. economy in the short term, while only 14 percent felt that way about Hillary Clinton. Last week, however, consumer confidence surged and individuals said that they were more optimistic about their financial future.

Corporate executives have also changed their tune and are now salivating at the prospect of lower taxes and a potential tax holiday to repatriate cash held overseas.

What’s the risk?

It’s hard to stand in front of a bullish stampede. The combination of a positive turn in fundamentals, and better investor psychology have created a tailwind for stocks. In addition, underperforming hedge fund and other managers are scrambling to buy risky assets as year-end approaches (aka the career risk trade) makes Callum Thomas’ SPX 2400 year-end projection a realistic possibility.
 

 

What could go wrong? Not much in 2016. But Inauguration Day is when the hope meets reality. Starting January 20, the market will start come face to face with the operational risks of a Trump administration.

As an example, Trump’s recent telephone call with President Tsai Ing-wen of Taiwan could create a major diplomatic rift with China (see Ian Bremmer’s alarmist reaction). While I may not necessarily agree with Bremmer’s negative view of this incident, another risk is Taiwan interprets these events in a way that assumes a level of American support that may not be there. For now, the Obama State Department (!) is in place to soothe ruffled feathers and clarify matters. But rookie mistakes like this one just highlights the risk of major fumbles on many fronts, not just foreign policy, as the new team takes over the White House.

As well, Reuters reported that Donald Trump is a micro-manager, which is a bad quality in a President:

It has proven one of Donald Trump’s greatest strengths in building a worldwide luxury brand: An obsessive attention to detail, down to the curtains hanging in hotel rooms and the marble lining the lobby floor.

As president, it may prove one of his major liabilities, presidential historians warn.

Remember Jimmy Carter? He was another notorious micro-manager:

Even if he does make a clean break, Trump will have to guard against getting bogged down in the bureaucratic minutiae inherent in the office. He should avoid the example of President Jimmy Carter, another famous micromanager, who spent his first months in office poring over the White House tennis court schedule, said Ross Baker, a professor of political science at Rutgers University.

Micromanagers rarely make successful presidents, said Rick Ghere, an associate professor of political science at the University of Dayton in Ohio. To be effective, presidents must delegate authority to members of their cabinet and rely on a range of expertise, he said.

“Being a decisionmaker in a high-level public position is a lot different than being a CEO,” Ghere said.

Increasingly, the market action during post-Inauguration period is likely to see a hangover effect from a post-electoral rally. The combination of a strong USD, probable December rate hike, and rising bond yields are going to put downward pressure on stock prices. Expect a softer and corrective period for stock prices in Q1.

President Trump will undoubtedly get tested in the days and weeks ahead, in the realm of domestic policy, economic policy, trade policy, foreign policy, and so on. The first test will come in December, when the FOMC is very likely to raise rates by a quarter point. How will Trump respond? Most of his supporters come from the hard-money and audit-the-Fed school who hated the Fed’s QE programs. Will Trump view the rate hike as a welcome move and consistent with the withdrawal of monetary stimulus (and QE)? Or will he view it as a challenge to his stimulus program?

Already, a number of economists and analysts are questioning the wisdom of fiscal stimulus when the economy is nearing full capacity, as evidenced by an unemployment rate of 4.6% and GDP growth rate of 3.2%. Fiscal stimulus at this stage of the cycle would only raise inflationary pressures. Moreover, cost-push inflation that buoys wages would put downward pressure on operating margins, which would negative for stock prices.

My game plan for 2017

From a technical perspective, it’s hard to argue with the bull trend. The chart below depicts the weekly NYSE McClellan Summation Index, which is in the early part of a rising cycle and nowhere near overbought territory. These readings suggest that the market advance has much more room to run.
 

 

The chart below shows a 20 year history of the Wilshire 5000 and MACD bullish crossovers. In the past, such buy signals (blue vertical lines) have tended to lead to further gains that can last for many months, and sometimes years.
 

 

The MACD crossover is a trend following indicator. Back in August, I also featured another trend following buy signal from Chris Ciovacco’s three moving averages (click link to see his video, also see my post The roadmap to a 2017 market top).
 

 

In my past post, I analyzed previous Ciovacco buy signals and found that about half lasted about 1.5 years, and the remainder went on for much longer. My assessment of the current macro and fundamental backdrop suggests that this latest buy signal will be of the shorter variety. Note, however, that trend following models tend to be slow and they will not catch the exact top of a market. Bottom line: these readings are pointing to a cyclical market top in the second half of 2017.
 

 

I wrote that I am going on recession watch because some of the long leading indicators are starting to wobble (see Going on recession watch, but don’t panic!). Most notably, rising bond yields are pressuring mortgage rates, which will eventually act to depress the cyclically sensitive housing sector. For now, risks are elevated but not at panic levels. Therefore the recession watch is only cautionary.

