Page 76 – Humble Student of the Markets

Stay bullish for the rest of 2016

Posted by Cam Hui - September 4, 2016

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.

Stay focused on the big picture

Here at Humble Student of the Markets, I use technical analysis as a way of measuring market psychology. The combination of price, volume, sentiment, and how the market response to news convey important information about the psychology of market participants. At the same time, I use fundamental and macro-economic analysis to derive information about the drivers of stock prices, such as valuation and the momentum of fundamentals. In particular, fundamental and macro analysis yield clues about how the E in the P/E ratio is likely to evolve.

During confusing times like these, it’s important to stay focused on the big picture. Cross-currents such as negative macro surprises against a backdrop of improving growth can be confusing for investors. A rigorous analytical framework can be informative about the likely direction of stock prices. Here is the big picture:

The equity bull market is still alive for the remainder of the year
The economic cycle is maturing fast and the timing of a cyclical market top will depend on Federal Reserve action
The next downturn could be very ugly

These conditions are indicate a bullish stance on stocks for the remainder of 2016. After that, my crystal ball gets a little cloudy and I will become more “data dependent”.

Macro: Growth upturn continues

Investors can get easily disoriented by conflicting macro-economic data. The weakness in ISM and Markit PMI came as a surprise. However, this chart from Calculated Risk shows that ISM is a very noisy number and it has flashed numerous false recessionary warnings in the past.

The ISM miss was then followed by a disappointing Jobs Report. Headline non-farm payroll (NFP) came in at 151K, which was short of Street expectations of 180K. Does that mean that the growth rebound is stalling?

A way to cut through the noise is to use the analytical framework used by New Deal democrat. NDD separates high frequency economic indicators into coincidental, short leading and long leading indicators. His latest analysis of these three groups show that while coincidental indicators are mixed, short and long leading indicators are pointing to continued, though slightly wobbly, strength,

Despite the recent headlines of economic weakness, the latest Atlanta Fed GDPnow nowcast of Q3 GDP growth shows accelerating growth. GDPNow rose to 3.5% from 3.2%. The upward revision was attributable to an improvement in exports.

Last week also saw consumer confidence rise and beat market expectations for a third consecutive month.

Economic strength isn’t just confined the the US. On a worldwide basis, Markit reported that global PMI remains in expansion mode.

When I switch my focus from a top-down to a bottom-up perspective, the data is equally encouraging. The latest update from Factset shows that the Street continues to revise forward 12-month EPS upwards. That’s a bullish data development that stock investors should not ignore.

We are seeing a similar picture on earnings on a worldwide perspective. Jeroen Blokland highlighted BAML analysis showing that global earnings estimates are being revised upward.

These are not signs of stalling growth.

Technical: Bullish momentum

Technical analysis is the art of listening to the message of the market. The chart below shows that the market broke out to new all-time highs in July. It has been consolidating sideways since then, but it has held above the breakout point. What message is it telling us?

In addition, I highlighted analysis last week from Chris Ciovacco showing a rare bullish crossover of the 30, 40, and 50 week moving averages.

In the past, such buy signals have last lasted between several months and several years.

NedDavis Research pointed out last week that long-term breadth is holding up despite the recent consolidation and minor pullback to the bottom of the range. Ed Clissold of NDR interpreted these readings bullishly. It suggests that any seasonal weakness is likely to be contained.

Price action is telling a story and its tale of bullish momentum has to be respected.

Investors still skeptical

Despite extensive evidence of fundamental and technical momentum, investors are still cautious. This chart from Rich Bernstein shows that low beta stocks are trading at a premium to high beta stocks. To the extent that investors had been buying stocks, their participation had been confined to the defensive sectors of the market. This is a sign of excessive skepticism.

The latest readings of the AAII survey and Rydex traders also show lukewarm enthusiasm for stocks. Sentiment among individual investor is dead neutral, in spite of the nearness of all-time highs.

The weekend cover of Barron’s shows a high degree of cautiousness from Street strategists.

The BAML Sell-Side Indicator graphically illustrates the Street`s defensive posture and it has flashed a contrarian buy signal.

Stock markets tend to top out when investors are all-in, not when they are skeptical. From a purely technical perspective, the combination of positive price momentum and investor skepticism suggests that equity market strength has a lot further to run before it tops out.

Turbulence in 2017?

However, there may be some market turbulence ahead in 2017 (see The roadmap to a 2017 market top). The current round of macro momentum is likely to start petering out in 6-12 months.

For instance, the latest Jobs Report is showing the typical signs of a late cycle economic expansion. In the last two cycles, temp jobs (blue line) peaked out between 10 and 17 months before the NFP peak (red line). In the current cycle, temporary employment peaked in December 2015 and has plateaued since then. Unless temp job growth recovers, the clock is ticking and stands at eight months.

In the past, there has been a strong historical relationship between unemployment (blue line) and inflation (red line). Whenever the unemployment rate has fallen below 5%, inflationary pressures have manifested themselves. The current unemployment rate stands at 4.9%. The dilemma for policy makers is to correctly estimate the non-accelerating inflation rate of unemployment (NAIRU) in order to properly manage monetary policy. NAIRU estimation in this economic cycle is complicated by the unusual features of a high degree of slack in the labor force and an inflation rate that has been resistant to monetary stimulus.

Despite the apparent lack of inflation, Bloomberg reported that some major bond investors are starting to position themselves for its return. This time, inflationary pressure will not come from monetary stimulus, but from fiscal stimulus.

Many of them are once again predicting — and, more importantly, actually gearing up for — a pickup in inflation. Pioneer Investment Management, for instance, is setting up the first-ever global inflation-linked bond fund in its 88-year history. Partly with that same threat in mind, Pacific Investment Management Co. is cutting the duration of the bonds it holds in its $63 billion Income Fund.

This time will be different than those previous episodes, they say, because fiscal policy rather than monetary policy will serve as the principal driver of higher prices. From the U.S., where both presidential candidates are promoting stimulus plans, to Japan, where lawmakers approved a $46 billion infrastructure program, to the U.K., where the Chancellor of the Exchequer has indicated he could ramp up spending, talk of fiscal largesse is in the air.

The shift in the debate is in part something of an acknowledgment that lax monetary policy, for all the work it did propping up the global economy in the wake of the 2008 crash, ultimately failed when left on its own to bring the rates of growth — and inflation — back to pre-crisis levels. Fiscal stimulus, the thinking goes, will be more effective at putting cash immediately in the hands of consumers.

“We have reached a point where governments realized that austerity will not help,” said Cosimo Marasciulo, who, as head of government bonds at Pioneer, helps manage $250 billion of assets. “Some are abandoning that idea and shifting their focus to stimulating the economy. They’ve not been aggressive yet, but it’s a start. We cannot underestimate its implication on inflation.”

The wildcard for investors is the Fed’s reaction function. How quickly will it recognize signs of economic strength and possible inflationary pressures in light of its “dual mandate [that] aims for maximum sustainable employment and an inflation rate of 2 percent” (via vice-chair Stanley Fischer)? If the new president were to propose an infrastructure spending program, as both Clinton and Trump have been promised, then will the Fed take that as a signal that it can start to raise interest rates? If so, how quickly would it act?

