A capitulation bottom?

Posted by Cam Hui -

Mid-week market update: In my weekend post (see Buy the dip!), I wrote that despite my tactical bullishness, “traders need to allow for a brief rally, followed by a sharp drop to a washout low before this shallow correction is over”. We are finally seeing signs of an oversold market and a short-term capitulation.

There were a number of signs of a short-term bottom. On Monday, the VIX Index closed above its upper Bollinger Band (BB), indicating an oversold condition for the market (see Three bottom spotting techniques for traders). As well, the SPX has been testing support located at its 50 day moving average (dma) in the last two days.
 

 

An oversold setup

Just because a market is oversold doesn’t mean that it can’t go down further. Indeed, a study of past occasions where the VIX Index had risen above its upper BB indicated that it tended to continue to decline. As the results of the study below indicates, negative price momentum tends to start reversing itself after one day the VIX Index rises above its upper BB. Wednesday is day 1.
 

 

Once VIX mean reverts and falls below its upper BB, returns have historically seen an upward bias..
 

 

Watch the VIX Index for the mean reversion move.

A near exacta buy signal

There are additional signs of market panic. My Trifecta Bottom Spotting Model (click link for a full explanation of the model) reached a near oversold reading on Tuesday. As a reminder, the Trifecta Bottom Spotting Model uses the following three components to determine an oversold market condition: inversion of the VIX forward curve; TRIN above 2; and a reading of below 0.50 on the intermediate term overbought/oversold model – all within three days of each other.

While the OBOS model is far from an oversold reading, the Trifecta Model hit a “qualified” exacta buy signal, which triggered two of the components. The VIX forward curve inverted today. While TRIN did not rise above 2, TRINQ, which is TRIN for NASDAQ stocks, went over 2 on Tuesday on an intraday basis. TRIN and TRINQ readings of over 2 are often reflective of price insensitive selling that are typical of forced “margin clerk” market sales.
 

 

Are those conditions enough to call this a capitulation bottom, or a market washout? I don’t know, but the combination of the technical test of the 50 dma, the oversold condition flashed by the VIX Index, and the near exacta buy signal make the answer a “qualified yes”.

Disclosure: Long SPXL, TQQQ

Buy the dip!

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

A growth revival

Sometime you don`t get the perfect signal. I had been watching for signs of an oversold extreme before covering my short positions and buying, but none of my tactical three bottom spotting models had flashed a buy signal yet (see Three bottom spotting techniques for traders).

Some got close. As this chart of the VIX Index shows, the VIX never managed a close above its upper Bollinger Band, but it traded above its upper BB several times.
 

 

Nevertheless, a combination of macro, fundamental, and sentiment models have turned sufficiently bullish for me to call an end to the current bout of minor stock market weakness. At a minimum, downside risk is likely to be low at current levels.
 

 

The triumph of “soft” data

For the past few weeks, analysts have observed a bifurcation between the soft (forecast) macro data and the hard (reported) data. The soft data had run far ahead of the hard numbers, and the gap was at or near historical highs. Many, myself included, believed that the forecasts were overly optimistic and were bound to turn down, which was bearish for the growth outlook.
 

 

Gavyn Davies recently featured an analysis of Fulcrum nowcasts of economic growth. The forecast called for extremely strong growth rates, especially in the developed economies. Much of the strength was derived from soft data.
 

 

An analysis of the effects of soft data in economic forecasting found many advantages of including soft data in nowcasts and economic forecasts:

  • Including soft data makes the forecast more accurate
  • Hard data forecasts are more volatile
  • Soft data is more timely
  • When soft data and hard data disagree, the soft data forecast tends to be better

Davies concluded that the buoyancy of the US soft data forecasts isn’t just an effect of the enthusiasm of Trump supporters, “The synchronised nature of the upswing in so many economies increases our confidence that the buoyancy of US growth is not just a consequence of fake survey news in the American economy.”

Liz Ann Sonders at Charles Schwab came to a similar bullish conclusion, though she acknowledged that the two data series tend to converge with soft data weakness and hard data strength:

It’s been our contention that the inevitable narrowing of the spread between the soft and hard data would likely be in both directions; i.e., confidence measures would likely ease, while the hard data would play at least a little catch up. According to Bespoke Investment Group (BIG), when soft data outperforms, hard data usually plays catch up in the following three and six months; while soft data almost always declines. With regards to the stock market, average and median returns have been skewed to the positive over these time frames as well.

