Six reasons why I am still bullish

Posted by Cam Hui -

Mid-week market update: I wrote on the weekend to buy Yom Kippur, which ends today (see Buy Yom Kippur! SPX 2500 by Passover?). My inner trader sent out an email to subscribers yesterday indicating that he had added to his long position by buying a high-beta small cap position.
 

 

I would like to outline the reasons why I remain intermediate term bullish on equities:

  • Market breadth is supportive of more gains
  • Risk appetite is healthy across the board
  • Investor anxiety is high, which is contrarian bullish
  • The Fed is equity market friendly
  • Growth expectations are healthy
  • A period of positive seasonality is approaching

Supportive breadth

From a technical viewpoint, market breadth is supportive of an advance to new highs. Ed Clissold at Ned Davis Research observed that breadth has been hanging in there despite the consolidation presented by the seasonally weak period. Almost 70% of the sub-industries that NDR monitors are still in uptrends.
 

 

Risk appetite remains healthy

The chart below shows different measures of risk appetite, as measured by high beta stocks vs. low volatility stocks (top panel), small caps vs. large caps (middle panel), and junk bond price vs. duration equivalent US Treasury price (bottom panel). All indicators are showing healthy relative uptrends.
 

 

Investor anxiety remains high

While most investor sentiment metrics are in neutral territory, a number of indicators are pointing to heightened levels of anxiety. Bloomberg pointed out that the cost of hedging against an equity market decline, defined as the cost of a put option vs. a call option, has hit an all-time high.
 

 

At a tactical level, the term structure of the VIX is also revealing a pattern of rising fear. As the chart below shows, the term structure of the VIX has been flattening for the last few days, indicating heightened concerns over downside risk.
 

 

I interpret these sentiment readings as contrarian bullish. Major market declines normally don’t begin with sentiment at these levels.

A friendly Fed

The minutes of the September FOMC meeting were released today. It seems that the major disagreement was over the degree of slack in the labor market (emphasis added):

In their discussion of the outlook, participants considered the likelihood of, and the potential benefits and costs associated with, a more pronounced undershooting of the longer-run normal rate of unemployment than envisioned in their modal forecasts. A number of participants noted that they expected the unemployment rate to run somewhat below its longer-run normal rate and saw a firming of monetary policy over the next few years as likely to be appropriate. A few participants referred to historical episodes when the unemployment rate appeared to have fallen well below its estimated longer-run normal level. They observed that monetary tightening in those episodes typically had been followed by recession and a large increase in the unemployment rate. Several participants viewed this historical experience as relevant for the Committee’s current decision making and saw it as providing evidence that waiting too long to resume the process of policy firming could pose risks to the economic expansion, or noted that a significant increase in unemployment would have disproportionate effects on low-skilled workers and minority groups. Some others judged this historical experience to be of limited applicability in the present environment because the economy was growing only modestly above trend, inflation was below the Committee’s 2 percent objective, and inflation expectations were low–circumstances that differed markedly from those earlier episodes. Moreover, the increase in labor force participation over the past year suggested that there could be greater scope for economic growth without putting undue pressure on labor markets; it was also noted that the longer-run normal rate of unemployment could be lower than previously thought, with a similar implication. Participants agreed that it would be useful to continue to analyze and discuss the dynamics of the adjustment of the economy and labor markets in circumstances when unemployment falls well below its estimated longer-run normal rate.

Developments since that meeting are supportive of the doves’ case of delaying a rate hike. In particular, the September Jobs Report showed that the participation rate edged up, which is indicative of greater slack in the labor market.
 

 

A November rate hike is definitely off the table. A December hike is likely, but not a done deal. It will be dependent on any market instability in the wake of the election. The Yellen Put still lives.

Growth expectations are healthy

At the same time, growth expectations are still healthy. I have highlighted before the steady growth in forward 12-month EPS estimates, which remains a positive for stock prices.
 

 

The bond market agrees. Despite the expectations of rising rates as measured by 2-year Treasury yields (top panel), the yield curve has been steepening, which is indicative of high growth expectations.
 

 

Positive seasonality

From a trader’s perspective, we are entering a period of positive seasonality. Notwithstanding some of the charts I showed in my weekend post (see Buy Yom Kippur! SPX 2500 by Passover?), options are expiring next week. Rob Hanna at Quantifiable Edges found that October OpEx has historically been seasonally positive for the bulls.
 

 

I have no idea exactly when the market is going to turn up, but these intermediate factors are all lining up bullishly. It`s time to buy Yom Kippur.

Disclosure: Long SPXL, TNA

Peak robo?

Posted by Cam Hui -

We all know about how the business model of the robo-advisor works. First, determine the appropriate asset mix based on the risk, return, tax regime and other specific needs of the client. Then, build the portfolio and rebalance it on a periodic basis. The typical investment process can be summarized by the following steps:

  1. Determine the target asset mix, which could change depending on market conditions.
  2. Re-balance if:
    • The asset mix weights moves more than a certain percentage, e.g. 10%, from the target weight; or
    • Periodically, such on an annual basis These are all sensible rules that have long been practiced in the investment industry. In essence, the strategy involves taking profits on winning asset classes and averaging down on losers as a form of risk-control discipline

By following these simple rules, a portfolio will get investing decisions similar to what is depicted in the chart below. The top panel shows the price chart of the Dow Jones Global Index and the bottom panel shows the relative price performance of DJ Global against US Treasuries. Depending on the exact rebalancing rules, a fixed-weight portfolio that re-balances periodically will buy stocks near the bottom of the market and sell them near the top.

 

While the basic business model of the robo-advisor remains unchanged, I can see a couple of competitive threats to the standalone robo model. In fact, these threats may spell a peak of the standalone robo-advisor.

Robo-advisor as fiduciary

First, the standalone robo business model faces a regulatory problem. ThinkAdvisor reports that the law firm of Morgan Lewis believes that robo-advisors may be deemed to be fiduciaries under the Investment Advisor Act of 1940:

Robo-advisors can satisfy fiduciary standards set out by the Securities and Exchange Commission’s “flexible” principles under the Investment Adviser Act of 1940, according to a newly released report by the law firm Morgan Lewis.

In their white paper, “The Evolution of Advice: Digital Investment Advisers as Fiduciaries,” Morgan Lewis attorneys argue that critics who have questioned robo-advisors’ ability to meet fiduciary standards “proceed from misconceptions about the application of fiduciary standards, the current regulatory framework for investment advisors, and the actual services provided by digital advisors.”

If that is indeed the case, then the cost structure of standalone robos will change in a dramatic fashion. No longer can portfolio advice can be generated by software, but varying degrees of human intervention will be required. Any standalone robo-advisor that tries to run its business on autopilot without human oversight is like a car company introducing a self-driving vehicle with imperfect software. The minute there is an accident, whether automotive or financial, it will be an invitation for class action litigation. Bottom line: extra costs will get passed on to customers.

From the client’s viewpoint, the value proposition of the robo-advisor will change as the fee structure rises.

Beating robo-advisors at their own game
In addition, there may be better ways of rebalancing a portfolio while keeping the basic principles of a customized asset mix. I came upon an intriguing paper by Granger, Greenig, Harvey, Rattray and Zou entitled Rebalancing Risk. Here is the abstract:

While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.”

You would think that, for example, given the massive losses seen during the Lehman Crisis episode, that a rebalanced portfolio where the investor bought all the way down would see superior returns. Interestingly, that was not the case. In the paper, the authors compare and contrast a simple drift weight strategy, i.e. not rebalancing at all, with a fixed weight monthly rebalancing strategy. The chart below shows how that the monthly rebalanced portfolio actually showed a higher risk profile than the passive drift portfolio. (There were other examples in the paper, but I will focus on this period for the purpose of this post).

 

By contrast, they advocate a partial momentum strategy. In essence, this amounts to the application of a trend following system to rebalancing. The idea is, as the stock market goes down and the bond market goes up, you keep overweighting your winners (bonds) and don’t rebalance the portfolio until momentum starts to turn. As the chart below shows, the portfolio with the partial momentum overlay performed better than either the monthly rebalanced or passive drift weight portfolio.

 

Talking their book?

These are intriguing results and a demonstration of the positive effects of using trend following techniques for portfolio construction. However, I would add a couple of caveats in my read of this paper. First, three of the five authors work for MAN Group, which is known for using trend following techniques in their investing. While this paper does show the value of these kinds of techniques, I am always mindful that researchers may be “talking their own book”.

As regular readers are aware, I extensively use trend following models in my own work, but I am cognizant of the weaknesses of these models. In particular, these models perform poorly in sideways choppy markets with no trends. As an example, consider this chart of sugar prices for the period from 1891 to 1938. Unless the trend following system is properly calibrated, the drawdowns using this class of model are potentially horrendous.

 

As another example, try wheat prices for the 1872 to 1944 period:

 

A second critique of the approach used by the paper is the use of monthly rebalancing as one of the benchmarks. In practice, no one rebalances their portfolio back to benchmark weight on a monthly basis. A more realistic rebalancing technique might be a rule based rebalancing approach of rebalancing either annually or if the portfolio weights drift too far from the policy benchmark. To be fair, however, the monthly rebalancing approach is an extreme one that does differentiate between a passive drift weight and a more frequently rebalanced portfolio.

Co-opting the robo model

In summary, this is an intriguing paper that compares and contrasts the use of price momentum, or trend following, techniques of chasing winners to a value-based rebalancing strategy of buying assets when they are down. This use of trend following principles could turn out to be a useful way to both reduce portfolio risk and increase returns at the same time. Before going out and blindly implementing a trend-following based re-balancing program, portfolio managers should study these approach and adopt it to their own circumstances.

Nevertheless, this simple exercise shows that the combination of regulatory changes and thoughtful human intervention allow human advisors to beat the robo-advisor at its own game. This suggests an approach of using robo advisory tools to form target portfolios for clients and at the same time allowing the flexibility of a human override as a “sanity check” on model output as different ways of adding value over and above what a standalone robo can offer.

Buy Yom Kippur! SPX 2500 by Passover?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Positive seasonality ahead

Recently, Jonathan Krinsky of MKM Partners highlighted a bullish seasonal pattern with a likely market bottom in early October (chart via Marketwatch, annotations in red are mine).

 

Jeff Hirsch also documented the trading results from the trader’s adage of “Sell Rosh Hashanah, buy Yom Kippur”, as well as the returns from Yom Kippur to Passover, which occurs in the spring.

 

Normally, I don`t give a lot of weight to seasonal patterns in my investing and trading, but it appears that macro-economic, fundamental, and technical factors are all lining up for the positive seasonal pattern for the remainder of the year.

The economy perks up

I have writing about an imminent improvement in the economic growth for several weeks now and we are finally starting to see signs of a turnaround. The Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, is starting to rise again.

 

Early last week, we saw good news from ISM Manufacturing, which rose and beat expectations (via Calculated Risk).

 

ISM Non-manufacturing, which is highly correlated with employment because it measures the more important and larger part of the US economy, also printed a blow-out number and jumped almost six points (via Calculated Risk).

 

The 4-week average of initial jobless claims fell to levels not seen since 1973, Together, these data points paint the picture of a healthy economic expansion.

 

Although the headline Non-Farm Payroll report missed expectations, the internals were healthy enough for Fed vice-chair Stanley Fischer to characterize it as “pretty close” to a “Goldilocks number”. The closely watched participation rate rose as more discouraged workers re-entered the work force.

 

Torsten Sløk of Deutsche Bank interpreted the Jobs Report as a sign of a booming economy: “For the first time in almost 20 years, we are now seeing a decline in the number of people outside the labor market. As the first chart shows, this is consistent with what we saw in the mid-1990s and 2006, when we also were at full employment.”

 

Equally encouraging was the revival in temporary employment, which tends to lead full time employment. Temporary employment growth had been decelerating and bottomed in June, but it may be in the process of turning up again.

 

Just as important, average hourly earnings were rising in a healthy manner. The wage growth among the non-supervisory workers is an indication that growth is not just restricted to the top tier of the labor market.

 

The Atlanta Fed confirmed this trend of cyclical strength by noting that part-time wage growth is accelerating at a faster pace than full-time wages. Broad based wage growth are positive for economic growth because lower paid workers tend to spend most of their earnings. More consumer spending can then kick starts the virtuous growth cycle of better consumer demand, more employment, which leads back to further consumer spending.

 

Poised for a good Q3 earnings season

From a bottom-up perspective, the future also looks bright. The latest update from John Butters of Factset indicates that forward 12-month EPS continues to rise. With Q3 earnings season just about to start, Butters also observed that the negative guidance rate is below average. The combination of rising Street optimism and below average earnings warnings add up to a possible blockbuster earnings reports in the weeks to come.

 

That upbeat assessment of equities is confirmed by the actions of Barron’s report of the “smart money” insiders, whose aggregate activity has been flashing a “buy” signals for three of the last four weeks.