How the Fed can trigger a bear market

Here is my base case scenario for the next 6-18 months. The stock market rises in response to a better growth outlook, both in the US and the rest of the world. The bull phase should last at least until the end of this year.

In response to a stronger growth outlook and rising inflationary expectations, the Fed then acts to start normalizing interest rates. The question of whether the first quarter point hike occurs at the September or the December meeting is not terribly relevant. The bigger question is the pace of rate normalization in 2017.

There may be additional bearish forces at play next year. I pointed out last week (see The roadmap to a 2017 market top) that a Clinton victory may see Fed governor Lael Brainard being offered a post within the administration. Such a development would deprive the FOMC of a dovish voice and raise the risk of a Federal Reserve policy error that could push the American economy into recession.

When does the three steps and a stumble rule, where three consecutive rate hikes trigger a bear market and recession, come into play? That is the big unknown that investors have to grapple with. That is also the reason for my “data dependence” in 2017.

Imagine the following scenario. The Fed makes a policy error by tightening the American economy into a mild recession. One scenario may involve monetary policy falling behind the inflation-fighting curve and the Fed has to respond with a series of staccato rate hikes that slams the economy into a recession. Alternatively, we could see a series of premature rate hikes that inadvertently pushes an already fragile economy into a slowdown.

Viewed in isolation, any Fed-induced slowdown should be relatively mild because of the lack of excesses built up in the current expansion. From a global perspective, however, a US recession could be a disaster. In this cycle, the excesses are not to be in the American economy, but abroad. The combination of the withdrawal of American consumer demand and past extravagances is likely to be lethal to China. In a recent post (see How bad could a Chinese banking crisis get?), I postulated a Chinese hard landing would tank most of Asia into recession. In addition, the loss of Chinese capital goods demand is likely to have the domino effect of pushing Europe into recession as well. In particular, Europe poses a special vulnerability for the world as it has not sufficiently address the problems in its banking system that appeared in the last crisis. In effect, a hard landing in China has the potential to set off dual banking crises in both China and Europe.

Business Insider reported that Bridgewater Associates largely agreed with my assessment of risks posed by China. Bridgewater recently reiterated its concerns over China’s “unsustainable buildup of credit”. It added that, “This rapid expansion in credit looks like it has created significant vulnerabilities in the Chinese financial system at a time when the economy is still near the front end of a material loss cycle”. The table below summarizes their projections of the likely consequences of a burst credit bubble in China. Much of the damage is mitigated by the fact that most of Chinese debt is domestic and the level of external debt is relatively low. Nevertheless, a Chinese financial crisis is likely to be resolved with several years of anemic growth, which would be devastating to many of her trading partners.

I recognize that my scenario of a market top and subsequent bear market is highly speculative and involves many moving parts. Nevertheless, it highlights the risks of a policy error by the Federal Reserve.

The week ahead

Looking to the week ahead, the intermediate term outlook is appears to be bullish. Nautilus Research recently featured a historical study showing that minor pullbacks tend to lead to renewed market strength.

Dana Lyons also showed historical analysis indicating that market tight consolidation ranges near new highs tended to resolve themselves bullishly. However, the initial break tended to start with a one day downdraft, followed by a prolonged price surge.

This time, the minor weakness on Thursday may be all the pullback we see. The disappointing news from the manufacturing reports on Thursday was a golden opportunity for the bears to push stock price downward, but the market bottomed intraday at a key support level and rallied to close the day roughly unchanged. In this case, the market’s inability to fall in response to negative news could be an indication that stock prices are ready to rise again.

After the close on Thursday, I tweeted a series of charts indicating that the market was sufficiently oversold to warrant a rally. However, I was reluctant to take a position given the risks posed by the Jobs Report that was scheduled for Friday morning. According to IndexIndicators, breadth indicators such as the percentage of stocks above their 10 dma had become sufficiently extended on an intraday basis to flash an oversold reading.

This chart of net 20-day highs-lows, based on closing prices, did flash an oversold condition on my trading model with a 1-2 week time horizon.

The market had experienced a positive RSI-5 divergence on the hourly chart.

In addition, the daily chart showed a positive RSI-5 divergence, a doji candle, which is indicative of market indecision as it tested a short-term support level, and the VIX Index could not rise above its Bollinger Band. All of these are bullish signs.

Market internals were positive. Risk appetite metrics such as the junk bond market and high beta small cap stocks confirmed the underlying strength of the market.

Further analysis of the normalized equity-only put/call ratio also showed signs of bearish exhaustion. The ratio had fallen to a level that in the past either signaled a period of sideways consolidation (blue lines) or correction (red lines). In the current instance, readings were normalizing from an excessively bullish condition but the bears could get the correction done.

In the wake of the equity benign Jobs Report, my inner trader concluded that downside risk was limited. He added to his long equity position by buying into high beta small cap stocks.

My inner investor remains bullish and overweight equities. He is positioned for an equity rally into further highs later this year and next year.

Disclosure: Long TNA, SPXL

Three key macro factors to watch in today`s market

Posted by Cam Hui - August 31, 2016

I have spent a lot of time in these pages writing about the influence of macro-economic factors on market analysis. Indeed, Matt King at Citigroup recently highlighted the growing importance of macro factors on the equity market (chart via Bloomberg):

[Please see Bloomberg story for chart]

Here are three key macro factors that I have been watching now for clues to the direction of the stock market and sector selection.

The yield curve

One common way to measure the yield curve is the spread of 10-year and 2-year Treasuries. A steepening yield curve, where the spread widens, is thought of as a bond market signal of rising economic growth and a flattening yield curve, where the spread narrows, is an indicator of slowing growth. In the past, an inverted yield curve, where the spread goes negative, has been a surefire indicator of recessions and equity bear markets.

What it`s saying now: The yield curve has been flattening and moved to a cycle low of 0.75% this week, but it is nowhere near an inverted state, which is a recessionary and bear market signal. In light of the slightly more hawkish tone from the Fed, I am monitoring the evolution of shape of the yield curve for signs of a stock market top.

In addition, the yield curve can be a useful signal for the relative performance of financial stocks. The chart below depicts the relative performance of the Bank Index against the market (black line) against the yield curve (green line). In the past, these two lines have show a close correlation with each other. Currently, we are seeing a second back-to-back negative divergence where bank stocks are outperforming while the yield curve is flattening. I interpret this as a warning against taking an excess overweight position in the sector.

It’s the exchange rate, stupid!

Business Insider recently featured analysis from BAML credit analyst Hans Mikkelsen showing that EBITDA growth for domestic companies with high grade credits have been flat for the last few years. By contrast, high grade credits with high levels of foreign sales have seen a high degree of EBITDA margin volatility. In other words, it’s all about the exchange rate!

In the chart below, I have overlaid the BAML analysis with the USD Index in the bottom panel. As the chart shows, EBITDA growth of companies with foreign exposure appears to be inversely correlated with the Y/Y change in the USD Index.

What it`s saying now: The USD has been weakening, which should give the earnings of multi-nationals a boost. However, the Dollar is now approaching a key support level. The market`s view of the intersection of the growth outlook and Fed policy will be a key determinant of future exchange rate movements (also see above discussion about the yield curve and growth).

Small caps and growth expectations

Regular readers know that I have been writing about the US undergoing a growth surprise for some time. Indeed, this chart of Markit PMI shows that economic activity is rebounding from the slowdown experienced last winter.