Indeed, Jeff Gundlach observed that the global economic is experiencing one of the most synchronized upturn in years (via Business Insider).
 

 

The global scope of the growth surge is good news for Europe. With eurozone business confidence rising…
 

 

The upturn is positive for eurozone companies because of their high operating leverage.
 

 

In the US, the latest update from Factset shows that forward 12-month EPS is rising, which reflects Wall Street’s continued optimism about earnings growth, a key driver of stock prices.
 

 

What about the NFP miss?

On the other hand, Friday’s March Employment Report was a shocker. The headline Non-Farm Payroll (NFP) came in at 89K, which was well short of market expectations of 175K. Looking through the internals, however, the March report presented a solid picture of growth.

First of all, much of the disappointment appeared to have been weather related. This chart of construction employment showed a dramatic slowdown in March, which was likely weather related and should reverse itself in the coming months.
 

 

More importantly, temporary jobs were strong. In the past, temporary employment (blue line) has peaked out before headline NFP (red line).
 

 

In addition, the labor force participation rate held steady, and the prime age participation rate rose.
 

 

Finally, the unemployment rate fell to a new cycle low at 4.5%.
 

 

Despite the headline NFP miss, I interpret this report as a solid report. These are all signs of robust economic growth.

Sentiment extremes = Buy signal

In addition to the strong macro and fundamental backdrop, I am also seeing signs of bearish sentiment extremes which led me to change the trading model from a “sell” to a “buy” last week.

This 10-year chart of Rydex cash flows show that Rydex investors had moved to a bearish extreme. In the past, the market had not necessarily rallied immediately when readings were this low, but saw limited downside during such episodes.
 

 

In addition, this chart of NAAIM exposure indicated that RIAs seemed to have panicked. In the past, NAAIM readings that fall to their lower Bollinger Bands have been good buy signals. Unlike the Rydex buy signals above that denote minimal downside risk, past NAAIM buy signals have seen the market rise.
 

 

Key risks

Despite the presence of all of these upbeat intermediate term factors, bulls should curb their enthusiasm as a number of key risks remain. First of all, the Atlanta Fed’s GDPNow nowcast of Q1 growth is coming in at a dismal 0.6%. The possibility of a negative surprise is still present. The big test for the stock market will be Q1 earnings season, which is just getting under way.
 

 

As well, the yield curve is flattening, which is the bond market’s way of telling us that it expects lower economic growth.
 

 

There may also be some unfinished business that the market needs to attend to from a sentiment viewpoint. The Fear and Greed Index did not reach oversold levels consistent with past bottoms. While every market is different, and we have already seen sentiment extremes from Rydex and NAAIM data, traders need to allow for a brief rally, followed by a sharp drop to a washout low before this shallow correction is over.
 

 

To be sure, the NYSE McClellan Summation Index (NYSI) is showing signs that it is undergoing a bottom process. Any pullback that produces a capitulation low is likely to be shallow.
 

 

Bullishly positioned

My inner investor remains bullishly positioned. The Wilshire 5000 remains on a long-term MACD buy signal.
 

 

He believes that the SPX point and figure price target of over 2500 is very achievable this year.
 

 

My inner trader flipped from short to long last week. He now has small initial long positions in SPX and NDX, which has been the recent leadership in the market.
 

 

Disclosure: Long SPXL, TQQQ

The miracle of Europe

Posted by Cam Hui -

Here in Canada, we are observing the 100 year commemoration of the participation of Canadian troops in the Battle of Vimy Ridge. While the Canadian Corp achieved its objectives of capturing the ridge, it was a typical battle of the First World War that left enormous casualties for both sides.
 

 

After the horrific human carnage of the First and Second World Wars, western Europe formed the European Coal and Steel Community (ECSC), which led to the European Economic Community (EEC). Thus the EU was born.

The political intent of the union was to bind France and Germany so tightly together that another major European conflict could not happen again. Despite the setback provided by Brexit, those political intentions have succeeded.