 

Reflation lives!

When I put all of these elements together, it spells R-E-F-L-A-T-I-O-N.  Jeroen Blokland described the current macro environment as inflation being just around the corner.

 

There is a case to be made for an inflationary surge. The chart below shows the number of times in the last 12 months that Core PCE has exceeded 2%, which is the Fed’s inflation target. In the past, the Fed has tended to start a rate hike cycle when the trailing count reached 6. The one exception that the Fed did not raise rates under these circumstances was in 2011, when Europe was gripped by a Greek debt crisis.

 

Risk appetite rising

If inflationary pressures are indeed around the corner, then the logical portfolio response is to overweight resource sectors and emerging markets because of their inflation hedge qualities due to their higher commodity sensitivity. Recently, the Leuthold Group flashed a buy signal for emerging market stocks over developed markets.

 

It’s not just the Leuthold Group buy signal for the high beta EM stocks that got me all excited. Market internals are also showing signs of renewed risk appetite. In the fixed income markets, US high yield (HY) bonds and emerging market bonds are also telling a risk-on story.

 

Even as the stock market consolidated sideways, there were other bullish divergences to be seen under the surface. Risk appetite indicators such as high beta vs. low volatility, and small caps vs. large caps show that the risk and TINA (There Is No Alternative) trades ares performing well.

 

On the other hand, defensive sectors such as Consumer Staples, Utilities, and Telecom have been lagging the market.

 

In addition, Jeffrey Kleintop observed that equity flows tend to follow trailing 5-year returns. With rolling 5-year returns turning up, equity fund flows could get a lot stronger in the weeks and months ahead.

 

Get ready for the year-end FOMO rally, especially in light of what Josh Brown terms the “career risk trade”, where under-invested managers scramble to buy stocks as we approach year-end. The bottom panel of the chart below shows pressure that managers are facing, which is in the form of rolling 52-week market return that has been trending up since the Brexit referendum.

 

Risk on! Let’s party!

S&P 500 at 2500?

In light of these bullish factors, I believe that the SPX point and figure target of over 2500 should be achievable by next spring.

 

The one key question is how the Fed responds to the signs of rising inflation pressures (see How the Fed could induce a bear market in 2017). Given the “Goldilocks” nature of the September Jobs Report, a December rate hike is more or less a done deal. The only question is the trajectory of interest rates in 2017. As the chart below shows, the composition of the FOMC next year will be more dovish than 2016 (annotations in red are mine).

 

The combination of improving fundamentals and a dovish FOMC 2017 are creating the tantalizing possibility of an equity market blow-off to levels that I may not be able to project.

The week ahead: Waiting for Yom Kippur

Looking ahead to next week, the sideways pattern of the stock market over the past weeks have been frustrating for traders. Volatility has risen since early September, but we have seen no significant breakouts or breakdowns out of the trading range.

Most sentiment and breadth indicators are showing neutral readings, which could be interpreted bullishly as the market is very close to its all-time highs. On the other hand, they provide little guidance as to the near-term outlook for stock prices. As an example, the Fear and Greed index is dead neutral.

 

AAII sentiment is in neutral territory. Rydex readings are neutral to mildly oversold.

 

Breadth indicators from IndexIndicators are not giving any hints of market direction either. Stocks above their 10 dma are slightly below neutral but not oversold.

 

Stocks with net 20 day highs-lows is showing a “wimpy” oversold reading, but there is no sign of excessive fear.

 

The single bright spot from a short-term trading viewpoint comes from the analysis of Twitter breadth from Trade Followers. As the chart below shows, bullish breadth has been slowly improving and bearish breadth has been falling, which results in a net rise in Twitter breadth.

 

My inner investor remains bullish on stocks. My inner trader is starting the get the FOMO fever and he may not be able to hold out much beyond Yom Kippur, which is next Wednesday. He is long the market, but he would prefer to see a decent pullback before buying in. In light of the imminent start of earnings season, he may start to add to his long positions next week on either a minor dip or a convincing breakout to new highs.

Disclosure: Long SPXL

My September Non-Farm Payroll guess

Posted by Cam Hui -

This Friday will be another potentially market moving Employment Report day, even though the release is based on noisy data with a high margin of error. The latest Fedspeak indicates that Non-Farm Payroll (NFP) would have to see a big downside miss before the Fed would change its plans to hike rates in December. Even super-dove Charles Evans has the green light to a December move: “I would not be surprised, and if data continue to roll in as they have, I would be fine with increasing the funds rate once by the end of this year”,

With that preface, what the likely result for the September NFP, especially in light of the miss in ADP’s private employment report? Will September NFP come in above or below the 175K estimate?

 

A clue from initial claims

In the past, I have had decent results from the analysis of initial jobless claims. The initial claims reports are useful because of their high frequency (weekly) and can be especially insightful if a report falls in the middle of the survey period for that month’s NFP report.

As the table below shows, the initial claims report for September 15, 2016, which represents the survey period for the NFP report, beat expectations. In fact, initial claims has been beating Street expectations for seven consecutive weeks, indicating a pattern of strong labor markets.

 

Based on this limited model, I expect a stronger than expected NFP report on Friday.

Don’t ask me about gold, ask about the USD

Posted by Cam Hui -

Mid-week market update: The market gods must be angry. Just as a goldbug predicted the demise of the US Dollar (and therefore the rise of gold) as of September 30, 2016 at 4pm ET, the USD rallied and gold cratered on Tuesday. The technical damage to gold was extensive, as it broke a key support level at 1300, though it did stabilize today.

 

I have had a number of questions about the outlook for gold in the past. My reply has always been the same. Don`t ask me about gold, ask about the US Dollar. Consider this chart of stated gold reserves. Assuming that the conspiracy theorists are wrong and the United States has all the gold it says it has, the market value of US gold reserves at $1300 per oz comes to roughly $340 billion. That`s not even a single year`s fiscal deficit!

 

The global holdings of US Treasury paper dwarfs precious metal holdings. From a portfolio viewpoint, gold cannot be anything but a miniscule weight in the aggregate holdings of a global portfolio. As the gold price is inversely correlated to the greenback, it makes sense to analyze the more liquid asset class, namely the USD.

Will the real USD Index please stand up?

The USD is just a single currency, measured against the currencies of other countries in the world. So how do we measure the USD? As the chart below shows, the technical picture of the Broad Trade Weighted Dollar indicates that it is range-bound.

 

By contrast, the Major Currency TWD is trading in a narrow wedge, which is also the pattern shown by the popularly used USD Index, DXY.

 

From a technical perspective, these charts of the USD doesn’t give us a lot of clue about the intermediate term direction of the currency. We need to see a definitive breakout before making a call on the USD, gold, and other commodity prices. In addition, an upside USD breakout may have bearish implications for equity prices, as greenback strength will have the effect of squeezing the operating margins of large cap companies operating overseas.

Signs of global reflation

However, there may be some hopeful clues for gold bulls. Gold is believed to be an inflation hedge and inflation may be on the verge of a comeback. Callum Thomas recently observed positive breadth patterns in commodity prices, which is bullish for the entire commodity complex, including gold.

 

In addition, the ratio of industrial metals to gold is tracing out a bottoming pattern. This suggests that the cyclically sensitive element in commodity prices, net of the inflationary hedge component, is signalling the return of global economic growth. Rising growth will eventually translate to higher inflationary pressures.

 

Short term gold bearish

In the short term, however, breadth metrics in the precious metal complex appear to be bearish. The ratio of high beta silver to gold (green line) is tanking. The % bullish measure is also tanking and confirming the weakness in gold. This trading pattern suggests that gold prices need to stabilize and find a bottom before it can sustainably rise again. The first area of support can be found at the 50% Fibonacci retracement level at about $22.

 

As well, sentiment doesn’t seem to be sufficiently washed out to form a durable bottom. My social media feed is still full of hopeful bulls. This chart from Hedgopia shows that large speculators, or hedge funds, have not reversed out of their crowded long positions yet.

 

Historical studies, like this one from Schaeffer’s Research, point to more short term pain first before a rally can occur.

 

Bottom line: It’s too early to buy yet, but stay tuned!

Dangerous over-valuation, or a New Era?

Posted by Cam Hui -

Business Insider recently featured a chart from Vanguard Group founder Jack Bogle, who observed that the market cap to GDP ratio has become highly elevated to its own history starting about 1996. You might recall that the market cap to GDP ratio was also said to be one of Warren Buffett’s favorite equity market valuation metrics, though he has been silent on the issue for a number of years.

 

What’s going on? Has the stock market become dangerously overvalued, or is this a New Era?

Decomposing the P/E ratio

The market cap to GDP ratio is really shorthand for a simplified aggregate price to sales ratio for the stock market. Most investors value stocks based on the price to earnings, or P/E ratio, which can be expressed as:

Price / Earnings = Price / (Sales X Net margin)

I went to FRED and charted the best approximation of after tax net margins, after-tax corporate profits to GDP. As the chart below shows, this ratio was range bound from 1947 to about 1994, when it began a secular rising trend.

 

Secular vs. cyclical effects

In other words, price to sales ratios are elevated because net margins have risen. The question for investors then becomes whether the rise in net margins is sustainable. Here, we have to distinguish between the secular and cyclical effects of the change in net margins. The secular trend can be explained by some old BAML analysis from 2014 (via Business Insider) showing that the rise in net margins was mainly attributable to lower interest expense (thank you, Federal Reserve) and lower tax rates (think Apple and tax inversion schemes).

 

On the other hand, Corporate America is operating in an economic environment where the labor market is at or near full employment. That’s when the cyclical effects are coming into play. The Atlanta Fed’s wage growth tracker shows steadily rising wage pressures, which will act to squeeze operating margins.

 

A survey of Avondale’s earnings call digest also reveals rising concerns over wage pressures on operating margins. Here is an excerpt from the 30-Sep-2016 digest:

Businesses are getting closer to full employment
“businesses are getting closer to full employment and we are seeing the checks per client slow, but we expect that frankly for the last couple of years as people came back from recession.” —Paychex CEO Martin Mucci (Payroll Processing)

Here is an excerpt from the 23-Sep-2016 digest:

Homebuilders continue to see tight labor markets
“there’s been very tight labor conditions across the country…we’ve had instances in some of our divisions where some contractors are coming back to us and basically saying they’re going to have to work over time with their folks or that they’re going to need to see some price increases in order to stay on the job.” —KB Home CEO Jeff Mezger (Homebuilder)

 “Land is expensive. Land is hard to come by. People are expensive and hard to come by. It’s hard to grow operations efficiently and effectively at an accelerated rate in a market where land and labor is really constrained.” —Lennar CEO Stuart Miller (Homebuilder)

 Bed Bath and Beyond is seeing wage pressure
“we believe payroll and wage pressure will continue. We’re not immune to it; it’s impacting our broader workforce including all of retail. It’s also something that we’re seeing…a more than one year impact that there are scheduled increases…for multiple years out” —Bed Bath and Beyond CEO Steven Temares (Home Goods)

Here is an excerpt from the 8-Sep-2016 digest:

Wage inflation is above 2% and the decline in food prices is moderating
“I think given the wage pressure, it’s probably slightly above the 2%…I mean, labor is — as Brian mentioned, we’re anticipating between 4% and 4.5% in the second half within that range also in the first half. So it’s a little more and [with] some reduced reduction in cost of sales on the food side, the margin side gets a little harder.” —Dave and Busters CEO Stephen King (Restaurant)

To circle back to the original question of whether the elevated market cap to GDP ratio represents a New Era, the answer is a qualified yes. However, investors should be aware of the rising cyclical headwinds that are likely to pressure operating margins in the near future.

If Deutsche = Lehman, then Greek banks = ?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

It’s always something: Deutsche Bank edition

Readers of a certain age will recall the immortal line of late Gilda Radner as “Rosanna Rosanna Dana” in Saturday Night Live, “It’s always something!”

Two weeks ago, the market was worried about the uncertainties posed by presidential debate. Last week, it was Deutsche Bank. This week, my market commentary will focus mainly on a tail-risk scenario of a Deutsche Bank sparking a European banking crisis.

To recap, the markets got spooked by continuing concerns over the financial health of Deutsche Bank (DB). The worries sparked a number of comparisons with the failure of Lehman Brothers, which sparked the Great Financial Crisis of 2008 (chart via Zero Hedge).

 

If you are still worried about DB, then consider the following: If Europe didn’t allow the Greek banks to topple during the last couple of Greek financial crises, would it allow a systemically important bank like DB to fail? If you accept the Deutsche as Lehman analogy, then what would that make Greek banks?

A banking primer

I start my analysis with a brief banking primer for the newbies. The chart below shows an idealized balance sheet of a bank. A bank takes in deposits and pays its depositors interest, which form the liabilities of the bank’s balance sheet. On the asset side, it invests the deposits into loans and other instruments, and maintains a prescribed level of Tier 1 capital. Typical Tier 1 capital consists of common equity, preferred equity, and contingency convertible (CoCo) bonds that collectively act as loan loss buffers.