I expect that stocks will continue their advance after a brief Q1 correction of no more than 5-10%. After that, I will be monitoring earnings expectations, interest rates, Fedspeak, and the new administrations interaction with the Fed and the markets.

The week ahead: ¯\_(ツ)_/¯

My inner investor continues to be bullish on equities. He is enjoying this party, but he is keeping a close eye on the long leading indicators I outlined above.

At a tactical level, traders should be aware that tax-loss selling season is upon us. Jeff Hirsch has identified a calendar effect in December, where early strength is followed by mid-month tax-loss selling weakness, which ends in a year-end rally. If 2016 were to follow that pattern, then expect a corrective period to begin early in the next week.
 

 

On the other hand, the hourly SPX chart below shows that the index pulled back and it is testing a key support zone, while exhibiting a minor positive RSI-5 divergence. At the same time, it is testing a downtrend line (blue). The market is unlikely to weaken significantly from these levels given the strong FOMO tendencies this time of year, with likely secondary support at about 2163 should the current levels be broken. My inner trader took an initial long SPX position on Thursday with a view that he would add to his long positions on weakness.
 

 

Which effect will be the strong one, tax-loss selling, or FOMO buying? I have no idea. trading is about knowing the possibilities, understanding the odds, and properly estimating the risk-reward ratio. That’s why my inner trader only took a partial long position.

¯\_(ツ)_/¯

Disclosure: Long SPXL

A glass half-empty

Posted by Cam Hui -

Mid-week market update: About two weeks ago, I wrote a post indicating that market had focused on the positives of a Trump presidency (see The Trump Presidency: A glass half-full?). Now it seems that market psychology is subtly shifting to a glass half-empty view.

It is very revealing when the new nominees for the key commerce and treasury cabinet posts make market soothing noises and stock prices barely move. Josh Brown’s reaction to Steven Mnuchin as the Secretary of the Treasury and Wilbur Ross as Secretary of Commerce is probably fairly typical of the market:

Good morning. Just wanted to check in briefly to voice my approval for the Treasury Secretary and Commerce Secretary picks announced by the Trump transition team this morning. They’re both highly accomplished and capable people who’ve held senior roles within businesses, even if they don’t have government experience.

To my knowledge, neither is looking to eject homosexuals, Jews or brown people from the country, so that’s a step in the right direction. I don’t believe that either has an agenda against women or takes money directly from Russian banks or posts frog memes on Twitter. Neither pick is a sitcom star from the 1980’s or one of the President-Elect’s children.

The hourly SPX chart below tells the story of a lack of positive reaction to good news. Such market reaction points to short-term bullish exhaustion.

 

A crowded long

There are a number of signs that the rally has gotten ahead of itself. Marketwatch reported that TrimTabs sounded a warning about the excess bullish enthusiasm that they were seeing in fund flows:

“Investors’ appetite for U.S. equity ETFs has been almost insatiable since the election, which is a negative contrary signal,” the firm wrote in a research report.

The category of funds saw positive flows every trading day between Nov. 8 and Nov. 22, amounting to “a stunning $52.2 billion” in overall inflows, TrimTabs wrote, adding that the level of inflows represented a record for an 11-trading-day period. November is on track to break the previous record for monthly inflows, December 2014, when $45.4 billion moved into the category…

“A wide range of sentiment measures suggests the bull camp has become quite crowded,” the firm wrote, citing its U.S. Equity ETF Index, which uses ETF flows to evaluate short-term market timing. On Nov. 18, the index hit a three-year low, which could presage a broader market pullback.

From a tactical perspective, Brett Steenbarger wrote that his composite trading model had sounded a cautionary note:

Readings of +3 or greater and -3 or less have had particularly good track records in and out of sample, anticipating price change 5-10 days out. Note that we hit a -3 reading on Friday; prior to that we saw +3 readings shortly before and after the election.

 

To be sure, these episodes can resolve themselves in sideways consolidation rather than downward corrections:

Thus far, we are not seeing significant breadth deterioration in stocks. For ten consecutive sessions, we have had fewer than 200 stocks across all exchanges register fresh monthly low prices. This breadth strength generally occurs in momentum markets; weakening of breadth–particularly an expansion in the number of issues making fresh lows–tends to precede market corrections. It is not at all unusual for momentum markets to correct more in time than price. We’ve seen selling pressure the past two sessions, but not significant price deterioration. This dynamic allows momentum markets to stay “overbought” for a prolonged period as price consolidates and often grinds higher.

While the predominant market psychology seems to be the “buy the dip” variety, there are a number of events that could change that in a hurry. First, there is the October Employment Report on Friday, which could be a big market moving event. In addition, both the Austrian presidential election and Italian referendum are scheduled to be held on Sunday, which are also potential market moving events with binary outcomes that are difficult to predict.