Lessons from the Gibraltar affair

Then we had the Gibraltar affair. For readers who hadn’t been paying attention, here is the account from Vanity Fair:

Until a week ago, 30,000 Gibraltans were quietly enjoying the best of both worlds, soaking up the Spanish sun while strolling past red phone boxes and dining out on fish and chips. Then Theresa May neglected to mention the British-ruled rock in her Article 50 letter, and the E.U. gave Spain the right to veto any Brexit deal made if it did not agree with arrangements made around the Rock. The situation descended into chaos. Speaking on live television, errant Tory Lord Howard declared possible war on Spain. Aboard a flight from Saudi Arabia, Theresa May laughed tightly and, quoting Winston Churchill, declared the situation more “jaw jaw” than “war war.” Back in Europe, her Navy raucously chased a Spanish ship out of British waters.

Sending the Royal Navy to defend Gibraltar? Is this the seed of another war in Europe?

Don’t be silly. Even as The Sun, which is a newspaper that has been staunchly anti-Europe in editorial tone, broadcast its Spanish antipathy on its front pages, it was also advertising £15 holidays in Spain at the same time.
 

 

Jaw-jaw. Not war-war. Here are the results of a recent European poll that asked “would you fight for your country?” (via onlmaps).
 

 

That’s the miracle of Europe, and the EU. It has traded endless meetings over Brexit and Greek debt for millions of war dead.

Lest we forget. (Now, back to your regular programming).

Is the gold/platinum ratio flashing a buy signal for stocks?

Posted by Cam Hui -

Mark Hulbert recently highlighted an equity buy signal from an obscure indicator, the gold/platinum ratio. The signal is based on a research paper by Darien Huang, an academic at Cornell.
 

 

The rationale behind the indicator goes something like this. Both gold and platinum are precious metals, which have defensive characteristics during equity bear markets. But platinum has more cyclical characteristics because of its use in the auto industry. A high gold/platinum ratio (as it is today) is indicative of fear in the market, and therefore stocks should be bought. Conversely, a low platinum/gold ratio signals complacency, which is a sell signal.

The way to approach cyclical indicators like these is to decide whether an investor should bet with them (momentum indicator), or against them when readings are extreme (contrarian indicator). The chart below shows the platinum/gold ratio (in red) and stock prices (in grey). The bottom panel shows the rolling one-year correlation between the ratio and stock prices.
 

 

Based on this chart, I can make a couple of observations. At first glance, this seems to be a reasonably good contrarian indicator at extremes. But given the wide ranges, how can you tell what’s an extreme reading?

One way to determine whether a contrarian indicator works well at extremes is to look at the correlations of the signals to the market. A good contrarian indicator should see negative correlations to the market at the time of buy or sell signals, or soon after buy and sell signals. An analysis of the lower panel indicates that is not the case. In fact, rolling correlations appear too unstable for this ratio to be an effective market timing indicator.

Maybe we are framing the problem incorrectly. Instead of using the SPX to measure the effectiveness of this model, how about using the stock/bond ratio as a measure of risk appetite? The chart below shows the same indicator overlaid on top of the stock/bond ratio. The correlations shown on the bottom panel are better, but they are still very unstable, and correlations were not negative when or after buy and sell signals.
 

 

Back to the drawing board? Not quite. There are better ways to measure the real-time strength of the cycle.

Better cyclical indicators

Darien Huang’s work with the gold/platinum ratio is thematically similar to Charlie Bilello’s research using the lumber/gold ratio. Bilello used lumber to stand in for the cyclical component of his ratio, instead of platinum.

The history of lumber prices don’t go back 20 years, but the chart below shows the lumber/gold ratio against the stock/bond ratio, as a measure of risk appetite. The bottom panel shows that rolling one-year correlations were more stable. My conclusion is this ratio is more suitable as a momentum indicator rather than a contrarian indicator. The rolling 5-year average of lumber/gold to stock/gold is 0.47, which is pretty good.
 

 

Currently, this ratio is supportive of a rising risk appetite as lumber prices, which is reflective of housing strength (and possibly the Trump wall with Mexico), are in a relative uptrend compared to gold.

One of the disadvantages of using lumber prices as the cyclical component in a lumber/gold ratio is lumber prices are reflective of regional demand and does not measure the global cycle. For that, industrial metals is a better substitute. Callum Thomas pointed out that copper, which is one of the major industrial metals, is highly correlated to Chinese manufacturing momentum.
 

 

The chart below shows a similar analysis using the industrial metals/gold ratio as a cyclical indicator. The bottom panel shows a similar level of stability in correlation, with the rolling 5-year correlation at 0.59, which is higher than the lumber/gold to stock/bond correlation of 0.47.
 