 

Now imagine that all of a sudden, depositors panic and ask for their deposits back from the bank. The loans that the bank has out are not very liquid and therefore it cannot quickly get the funds to pay back its depositors. That is what we call a liquidity crisis, or a bank run. The bank could then either ask other banks for short-term overnight loans to deal with liquidity shortfalls, or, as a last resort, ask the central bank for loans. That’s why the central bank is known as the lender of last resort.

On the other hand, if the bank suffers a large loss in the form of the default of a large borrower and it does not have enough financial cushion to offset that loss, then it suffers from a solvency crisis. In that case, the bank would either have to either find new capital, merge with a strong partner that has sufficiently large buffer, or go insolvent, where the shareholders get wiped out to zero and depositors may not get all of their money back.

Central bankers understand the mechanisms of liquidity crises well and they have built mechanisms to deal with such emergencies. Flooding the banking system with overnight loans can solve liquidity problems, but they cannot address solvency problems.

What happened to Deutsche Bank?

The concerns over DB is a potential solvency problem, not a liquidity problem. The market was spooked when DB management put out a statement indicating that the bank could be on the hook for up to $14 billion for past wrongdoings in the mortgage market:

Deutsche Bank AG (XETRA: DBKGn.DE / NYSE: DB) confirms that it has commenced negotiations with the Department of Justice in the United States (“DoJ”) with a view to seeking to settle civil claims that the DoJ may consider in connection with the bank’s issuance and underwriting of residential mortgage-backed securities (RMBS) and related securitization activities between 2005 and 2007.

The bank confirms market speculation of an opening position by the DoJ of USD 14 billion and that the DoJ has invited the bank as the next step to submit a counter proposal.

Deutsche Bank has no intent to settle these potential civil claims anywhere near the number cited. The negotiations are only just beginning. The bank expects that they will lead to an outcome similar to those of peer banks which have settled at materially lower amounts.

The proposed $14 billion settlement was a shocker. It also raised potential solvency concerns for investors. As these charts from Bloomberg shows, DB’s capital adequacy was a bit low compared to other major banks, as measured by Tier 1 capital.

 

In addition, leverage is higher than other major banks.

 

It didn’t help matters when the German government stated that it saw “no grounds” for a state sponsored rescue of DB. In addition, DB CEO John Cryan said in a newspaper interview that raising capital “is currently not an issue,” and accepting government support is “out of the question for us.” Much of Berlin’s statement was political posturing. The idea of rescuing German banks is not popular with the German public. Moreover, it could hardly consent to helping DB when it came out against Italy rescuing Italian banks. When the news hit the tape that a number of hedge funds withdrew their excess cash from their DB prime brokerage account last week, panic ensued and DB’s share price tanked as fears of a bank run spread.

Despite the concerns over a DB potential solvency crisis (and I would underline the word “potential” as the $14 billion figure represents only a proposal), there were no signs of a liquidity crisis at DB or anywhere else in Europe. The latest report from the European Central Bank shows that the banking system tapped the central bank for a measly €14 million in overnight loans.

 

In addition, financial contagion fears were well contained. Sure, the cost of insuring against the default of DB debt had spiked, but fear levels were not spreading into the global banking system.

 

Even at the height of the panic, European financial equities appeared to be tracing out a relative performance bottom. Such market action indicates that market fears over DB had not substantially spread into the rest of the financial sector.

 

When the news broke that DB was nearing a compromise where the DoJ fine is going to be reduced to $5.4 billion from $14 billion, the share price surged.

 

Apocalypse postponed? Yes, but this episode does illustrate the fragility of the European banking system. European banks haven`t cleaned up their balance sheet since the Great Financial Crisis. Leverage ratios of 30x to 50x make them highly vulnerable to unexpected shocks like these.

In the absence of tail-risk…

In the meantime, the US macro outlook appears to be constructive. Markit flash Composite PMI, which includes both manufacturing and services, has been rising at a measured pace.

 

The job market continues to improve. As the chart below shows, initial jobless claims (blue line, inverted scale) has shown itself to be inversely corrected to stock prices (red line).

 

The labor market recovery is showing signs of broadening out beyond the well educated cohorts.

 

Consumer confidence improved and beat Street expectations.

 

Even though manufacturing data has been a bit soft, Bill McBride at Calculated Risk identified a silver lining in that dark cloud. McBride observed that the Chemical Activity Barometer has been rising. In the past, such strength has foreshadowed better industrial production in the near future.

 

From a bottom-up perspective, the latest weekly update from John Butters of Factset shows that forward 12-month EPS continues to rise and the negative earnings guidance rate is below its historical average. This suggests that Q3 earnings season should beat aggregate Street expectations, which is bullish.

 

Callum Thomas confirmed my beliefs about likely positive surprises from Q3 earnings season. He observed that the ECRI Weekly Leading Growth Indicator tends to lead forward earnings growth. If the past is any guide, earnings growth should start to surge soon.

 

The Wilshire 5000 Index has flashed a bullish MACD crossover buy signal based on monthly data.

 

In summary, the status quo market outlook looks bright – in the absence of tail-risk.

The week ahead: Bullish tone, but volatile

In spite of the bullish tone of the intermediate term trend, the market may see some choppiness in the week ahead. Firstly, the DB situation is not fully resolved. CNBC cautioned on Friday that, despite the bullish news about the reduced fine, the $5.4 billion figure remains speculative and unconfirmed by the company:

If the number was correct, under German capital market rules Deutsche Bank would be required to confirm the amount by now. Its failure to do so indicates the number is not correct. Any eventual settlement, however, would almost certainly be well below the reported $14-billion opening bid by the Department of Justice in its talks with Deutsche.

Deutsche Bank is not publicly commenting on the supposed $5.4-billion figure.

Even if the $5.4 billion figure is correct, Holger Zschaepitz at Die Welt pointed out that JPM estimates that DB would be inadequately reserved.

 

In addition, the latest short-term breadth statistics from IndexIndicators shows that DAX index to be nearing an overbought level and therefore may be vulnerable to a pullback. However, longer term breadth indicators are still neutral and therefore the market may have more room to run to the upside after any market pause.

 

The SPX is also nearing a key resistance zone and may encounter difficulty overcoming those levels in light of the event-driven volatility from Q3 earnings season, the potentially market moving September Jobs Report on Friday, the next presidential debate next Sunday, and heightened earthquake risk in southern California.

 

As well, LPL Research pointed out that the market is in the middle of a period of high seasonal volatility.

 

My inner investor remains bullish on stocks. My inner trader is cautiously bullish and he is keeping some powder dry in preparation for the inevitable dips in the days ahead.

Disclosure: Long SPXL

The USD Apocalypse of September 30, 2016?

Posted by Cam Hui -

A reader asked me today if I knew anything about a forecast of an imminent US Dollar Apocalypse of September 30, 2016. After digging around, I found this article on Daily Reckoning. It turns out that the Chinese RMB is going to get included in the Special Drawing Rights (SDR) basket of currencies as of 4pm on Friday, September 30, 2016. The weight of CNY is going to be 10.9%, which is higher than the weight of the Japanese Yen at 8.3%.

 

The story of RMB inclusion in SDR is another nail in the coffin of King Dollar. The article then went on to reiterate the thesis about the destruction of the USD as a store of value.

 

The obvious solution is, of course, to buy gold. Oh, PUH-LEEZ!

 

Sorry to disappoint the goldbugs, but some simple calculations show that gold to be an inferior investment to a USD cash position if we factor in T-Bill interest payments.

The investment record

Let’s start with the inflationista’s favorite metal, gold. According to onlygold.com, the price of gold in 1900 was $20.67 and it was $1060.00 in 2015, which amounts to a return of 3.5% per annum. According to this inflation calculator, the inflation rate between 1900 and 2015 was 2.9%, which make gold`s real rate of return 0.6% over that period. Remember, this period included Washington taking the Dollar off the gold standard, two world wars, and Richard Nixon shutting down the gold window.

By contrast, the Credit Suisse Global Investment Handbook reveals that the real rate of return on USD T-Bills was 0.8%.

 

Despite all the harping about the loss of purchasing power, it turns out that USD invested in T-Bills showed a superior return to holding gold. Incidentally, I have not included the storage fees associated with holding gold in a vault, or as an alternative, the price of the guns, ammunition, freeze-dried food, claymore mines, and other equipment you will need to defend the gold yourself in your Idaho mountain stronghold.

Still not convinced? Isn’t it curious that even the perennially bearish Zero Hedge has not picked up on this end-of-world scenario? Ask yourself this, “How seriously can you believe an Apocalyptic scenario that even Zero Hedge won’t touch?”

Studies in market psychology: The Debate and Deutsche Bank

Posted by Cam Hui -

Mid-week market update: From a trader`s perspective, this market had been jittery and mainly driven by two themes. The first was the resolution of the uncertainty over the presidential debate that occurred Monday night. The other is the uncertainty over the fate of Deutsche Bank as a symptom of the systemic risk posed by European financials.

The market reactions to these themes can hold clues to short-term market direction.

The “debate” market effect

On the eve of the presidential debate, Bloomberg featured a story indicating that large speculators were in a crowded short in the Mexico peso (MXN). As MXN can be a market barometer of Trump’s perceived chances of winning the election, the record short position indicated that large speculators were positioned for a Trump debate win.

 

The chart below depicts the USDMXN market reaction to the debate. The peso rallied by about 1.8% overnight. The exchange rate has since stabilized and traded in a relatively narrow range since then.

 

Preliminary real-time metrics also shows that Hillary Clinton “won” the debate. Nate Silver observed that Google searches for “donate Hillary Clinton” exceeded similar searches for “donate Donald Trump” in the post debate period. Indeed, the first post-debate poll shows that Clinton gained four percentages points of support against Trump.

 

I pointed out on the weekend that Clinton is the status quo candidate and the markets prefer the status quo (see Clinton vs. Trump: Charting the possible market direction), this debate result should be interpreted bullishly for stocks.

However, the electoral road ahead is still likely to be bumpy. Both candidates have extremely high negative ratings by the public. Bespoke recently highlighted a survey of the words that best described Hillary Clinton and Donald Trump. The word cloud for Clinton shows that 15% of the respondents characterized as a “liar”, followed by “untrustworthy”. It isn’t until we get to the third word that we see something that can be characterized as positive: “experienced”.

 

The results for Trump even worse. The top word used to describe him was “idiot”, followed by “a**hole”, “racist” and “arrogant”.

 

My interpretation of these results lead to the conclusion that the markets will remain on edge until the election. The stock market’s weak rally in the wake of the bullish Clinton debate win also suggests further volatility lies ahead.

Deutsche Bank: What now?

One possible reason for the feeble strength of the post-debate rally could be attributable to the news surrounding Deutsche Bank (DB). As the chart below of the DB stock price and its CDS shows, the bank’s misfortunes are no surprise. It’s just that the market appears to have shined the spotlight on DB recently.

 

The Telegraph recently featured an article speculating that the Deutsche Bank crisis could take down Angela Merkel – and the euro. The German government has ruled out a bailout of Deutsche for political reasons. If Berlin is against the idea of Italy bailing its banking system, how could it possibly defend a DB rescue? On the other hand, if the financial stability of a large institution like Deutsche were to be viewed as suspect, then market fears could cause the inter-bank market to seize up and spark a banking crisis in the eurozone.

The European markets staged a relief rally early Wednesday when a report by Die Zeit surfaced indicating that the German government was preparing a backup plan to buy as much as 25% of DB should the bank be unable to raise the necessary capital. The German finance ministry swiftly denied the report, but the shares of DB and other European financials appear to have nevertheless stabilized.

From a technical perspective, DB’s troubles does not appear to be at risk of spreading to the European financial sector. The RRG sector rotation chart of European sectors showed that European financials were in the “improving” category. Typically, the next stage in development for financials is to become the new sector leadership over the next few weeks.

 

The chart below of the relative performance of the European financials also tells the same story. The sector has been performing well on a relative basis for the past couple of months. Its relative performance is well of the panic lows seen in July, though it remains in a longer term relative downtrend.

 

From a technical perspective, European financials appear to be the mend. The market reaction to DB’s problems may be interpreted as a wash-out sector on the verge of recovery.

More choppiness ahead

In the short run, however, the inability of the SPX to rally and test the old highs in light of bullish debate developments and the constructive technical backdrop of European financials is a concern. The hourly chart below shows gaps everywhere that have been filled. The next target is the gap above at about 2172-2178.

 

My base case therefore calls for a rally, followed by failure at resistance and a decline back down towards the bottom of the range, either at 2140 or 2120. In other words, expect more choppiness ahead.