In a recent CNBC interview, market strategist Tom Lee issued a call to buy small cap stocks as a way of capitalizing on their economic torque, or operating leverage:

Investors have been rewarded for following signals in credit and derivatives markets this year, and a new one recently started sending a buy signal for small-cap stocks, according to Fundstrat Global Advisors co-founder Tom Lee.

“I think a really strong message is coming to buy small caps, because when economic data picks up and credit eases, small caps almost always win,” he told CNBC’s “Squawk on the Street” on Monday.

Jim Paulsen of Wells Fargo Asset Management had the same investment insight. Paulsen issued a call to buy small caps because of their operating leverage. In his case, he was making a bet on high inflation, which would disproportionately benefit small cap companies, but the idea is the same:

Essentially, small companies with tight profit margins, have greater “operating leverage” compared to larger companies. Thus, when inflation accelerates and selling prices can be raised, a larger portion of the enhanced selling price falls to the bottom line of narrow margin small cap companies. While disinflation is more challenging for small companies, rising inflation tends to boost both profit margins and earnings performance for small cap stocks relative to their larger brethren.

Indeed, the chart below shows the evolution of consensus forward 12-month EPS estimates in the top panel and the relative performance of small cap stocks in the bottom panel. This chart shows the close correlation between expected growth and the relative performance of small cap stocks, which is an illustration of their leverage to growth expectations.

In conclusion, this has been an illustration of the value of cross-asset analysis, which is also known as inter-market analysis. By identifying important cross-asset relationships and fundamental drivers of returns, changes in the pricing of one asset market can affect the returns of an entirely different asset class. It is also another way of showing how macro analysis is becoming important in the art of market analysis.

A possible Non-Farm Payroll surprise?

Posted by Cam Hui - August 30, 2016

Mid-week market update: In the wake of Federal Reserve vice chair Stanley Fischer’s remarks about Friday’s Job Report, the market is mainly playing a waiting game for the results of that announcement. However, there are signs that the Jobs Report may be setting up for a negative surprise which could be bullish for bond and equity prices and bearish for the USD.

Firstly, Bloomberg reported that the August Jobs Report has had a record of undershooting the consensus in the last five years. I have no idea whether this represents a statistical fluke or the result of improperly adjusted seasonal effects. If history were to repeat itself, then expect Treasury yields to sink, bond prices and stock prices to rise, and weakness in the US Dollar.

In addition, the preliminary results of my rather unscientific Twitter poll (still time to take the poll) shows the consensus to be heavily tilted towards better than expected Non-Farm Payroll (NFP) figure. If the poll is any way representative of how traders are positioned and the NFP disappoints, then expect a violent market reaction to the upside for stock and bond prices.

Lastly, a Bloomberg story by Luke Kawa suggested that Stanley Fischer may be isolated on the FOMC:

Among the voting members of Federal Open Market Committee, however, it seems Stan is more of the “odd man out,” according to Jefferies LLC Chief Market Strategist David Zervos.

“There seems to be no other ‘relevant’ member of the FOMC that is pushing in [Fischer’s] direction,” he writes. “In fact, both [Atlanta Fed President Dennis] Lockhart and [St. Louis Fed President James] Bullard pushed back on the two-hike notion quite aggressively over the weekend.”

As such, Morgan Stanley fixed income strategists led by Matthew Hornbach are advising traders not to fight the Fed, but to fight the Fischer and buy the dip in the five-year U.S. Treasury bond.

“We think the higher yields that resulted from the market reaction to Vice Chair Fischer’s comments presented an opportunity to buy 5-year notes at better levels than what we earlier suggested,” they write. “While August payrolls present an obvious risk, we continue to believe market-implied probabilities for a September rate hike will end at zero, not 100.”

Analysts are now wondering whether Fischer, who was once seen as something of a “shadow” Fed Chair given his illustrious resume, has become somewhat removed from the consensus view at the central bank.

Notwithstanding the results of the August Jobs Report, current expectations of a possible September rate hike may be far less probable than market expectations. It would also set the market up for a more bullish undertone to both stock and bond prices for the remainder of the year.

How bad could a Chinese banking crisis get?

Posted by Cam Hui - August 29, 2016

In my last post (see The roadmap to a 2017 market top) I wrote that one possible bear market trigger would be a debt crisis in China. In response, an alert reader sent me this Bloomberg tweet and asked for my comment.

How bad could a China debt crisis get? In this post, I try to model the global effects of a China hard landing.

Not your father’s emerging market debt crisis

The banking system figures look scary. Bruegel pointed out that the Chinese banking system is now the largest in the world. We have all seen the stories about the white elephant infrastructure projects and see-through buildings financed with government mandated loans. What happens if the Chinese economy hits a debt wall and all of those bad debts have to get paid back?

First of all, the global impact of a Chinese debt crisis should be limited as most of the debt is yuan denominated. The latest report shows that China has USD 1.36 trillion, of which USD 849 is short-term debt. A China debt implosion will be very different from previous emerging market debt crisis given the immense size of China’s foreign currency reserves.

In a banking crisis, the external debt that is most at risk is short-term debt because the borrowers need to periodically roll over the amount owing. Assuming that 50% of the short-term external debt goes bad and lenders recover 70% of the value owing, bad debt writedown would amount to USD 127 billion. If the losses were to be concentrated in just a few lenders, it would undoubtedly cause panic and possibly strain the global financial system. On the other hand, the pain would be quite manageable if it were spread among many lenders. For some context, USD 127 billion is a blip compared to the $13 trillion loss suffered by equity investors in the minor market correction of September 2015 (chart via Zero Hedge).

In addition, the Bloomberg article cited in the above tweet pointed out that most of the debt is corporate debt, and much of the corporate debt have been issued by State-Owned Enterprises (SOEs). Therefore Beijing has is far more flexible in how it mitigates the damage:

If overwhelming debt does trigger a crisis in China, it’s more likely the spark would come from corporations and their main creditors, the banks. China’s bond market has shown signs of growing stress, including 17 defaults through June 30, almost triple the number in 2015. That and a series of delayed payments prompted rising credit spreads and cancellations of new issues…

China is different from other markets in an important way. Many large corporations and nearly all the major banks are state-owned. In other words, the debtors and creditors are ultimately owned by the same entity. That means the country could address debt problems in some unusual ways. One scenario is the state could take from the prosperous—coastal regions or high tech, for example—and give to the struggling. Another is that the government could simply cover debt. Some unprofitable state-owned enterprises are supported by lending from their banks essentially to keep employment at acceptable levels. Such debts could eventually be absorbed by the state as part of its social welfare expenditures.

I agree 100% with that assessment. The Chinese authorities have many tools available to address tail-risk, mainly by socializing the costs. But investors should still remember that someone still has to pay the price of the debt writeoffs. At the end, the most obvious candidate is the household sector. Cost socialization will come at a price of a much lower growth trajectory. Expect a lost decade of Chinese growth should Beijing choose such a strategy.

Damage of collapsing trade

Under such a scenario, what are the global growth effects through a downshift in trade? A separate Bloomberg article detailed the exposure of China’s major Asian trading partners. In Asia, the economics of Singapore, Taiwan, Vietnam, South Korea, Malaysia, and Thailand would be most affected. Expect those countries, plus Hong Kong, to fall into recessions.