 

What are they saying now?

If we are to reject the Huang model based on the gold/platinum ratio in favor of the lumber/gold and industrial metal/gold ratio, what are they saying now?

As the chart below of these ratios using daily prices shows, there is a bifurcation between these two indicators. The lumber/gold ratio is rising, which tells an upbeat story of US housing. By contrast, the industrial metal/gold ratio has been in a slow downtrend, which is reflective of lagging growth outside the US.
 

 

I interpret these readings cautiously, with continued cyclical strength in the US, but non-US growth (China in particular) needs to be watched carefully.

How a China crash might unfold

Posted by Cam Hui -

As Donald Trump prepares to meet Xi Jingping this week, I am reminded of the long-term challenges that face China, namely its growing debt. There have been many analysts warning of the credit buildup, here is this chart from BCA Research is one of many examples.
 

 

While I am not calling for an imminent crash in China, here is a template of how a collapse might occur.
 

The case of Huishan Dairy

Investors may be familiar with the story of Huishan Dairy (6863.HK), a vertically integrated dairy company listed in Hong Kong. The shares cratered 85% on March 24 and USD 4 billion in market value evaporated in a single day.
 

 

Here is the Bloomberg account of the sorry saga:

A muddled tale of corporate woe has since emerged involving a missing company treasurer, a leverage-happy chairman and serious doubts about the company’s future.

Who went missing?
The executive director who managed Huishan’s treasury and cash operations. The company said on March 28 that its last contact with the director, Ge Kun, was a March 21 letter to Chairman Yang Kai explaining that work stress — heightened by Block’s critical report — had taken a toll on her health and that she didn’t want to be contacted.

So not a good day for the chairman?
It got worse, according to Huishan’s account. That same day, Yang realized Huishan had been late on some bank payments. By March 23, Huishan had arranged an emergency meeting with creditors and government officials in Liaoning province, where the company is based. Huishan said its major lenders, including Bank of China Ltd., expressed confidence at the meeting. But that was before the stock collapsed.

Since the publication of that article, Bloomberg further reported that the company’s four non-executive directors have resigned, and it still can’t locate its head of treasury. Ouch!

To summarize, the company got over-levered, and there was leverage piled on top of leverage. The company missed a payment, confidence collapsed, and the rest is history.
 

We’ve seen this movie before

My initial reaction was, “So what?” This is how capitalism and free markets work. Leverage is a double edged sword, and Chinese tycoons  have been known to over-extend themselves and crash. The Huishang saga is nothing unusual.

There is more to that story.

Go back a little over a year to early 2016, and let me tell you the story about another Hong Kong listed company named Hang Fat Ginseng (now renamed Qinghai Health). Here is the story from the South China Morning Post entitled Hang Fat – A tale of greed in Hong Kong’s stock market:

This is a classic tale of what has and would happen to the dozens of newly listed companies in the past two years. It is a tale of greed.

Yeung is no stranger to the game.

The so-called “King of American Ginseng” loved to talk about his clever bets on apartments, currencies as well as derivatives…

As Hang Fat’s price shot up, so has the borrowing of Yeung and his family, as suggested by records with the Central Clearing System(CCASS)…

In the meantime, Yeung and his brother like many of the bosses of newly listed companies have made bets with all sorts of investment schemes proposed by their private bankers with money from margin finance. It was jolly good.

By summer, it was all over. The A share market crashed; the yuan depreciated; and Hang Fat’s price dropped 30 per cent.

The brothers pledged more shares to pay up the margin call and to support Hang Fat’s price.

They spent at least HK$220 million buying up Hang Fat between August and December, according to company announcements. They had no choice because the lower the price, the worse the margin calls.

It was futile. The market headed south with the renminbi…

They were forced to sell 6.17 per cent at a 50 per cent discount for a meagre HK$23 million. To who? Surprisingly, it’s the clients of CIS. Yeah it is bloody.

So what? Another story of Chinese tycoons who over-levered themselves and crashed.
 

 

Here is the clincher to the story, Bloomberg reported that one of the possible rescuers of Hang Fat was none other than the chairman of Huishan Dairy:

On Feb. 4, following a failed attempt to sell control of the company to another Hong Kong company, the Yeungs announced they were selling 1.23 billion of their own shares to a company run by China Huishan Dairy Holdings Co. Chairman Yang Kai in an off-market deal for HK$23.4 million. Yang sold almost all the shares a day later for HK$77.1 million, exchange filings show. A Huishan Dairy spokesman declined to comment on the transaction.