Disclosure: Long SPXL

Some surefire stock winners under a Clinton presidency

Posted by Cam Hui -

As I write these words before the first presidential debate, expectations have been racheted up for a Trump win and Clinton loss. Here is just one example (via Politico):

‘She will have to answer every single question flawlessly, exude gravitas…not cough, wear an acceptable pantsuit, smile enough, be likable, not laugh and have a good hair day. Donald Trump will just have to show up,” said an Ohio Democrat.

I have no idea of who might come out on top, or who will be the next president of the United States. Given the low expectations for a Clinton victory in the debates, here are some stocks with a common theme that could benefit should HRC perform well in the debate.

“A muscular foreign policy”

As I wrote before (see How to trade the US election), the one sure thing about a Hillary Clinton presidency is a more muscular foreign policy compared to the Obama administration. Here is the New York Times of Clinton on her philosophy on foreign policy:

As Hillary Clinton makes another run for president, it can be tempting to view her hard-edged rhetoric about the world less as deeply felt core principle than as calculated political maneuver. But Clinton’s foreign-policy instincts are bred in the bone — grounded in cold realism about human nature and what one aide calls “a textbook view of American exceptionalism.” It set her apart from her rival-turned-boss, Barack Obama, who avoided military entanglements and tried to reconcile Americans to a world in which the United States was no longer the undisputed hegemon. And it will likely set her apart from the Republican candidate she meets in the general election. For all their bluster about bombing the Islamic State into oblivion, neither Donald J. Trump nor Senator Ted Cruz of Texas has demonstrated anywhere near the appetite for military engagement abroad that Clinton has.

Think Nixon or Reagan, rather than Bill Clinton or Barack Obama.

I have no idea of whether a HRC administration would put boots on the ground in the Middle East or anywhere else, but a much better bet would be the enlargement of the intelligence budget. Then I came upon this article from The Nation, entitled “5 Corporations Now Dominate Our Privatized Intelligence Industry”. While the tone of the article was meant to spark outrage, my ears perked up.

Privatization of intelligence services? Oligopoly? Oligopolistic pricing? Tell me more! After all, the barriers to entry in this industry are high. It isn’t as if anyone can hang out their shingle and become a government intelligence services contractor. If the government wasn’t satisfied with any company’s services, there aren’t a lot of alternatives.

The article from The Nation outlined five companies that employed about 80% of the privatized intelligence industry. My comments are bolded and in parentheses. Any data is comes from either Yahoo finance or company 10K filings.

In August, Leidos Holdings, a major contractor for the Pentagon and the National Security Agency, completed a long-planned merger with the Information Systems & Global Solutions division of Lockheed Martin, the global military giant. The 8,000 operatives employed by the new company do everything from analyzing signals for the NSA to tracking down suspected enemy fighters for US Special Forces in the Middle East and Africa. (Ticker: LDOS, about 70% of revenues comes from military/intelligence. L12m P/E 11.3 Fwd P/E 13.7)

Booz Allen Hamilton, which has stood like a colossus over US intelligence as a contractor and consultant for over 30 years, is partly owned by the Carlyle Group, the politically connected private-equity firm. Booz is basically the consigliere of the Intelligence Community (known in Washington as the “IC”), serving “the Director of National Intelligence, Undersecretary of Defense for Intelligence, National Intelligence and Civil Agencies, and Military Intelligence,” according to the company’s website. And this work can be lethal: Under a contract with Army intelligence, Booz personnel “rapidly track high-value individuals” targeted by the US military in a system now “deployed, and fully operational in Afghanistan.”

CSRA Inc. was created out of a merger between CSC, which developed and manages the NSA’s classified internal-communications system, and SRA International, a highly profitable company with a long history of involvement in intelligence, surveillance, and reconnaissance (ISR). Among scores of other contracts, CSRA, which has close ties to the US Air Force, provides 24/7 support for the “global operations” of US commands in Europe and Africa and, under a January 2016 contract, manages the “global network of intelligence platforms” for the most advanced drones in the US arsenal. And in a bizarre set of contracts with the Pentagon’s prison in Guantánamo, it was hired to help both the defense and the prosecution in the military trials of individuals accused of planning the 9/11 attacks. (Ticker: CSRA, about 50% of revenues from military/intelligence. Mkt cap: $4.5b. L12m P/E 52 Fwd P/E 13.0)

SAIC is a well-known military contractor that has expanded into spying by buying Scitor, a company deeply embedded in the Pentagon’s top-secret satellite operations. Scitor’s real value for SAIC is its reach into the National Reconnaissance Office (NRO), which manages those satellites and integrates downloaded signals and imagery from space for the NSA and the National Geospatial-Intelligence Agency (NGA). SAIC’s latest project: an $8.5 million contract from the Army’s Intelligence and Security Command for “aerial ISR” in Afghanistan to be partly carried out at the NSA’s huge listening post in Fort Gordon, Georgia. (Ticker: SAIC, about 76% of revenues comes from military/intelligence, rest from civilian federal government, Mkt cap: 3.1b. L12m P/E 24.5 Fwd P/E 19.2)

CACI International is the Pentagon contractor infamous for supplying interrogators to the US military prison at Abu Ghraib in Iraq. CACI recently acquired two companies doing extensive work for the NSA and the CIA: National Security Solutions (bought from L-3 Communications) and Six3 Intelligence Solutions. Both have given CACI new inroads into national intelligence. Six3, for example, recently won substantial contracts to provide “counterinsurgency targeting” to NATO forces in Afghanistan. It also just won a new Army contract to provide intelligence to US military forces in Syria—an indication of how deeply US forces are now engaged there. It’s also the only contractor I know that quantifies its results: CACI’s intelligence services have “identified more than 1,500 terrorists threatening our nation,” it claims. (Ticker: CACI, about 65% of revenues comes from military/intelligence. L12m P/E 17.7 Fwd P/E 15.1)

Under a HRC president, these “pure” plays in the sector and they should therefore receive the lion’s share of the benefit of any enlargement of the intelligence budget. This represents a macro sector theme and my individual company due diligence has been highly limited. Anyone who wishes to buy into such an investment thesis should either perform their own company research, or use a portfolio approach of buying all of these stocks.

Clinton vs. Trump: Charting the possible market reaction

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Reading the electoral tea leaves

Recently, there have been numerous reports on the unsettled macro and market environment as a result of the US presidential election. Bloomberg reported that consumer uncertainty had spiked.
 

 

Business Insider highlighted the deterioration in small business confidence ahead of the election:
 

 

Tom McClellan also identified a rough correlation between the stock market and the polls. The market seems to interpret a rising Clinton lead as bullish and rising Trump lead as bearish.
 

 

It’s time to ask the question, “What is the likely equity market trajectory under a Clinton or Trump presidency?”

Clinton vs. Trump

It is said that while Trump has ideas, Clinton has policies. This article details the Clinton team’s meticulous policy preparations and implementation details:

It’s just that they’re focusing on November 9, and what Clinton would do if she manages to make it to the White House—where she would face an even less habitable political environment than Obama did. Unlike him, she’ll be entering office without a huge reserve of personal popularity to draw on. She’ll be hemmed in by Republicans on one side and a newly emboldened progressive wing of the Democratic Party on the other. With almost no room to maneuver, Clinton has to find a way to do something good for America. It almost makes the election look like the easy part.

By contrast, it’s difficult to pin Trump down on what his administration might do. This New Yorker article explains:

Many of Trump’s policy positions are fluid. He has adopted and abandoned (and, at times, adopted again) notions of arming some schoolteachers with guns, scrapping the H-1B visas admitting skilled foreign workers, and imposing a temporary “total and complete shutdown of Muslims entering the United States.” He has said, “Everything is negotiable,” which, to some, suggests that Trump would be normalized by politics and constrained by the constitutional safeguards on his office.

While Trump has shown himself to be mercurial, he has shown that he has some core principles:

When Trump talks about what he will create and what he will eliminate, he doesn’t depart from three core principles: in his view, America is doing too much to try to solve the world’s problems; trade agreements are damaging the country; and immigrants are detrimental to it. He wanders and hedges and doubles back, but he is governed by a strong instinct for self-preservation, and never strays too far from his essential positions.

Ideas? Definitely. Policies? Well, the devil is in the details.

Consider, for example, the idea of putting restrictions on Muslims, whether as US visitors, or American citizens and residents. In order to implement a policy like that, the federal government would have to create an enormous bureaucracy to identify, verify, and monitor the religious beliefs of every US visitor and resident. I doubt if that’s the sort of Big Brother intrusion that Trump supporters had in mind.

How about a compromise solution of banning visitors from key Muslim Middle Eastern countries that are at high risk of being sources of terrorism, such as Egypt, Syria, Libya, Yemen, and so on? “Mr. President, what do we do about the Coptic Christians in Egypt, which is one of the oldest Christian sects around?” (See above discussion about monitoring religious beliefs).

Here are some more examples from the New Yorker article:

In some cases, Trump’s language has had the opposite effect of what he intends. He professes a hard line on China (“We can’t continue to allow China to rape our country,” he said in May), but, in China, Trump’s “America First” policy has been understood as the lament of a permissive, exhausted America. A recent article in Guancha, a nationalist news site, was headlined “Trump: America Will Stop Talking About Human Rights and No Longer Protect NATO Unconditionally.”

…Other militant organizations, including ISIS, featured Trump’s words and image in recruiting materials. A recruitment video released in January by Al Shabaab, the East African militant group allied with Al Qaeda, showed Trump calling for a ban on Muslims entering the U.S.; the video warned, “Tomorrow, it will be a land of religious discrimination and concentration camps.”

…Closer to home, Trump’s criticism of Mexico has fuelled the rise of a Presidential candidate whom some Mexicans call their own Donald Trump—Andrés Manuel López Obrador, a pugnacious leftist who proposed to cut off intelligence coöperation with America. In recent polls, he has pulled ahead of a crowded field. Jorge Guajardo, a former Mexican diplomat, who served in the United States and China, warns that the surge of hostility from American politicians will weaken Mexico’s commitment to help the United States with counter-terrorism. “Post-9/11, the coöperation has gone on steroids,” Guajardo told me. “There have been cases of stopping terrorists in Mexico. Muammar Qaddafi’s son wanted to go live in Mexico, and Mexico stopped him. But people are saying, If the United States elects Trump, give them the finger.”

I could go on, but you get the idea.

Clinton = Status quo

I believe that the market’s reaction to the polling results is not so much as an affinity for Hillary Clinton, but a preference for the status quo that Clinton represents. This interpretation is confirmed by this WSJ article indicating that nearly one-third of Fortune 100 CEOs supported Mitt Romney in the last presidential election, but none have supported Donald Trump this year. Markets don`t like the uncertainty of a Trump presidency, because the implementation details of his policies are unknown.

Under the status quo (Clinton win) scenario, there are numerous good reasons to be bullish on stocks. Josh Brown recently charted the “career risk trade”. SPX YoY returns have turned positive since the Brexit rally and managers are likely to be buying and chasing performance into year-end.
 

 

Sam Bullard of Wells Fargo wrote about the expectation of further fiscal stimulus in 2017. Both Clinton and Trump have committed themselves to more government spending which should provide a short-term boost to the growth outlook (chart via Business Insider).
 

 

In addition, there is room for optimism for the Q3 and Q4 earnings outlook. I wrote last week that analysis from Lipper Alpha Insight indicated that Q3 earnings season is likely to see an upbeat tone because of the falling level of negative guidance.
 

 

John Butters at Factset also pointed out that the Street expects the earnings recession to end shortly. Coupled with a better than expected Q3 earnings season, these developments should be good news for stock prices.
 

 

The expected earnings revival seems to be on track. Butter’s weekly earnings outlook report shows that last week’s decline in forward 12-month EPS turned out to be a data blip. The latest figures show that forward EPS has resumed its rising trend. This is another good reason for optimism stock prices to rise (annotations in red are mine).
 

 

Rising earnings growth is bullish for stock prices, even if the Fed were to raise interest rates. Jim Paulsen at Wells Fargo Asset Management provided analysis showing that the stock market tends to perform well when YoY earnings growth exceeds the 10-year Treasury yield. Assuming that we get the positive earnings surprise and the earnings recession ends, equity prices should see a rising tide into year-end and beyond.
 

 

Bullish technical outlook

The intermediate term technical outlook also appears to be bullish. The Wilshire 5000, which is the broadest index of the US stock market, is on the verge of a bullish MACD crossover on the monthly chart. Such signals have tended resolve bullishly in the past.
 

 

Also don’t forget that the upside breakout is holding on the point and figure chart, with an intermediate term upside SPX target of over slightly over 2500.
 

 

Moreover, a survey of the charts of high beta and glamour stock groups show that their relative performances are either constructive or showing signs of strength. These are all signs of bullish internals that will likely lead the stock market higher in the weeks and months ahead.
 