Commodity producing countries such as Australia, Canada, and Brazil would also be hard hit. China will need a lot less copper, iron ore, nickel, chemicals, and other natural resources because infrastructure spending would come to a screeching halt. In addition, Chinese real estate investment demand in places like Sydney, Melbourne, Vancouver, and Toronto would tank and put substantial pressure on the banking system in those countries as bad loan provisions pile up.

What about Europe? A European Commission document revealed the nature of European Union trade with China. EU exports to China amount to roughly 1.2% of GDP. At least half of the exports are in the form of capital goods, most of which come from Germany.

If China were to socialize the costs of a banking crisis through socialization, then Chinese GDP growth would fall substantially and so will imports. Pencil in a decline in EU exports to China of between one-third and one-half, that amounts to a reduction of between 0.4% to 0.6% of EU GDP.

Could Europe fall into recession under such circumstances? At first glance, direct trade effects would be negative but may not be enough to push Europe into recession. However, the secondary effects of such a trade shock could be more substantial. Much of the burden of the collapse in Chinese trade would fall mainly on Germany, which has been an export powerhouse. In response, German domestic demand would crater, and that would also have a negative domino effect on her European trade partners. In addition, how will the already fragile European banking system handle a recession of this nature? Much of the European bond market already have negative interest rates, will the ECB be out of bullets in the face of such a slowdown?

From a global perspective, the one silver lining of a Chinese banking crisis scenario is the US. The value of US exports to China amounts to a minuscule 0.6% of GDP, which represents a minor and survivable hit to growth.

A scenario, not a forecast

In summary, I have modeled the consequences of a Chinese banking crisis and slowdown. Even assuming minimal disruption through financial linkages, the negative effects through the trade channel would still be quite substantial. Much of Asia along with commodity exporting countries would fall into recession. The European economy would teeter on the edge. The US would have the least exposure.

I would add the caveat that this is only a scenario, not a forecast. However, I give the last word to Michael Pettis on the risks and the timing of a possible Chinese banking crisis:

Even after overwhelming the analysis with implausibly optimistic assumptions – discounting the disruptions caused by shifting strategies, for example, assuming financial distress costs are close to zero, and ignoring the impact on debt sustainability that results from rolling over a significant share of total loans that cannot be repaid – it is pretty clear that without a major change in policy or a tolerance for slower GDP growth it will be hard to prevent debt from becoming unsustainable. At some point, and my guess is that this would occur within the next two to three years at current growth rates, China runs the risk of a very disruptive adjustment as it reaches debt capacity limits, perhaps even the risk of negative GDP growth rates.

Pettis wrote those words on June 22, 2016. He expects a “disruptive adjustment” within 2-3 years under relatively optimistic assumptions.

The roadmap to a 2017 market top

Posted by Cam Hui - August 27, 2016

The latest signals of each model are as follows:

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

A 2017 market top?

I don’t want anyone to get the idea that I am a permabull. I have been steadfastly bullish on stocks for all of 2016. This may be the time to sound a cautionary note by outlining a scenario of how stock prices could make a cyclical top next year.

The chart below shows how the stock market behaves during the four-year presidential cycle. The black line shows the pattern based on past monthly median returns and the blue line shows the pattern based on average monthly returns. Statistically, median returns (black line) are better representations than average returns (blue line) because averages can be distorted by large outliers, such as the Crash of 2008.

The stars may be aligning for a replay of the presidential cycle, where stock prices rise into next year and possibly top out next summer. In this week’s post, I will discuss:

The bullish tailwinds prevailing for stocks today
The timing of a possible cyclical peak
The bearish headwinds that could lead to the formation of the market peak.

Why I am a bull

I hate to sound like a broken record week after week so I’ll be brief in setting out the bull case, consisting of an overly defensive investment community that was caught flat-footed by a growth revival. The result is a FOMO (Fear Of Missing Out) rally. This rally is just getting started and it`s likely to last for several more months before petering out.

We can see signs of a FOMO rally from the results of the latest BoAML Fund Manager Survey. Global growth expectations are just starting to tick up from a subpar level.

Profit expectations are rising, also from depressed levels.

On the other hand, fund managers were overly defensive in their portfolio positioning. Their equity allocations have been low and just starting to rise. As equity weights are nowhere near a crowded long reading, there is significant potential for higher prices should a buying stampede develop.

This chart also shows that managers had taken out tail-risk protection as fear levels spiked, and that protection is in the process of being unwound.

In the meantime, fundamental momentum continues to be positive. The latest weekly update from Factset shows that forward 12-month EPS estimates are continuing to rise, which reflect Street optimism about the earnings outlook (annotations in red are mine).

The better growth outlook is not just restricted to the US market. Global developed market EPS estimates are tracking higher as well (via Gavekal).

When I put it all together, we have the ingredients for a market melt-up. A growth surprise has sparked a risk appetite revival, which is only in the initial stages of an upturn. The potential for a buying stampede is high, as readings are nowhere near crowded long levels.

Timing the market peak

Given the bullish triggers that I have outlined, the next question is the timing of a market peak. A possible answer came from some terrific analysis put out by Chris Ciovacco last week (click link to see his full explanation on video). Ciovacco found a rare buy signal that has occurred only 10 times since 1982, where the 30, 40, and 50 week moving averages (WMA) of the NYSE Composite all turn up. In these signals, the 30 WMA is above the 40 WMA and the 40 WMA is above the 50 WMA. In the past, such signals have led to market uptrends that can last up to several years. The chart below shows past buy signals along with their length.

To determine the likely length of the current buy signal, there are two things to consider. First, the combination of the three weekly moving averages is a trend following model, but trend following models tend to be late in spotting turning points in a trend. Typically, the market tops out one or two months before the crossing averages flash a sell signal. If the market were to top out in 26-78 weeks, then subtracting 4-8 weeks, or 1-2 months, yields a market top in 6-12 months.

Instead of just calculating the average length of a buy signal, I tabulated the frequency of the length of each buy signal. This analytical technique yielded an interesting 1.5 year longevity rule. If the bull phase lasts more than 1.5 years, then the bull phase is likely to be more lengthy and has the potential to last 3-5 years. Otherwise, there seems to be a cluster of buy signals that lasts about 6-12 months.

Ciovacco’s analysis lends a technical underpinnings to my thesis of a sustained intermediate term uptrend in stocks. When I combine his insight with my examination of the macro and fundamental forces of bearish headwinds that are forming, it suggests a market rally in the short-dated 6-12 month cluster in the distribution chart above.

Lurking bears

No market goes up forever. Here are the four fundamental and macro factors that are likely to stall a market rally in the next 6-12 months:

Valuation
Rising wages pressuring corporate margins, which will pull down earnings growth
The rising risk of a China debt crisis
Possible changes at the Fed

Valuation: The Morningstar fair value estimate is one way to measure valuation. Currently, this metric shows that the market is slightly overvalued. Should we see a FOMO rally and melt-up, stock prices will start to lose valuation support.

For now, the Barron’s weekly report of insider activity shows that the behavior pattern of this group of “smart” investors is relatively benign. In the past, the combination of excess valuation and sustained insider sell has been a warning for the markets.