The stories of Hang Fat and Huishan Dairy illustrates how Chinese corporations are all playing the same game of leverage on top of leverage, and taking the cash to speculate into other “hot” markets, such as real estate and equities. I have no idea when the entire house of cards comes crashing down, but the buildup of debt at the corporate and individual level on top of Chinese local government debt is worrisome.

If and when this collapses, it will likely occur suddenly and without warning. Another concern is the systemic effects of inter-connected firms, and the cascading effects on a single financial accident that could trigger the loss of market confidence. An event like this would probably be accompanied by mass capital flight, a falling exchange rate, and the imposition of currency controls.

Apocalypse Not Yet

Despite this dire scenario of how China might crash, there are few signs of an imminent crisis. In all likelihood, the authorities will do everything in their power to keep the economy growing until the Party Congress this fall. As an example, CNBC reported that China is creating a new economic zone in Hubei province, using the template of Shenzhen and Pudong district in Shanghai. Hubei  Hubei is an area that had been hit by large layoffs, and this initiative is an effort to boost economic growth.

Indeed, the latest update from Callum Thomas of Topdown Charts shows that China’s Manufacturing PMI is pointed up. Moreover, the % of PMI subindices above 50, which indicate growth, are surging. Also see my post from two weeks ago, China’s revival and what it means.
 

 

On the other hand, Bloomberg pointed out that default rates have risen, and credit spreads are widening.
 

 

Apocalypse Not Yet, but be aware of the growing risks.

Monetary Armageddon ahead?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Prepare for Central Bank Armageddon?

In the last two weeks, we have seen a parade of Fed speakers reinforcing the view that three rate hikes would be the appropriate policy for 2017. At the same time, I am reminded of this chart indicating that Fed tightening cycles often don’t end well because of policy overshoot.
 

 

In addition, global inflation surprise indices are spiking, which suggests that a re-synchronization of monetary policy is on the horizon. World central banks are poised to raise interest rates.
 

 

Is it time to start preparing for Monetary Armageddon? Will central banks overshoot crash the global economy?

Re-synchronized monetary policy

If this site was Zero Hedge, otherwise known as the financial tabloid of doom (found at your supermarket checkout everywhere), I would just focus on the risks.

Consider, for example, the case of rising inflationary expectations depicted in the above chart. Gavyn Davies argued that the global economy is recovering, and global central banks are poised to start withdrawing accommodation.
 

 

If you believed that QE was holding up equity markets, what happens when central banks start to withdraw liquidity?
 

 

I recognize that eurozone core inflation rates came in well behind expectations in March, and the market reacted by reducing the odds of an ECB taper. But the Easter holidays falls in April this year, compared to March last year, and therefore inflation rates should snap back in April.
 

 

Equally worrisome is the problem of overly low real rates. Bloomberg recently highlighted analysis by Deutsche Chief Global Strategist Binky Chadha indicating that real rates are too low and they are poised to jump further than the market expects:

Real rates, which have generally moved in lockstep with real gross domestic product, are some two percentage points below what’s implied by the momentum of the U.S. economy, an unsustainable divergence, according to Deutsche Bank AG.

“We see real rates as extremely misvalued if not in a bubble,” Deutsche Bank analysts, led by Chief Global Strategist Binky Chadha, wrote in a note on Friday.

Inflation-adjusted yields can’t defy economic gravity for much longer, they argue, setting the stage for a correction that may imperil risk appetite in bond markets over the summer.

 

The problem of a re-synchronization of monetary policy is truly a global problem. Even as the Fed is on course to raise rates, Bloomberg highlighted the risk posed by rising exposure of USD loans in the offshore market.
 

 

The chart below depicts the sensitivity to a 1% increase in rates. Monetary policy in Washington is in effect raising the risk of an emerging market debt crisis.
 

 

Even though stock prices tend to rise during the initial phase of a tightening cycle because the market focuses on the prospects for improving growth, history has shown that psychology can turn very quickly. As the chart below shows, we are currently in the low rate region (blue triangles) where rates are low and moves in stock prices are correlated with changes in bond yields. However, the Taper Tantrum of 2013 (red squares) demonstrated that market perceptions can change on a dime. During that episode, bond yields were negatively correlated with equity returns, as rising bond yields tanked stock prices.
 