 

The Trump surprise

By contrast, a Trump victory, or even the whiff of a Trump win, is likely to create market uncertainty. As I stated before, Trump has ideas but few actual policies with implementation details. As I have written before , the most likely beneficiary of a Trump presidency is gold (see The Trump arbitrage trade). As the chart below shows, the gold vs. stock pair trade remains in a trading range.
 

 

If you want to bet on a Trump victory, the gold/stock pair trade is the most obvious choice. However, the macro fundamentals of a Trump presidency may not necessarily be equity bearish. Fiscal policy is likely to be very loose and it could be the equivalent of the American government throwing a HUGE party. The USD would crater, which would be positive for earnings growth and therefore equity bullish (see Super Tuesday special: How President Trump could spark a market blow-off).

If you are really, really, really worried about Trump, there is always Maple Match as a way of escaping to Canada.
 

 

The week ahead: Be careful

Looking to the week ahead, my inner trader is getting more cautious. I sent out an email alert to subscribers on Friday indicating that I was reducing my long exposure (also see Back in the rut).
 

 

Another reason for caution comes from the outsized positive market reaction to the FOMC statement on Wednesday. Urban Carmel wrote back in December 2015 that 1%+ rallies on FOMC days tended to retrace themselves in short order (red line represent the average market trajectory after 1%+ gains on FOMC days).
 

 

Other historical studies came to a similar conclusion. This one is from Nautilus Research.
 

 

The VIX/VXV ratio, which measures the term structure of the VIX Index, is showing signs of complacency. In the past, the market has tended to consolidate sideways or correct when such readings were at similar levels.
 

 

On top of that, there is possible volatility from the presidential debates scheduled for Monday. Given the dynamics of the race, the potential of a “I knew Jack Kennedy” moment from either side that blows the race up is high.
 

 

Here is Nate Silver’s summary of the race:

In football terms, we’re probably still in the equivalent of a one-score game. If the next break goes in Trump’s direction, he could tie or pull ahead of Clinton. A reasonable benchmark for how much the debates might move the polls is 3 or 4 percentage points. If that shift works in Clinton’s favor, she could re-establish a lead of 6 or 7 percentage points, close to her early-summer and post-convention peaks. If the debates cut in Trump’s direction instead, he could easily emerge with the lead. I’m not sure where that ought to put Democrats on the spectrum between mild unease and full-blown panic. The point is really just that the degree of uncertainty remains high.

My inner investor is focused on the longer term outlook and he is unperturbed by these short-term developments. Clinton is still leading in the polls and a Clinton win remains his base case investment scenario.

My inner trader is bullish but nervous. That’s why he reduced his long position into next week. The market may be poised to repeat seasonal pattern of past election years (chart via Callum Thomas).

Disclosure: Long SPXL

How the Fed could induce a bear market in 2017

Posted by Cam Hui -

The Federal Reserve has spoken (see FOMC September statement). With three dissenting votes on the FOMC, a December rate hike is more or less baked in. The Fed will take a gradual approach to rate hikes, with the median “dot plot” forecasting a December rate hike and two more in 2017.
 

 

While the market doesn’t really believe in the “dot plot” projections anymore, as actual action has consistently been below projections. This time may be different. There is a case to be made that the market is poised for a nasty upside surprise in 2017, where the pace of rate normalization will be higher than expected. Should such a scenario unfold, it would be very bearish for stock prices.

A 2017 inflation surprise?

In the press conference, Janet Yellen stated that she expects that inflation will rise to the Fed’s target rate on 2-3 years. What if it rises more quickly?

The top panel of the chart below comes from Callum Thomas, who pointed out that the breadth of global (headline) inflation surprise has been rising dramatically. This may be a surprise to investors as major central banks like the ECB and BoJ have been struggling to get inflation to rise. The bottom panel of the chart, which shows the CRB Index and its 52-week rate of change, shows that major moves in headline surprise have historically been driven by commodity prices.
 

 

The US is not immune to this effect. The chart below shows Core PCE inflation (blue line), which is the Fed’s preferred inflation metric, and producer prices for all commodities (red line). As the chart shows, commodity inflation has tended to either lead or were coincidental with Core PCE, which indicates that major trend changes in commodity prices eventually feed into measures of core inflation.
 

 

Accelerating inflation = Rising rates = Equity bearish

Another bearish factor for equity prices comes from Ed Yardeni, who believes the kind of inflation that is emerging is the unhealthy variety. Yardeni recently delved further into the factors behind the upward pressure on CPI:

There are also two kinds of inflation. There’s the kind that stimulates demand by prompting consumers to buy goods and services before their prices move still higher. The other kind of inflation reduces the purchasing power of consumers when prices rise faster than wages. That variety of inflation certainly doesn’t augur well for consumer spending.

During the 1960s and 1970s, price inflation rose faster than interest rates. The Fed was behind the inflationary curve. So were the Bond Vigilantes. However, wages kept pace with prices because unions were more powerful than they are today, and labor contracts included cost-of-living adjustments. Back then, the University of Michigan Consumer Sentiment Survey tracked rising “buy-in-advance” attitudes. Those attitudes remained particularly strong in the housing market through the middle of the previous decade. On balance, inflation stimulated demand more than weighed on it. Borrowing was also stimulated…

The variety of inflation that the US is experiencing isn’t the kind that stimulates economic growth. On the contrary, it has been led by rising rents, and more recently by rising health care costs. It is very unlikely that buy-in-advance attitudes cause people to rent today because rents will be higher tomorrow, or to rush to the hospital to get a triple-bypass today because it will be more expensive tomorrow! Higher shelter and health care costs are akin to tax increases because they reduce the purchasing power available for other goods and services.

In other words, the inflation forces that are pressuring prices upwards is not conducive to growth. Now imagine the following scenario. The Fed sees inflation edging upwards and responds with rate hikes. In addition, inflation pressure is the “bad” growth inhibiting variety. That combination would create a double whammy for the equity outlook.

Bridgewater also came out with a recent bearish research note indicating that Fed tightening during a deleveraging cycle would constitute a policy mistake:

In the note, Bridgewater flagged several cases of tightenings during deleveragings: the UK in 1931, the US in 1937, the UK in the 1950s, Japan in 2000 and 2006, and Europe in 2011.

“In nearly every case, the tightening crushed the recovery, forcing the central bank to quickly reverse course and keep rates close to zero for many more years,” the note said.

In those cases, markets have tended to tank, recoveries fade, and inflation drop.

More specifically, the average rate hike during a deleveraging “caused, over the next two years, a 16% drawdown in equities, a 2% increase in economic slack and a 1% fall in inflation.”

In conclusion, the Fed could be poised to raise rates in 2017 faster than the market expects. Should such a scenario unfold, the macro backdrop is equity bearish and could signal the start of a bear market next year.

My inner investor regards this potential development as a risk only. While such a scenario represents a substantial risk, he is not willing to take any investment action based on the speculation of possible developments on the inflation front and the subsequent FOMC reaction (yet).

Back in the rut

Posted by Cam Hui -

Mid-week market update: The world is full of surprises. Not only was I beside myself when news of the Bragelina breakup hit the tape, I mistakenly believed that the stock market did not display sufficient fear to form a durable bottom (see the trading comments in Is a recession just around the corner?).

Last week, Mark Hulbert found that the bullishness of his sample of NASDAQ market timers had retreated but readings weren’t at a bearish extreme, which suggested that a scenario of more market choppiness.

 

The CNN Money Fear and Greed Index had fallen to levels where the market had bounced before, but it could have gone a lot lower. Even if it were to bottom at these levels, I would not necessarily discount a W-shaped bottom where the index declined to the recent lows before rising again.

 

I was wrong. Life is full of surprises.

A re-test of the highs?

I should have known better. The Twitter poll by Helene Meisler last Friday was a foreshadowing of what was to come. These polls are notoriously good contrarian indicators. There were too many short-term bears.

 

In the wake of the news from the BoJ and the Federal Reserve, SPX rallied above its interim resistance at 2150. The most likely short-term path is a re-test of the old highs at 2200. The next level of resistance is the 50 dma, which currently stands at 2168. In all likelihood, the gap at 2168-2177 will get filled.

 

In all likelihood, the market will rise and re-test technical resistance at the old highs, following by a failure and a retracement back to test support at around 2120. We may need more to see more fear and capitulation in order to launch a durable rally into year-end.

While my inner investor remains intermediate term bullish, my inner trader is using the trading range as his base case scenario and will probably lighten up on his long positions should the market rally to the top of the range. He remains data dependent – as always.

Disclosure: Long SPXL, TNA

How China’s Great Ball of Money rolled into Canada

Posted by Cam Hui -

I live in Vancouver on Canada’s west coast. This was the city I grew up in and where I chose to settle after I went into semi-retirement. It’s a great town, but property prices are sky high and have become unaffordable for many locals.

Some real estate boosters will resort to the standard explanations such as “we’ve hosted the Winter Olympics” and therefore “it’s a world class city”. But have property prices gone parabolic in other “world class city” Winter Olympics host cities like Turin, Salt Lake City, Nagano, Lillehammer, Sarajevo, or Lake Placid? I didn’t think so.

The main reason for the stratospheric prices has been called China’s Great Ball of Money and it has rolled into Canadian real estate. Factset recently documented how residential property prices have skyrocketed in Vancouver and Toronto while the rest of Canada have been flat as Mainland Chinese money has been buying in those two cities. Based on the stories that have surfaced recently, the flood of money has made the Vancouver and Toronto real estate markets a Wild West (chart annotations below are mine).

 

I am not here to write about how foreign money pouring into Vancouver and Toronto have caused affordability problems for local residents (true, see #HALTtheMadness on Twitter), or how Canadian authorities have turned a blind eye to the problems of money laundering and tax evasion due to offshore money flows (see this SCMP article). This is a post about vulnerabilities posed by the financial linkages between China and the rest of the world (see my previous post How much “runway” does China have left?). What happens if we see a hard landing or banking crisis in China?

Peeking under the hood of Chinese fund flows

Canada’s immigrant-investor program, which has been terminated, spawned several waves of ethnic Chinese immigration over the last few decades. The 1990’s saw emigrants come from Hong Kong and Taiwan. The latest comes from Mainland China. While there were some abuses of the program some 20 years ago, where a Canadian Revenue Agency study found a number of emigrants in luxury houses who declared “average household incomes of about C$23,000, compared to more than C$368,000 for the handful of long-term Canadian residents who bought in the same price brackets” (via SCMP article), the magnitude of the Mainland Chinese immigration today dwarfs any of the previous episodes.

A recent Globe and Mail article reported that students without income have bought CAD 57 million in Vancouver homes in the last two years. Great Ball of Money indeed!

More worrisome are the stories of the involvement of the Chinese official banking and shadow banking system to purchase real estate in Canada and elsewhere. Such arrangement create financial linkages should the Chinese economy wobble. As an example, CBC reported a case before the Canadian courts where a Chinese bank claims that a Chinese fugitive borrowed money from the bank in China and used the funds to buy several properties in the Vancouver area. He proceeded to default on the loan and then flee China.

A separate article of investigative report by Canada’s Globe and Mail detailed the story of illicit Chinese money flows and how it fueled the property market boom. It documented the story of Jun Gang Gu, also known as Kenny Gu, a former civil servant originally from Nanjing, who emigrated to Canada in 2009.

 

Translated for The Globe, [the documents] show that Mr. Gu, or his companies, are hidden – the legal term is “beneficial” – owners of certain properties, even though absentee foreign clients bankroll everything from the down payment and mortgage payments to property-related taxes and other expenses. The homes and mortgages are registered in the names of his clients, their companies or spouses.

The financing Mr. Gu’s companies receive from those clients comes in the form of loans that are not taxable, and that fall within what’s known as “shadow banking” – an unregulated system that has exploded in popularity in China, and now appears to be getting a toehold in Canada. Such “peer-to-peer” loans, as they are also called, sidestep banks entirely, and promise lenders significantly higher returns than they can get elsewhere.

Mr. Gu’s lender clients earn their wealth primarily in China, while coming and going from Vancouver, according to Mr. Lazos. Records show that they give Mr. Gu power of attorney to facilitate everything through his small, nondescript Vancouver office, but his stake in the properties remains hidden. And although he is not licensed to broker mortgages or manage investments, records suggest he does both.

Those records also link him and his clients to activity involving at least 36 properties over the past five years. Yet Mr. Gu, 45, paid next to nothing in taxes last year, while millions of dollars flowed through his business and personal accounts.

In other words, Gu had created a network of companies that he controlled, using offshore Chinese clients as “fronts”, to buy Canadian real estate. The financing was done through China’s shadow banking system that promised investors high rates of return. In effect, this was a case of subprime lending via the Chinese shadow banking channel that fueled Gu’s real estate speculation in Canada.

In this case, the cockroach theory holds for Chinese money flows. If you see one cockroach, there are likely others. If the Globe and Mail found one Kenny Gu, then there are probably many others using similar financing channels.