Wage pressures: While we are currently seeing the positive macro effects of better economic growth, those tailwinds are unlikely to last very long. That’s because a tight labor market is pressuring wage growth, which has risen to levels well beyond the Fed’s 2% inflation target.

Variant Perceptions pointed out that the unemployment rate tends to lead profit margins by about two years. This effect should be especially noticeable, as the economy is at or near full employment, which puts upward pressure on wages that cut into operating margins.

China debt crisis: I recently wrote about the possibility of a China slowdown and debt crisis (see How much “runway” does China have left?). In that post, Michael Pettis had made a number of optimistic assumptions and modeled the likely outcome. He concluded that China is likely to experience a debt crisis in 2-3 years. In a year from now, that time horizon shrinks to 1-2 years under some fairly optimistic assumptions. The stress levels in China are likely to rise and so will global risk levels.

Bruegel highlighted the growth of the Chinese banking system, which is now the world`s largest. Even though much of the debt is denominated in yuan and any debt crisis is likely to be relatively contained within China, an implosion in the world`s largest banking system can`t be a good thing for global finance.

Recently, the IMF warned that USD 2.9 trillion in the Chinese shadow banking system is classified as “high risk”. The Chinese property canaries in the coalmine are warning of rising risk levels, as the real estate market is rolling over again. I have no idea how long Beijing can hold this together, but risk levels is likely to rise as the Chinese authorities continue to kick the can down the road.

Changes at the Fed: This may seem like an “inside the Beltway” story, but I have been watching how the composition of the Federal Reserve board might change after the election. Right now, the odds indicate that Hillary Clinton is likely to become the next president of the United States. A NY Times profile of Fed governor Lael Brainard indicates that Clinton may tap Brainard for a post within the new administration. Should such a development occur, it would deprive the Federal Reserve a leading dove (see my assessment of the three camps within the Fed at Showdown at Jackson Hole? Forget it!).

Ms. Brainard has become the leading voice among Fed officials for a concern widely shared among left-leaning economists: that the central bank will raise rates too quickly, potentially stifling economic growth. It is a role that has raised her profile in Democratic circles, and driven speculation that she is in line for a top job if Hillary Clinton wins the White House.

Gene Sperling, a longtime Democratic policy maker who is now advising Mrs. Clinton’s presidential campaign, hired Ms. Brainard as his deputy at the Bill Clinton White House in the mid-1990s. He said he was tickled that lately, when he gives public speeches, he is often asked about her views.

“My outside impression is that she has been as much a champion as anyone on the inside for the go-slow, full-employment perspective that many of us on the outside are advocating for,” Mr. Sperling said.

Ms. Brainard has fueled the talk about her future by donating $2,700 to the Clinton campaign — the maximum amount an individual can give — raising eyebrows at the Fed and among congressional Republicans. Mrs. Clinton has said she intends to fill half her cabinet with women, and Ms. Brainard is among the few widely regarded as having the relevant credentials to serve as United States trade representative — or, even better, Treasury secretary, a job no woman has ever held.

Within the Fed, the opinions of governors like Lael Brainard tend to hold much more weight than regional presidents. As an example, a recent Bloomberg story documented how the boards of 8 of the 12 regional banks had voted to raise rates, but policy remained accommodating, largely because of dovish voices such as Lael Brainard. While I don’t want to over-emphasize the importance of any single Fed governor, the absence of Brainard will, at the margin, result in a more hawkish monetary policy. It would also raise the risk of an overly aggressive Fed tightening so much that the economy falls into recession.

When I put it all together, my base case scenario calls for a market melt-up with an upside SPX potential of 2400-2600, followed by a cyclical market top in the spring or summer of 2017.

Upside potential of 10-20%

Having outlined the possible bullish and bearish catalysts for a market melt-up and market top, I know that I will get asked about my upside target for the market. For that, I turn to point and figure charting. By varying different parameters in the point and figure chart, I get a range of SPX targets that range from 2270 to 2579, with two clusters. One cluster is in the mid 2300 level and the other is in the 2540-2579 range. That puts the potential upside at roughly between 10-20% from current levels.

The week ahead: All eyes on the Jobs Report

Looking to the week ahead, I wrote that the SPX may be vulnerable to a shallow pullback to the 2100-2140 level (see The market catches round number-itis). My assessment is unchanged. In addition, major market indices experienced an outside day reversal while closing down. This pattern typically resolves itself with a period of weakness.

On the whole, market participants are likely to be jittery next week. They will mainly be keying in on the Jobs Report, which will be released next Friday. Fed chair Janet Yellen’s remarks on Friday that “the U.S. economy [is] now nearing the Federal Reserve’s statutory goals of maximum employment and price stability” is agreement with vice chair Stanley Fischer’s speech indicating that “we are close to our targets”. In an interview on CNBC, Fischer stated that Yellen’s speech is consistent with two rate hike in 2016, but it would depend on incoming data. In particular, he singled out the August Jobs Report as a key data point to be watched.

The current readings of the CME FedWatch Tool shows that the market is only discounting a single quarter point rate hike this year. The odds of a rate hike in September is 33%:

…and the odds of two rate hikes by December is only 14.7%:

Should the August report come in at or better than expectations of 180K, expect stock prices to weaken as it discounts the possibility of two rate hikes. In the meantime, the market is likely to be stay nervous until the Jobs Report on Friday.

My inner investor remains bullish on equities. He believes that any pullbacks are likely to be minor, as he is betting on continued growth surprises from both the economy and company fundamentals. Intermediate term price momentum is strong, which is technically bullish. Moreover, recession risk remains low and therefore there is minimal risk of a cyclical bear market over the next 3-6 months.

My inner trader is constructive on stocks as he doesn’t want to fight the bullish intermediate term trend. On the other hand, he is nervous about the near-term downside risks to prices. He has a partial long position and he is prepared to buy more should the market weaken.

Disclosure: Long SPXL

Showdown at Jackson Hole? Forget it!

Posted by Cam Hui - August 25, 2016

The markets have been nervous as we await Janet Yellen’s speech at Jackson Hole. Now that the agenda for the Jackson Hole symposium has been released, I believe that Yellen is unlikely to announce any major shift in monetary policy in her speech.

The intent of the Jackson Hole symposium is for Federal Reserve officials to think long term. The intent isn’t to make a decision on whether to raise interest rates in September, December, or next year. Instead, the purpose of the meeting is to think about different frameworks for Fed officials to do their job. Possible topics include the conduct of monetary policy and their mechanisms, financial regulation, and so on.

Three camps at the Fed

If Yellen did indeed want to signal a philosophical focus in the conduct of monetary policy, then the logical course of action is to allow one or more academics to present research in support of such a shift. Ostensibly, the presentation would be for discussion purposes only, but the real intent would be to create sufficient buzz to change how the discussion could be framed at future FOMC meetings. I had been watching the agenda for some hints that Yellen could find herself shifting her opinion towards one of three camps at the Fed:

The traditionalists: The leader of the traditionalist faction is Stanley Fischer. Fischer is an experienced old-time central banker who views the world in a conventional way. Traditionalists think mainly in terms of economic cycles. So when Fischer said in his most recent speech:

The Fed’s dual mandate aims for maximum sustainable employment and an inflation rate of 2 percent, as measured by the price index for personal consumption expenditures (PCE). Employment has increased impressively over the past six years since its low point in early 2010, and the unemployment rate has hovered near 5 percent since August of last year, close to most estimates of the full-employment rate of unemployment. The economy has done less well in reaching the 2 percent inflation rate. Although total PCE inflation was less than 1 percent over the 12 months ending in June, core PCE inflation, at 1.6 percent, is within hailing distance of 2 percent–and the core consumer price index inflation rate is currently above 2 percent.1

So we are close to our targets.