 

A determined Fed

Even though the Fed is well aware of these risks (see Fed governor Lael Brainard on the risks posed by global linkages), Tim Duy highlighted a speech by New York Fed President William Dudley:

A particular risk of late and fast is that the unemployment rate could significantly undershoot the level consistent with price stability. If this occurred, then inflation would likely rise above our objective. At that point, history shows it is very difficult to push the unemployment rate back up just a little bit in order to contain inflation pressures. Looking at the post-war period, whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points, the economy has always ended up in a full-blown recession with the unemployment rate rising by at least 1.9 percentage points.

This is why the Fed does not want the forecast for unemployment to drift more than 0.3 percentage point below the estimate of the natural rate. Anything more and they risk being unable to quell an inflationary outbreak without a recession. And recessions are costly, something that is easy to forget now that unemployment is back below 5 percent.

In a separate speech last week, Dudley made it clear that the risks are not tilted to the upside and he favors scaling back monetary accommodation:

While there is still considerable uncertainty about fiscal policy and its potential contribution to economic activity, it seems likely that it will shift over time to a more stimulative setting. Consequently, it appears that the risks for both economic growth and inflation over the medium to longer term may be shifting gradually to the upside.

Even after the latest increase, the federal funds rate target range at three quarters of a percent to 1 percent is still unusually low in both nominal and inflation-adjusted terms. While most FOMC participants judge the equilibrium short-term real interest rate that is consistent with a neutral monetary policy to be low—perhaps in a range of 0 to 1 percent—this is still above the current inflation-adjusted federal funds rate. In such circumstances, it seems appropriate to scale back monetary policy accommodation gradually in order to reduce the risk of the economy overheating, and to avoid a significant inflation overshoot in the medium term.

This is not Zero Hedge…

If this were Zero Hedge, I would stop here and let the fear take over. But this is not Zero Hedge and I try to provide a balanced view of the market. Here is the bull case.

Analysis from BAML equity and quantitative strategist Savita Subramanian indicated that the last phase of an equity bull market is one of the most profitable. So don’t sell too soon:

The market does exhibit some classic late-cycle signs: heightened leverage, accelerating inflation, a flattening yield curve, and elevated valuations by a variety of measures. But what has been lacking throughout this bull market, and is still absent, is all out euphoria. In the late stages of a bull market, fundamentals and valuation typically take a backseat to sentiment and technicals. The last year of a bull market typically sees capitulation-like inflows, with median SP 500 returns of ~20%. And this, coincidentally, is roughly equivalent to the target return of our key sentiment model, the Sell Side Indicator.

 

Subramanian argued that we haven’t seen the excesses in the market yet, so this aging bull still has some time left.
 

 

Sentiment excesses everywhere

I beg to differ on the question of investor psychology, as I am seeing signs of giddiness everywhere. The T-D Ameritrade Investor Movement Index (IMX), which measures the sentiment of that firm’s retail investors are, is at an all-time high.
 

 

Other long-term metrics of individual investor sentiment are showing crowded long readings. The Conference Board’s survey of household confidence in equities is at a 17-year high (via Bloomberg).
 

 

At an anecdotal level, Helene Meisler observed that the mood is not what you find at market lows. Here is one example.
 

 

Here is another example.
 

 

Here is a third example. You get the idea.
 

 

As for institutional managers, Savita Subramanian’s own estimates of US large cap manager equity beta hit at a new cycle high before pulling back a bit.
 

 

Investor giddiness – definitely. Euphoria? You decide.

No recession in sight

While signs of giddy sentiment does put the stock market at risk, near-term downside risk remains limited because growth remains healthy and there is no recession in sight. While minor disappointments such as the possible failure of the Trump administration to implement a tax cut could take the market down 10-15%, the ultimate bull market killer is a recession, which is not in the cards yet.

New Deal democrat, who monitors high frequency economic releases and divides them into coincident, short leading, and long leading indicators, summarized the weekly data as, “The outlook over the next 6 to 8 months remains very positive. The outlook for one year and more out 12 month remains generally neutral” (though it has deteriorated from positive).

However, I would anticipate that further central bank action later this year could slow the global economy enough for recession risk to rise. But those risks are in 2018 and beyond. Since markets are forward looking, it would peg the timing of a potential market top late this year or early next year.