Notwithstanding the fact that this scheme was skirting the rules against money laundering activity and violated Canadian tax laws, this all works as long as the property market is rising and liquidity is available to finance these loans. So what happens when the music stops?

In response to the popular outcry over housing affordability, the provincial government recently slapped on a 15% stamp duty on purchases of residential property by foreigners. The 15% tax has cooled the market and the buying stampede psychology has been stopped in its tracks. Now there are reports that the Great Ball of Money is rolling into Toronto and nearby Seattle.

From a global macro perspective, skyrocketing property prices in places like Vancouver, Toronto, Seattle, Sydney, and Melbourne can be attributed to excess liquidity sloshing around in China. Should China experience a banking crisis, the reverberations will be felt all over the world, not just through falling trade (see How bad could a China crisis get?), but financial linkages.

The music is still playing

For now, the music is still playing in China and any immediate risk of collapse is low. Bloomberg reports that Chinese authorities are ramping up loan growth again in a targeted lending program:

 

At least 2 trillion yuan (almost $300 billion) in new financing for lending has been amassed at the so-called policy banks, according to data compiled by Bloomberg.

The China Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China have raised a combined 3.4 trillion yuan ($509 billion) through bond sales and low-rate credit from the People’s Bank of China this year, the data show once funds to repay maturing debt is included. That’s almost eclipsed the record 2015 total.

In the process, the combined assets of the three policy banks has swollen to 21.3 trillion yuan — or bigger than the U.K.’s gross domestic product. By the end of 2016, policy bank assets will make up about 15 percent of the total banking sector, up from 8 percent three years ago, according Larry Hu, the head of China economics at Macquarie Securities Ltd. in Hong Kong.

And more is on the way: China will encourage policy banks to increase credit support to investment projects, according to a statement last week after a State Council meeting led by Premier Li Keqiang. That’ll give another dose of stimulus and grant President Xi yet more control over where the money should flow.

Indeed, Chinese money supply growth is rising dramatically again in a way that is reminiscent of another QE program (via Jeroen Blokland).

 

Risk levels are nevertheless rising. The Telegraph reported that BIS sounded the warning bells about China’s excessive debt ratios:

The Bank for International Settlements warned in its quarterly report that China’s “credit to GDP gap” has reached 30.1, the highest to date and in a different league altogether from any other major country tracked by the institution. It is also significantly higher than the scores in East Asia’s speculative boom on 1997 or in the US subprime bubble before the Lehman crisis.

Studies of earlier banking crises around the world over the last sixty years suggest that any score above ten requires careful monitoring. The credit to GDP gap measures deviations from normal patterns within any one country and therefore strips out cultural differences.

We’ve heard these kinds of warnings before from BIS. While the risks are clearly present, it is unclear when China might hit the proverbial debt wall. Michael Pettis studied the problem in June 2016 concluded that, even using optimistic assumptions, Beijing can keep the music going for another 2-3 years before it runs into a “disruptive adjustment”. If and when that happens, the financial linkages that I outlined in this post raise the vulnerability of the global financial system.

Is a recession just around the corner?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

My answer to Northy

Recently, a lot of US macro economic releases has been coming in a bit on the soft side. As the chart below shows, stock prices have a high degree of correlation with the Citigroup Economic Surprise Index, which measures whether economic data is beating or missing expectations.

 

As a result, I am sensing a heightened level of anxiety among some of my readers. I have received several requests for comments to the macro post written by Sven Henrich, otherwise known as Northman Trader (Northy). In his post, Time to get real, Part II, Northy laid out the macro view for an impending recession. He correctly pointed out that recessions, which are bull market killers, often occur during the first year of a presidential term. So, with macro data weakening, is a recession just around the corner?

 

In conjunction to my response to Northy’s recessionary post, I thought that it would also be timely to review the message from my Recession Watch indicators.

Torturing the data until it talks

Good quants and traders are naturally wary of backtested results. Too often, backtested systems overfit data and yield stellar returns during the study period, but fail dismally when put into production. In his post, Time to get real, Part II, Northy also wrote that he “found 4 recurring, common elements preceding recessions”. Unfortunately, his study may be a case of data overfitting and torturing the data until it talks.

One of the basic techniques to sidestep problematical backtest results is to define what constitutes a signal ahead of time before running the test. Northy’s study appears to have violated many of those rules in his study design.

Consider that the first of the four “recurring common elements preceding recessions” was slowing corporate profit growth, shown in the chart below. But what constitutes a recessionary warning signal? If the criteria for a signal is a falling line (marked with red arrows) in the chart below, then there were plenty of false positives (black circles). Incidentally, corporate profits can be a useful recessionary indicator and it is one of my indicators. As you will see later, I use the level and look for peaks instead of YoY changes that Northy used.

 

The study cited falling household net worth as the second common element. When I look at this chart, two questions come to mind. What constitutes a significant enough decline to qualify as a recession warning? How many false positives were there during the test period?

 

The next factor was falling consumer confidence, as measured by the University of Michigan survey. I have marked in black the instances where consumer confidence fell below the zero line. Imagine that this indicator as a trading system, what trader would bet on this kind of model?

 

Lastly, the rate of change in U-6 unemployment was the fourth factor picked as a recession forecaster. The study showed that the rate of change in unemployment tends to rise before the last two recessions.

 

When I analyzed the methodology behind this indicator, the focus on the rate of change of the unemployment rate, instead of the level of unemployment, was a bit puzzling. The use of the U-6 unemployment rate (red line below) was also an odd choice as the history of U-3 unemployment (blue line) goes back much further. As the chart below of unemployment levels show, both data series are highly correlated with each other. The chart below took the data back to 1948 and shows that unemployment, regardless of how it’s measured, tends to bottom out just before recessions.

 

In addition, we can see that there were many false recessionary signals even if we use the same methodology of using a rising rate of change in the unemployment rate as a forecasting model.

 

Incidentally, Georg Vrba uses unemployment data as one of his recession forecast factors. The latest update shows that recession risk is low.

Be data dependent

In conclusion, is this study just an example of poorly executed quantitative analysis where the analyst is torturing the data until it talks, or the case of starting with a conclusion first and then picking the data to support the investment case? I have no idea.

What the analysis does show is the pitfalls of building a proper quantitative investment framework. It’s easy to learn about quant tools. Applying them properly is much harder.

Recession Watch

By contrast, the Recession Watch framework is built more robustly. It was based on the work by the noted economic cycle researcher Geoffrey Moore, and adapted by New Deal democrat to build a set of long leading indicators (see the NDD post outlining his methodology here). This technique is designed to spot a recession a year in advance. NDD qualified the usefulness of these indicators this way:

Note that none of the indicators are perfect. None of them forecast the 1981 “double-dip,” which was engineered by the Volcker Fed. If the Fed similarly decided to raise rates aggressively in the next 6 – 9 months, or if there were an Oil price spike caused by a Middle eastern War, a recession could happen anyway.

Each of the seven long leading indicators and are shown below (click on links for the latest FRED charts).

  • Corporate bond yields: Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession.

 

 

  • Housing starts: Housing starts peaked at least one year before the next recession. Housing starts may have plateaued and this indicator bears watching. Score this as neutral for now.

 

 

  • Money supply: In addition to the 1981 “double dip,” on only 2 other occasions have these failed to turn negative at least 1 year before a recession.

 

 

  • Corporate profits (blue line) and its more timely cousin, Proprietors` income (red line): Corporate profits have peaked at least one year before the next recession 8 of the last 11 times, one of the misses being the 1981 “double-dip”. These two indicators are currently flashing divergent readings. Corporate profits are weak while proprietors`income is robust. One possible explanation is the corporate profits sample has a higher weight in the energy producing sector, which was hurt by falling oil prices, compared to the proprietors`income sample. We saw a similar pattern in the 1990’s, when corporate profits peaked along with oil prices while proprietors’ income continued to rise. Score this as neutral.

 

 

  • Yield curve: The inverted yield curve has been an uncanny recession forecaster.

 

 

 

 

  • Real retail sales: It has peaked 1 year or more before the next recession about half of the time. Real retail sales looks rather wobbly. Score this as a negative.

 

 

Of the seven leading indicators, four are solidly green, two are neutral, and one is red. I interpret this as an economy that is past the mid-cycle phase of its expansion, but there is no recession in sight. For the last word on this topic, here is New Deal democrat’s interpretation of the latest high frequency economic data:

In general, low interest rates are really driving positivity. The recent decline in commodities and spike in bank rates suggest a further bout of global weakness, and that may also be reflected in the slight rise of the US$ and increase in Treasury yields. While US monthly data for August has generally been poor, neutral staffing and slightly negative rail — both improved from earlier this year — argue that there is no real downturn.

Looking out to next year, the most likely recessionary trigger is a Federal Reserve policy error that tightens rates too much and pushes the American economy into a mild slowdown with blowback coming from overseas. Deutsche Bank recently modeled the GDP effects of a quarter-point rate hike after two years and the worst hit economy is China (chart via Bloomberg). When we combine the fragility of the Chinese financial system with a US consumer led slowdown, the global effects could be devastating.

 

Nothing to worry about (yet)

For now, there is nothing to worry about (yet). There is no point in taking investment action based on speculation of Fed actions this year or next year (see Rate hike vs. rate hike cycle).

From a technical perspective, the market has pulled back to test the breakout level, which is now support. Unless we see a definitive break below the 2120 level on a weekly closing basis, the intermediate term trend is still bullish.

 

The latest update from John Butters of Factset shows forward 12m EPS edged down after rising for many weeks, possibly in reaction to the recently softer macro data. Forward EPS needs to be monitored carefully to see if this decline is just a blip in the data or part of a larger trend. On the other hand, the negative guidance rate is below the five-year historical average, which is a positive.

 

Lipper Alpha Insight sounded a similar optimistic note based on their assessment of earnings pre-announcements. Q3 earnings could come in well ahead of expectations, as the rate of downward revisions has been below average:

Although analysts are not especially bullish on Q3 earnings, there are some signs that the quarter could be better than expected. In a typical quarter, the EPS growth estimate falls 4.0 percentage points. As we near the end of the calendar quarter, the growth rate has fallen by only 2.9 percentage points, so the bearish analyst sentiment is actually slightly stronger than it may otherwise be.

In addition to analyst sentiment, management teams are more optimistic about Q3 results than they have been in several years. The ratio of negative to positive preannouncements for Q3 stands at 2.2. As seen below in Exhibit 2, this is the lowest this ratio has been in over five years. Even though there is still more negative guidance than positive, the extreme pessimism that company management teams exhibited relative to the analysts covering their companies has abated.

 

If we can get to October without the market getting overly spooked by either the Fed, the BoJ, or other news, Q3 earnings season could see some bullish tailwinds.

The week ahead: Not enough fear?

Looking to the week ahead, the most likely path for stock prices is unclear. In my last post (see Bottom spotting), I suggested watching for a Zweig Breadth Thrust setup as a possible oversold buy signal for the market. That signal has not materialized.

 

In addition, I was watching for a Trifecta Bottom Spotting Model buy signal. While two of the three conditions were satisfied last week, which makes it a Exacta buy signal that can be quite powerful, the full Trifecta buy signal hasn’t been achieved yet.

 

The short-term 30 minute chart of Trifecta model readings showed some signs of panic at the open last Monday when the VIX term structure briefly inverted, but that hardly counts as capitulation. More constructive were the steady signs of price insensitive selling on Tuesday. (The OBOS model readings are not updated on an intraday basis and therefore not shown in the chart below).

 

Virtually all of the historical studies, such as the resolution of tight consolidation near new highs, 90%+ down volume Fridays, and ;sharp VIX spikes, all point to higher prices in the weeks ahead. However, fear levels are elevated but not at capitulation levels and we may need a washout low before the market can bottom. I am therefore open to the possibility that the market may follow the seasonal pattern highlighted by Callum Thomas in the chart below.

 

More choppiness and fear may be necessary for a durable bottom to occur. The CNN Money Fear and Greed Index has seen market bottoms at these levels, but the indicator has the potential to go much lower.

 

Mark Hulbert found that the bullishness of NASDAQ-oriented market timers have significantly retreated, but readings are not at capitulation levels yet. Should the stock market strengthen here, the rally is likely to stall out when it tests the all-time highs.

 

Similarly, Rydex short-term trader behavior and AAII surveys are telling a story of fading bullishness, but sentiment haven’t even retreated to the mild levels seen at the Brexit panic lows.

 

My inner investor is still bullishly positioned in his portfolio. My inner trader remains constructive on equities, but he is waiting for signs of a panic capitulation before committing more funds to the long side. Catalysts for a bearish capitulation could come from anywhere, such as rising risk premium over weekend events like the bombing in New York or the rebel attack in Kashmir, which India has accused Pakistan of supporting, could lead to conflict between two nuclear armed states.