By the remark “we are close to our targets”, Fischer means it’s time to start raising rates. The Fed has done its job as a fire fighter in the Great Financial Crisis and rescued the economy. It’s time to normalize monetary policy.

The uber-doves: By contrast, there is a group of doves at the Fed led by Lael Brainard and Charles Evans. Brainard is highly focused the global downside risk of raising rates. In a speech on June 3, 2016, she warned about the global effects of rising US interest rates:

Of course, there are risks to the projection that future GDP growth will be strong enough to deliver progress on inflation and employment. Most immediately, there is important uncertainty surrounding the United Kingdom’s June 23 “Brexit” referendum on whether to leave the European Union (EU). The International Monetary Fund has noted that a vote in favor of Brexit could unsettle financial markets and create a period of uncertainty while the relationship between the United Kingdom and the EU is renegotiated. Although the economic effects of this uncertainty and the costs of adjusting to altered trade and financial ties are difficult to quantify, we cannot rule out a significant adverse reaction to such an outcome in the near term, such as a substantial jump in financial risk premiums. Because international financial markets are tightly linked, an adverse reaction in European financial markets could affect U.S. financial markets, and, through them, real activity in the United States.

In addition, we should not dismiss the possible reemergence of risks surrounding China and emerging market economies (EMEs) more broadly. In recent months, capital outflows in China have moderated as pressures on the exchange rate have eased. Should exchange rate pressures reemerge, we cannot rule out a recurrence of financial stress, which would affect not only China but also other emerging markets that are linked to China via supply chains or commodity exports and, ultimately, conditions here. China is making a challenging transition from export- to domestic demand-led growth, and the cost of reallocating resources from excess capacity sectors to more dynamic sectors could further impair growth in the near term. While China has taken policy steps to limit the extent of the slowdown, there is an evident tension in policy between reform and stimulus, and the effect of the stimulus may already be waning. Vulnerabilities–such as excess capacity, elevated corporate debt, and risks in the shadow banking sector–appear to be building, and could pose continued risks over the medium term.

The fragility of the global economic environment is unlikely to resolve any time soon. Growth in the advanced economies remains dependent on extraordinary unconventional monetary policy accommodation, while conventional policy continues to be constrained by the zero lower bound. Conventional policy, whose efficacy is more tested and better understood than unconventional policies, can respond readily to upside surprises to demand, but presently would be constrained in adjusting to downside surprises. This asymmetry in the capability of policy effectively skews risks to the outlook to the downside.

Brainard has been highly focused on the tight global linkages between markets. Her dovish ally has been Charles (don’t raise until you see the whites of inflation’s eyes) Evans.

The secular stagnationists: The third camp at the Fed are those who advocate the view that the economy is caught in a slow growth environment. The spiritual leader of this movement is Larry Summers, who is not a Fed official. His allies are Williams of the San Francisco Fed and Bullard of the St. Louis Fed.

Most recently, John Williams penned a provocative essay, “Monetary Policy in a low R-star World“. In that essay, Williams fretted about the low level of neutral interest rate, or r*, that the economy seems to be caught in. What happens in the next recession? Will the Fed be out of ammunition?

The critical implication of a lower natural rate of interest is that conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. This will necessitate a greater reliance on unconventional tools like central bank balance sheets, forward guidance, and potentially even negative policy rates. In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher (Reifschneider and Williams 2000). We have already gotten a first taste of the effects of a low r-star, with uncomfortably low inflation and growth despite very low interest rates. Unfortunately, if the status quo endures, the future is likely to hold more of the same—with the possibility of even more severe challenges to maintaining price and economic stability.

To address these problems, Williams suggested that the Fed consider either raising the inflation rate target, or target nominal GDP growth as a policy framework.

Larry Summers, who is the leader of the secular stagnation camp, went even further. He thought that John Williams was being too wimpy:

I am disappointed therefore that Williams is so tentative in his recommendations on monetary policy. I do understand the pressures on those in office to adhere to norms of prudence in what they say. But it has been years since the Fed and the markets have been aligned on the future path of rates or since the Fed’s forecasts of future rates have been even close to right. I cannot see how policy could go badly wrong by setting a level target of 4 to 5 percent growth in nominal GDP and think that there could be substantial benefits. (I expect to return to this topic in the not too distant future)

Please tell us how you really feel, Larry.

No sign of a policy shift

As I mentioned, the way Janet Yellen might signal a shift in how she thinks about monetary policy would be to *ahem* plant academic papers that support the views of one of the major camps. Instead, there is no sign of such a speech on the agenda. Here is the schedule:

Friday (all times local)
0800 Janet Yellen, opening remarks
0830 Adapting to Changes in the Financial Market Landscape, Darrell Duffie and Arvind Krishnamurthy
0955 Negative Nominal Interest Rates, Marvin Goodfriend
1055 Evaluating Alternative Monetary Frameworks, Ulrich Bindseil (ECB)
1300 Luncheon address, Christopher A. Sims, Nobel laureate

Saturday
0800 Central Bank Balance Sheets and Financial Stability, Jeremy C. Stein, Robin Greenwood, and Samuel G. Hanson
0900 The Structure of Central Bank Balance Sheets, Ricardo Reis
1025 Overview Panel, Agustín Carstens (Bank of Mexico), Benoít Coeuré (ECB), and Haruhiko Kuroda (Bank of Japan)

When I look over the schedule, a few things jump out at me. First, Janet Yellen’s speech is only 30 minutes, which is not a lot of time to announce a major policy shift. The papers being presented are mostly technical in nature about the nuts of bolts of monetary policy and financial regulation and show few signs of a shift in philosophical focus.

The only possible exception is the Sims luncheon address. Here is how Wikipedia described the work that led to his Nobel prize:

On October 10, 2011, Christopher A. Sims together with Thomas J. Sargent was awarded the Nobel Memorial Prize in Economic Sciences. The award cited their “empirical research on cause and effect in the macroeconomy”. His Nobel lecture, titled “Statistical Modeling of Monetary Policy and its Effects” was delivered on December 8, 2011.

Translating his work into everyday language, Sims said it provided a technique to assess the direction of causality in central bank monetary policy. It confirmed the theories of monetarists like Milton Friedman that shifts in the money supply affect inflation. However, it also showed that causality went both ways. Variables like interest rates and inflation also led to changes in the money supply.

Bottom line: I don’t expect much in the way of new policy direction out of Jackson Hole. In that case, any risk premium developed over the past few days should contract. Expect a brief but short relief rally.

The market catches round number-itis

Posted by Cam Hui - August 24, 2016

Mid-week market update: On the weekend (see The market’s hidden message for the economy, rates and stock prices), I wrote that the short-term outlook was more difficult to call than usual. On one hand, we were seeing broad based strength, which argued for an intermediate term bullish call. On the other hand, Urban Carmel pointed out that the market has a tendency to pause when it nears a round number. In this case, the hurdle is 2200 on SPX.