A late cycle advance

Investors should therefore remain intermediate term constructive on equities. As global inflationary pressures rise, central bankers poised to become less accommodative, but the best and final phase of the bull market ahead of us, these conditions are the classic signs of a late cycle market.

Consider the effects of the re-synchronization of global monetary policy from easy to tight, which should begin later this year. The chart below shows the yield spread between Treasury and Bunds. As the ECB shifts from accommodative to tapering, and ultimately tightening mode, the spreads should start to narrow. Narrowing spreads would put downward pressure on the US Dollar, which raises inflationary pressures within the US.
 

 

As this chart from BAML indicates, a rising inflation environment would be beneficial for asset classes like gold and emerging market equities.
 

 

At a sector level, the sectors most exposed to inflation are energy, real estate, and materials. The inflation beta of the US materials sector has been dampened by a lack of major mining companies in the US, such as BHP, Rio Tinto, etc., and the presence of downstream companies such as chemicals, which would negatively affected by rising material costs as inputs.
 

 

In conclusion, investors should not panic at the prospect of rising rates and the re-synchronization of global monetary policy. As William Dudley put it in his speech last week, “I don’t think we are removing the punch bowl, yet. We’re just adding a bit more fruit juice.”

In all likelihood, investors are likely to see another leg up in equity prices before the ultimate cyclical top. In that context, the SPX point and figure chart target of 2500-2600 makes sense, and investors can add further returns in this environment by tilting towards inflation hedges such as gold and energy.
 

 

The week ahead: Lines in the sand

Looking to the week ahead, I reiterate my view that intermediate term indicators are only showing the initial signs of a bottom, and more consolidation is ahead. The Fear and Greed Index, despite last week`s bounce, has not historically bottomed with readings in the 30s.
 

 

The NYSE McClellan Summation Index (NYSI) may be starting to bottom based on its stochastic readings. In the past, the NYSI has seen a few weeks of choppiness before a durable bottom was made.
 

 

In the short run, the market is approaching some lines in the sand that delineate bullish and bearish impulses. The SPX successfully tested its 50 dma last week and it is now testing downtrend resistance. Further strength will likely signal a rally to test the old highs.
 

 

My inner trader remains bearishly tilted. This chart from Index Indicators shows that short-term momentum reached a minor overbought level and it is starting to roll over. The odds still favor weakness ahead for next week.
 

 

My inner investor remains bullishly positioned. He is waiting for the bullish finale of this equity bull run.

Disclosure: Long SPXU, TZA

Is the correction over?

Posted by Cam Hui -

Mid-week market update: On Monday, the major market averages successfully tested their 50 day moving averages (dma) and bounced. Does this mean that the correction is over?

Not so fast. There are several indications that the market still has unresolved business on the downside for Monday’s test to be a durable bottom. First of all the SPX remains in a short-term downtrend, and the breach of that downtrend line is the first test of this rally.
 

 

Unfinished business

The first clue of unfinished business comes from the CNN Money Fear and Greed Index. The Fear and Greed Index has not fallen to levels where it bottomed in the past three years. While every bottom is different, these readings suggest that the market needs a final flush, or panic, before calling an intermediate term bottom.
 

 

As well, other measures of short-term market breadth are not behaving well. This chart of Twitter breadth from Trade Followers shows that bullish breadth remains in a downtrend. Where is the positive divergence? Market bottoms normally don’t look like this.
 

 

My internal metrics of risk appetite have improved, but they remain in downtrends.
 

 

Finally, on a very short-term basis, this measure of market breadth from Index Indicators nearing overbought territory. How much upside is left?
 

 

In conclusion, intermediate term indicator are not consistent with readings seen at the bottom of a correction. Short-term indicators are near overbought. While overbought markets can get more overbought, the risk-reward ratio is tilted in favor of the bears. In all likelihood, the final bottom to this correction has not been seen yet.

Disclosure: Long SPXU, TZA

A passive index fund built to outperform?

Posted by Cam Hui -

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

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

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

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

1980’s technology

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

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

 

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

 

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

 

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

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

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

 

Factors for all seasons?