Disclosure: Long SPXL, TNA

Bottom spotting

Posted by Cam Hui -

Mid-week market update: Did you think that a market bottom was going to be this easy? I got worried on Monday when I received several congratulatory messages and high-fives for my weekend tactical bullish call (see Macro weakness: Just a flesh wound?). That rebound seemed a bit too easy. especially when I saw the latest research report from JPM derivatives analyst Marko Kolanovic.

Forget about the usual explanations about rising bond yields, uncertainty over Fed actions or the credibility of the ECB, BoJ, etc. Kolanovic advanced a positioning explanation the market turmoil (via Value Walk):

The stock market needs to move only 1% to 2% lower for volatility to dramatically increase to the downside, as highly leveraged strategies could engage in mechanical selling.

“Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near alltime highs,” Kolanovic wrote. “The same is true for CTA funds who run near-record levels of equity exposure.”

When markets are pushed to extremes, the snap-back to normalcy can be hard. Kolanovic notes that record leverage in these strategies could push the market lower and volatility higher. The market might not even need a catalyst to increase volatility, seasonality in September and October could do the trick. When the systematic strategies start to deleverage nearly $100 billion in assets could be pulled from the stock market, Kolanovic projected.

In other words, a number of algo driven strategies, such as CTAs and risk parity funds, got into a levered crowded trade during the period of low volatility. The sell-off on Friday was the trigger for an unwind of that trade. According to Kolanovic, it could be very ugly.

There is some good news and bad news for the bulls. The good news, according to this Dana Lyons historical study, suggests that downside risk is limited at current levels. The bad news is the market is likely to be choppy and volatile for the next few weeks.

 

With that trading environment in mind, I can offer traders a couple of near sure-fire ways of spotting market bottoms.

Zweig Breadth Thrust setup

I have written about the Zweig Breadth Thrust before (for an explanation see A possible, but rare bull market signal). The key isn’t so much realizing the full ZBT buy signal, but watching for the oversold condition that sets up a possible ZBT signal.

We don’t have a ZBT setup yet, but this is a relatively rare oversold signal to watch for. The ZBT Indicator will signal a setup when it fall below 0.40. As stockcharts.com can be sometimes slow in updating their data, I use the bottom panel to calculate an approximation for the ZBT Indicator. For readers who want to follow along at home, please use this link to get an update of the chart below.

 

Trifecta Bottom Spotting Model

I have also written about my Trifecta Bottom Spotting Model, which has shown an uncanny 88% success rate in the last few years (for a full explanation use this link). The last time this signal was triggered, it managed to pick the exact day of the bottom on the Monday after the Brexit panic (see Hitting the Brexit trifecta).

As a reminder, the Trifecta Model is based on the following three elements:

  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.

As the chart below shows, the VIX/VXV ratio is below 1 and therefore not inverted, indicating extreme fear. However, TRIN did spike to 3.17 on Tuesday, which is indicative of the kind of price insensitive selling consistent with Marko Kolanovic’s thesis of large scale portfolio re-positioning. The OBOS model is nearing an oversold reading, but not yet.

 

For readers who would like to follow the progress of this model at home, please use this link. I would point out that stockcharts.com does not update the elements of the OBOS model on an intraday basis, but there is a quick-and-dirty fix to that. You can approximate the OBOS by estimating its elements. First, IndexIndicators.com does offer temporary time-delayed updates of stocks above their 50 dma.

 

While they don’t offer stocks above their 150 dma, they do show stocks above their 100 dma…

 

…and stocks above their 200 dma.

 

We can then make a first order approximation of the OBOS model with stocks above 50 dma /((stocks above 100 dma + stocks above 200 dma)/2). Further, we can add a “fudge factor” by observing that the actual reported OBOS reading was 0.53 on Tuesday and Tuesday’s approximation using IndexIndicators.com data was 0.56. The difference, or “fudge factor”, is -0.03. We therefore subtract 0.03 from the real-time IndexIndicators.com to approximate an OBOS reading.

Based on Wednesday’s closing figures, we arrive at a OBOS model reading of 0.53, which is unchanged from Tuesday.

Where are we now?

In closing, the market appears to be short-term oversold on many breadth metrics, such as stocks above their 10 dma.

 

In addition, there was a positive RSI-5 divergence and a minor RSI-14 divergences when the SPX tested a key support level. Based on these readings, the risk-reward is skewed to the upside.

 

However, the unwind that Kolanovic postulated may not be complete. My inner trader is keeping his long position and watching for signs of a capitulation and market washout based on my aforementioned indicators before he uses his remaining cash.

Disclosure: Long SPXL, TNA

Rate hike vs. rate hike cycle

Posted by Cam Hui -

Recently, there has been a parade of regional Fed presidents calling for a serious consideration of a rate hike:

  • Boston Fed’s Rosengren, who appears to have becoming more hawkish after being a dove
  • Richmond Fed`s Lacker
  • San Francisco Fed`s Williams
  • Kansas City Fed’s George
  • Atlanta Fed’s Lockhart

The hawkishness of regional presidents is no surprise. Bloomberg reported that the boards of eight of 12 regional Feds had pushed for a rate hike.

The hawkish tone by regional Feds has been offset by more the dovish views of Fed governors. Fed governor Daniel Tarullo told CNBC last week that he was open to rate hikes in 2016, but he wanted “to see more inflation”. Today. uber-dove Fed governor Brainard stayed with a dovish tone in her speech stating that the “asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation”.

The market’s intense focus of when the Fed moves rates is the wrong question to ask. Rather than ponder the timing of the next rate hike, the better questions to ask is, “What is the trajectory of rate normalization for 2016 and 2017 and what are the investment implications?”

The Hamilton checklist

James Hamilton studied the past four rate hike cycles and he found common elements that undoubtedly had profound influences on Fed policy:

These 4 episodes have several things in common. First the inflation rate rose during each of these episodes and was on average above the Fed’s 2% target, a key reason the Fed moved as it did. Second, the unemployment rate declined during each of these episodes and ended below the Congressional Budget Office estimate of the natural rate of unemployment, again consistent with an economy that was starting to overheat. Third, the nominal interest rate on a 10-year Treasury security rose during each of these episodes, consistent with an expanding economy and rising aggregate demand.

 

If we are to focus on the likely trajectory of interest rates for this year and next year, let’s consider the Hamilton checklist:

Inflation rate above the Fed’s 2% target: You have to be kidding! One of the mysteries of this expansion has been the tame behavior of the inflation rate. While Core CPI has been rising, neither core PCE, which is the Fed’s preferred inflation metric, nor inflationary expectations has moved above the Fed’s 2% target. In fact, inflationary expectations has been falling, not rising.
 

 

Unemployment below the natural rate: No. The current unemployment rate stands at 4.9%, while the current CBO estimate of the natural rate of unemployment is 4.8%.
 

 

Tim Duy recently worried about the risk of a policy error if the Fed ignores the warnings from a maturing economic expansion and tightens the economy into recession:

I don’t know that there is an economic mechanism at work here. I don’t know that there is a law of economics where the unemployment can never be nudged up a few fractions of a percentage point. But I do think there is a policy mechanism at play. During the mature and late phase of the business cycle, the Fed tends to overemphasize the importance of lagging data such as inflation and wages and discount the lags in their own policy process. Essentially, the Fed ignores the warning signs of recession, ultimately over tightening time and time again.

For instance, an inverted yield curve traditionally indicates substantially tight monetary conditions. Yet even after the yield curve inverted at the end of January 2000, the Fed continued tightening through May of that year, adding an additional 100bp to the fed funds rate. The yield curve began to invert in January of 2006; the Fed added another 100bp of tightening in the first half of that year.

This isn’t an economic mechanism at work. This is a policy error at work.

Rising 10-year Treasury yields (in response to better growth outlook);  A qualified yes. The 10-year Treasury yield has edged up from its recent lows, but not very much.
 

 

James Hamilton concluded that it’s too early for the Fed to think about starting a rate hike cycle:

But in several other respects this isn’t shaping up like the earlier cycles. Inflation is a little higher than it was last year, but is still a full percentage point below the level that the Fed says it would like to see. The unemployment rate has barely budged, and has not yet moved below the CBO estimate of the natural rate. And most revealing of all, the long-term interest rate has fallen dramatically, completely unlike the behavior in a typical Fed tightening cycle.

In order to calm the cacophony from the hawks and keep peace within the FOMC, Yellen will probably respond with one rate hike in December, not September. The bigger question is how much and how quickly they raise rates next year.

Investment implications

I have warned about a possible stock market top in 2017 from to a Fed induced recession (see Stay bullish for the rest of 2016). For now, inflation and inflationary expectations remain dormant. The Brookings Institute pointed out that the US is currently in a tightening phase in its fiscal cycle, but that may change with a new president as the rhetoric from both Clinton and Trump tilt towards expansionary fiscal policies. Should a new administration propose more government spending, the Fed may feel greater leeway to respond with a resumption of its rate normalization policy.
 

 

In my post (see Stay bullish for the rest of 2016), I had postulated that a series of Fed rate hikes could push China into a slowdown and possible debt crisis. Such an event has the potential to have a domino effect on the rest of the world. My hypothesis gained support from this Bloomberg report of Deutsche Bank’s model of the global effects of a Fed rate hike, which shows that China gets hit the most of any country.
 

 

As a reminder, the analysis from Deutsche only models the effects of a single quarter-point rate hike. If the Fed were to start a tightening cycle, it would raise rates much more than that. However, I would caution against multiplying the estimated rate hike effects by the number of quarter points that you expect as the effects of these models tend to be non-linear.

In conclusion, the timing of the next recession is highly dependent on the Fed’s reaction function and perception of incoming data. I am not in the business of making investment decisions by anticipating model readings, but by reacting to them. It’s far too early to get bearish and I am enjoying the party thrown by the bulls, but I am starting to edge towards the door. The cops are going to come and raid the party at some point, I just want to be ready.

Macro weakness: Just a flesh wound?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Weak macro = Weak stock market?

Friday’s dismal market action got me thinking about the Black Knight scene in Monty Python’s Holy Grail. Did his arm get chopped off, or was it just a “flesh wound”?
 

 

The macro data had been disappointing even before Friday’s market downdraft, which undoubtedly contributed to the slightly sour tone in stock prices. The combination of disappointments in ISM Manufacturing and Services, a so-so Beige Book report, and softness in the Labor Conditions Market Index all contributed to the downbeat macro-economic momentum.

One key indicator of macro disappointment is the Citigroup Economic Surprise Index (ESI), which measures whether high frequency economic releases were beating or missing market expectations. As the chart below shows, ESI has been falling in the past few weeks on both sides of the Atlantic.
 

 

As a detailed examination of US ESI shows, there may be a seasonal pattern where the ESI weakens in the autumn and then recovers later. Or is that my imagination?
 

 

A case could be made that the dip in ESI is just a blip. A check of bottom-up fundamental indicators and technical market breadth shows that both of these other dimensions of market health are signaling further stock market gains. For now, I am inclined is to give the bull case the benefit of the doubt.

Macro disappointment spooks the market

Recent macro reports has seen a weaker tone lately. One major disappointment is the softness in both ISM Manufacturing and Services, which may be foreshadowing a loss of momentum for 2H economic growth.
 

 

Despite the apparent reported “modest pace” of economic expansion, one notable feature of the Beige Book was “flatness”. David Rosenberg observed that there seemed to be a lot of the use of the word “flat” in the report.
 

 

More worrisome is the softness in the Labor Market Condition Index (LMCI). The LMCI may be in the process of rolling over even as the Fed signals its eagerness to raise interest rates. A policy of interest rate normalization in the face of labor market weakness is just the kind of policy error that could push the economy into recession. No wonder the stock market was getting spooked,
 

 

Despite these signs of weakening macro data, a disconnect is appearing. As Capital Economics pointed out, one of the graphs below is wrong. Either ISM is signaling weakness in GDP growth…
 

 

…or Q3 GDP nowcasts from both the Atlanta Fed (3.3%) and the New York Fed (2.8%) are wrong. While GDP nowcasts have declined a bit, they are nevertheless strong and remain above the Street expectations.
 

 

Here is another puzzle. Some analysts have attributed last week’s stock market weakness to rising interest rates, as the 10-year Treasury yield has risen (top panel of chart). Rates are rising because the Fed views the economy as strong enough to withstand one or more rate hikes. But the macro data that has been coming in has been a bit on the weak side. If so, why is the yield curve (bottom panel) steepening, which is a signal that the bond market anticipates a stronger economy? Isn’t stronger growth supposed to be equity bullish, not bearish?
 

 

I interpret these apparent contradictory readings as uncertainty over whether the economy has recovered from the shallow industrial recession that it experienced last winter. New Deal democrat is coming to the same conclusion from his weekly assessment of high frequency economic indicators:

Last week I noted that the recent paradigm of positive leading and mixed to negative coincident indicators wobbled some. In general, the coincident indicators, as anticipated, have followed the positive leading indicators. But some of the leading indicators themselves — in particular purchase mortgage applications and commodities — have weakened.