The latter scenario seems to be winning out. The market is catching a case of round number-itis for the following reasons:

Macro momentum became “overbought”;
Overly bullish short-term sentiment; and
Deteriorating short-term breadth.

I would caution that this is purely a tactical call of a short-term SPX correction of no more than 3-5%. As I wrote two weeks ago: Be patient, it’s hard to argue against the intermediate term bullish trend.

Macro momentum: Too far too fast

In the past few weeks, I have detailed how a turnaround in growth expectations caught many investors off-guard and fostered a FOMO (Fear Of Missing Out) and TINA (There Is No Alternative) rally. Now that the rally is in full swing, macro momentum is starting to peter out. While it`s still positive, the degree of improvement is decelerating. As an example, the Citigroup US Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations, is slowing dramatically.

Callum Thomas also highlighted a slight slowdown in global PMIs. While PMIs are still positive, the latest figures paint a picture of slightly softer manufacturing in August.

To be sure, the fundamental momentum is still positive where it really counts for the stock market. The latest update from Factset shows that the Street is still revising forward 12-month EPS upward.

A crowded long

From a sentiment viewpoint, models are showing that the fast money has rushed to the long side. Stock prices have tended to encounter trouble advancing under such conditions.

Hedgopia reports that large speculators, or hedge funds, have moved to a crowded long in the high-beta NASDAQ 100 e-mini contract. I have found in the past that the Commitment of Traders report on NDX futures contract has been the best contrarian indicator of market direction.

Mark Hulbert also found that NASDAQ timing newsletters are in a similar crowded long reading, which is also contrarian bearish.

Deteriorating breadth

In addition, short-term breadth is deteriorating. This chart from Trade Followers shows a pattern of deteriorating bullish Twitter breadth and improving bearish Twitter breadth.

This chart from IndexIndicators tells the same story. While short-term breadth measures such as the % of stocks above their 10 dma are stuck in neutral, they are also displaying a series of lower highs. This pattern is indicative of deteriorating internals that foreshadow corrections.

Choppiness ahead

This week, BoAML strategist Savita Subramanian called for a correction. While I agree with her on direction, her correction forecast is largely overblown. The reasons that she cited are mainly fundamental, which have been in place for quite some time before her correction call. So what has changed? By contrast, my correction call is based on the short-term technical outlook of the market.

Urban Carmel‘s analysis indicated that past round number-itis pullbacks have ended at around the 20 week moving average, which currently stands at 2113 and it’s rising fast. That level is also the breakout level of the SPX, which was resistance now turned into support. If the market were to pull back, the 2100-2120 level is the most logical level of support.

My inner investor continues to be bullishly positioned. He is unconcerned about 3-5% corrective blips in the market.

Despite my near-term cautious outlook for the market, my inner trader is not inclined to sell everything just yet. Today`s SPX decline of 0.5% has seen the VIX Index close above its upper Bollinger Band. As the chart below shows, past episodes have marked tradeable bottoms that lead to rallies that typically lasts for 2-3 days.

The key takeaway from this analysis suggests that we are in for a period of greater volatility as the market corrects for the next 2-3 weeks.

Disclosure: Long SPXL

A second chance on Europe

Posted by Cam Hui - August 23, 2016

About three weeks ago, I wrote about opportunities in European equities (see Worried about US equities? Here’s an alternative!). I pointed out that stock prices in Europe were far cheaper than US, the fears about European integrity and financial system were overblown, and the market seemed to be ignoring signs of a growth recovery.

Since then, the FTSE 100 has moved to new recovery highs since the Brexit vote.

The Euro STOXX 50 has rallied through a downtrend resistance level and it’s has retreated to test support.

American investors can see a similar pattern on the USD denominated ETF (FEZ).

If you missed the first opportunity to buy into Europe, this may be your second chance.

Fears are abating

There are numerous signs that investor fears are fading over Europe. The latest BoAML Fund Managers Survey shows that concerns over a European risk premium have fallen from first place to third.

As the chart below shows, portfolio managers have been selling down their eurozone positions, but portfolio weights may have bottomed last month as the weightings ticked up slightly.

Remember all the hand wringing over European banks? This chart of European financials show that they are in an uptrend and broke out to a post-Brexit recovery high today.

When I put it all together, these are signs that Europe equities are healing. If you haven’t diversified your equity holdings into Europe, it’s not too late.

The market’s hidden message for the economy, rates and stock prices

Posted by Cam Hui - August 21, 2016

The latest signals of each model are as follows:

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

The message from inter-market analysis

I have always believed in listening to the markets. Technical analysis is useful as it can be a way of discerning the market’s hidden message, especially when performing inter-market analysis, otherwise known as cross-asset analysis.

I have found point and figure charts to be particularly useful tools because they filter out a lot of the price noise, especially when markets trade sideways in a tight range as they have recently. As an example, my recent post that featured a SPX weekly point and figure chart got a lot of attention (see Be patient). Since I performed that analysis, not much has changed. The latest weekly chart pattern remains unambiguously bullish on an intermediate term basis. It also tells the bullish story of powerful price momentum, TINA (There Is No Alternative) and FOMO (Fear Of Missing Out), all rolled into one.

I reviewed my charts using this technique in order to get a fresh point of view and what I found astonished me. Over and over again, I was getting a lot of chart patterns like this from a single market sector.

Bullish or bearish? The charted instrument is in a well-defined uptrend, but there is overhead resistance nearby. While I interpreted it bullishly, I wanted to be sure. A Twitter poll showed that the crowd agreed with me.

This results of this analytical approach was in effect a hidden message from Mr. Market. More importantly, the message has crucial medium term implications for the economy, interest rates, stock prices, and the likely trajectory of Fed policy.

A reflationary rebound

Intrigued? The mystery chart turns out to be industrial metals, which bottomed out late last year. The price of industrial metals are an important global signal of cyclical sensitivity. Their price recovery is telling the story of a global reflationary rebound.

Here is the CRB Index. The CRB Index is heavily weighted in the energy complex and therefore more sensitive to movement in oil prices, which has been dragged down by its own demand-supply dynamics. Nevertheless, the pattern of a bottom and a recovery is the same as what we saw in industrial metals.

The charts of the commodity sensitive currencies are also telling the same story. Here is the Australian Dollar:

Here is the New Zealand Dollar:

The Canadian Dollar is thought to be more sensitive to crude prices. As oil have not performed as well as industrial metals, the loonie is not showing the same kind of bottom and uptrend as AUDUSD and NZDUSD. Nevertheless, it has participated in the commodity sensitive rally.

Commodity prices have been thought of primarily a barometer for Chinese growth, but their recovery is not just a story of Chinese demand. Analysis from Morgan Stanley shows that it is strong infrastructure spending from other Asian countries that is driving up commodities. Simply put, global commodity demand is broadening, which is indicative of broad based cyclical strength (via Bloomberg).

If commodity prices and commodity sensitive currencies are strengthening, then what does that mean for the inversely corrected US Dollar? As this two-year USD Index chart below shows, the USD has broken down out of an uptrend and it is approaching an important support zone.