No signs of a major top

Despite these signs of short-term weakness from sentiment models, Ed Yardeni showed that sentiment is nowhere near levels that are consistent with major market tops (h/t Urban Carmel):

 

Still this equity rally still has a FOMO (Fear Of Missing Out) quality as underperforming managers scramble to buy risk as stock prices rise. Watch for the greed factor to dominate as we approach year-end, as exemplified this seasonal pattern analysis from Callum Thomas.

 

My inner trader remains in cash, but he is prepared to buy any dips in anticipation of a December market surge.

Nine years ago today…

Posted by Cam Hui -

It was nine years ago today, Humble Student of the Markets was born. My first post at the time was entitled What exactly are hedge funds hedging? I went on to show that hedge fund returns were correlated with equity returns. That makes conceptual sense, because hedge funds are in the business of taking risk and equity risk is a major component of investing risk.

HFs are so 20th century…
Nine years later, hedge funds have done even worse than what I showed in 2007. Charlie Bilello showed that their returns have flattened out. They are no longer correlated with equity returns.

It could be argued that HFs are absolute return vehicles and therefore it is unfair to compare them against equities. Bloomberg showed that their performance against a balanced fund benchmark has been nothing to write home about either.

The market has reacted and the latest figures show that YTD hedge fund fund flows have turned negative. YTD redemptions are 77b as of October 2016.

Alpha is hard to find
My assertion back in 2007 that alpha is hard to find turned out to be correct. Many HF strategies, such as convertible arbitrage, long/short equity, event-driven, emerging markets, and so on, can be approximated by combinations of factors. In other words, you were paying for beta when you thought you were buying alpha. Since then, even those beta strategies have turned into…I don’t know what as aggregate HFRX Indices have flattened out over the last few years.

The field is getting far too crowded to extract significant alpha. Back in the early 1990’s, when swashbuckling managers like Julian Robertson and George Soros dominated the field, a billion dollar hedge fund was an enormous fund. Today, a fund with AUM that size just gets lost in the crowd.

Too early to buy gold and gold stocks

Posted by Cam Hui -

The stars seem to be aligning for a revival in gold prices. Prices saw a nice bounce today as equities weakened. The trends in other asset classes, such as stocks, bonds, and the US Dollar, look very stretched in the short-term and poised to reverse. From an inter-market analyst viewpoint, gold also seems to be in that camp.

The chart of gold below tells the story. Bullion prices have been falling and they are oversold on RSI-14. The violation of key support at the 1205-1210 zone has prompted high volume selling, which is indicative of investor capitulation. From a technical perspective, gold prices are now testing a Fibonacci retracement level at 1170.
 

 

This seems to be a classic setup for a revival in gold prices. Not so fast! While gold prices may stage an oversold rally here, a durable bottom may not be in place just yet.

Sentiment not washed out

There are a couple of reasons why it may be too early to buy gold for anything other than a tactical bounce. First, Mark Hulbert observed that sentiment is not washed out yet. His monitor of gold timing timers shows that they haven’t totally capitulated yet:

Consider the average recommended gold exposure level among several dozen short-term gold timers who I monitor on a daily basis (as measured by the Hulbert Gold Newsletter Sentiment Index, or HGNSI). This average currently stands at minus 18.0%, which means that the typical short-term gold timer is allocating 18% of his gold trading portfolio to going short.

To be sure, that means the typical gold timer isn’t bullish right now. And, other things being equal, you’d think that contrarians would be encouraged by this reading. But, as you can see from the accompanying chart, gold’s rallies in recent years that lasted more than a few days typically began when the HGNSI was below minus 30%.

Another bad omen for gold came in the wake of Wednesday’s big drop in the price of gold. Since the normal pattern is for bullishness to rise and fall more or less in sync with the market, we would normally have expected the HGNSI to fall Wednesday. Contrarians consider it a bad sign that the HGNSI in fact didn’t budge.

 

An examination of the amount of gold held in GLD tells a similar story. While gold prices have declined (black line), the amount of gold held (blue line) have not fallen to levels that signal a sentiment washout.
 

 

Wait for the re-test

In addition, a careful review of the % bullish metric on gold stocks shows that these stocks are oversold (bottom panel). Initial oversold readings, where % bullish has fallen below 10%, are marked with blue vertical lines. These stocks have tended to see a least a second test of the oversold lows before launching into a bull phase, where the final low are marked with red vertical lines. The current decline is only showing an “initial” oversold condition. If history is any guide, then we are likely to see a rally, followed by a re-test of the lows before GDX can launch into a sustainable bull phase.
 

 

Bottom line: Gold bullion and gold stocks may stage an oversold bounce here, but the bottoming process is incomplete. Wait for signs of further sentiment deterioration, couple with a re-test of the breadth metrics, before a bullish revival can be sustained.