However, there are no signs of weakness in his leading indicators, though coincidental indicators is showing an uncertain growth picture:

The coincident indicators remain mixed…

Short leading indicators are almost all either positive or neutral..

With one exception, all long leading indicators are either positive or neutral.

In other words, don’t panic. The economy continues to expand at at “modest pace”. There is no sign of recession in sight.

Bottom-up growth still robust

From a bottom-up basis, incoming data is inconsistent with the picture of an economy that is losing steam. The latest update from Factset shows that consensus forward 12-month EPS estimates are still rising, which is a signal of Street optimism. Moreover, Q3 negative corporate guidance is coming at slightly below average, which is another positive sign.
 

 

Avondale’s monitor of company earnings call and presentation is telling a similar story. The latest update shows a relatively upbeat assessment from a survey of corporate management. Here are some key excerpts:

  • Walmart hasn’t seen any meaningful change in the consumer: “We haven’t seen a meaningful change in the consumer. I think the consumer generally is okay.”
  • Industrial CEOs are starting to feel encouraged
  • The impact from inventory destocking is becoming less significant
  • Leaner inventories coupled with stronger demand leads to pricing power

This doesn’t sound like the economy is going through a soft patch.

Strong technical breadth underpins the market

When I view the stock market through a chartist’s lens, intermediate term technical breadth is holding up well. US investors and traders have been frustrated by the multi-week SPX consolidation as the index traded in a very narrow range. However, looking beneath the surface reveals a picture of positive breadth.

The chart below shows the price charts of the broadest US market index, the Wilshire 5000 (WLSH), the large cap SPX, and different flavors of mid and small cap indices. The SPX broke out to new highs in July, consolidated sideways, and it is now pulling back to test the breakout level, which is hardly the picture of a market that’s falling apart. Even as the SPX traded sideways and caused untold levels of frustration to traders, little noticed was the new all-time high made by WLSH last week before Friday’s weakness. As well, the other flavors of mid and small cap indices were all in a stealth bull phase instead of the sideways consolidation shown by large cap stocks. These are classic bullish signs of positive breadth that are difficult to ignore.
 

 

Evidence of strong breadth is not only found in the US, but all over the world. As an example, Nautilus Research highlighted this historical study of positive global breadth.
 

 

The Dow Jones Global Index advanced to a new high last week. We also saw similar displays of positive breadth from the major European stock indices.
 

 

Over in Asia, the Chinese stock market and the stock markets of her major trading partners are all either breaking out strongly or in uptrends. There was some minor weakness in Singapore and Australia, but those markets remain in uptrends.
 

 

To conclude, the combination of positive bottom-up fundamentals and technical breadth are the reasons why I am giving the bull case the benefit of the doubt – for now.

The week ahead

Last week, I highlighted historical analysis from Dana Lyons indicating that narrow trading ranges near new highs tend to resolve themselves with weakness for one day and a steady rebound afterwards. I am using that as my default template for current market conditions. I would be more concerned if Friday`s 2.5% sell-off occurred for some fundamental reason, but there were none (other than a surprise North Korean nuclear test).
 

 

Under these circumstances, it’s time to cue the historical studies, such as this one of 90%+ NYSE down volume days on a Friday. If history is any guide, stock prices tend to rebound soon afterwards.
 

 

Charlie Bilello point out that Friday`s VIX spike was the 11th highest in history, with the Brexit being the 5th highest. Bill Luby of VIX and More contributed this table of of large VIX spikes. The analysis is slightly dated as it was written on June 29, 2015, but its bullish conclusions are the same.
 

 

Next week is option expiry week. As this chart from Rob Hanna of Quantifiable Edges shows, September OpEx tends to have a positive bias.
 

 

The technical damage done to the market on Friday was relatively minor (a mere flesh wound). The SPX weakened but remains above its breakout level and the index appears to be in the process of testing that breakout level. Callum Thomas identified a possible head and shoulders top on the SPX on Friday. Assuming that technical formation is valid, the measured downside target is roughly 2120, which is only a measly 8 index points below Friday`s close. The market is oversold on RSI-5 and the VIX Index has overrun its upper Bollinger Band, which is another sign of an oversold market. The vertical lines in the chart below depict past instances when these two conditions have occurred simultaneously. While the sample size is small, there have been four instances (blue lines) of market bounces, and only one instance (red line) of continued weakness.
 

 

Other breadth indicators from IndexIndicators also show the market to be oversold. This chart of stocks above their 10 dma indicates that the market is oversold on a short-term (1-3 day) basis. Readings are levels seen in past panic bottoms.
 

 

This chart of net 20-day highs-lows shows the market to be oversold on a medium term (1-2 week) basis.
 

 

Trading is about playing the odds. The combination of past historical studies and my assessments of short-term technical conditions suggest that a bottom is very near. My inner investor remains constructive on stocks and he views further weakness as an opportunity to add to his positions.

My inner trader did not sell his long positions during Friday’s sell-off. He is also bullishly positioned. In the absence of a fundamental trigger for the decline, he believes that downside risk is likely to be limited from current levels.

The one wildcard to my bullish outlook is the speech by the uber dovish Fed governor Lael Brainard on Monday. Brainard has been extremely dovish and she has indicated her reluctance to raise rates because of concerns over global financial instability. Should she change her tune to a more hawkish stance, then all bets are off and it could signal a much deeper correction.

Disclosure: Long SPXL, TNA

Why a crowded VIX short isn’t equity bearish

Posted by Cam Hui -

Mid-week market update: Two weeks ago, I had forecast a minor stock market pullback as the SPX neared 2200 (see The market catches round number-itis). The corrective move hasn’t happened and remain in a tight trading range. The one bright spot for the bull case is stock prices haven’t fallen in response to bad news, such as the surprising shortfalls in both manufacturing and services ISM in the past week. On the other hand, the tight trading range appears to be encouraging traders to short volatility, which is worrisome.

I’ve become increasingly concerned about a prolonged crowded short reading by large speculators on VIX futures. Here is the chart from Hedgopia.

 

The crowded short position by large speculators is worrisome because it invites a disorderly unwind of the shorts, which would lead to a spike in volatility. As the VIX Index tends to be inversely correlated with equity prices, VIX strength would therefore translate into equity weakness. At the same time, the SKEW Index indicated a heightened appetite for tail-risk protection.

 

As both my inner investor and inner trader have adopted bullish views, the prolonged period of an extreme net short VIX position was a nagging concern – until I realized the explanation for traders to be short VIX. Using the new analytical framework, these readings did not appear to be equity bearish at all.

An option math primer

Readers who are familiar with the option modeling techniques can skip over this part. For newbies, the VIX Index, which is a measure of volatility, is an input to the Black-Scholes option model. I am not going to get into all the math behind the option model, but there are several key inputs that determine the price of a call option.

  • Time to option expiry (longer = higher call option price)
  • Risk-free rate (higher rates = higher call option price)
  • Difference between current price and exercise price (higher difference of market price – strike price = lower call option price)
  • Volatility (higher volatility = higher call option price)
Of all the inputs cited, the only value that is not directly observable is volatility. Everything else being equal, it is the implied volatility that determines the price of an option.From the observed price of an option, we can back out the implied volatility. The CBOE publishes several implied option volatility estimates based on an at-the-money option with different expiry dates:

  1. VXST: 7 day implied volatility
  2. VIX: 1 month implied volatility
  3. VXV: 3 month implied volatility
  4. VXMT: 6 month implied volatility

Term structure arbitrage

When we observe the chart below of the term structure of implied volatility, we can see that the slope is upward sloping, otherwise known as contango. Under such conditions, a trader could lock in a profit by buying short-dated volatility and then hedge his long with a short position in long dated volatility, such as a VIX futures contract. As long as the steep contango holds and the short dated long positions can be rolled forward at similar rates, a profit can be assured.

 

Think of these positions are a form of the “carry trade”, but using volatility over different time frames. There is an additional bonus to this kind of volatility term structure arbitrage trade. If realized volatility were to spike because of a stock market sell-off, these positions may not necessarily become unprofitable. Should stock prices fall, VIX term structure usually flattens and sometimes even inverts, with short-dated vol trading above long-dated vol. The profit from the long short-dated vol would likely offset any losses from the short in long-dated vol.

As the chart below shows, the VIX (1 month)/VXST (7 day) ratios and VXV (3 month)/VIX (1 month) ratios are at historically high levels, which makes the volatility term structure arbitrage position that I described very profitable. For example, the 1.21 VIX/VXST ratio shown in the chart indicates that if a trader could hold that long/short position and roll it forward at those pricees until the one-month VIX maturity, he would realize an un-annualized return of 21%. Similarly, the 1.30 VXV/VIX ratio indicates an un-annualized return potential of 30%.

 

From this point of view, the crowded short in VIX futures makes perfect sense. These positions are not simple bets on falling volatility, but hedged positions. (Hey kids: don’t try this at home. Putting on these kinds of positions involve a higher understanding of option math and tricky position management techniques than what I’ve explained here.)

Mystery solved. There is no crowded VIX short, therefore these readings are not equity bearish.

When does volatility spike?

Notwithstanding the volatility structure arbitrage trade, volatility remains very muted. The chart below from Dana Lyons shows that realized volatility is at all-time lows. When does volatility start to rise again?

 

There may be trading related reasons why volatility continue to remain low. Rachel Shasha observed that the proliferation of short-dated equity index derivatives may be acting to suppress volatility:

I won’t bore you with too much detail about my option, but a quick note that I believe this is negative for short term traders. I think all these new shorter term derivatives (SPX now expires 3x a week) are partly to blame for the very tight ranges lately. With constant pinning taking place, it seems price always needs panic or FOMO to make any range breaks hold. Furthermore, with high strikes piling up on so many short term vehicles, range expansions (when they finally occur) can have an exaggerated affect due to all the delta heading.

In short, we may need some sort of surprise, such as a surprise on a closely watched macro data point like the Employment Report or a major product announcement from an index heavyweight like AAPL, before volatility can break out to the upside.

Oh wait…

Disclosure: Long SPXL, TNA

Thanks, but I’m not that good!

Posted by Cam Hui -

It’s always nice to get positive feedback from subscribers. One subscriber praised me for my trading model and wanted real-time updates of signal changes (which I already provide but wound up in his spam folder).

 

Another subscriber complimented me on my series of tweets indicating an oversold market on Thursday, which suggested that the market was poised to rally should the Jobs Report on Friday morning was benign (click links to see tweet 1, 2, 3, 4, and 5).

Thanks, but I’m not that good.

Teaching my readers how to fish

Humble Student of the Markets is not intended to be a trading service. I addressed this issue in my post Teaching my readers how to fish.

Think of a building a boat as like building a portfolio. The portfolio management process consists of the following steps:

  1. Deciding on what to buy and sell;
  2. Deciding on how much to buy and sell; and
  3. Deciding on how to execute the trade.

While we discuss step 1 endlessly in these pages and elsewhere, the other steps are equally important. Step 2 is also a reason why what I write in these pages is not investment advice, namely I know nothing about you:

  • I know nothing about your cash flow, or spending needs;
  • I know nothing about your return objectives;
  • I know nothing about how much risk you are willing to take, or your pain threshold;
  • I know nothing about your tax situation, or even what tax jurisdictions you live in;
  • And so on…

If I know nothing about any of those things, how could I possibly know if anything I write is appropriate for you? I was asked recently why I don’t post my portfolios and their performance. While posting my trades represent a disclosure of any possible conflicts in my writing, my own portfolios are a function of my own cash flow needs, my return objectives, my own pain thresholds, etc. How could any portfolio that I post be appropriate to anyone else?

A terrific call, or terrible call?

Consider the following example. On February 24, 2009, a week before the ultimate market bottom, I made a call to buy a high-beta portfolio of low-priced stocks, which I termed a Phoenix portfolio (click link for post):

  • Stock price between $1 and $5 (low-priced stocks)
  • Down at least 80% from a year ago (beaten up)
  • Market cap of $100 million or more (were once “real” companies)
  • Net insider buying in the last six months (some downside protection from insider activity)

Was that a terrific call, or a terrible call? You be the judge.

 

At one level, the call to buy a high-beta portfolio a week before a possible generational bottom for stocks could be a career making call. On the other hand, the market fell -11.9% based on closing prices before the final bottom was reached.

For investors, the Phoenix portfolio was well-timed and it went on to roughly triple its value in about a year. For short-term traders, the 11.9% drawdown was a disaster.

This brings me to my point. Don’t blindly follow what I do. My return objectives are not the same as yours. My pain threshold will be different from yours, which affects the placement of stop loss orders.

Your mileage will vary. I can only teach you how to fish, not fish for you.