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

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

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

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

 

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

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

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

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

Could “animal spirits” rescue the Trump rally?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

A shift in tone

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

 

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

 

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

A question of sentiment

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

 

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

 

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

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

 

 

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

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

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

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

 

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

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

Capex hurdles

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

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

 

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

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

 

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

 

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

Global growth tailwinds

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

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

 

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

 

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

 

Better news ahead

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

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

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

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

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

 

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

 

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

Correction ahead

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

 

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

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

 

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

 

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

 

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

 

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

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

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

 

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

Disclosure: Long SPXU, TZA

Three bottom spotting techniques for traders

Posted by Cam Hui -

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

 

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

 

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

The Zweig Breadth Thrust oversold setup

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

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

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

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

 

Watch the VIX!

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

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

 

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

 

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

Trifecta bottom spotting model

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

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

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

 

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

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

Disclosure: Long SPXU, TZA

China’s revival and what it means

Posted by Cam Hui -

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

 

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

Strength from “Greater China”

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

 

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

 

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

 

What doom and gloom?

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

 

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

 

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

 

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

There is still time to party.

Rate hikes ≠ The Apocalypse

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Pundits vs. the bond market

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

 

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

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

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

The bear case

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

 

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

 

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

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

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

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

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

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

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

 

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

Global central bank balance sheets

 

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

 

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

 

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

Here is what I am watching.

Rising consumer stress

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Don’t fight the tape

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

 

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

 

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

 

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

 

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

Peak reflation growth?

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

 

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

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

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

 

The week ahead: The start of a correction?

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

 

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

 

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

 

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

 

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

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

Disclosure: Long SPXU, TZA

Sell St. Patrick’s Day?

Posted by Cam Hui -

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

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

 

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

 

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

 

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

 

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

 

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

OpEx study

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

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

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

 

 

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

 

And a chart of % positive by month.
 

 

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

 

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

 

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

Disclosure: Long SPXU, TZA

3 steps and a stumble: The bull and bear cases

Posted by Cam Hui -

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

 

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

 

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

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

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

The bull case for stocks

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

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

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

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

 

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

 

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

 

Currently, Citigroup Global ESI readings are very upbeat.
 

 

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

The bear case

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

 

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

 

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

 

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

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

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

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

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

Getting late in the party

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

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

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

 

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

 

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

 

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

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

Posted by Cam Hui -

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

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

 

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

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

 

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

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

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

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

EU objections to BAT

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

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

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

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

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

A 170% tax rate?

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

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

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

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

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

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

 

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

Be prepared, and pick your poison.

A toppy market, but not THE TOP

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Valuation and sentiment vs. momentum

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

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

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

 

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

 

But average CAPE has been rising over time.
 

 

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

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

Another valuation perspective

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

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

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

 

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

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

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

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

 

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

Soft vs. hard data

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

 

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

 

The music is still playing

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

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

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

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

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

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

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

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

 

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

 

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

 

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

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

 

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

Investment implications

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

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

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

 

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

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

 

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

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

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

 

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

 

Toppy, not THE TOP

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

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

 

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

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

 

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

 

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

The week ahead: Both overbought and oversold

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

 

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

 

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

 

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

 

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

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

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

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

A sentimental warning for bulls and bears

Posted by Cam Hui -

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

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

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

 

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

Too much bullishness

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

 

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

 

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

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

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

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

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

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

 

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

 

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

Sentiment an inexact top calling indicator

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

 

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

 

Caution, not panic

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

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

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

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

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

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

 

Disclosure: Long SPXU, TZA

A track record update

Posted by Cam Hui -

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

 

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

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

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

 

Judge for yourself.

Why I am cautious on the market

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

An over-valued and frothy market

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

  • Valuation
  • Interest rates outlook
  • Growth
  • Psychology

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

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

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

An expensive market

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

 

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

 

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

 

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

 

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

 

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

 

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

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

The Fed has spoken

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

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

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

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

An uncertain growth outlook

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

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

 

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

 

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

 

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

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

 

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

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

The Trump effect on growth

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

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

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

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

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

 

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

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

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

A frothy market

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

 

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

 

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

 

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

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

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

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

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

 

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

 

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

The week ahead

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

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

 

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

 

Disclosure: Long SPXU

A frothy, over-extended stock market

Posted by Cam Hui -

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

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

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

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

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

What about Buffett’s bullish comments?

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

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

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

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

Isn’t growth rising?

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

 

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

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

 

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

 

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

 

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

What about price momentum?

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

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

 

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

 

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

Disclosure: Long SPXU