The USD strengthened strongly in late 2014 and early 2015, but it has largely flattened out since then. Dollar strength has had the negative effect of squeezing the operating margins of large multi-nationals, which created headwinds for earnings and therefore stock prices. The chart below is a little dated as it was produced in September 2015, when YoY exchange rate comparisons were still a problem for US exporters, but you can see the magnitude of the earnings effect.

I therefore believe that the first message from the markets is the world is undergoing a reflationary rebound. Ed Yardeni pointed out last week that global industrial production has hit a new all-time high.

Stock markets around the world have begun to respond to the growth revival. Callum Thomas highlighted this chart, which shows the percentage of global market that have undergone golden crosses, which indicate technical uptrends (bottom panel). If history is any guide, this global reflationary rally has much more room to run.

Rising commodity inflation = ?

The second takeaway from this analysis is a signal of a resurgence in commodity inflation, which is likely to feed into the Fed’s inflation metrics. Such a change will eventually affect the tone of Fed policy, from the current cautious and dovish stance to a more aggressive program of interest rate normalization.

Rising commodity inflation is evident from the chart pattern of the hard asset sensitive industries and sectors of the US stock market. The chart below of the Metals and Mining stocks shows that they are experiencing upside breakouts in an uptrend (top panel). In addition, these stocks are in a well-defined relative uptrend when compared to the market (bottom panel).

Energy prices have been weak compared to other major commodities. Nevertheless, energy stocks achieved an important upside breakout last week (top panel). In addition, they are tracing out a constructive saucer shaped bottom on a relative basis (bottom panel).

I used Sotheby’s Holdings (BID) as a proxy for the collectibles market. As the chart below shows, BID has rallied strongly and achieved an upside breakout, both on an absolute and relative basis. The stock appears to be a bit extended and may be due for a pullback, but the message from the market from mining, energy, and BID is the same: resurgent hard asset inflation.

Commodity inflation “transitory”?

Wait a minute! Doesn’t the Fed measure inflation on a core basis, which strips out the effects of food and energy? In the past, it has interpreted such price surges as transitory and ignored their effects. Indeed, most of the Fed’s metrics of inflation expectations have been trending down, not up.

This time may be different. That’s because the economy is the late stages of an expansion and excess capacity is diminishing. With the labor markets getting very tight and wage rates rising, hard asset inflation is likely to start leaking into both the core inflation rates and inflationary expectations. The Atlanta Fed’s Wage Growth Tracker shows that hourly wages have been steadily trending upwards and now stand at 3.4%, which is well above the Fed’s inflation target of 2.0%. Sooner or later, wage pressures will lead to cost-push inflation. Note that the wage cost-push inflation effect is independent of hard asset inflation.

Inflationary expectations are also likely to start rising soon. The chart below shows the University of Michigan’s survey of inflation expectations (blue line, left scale) and commodity prices (red line, right scale). These two series have closely tracked each other in the past. Rebounding commodity prices are likely to start feeding into inflation expectations, which is a key input into monetary policy. So how “transitory” are food and energy effects on inflationary expectations?

The Fed’s delicate balance

In summary, the stage is set for a global reflationary rally in stock and commodity prices that will likely continue into 2017. The party is getting going. The key question for investors is when the Fed takes away the punch bowl.

Currently, the CME Group’s Fedwatch Tool shows the odds of a rate hike at the September meeting to be only 18%, indicating a low probability of a September increase in the Fed Funds rate.

The odds of a rate hike at the December meeting is just over even odds at 53%. The Yellen Fed has shown an unwillingness to surprise the markets. If Janet Yellen plans to raise rates at the September meeting, then she will have to communicate a much tougher hawkish message at her Jackson Hole speech on Friday.

While I recognize that the Fed is always “data dependent”, the message from the commodity and currency markets is rising inflation and eventually inflationary expectations, which is a key input into monetary policy. These readings suggest that if the Fed becomes overly complacent and dovish because of concerns over “asymmetric” and “downside risks”, then it may find itself behind the inflation fighting curve. It will then have to respond with a series of rapid rate hikes which would push the economy into recession.

It’s a delicate balance, and I don’t have a great sense of the Fed’s reaction function to developments. In the past, they have been far more dovish than I expected. For equity investors, the most important indicator to watch will be the yield curve. A steepening yield curve, where the 10-2 year Treasury yield spread widens, will be a signal from the bond market of higher growth expectations. On the other hand, a flattening curve that inverts, or when the spread goes negative, will be a warning of recession. Right now, the yield curve is flattening, but readings are nowhere near a recession signal.

The week ahead: Round number-itis?

As I look forward to the week ahead, I am finding short-term market direction to be a more difficult call than usual. On one hand, risk appetite, breadth, and momentum metrics are all flashing bullish signs. The chart below depicts the relative returns of High Beta vs. Low Volatility as a measure of risk appetite (bottom panel). Risk appetite has staged a breakout through a relative downtrend and it’s nowhere near levels that indicate wild exuberance. The TINA and FOMO rally has a lot of room to run.

In addition, Todd Salamone has shown that past instances of tight trading ranges and low volatility markets have led to above average returns. Will the current episode be any different?

On the other hand, Urban Carmel pointed out that the stock market tends to pause when the index encounters round number resistance. As the SPX approaches the 2200 level, a pullback into the initial breakout level of 2100-2120 would not be a surprise.

As well, Nautilus Research highlighted the fact that the USD Index has fallen below its 100 week moving average, which is consistent with my observation of commodity price strength. Past crossover episodes have resulted in short-term stock market weakness over a one-month time frame. Stock prices then recovered and advanced over the next three and six months.

My inner investor remains bullish on stocks, with overweight positions in energy stocks. He’s not overly worried about a possible correction back to 2100 as that only represents a blip in portfolio values.

My inner trader is confused and he doesn’t quite know what to think. He is open to all possibilities and he is partially long the market, but keeping some powder dry should stock prices weaken.

Disclosure: Long SPXL

Waiting for the consolidation to end

Posted by Cam Hui - August 17, 2016

Mid-week market update: The intermediate term outlook that I’ve been writing about for the past few weeks hasn’t really changed (see Get ready for the melt-up and Party like it’s 1999, or 1995?). The stock market continues to enjoy a tailwind based on the combination of overly defensive investors and a growth turnaround which is leading to a buying stampede.

The Dow, SPX and NASDAQ made simultaneous new all-time highs (ATHs) on Friday, August 5, 2016 and repeated that feat again this week on Monday, August 15, 2016. Ryan Detrick of LPL Research pointed out that such events tend to be bullish. The chart below shows past instances of simultaneous new highs.

The table below details stock market performance after such events. Current circumstances are consistent with my buying stampede thesis.

However, it is not at all unusual for stock prices to trade sideways after breakouts to ATHs. As long as the consolidation action is benign, the path of least resistance is up. The minor market weakness in the last couple of days is also consistent with my view of sideways consolidation.

Sideways action until Friday?

I had previous highlighted analysis from SDJ10304 indicating that when the VIX Index fell below its lower Bollinger Band (BB) and the BB was narrow, SPX median returns were flat for one and two weeks. This condition was triggered on Friday, August 5 and this is the second of the two weeks. If history is any guide, then expect some continued choppiness until the end of the week, after which equity returns should improve.

Equity options (OpEx) expire this week and OpEx weeks have tended to see a positive bias, but prices mean revert in the week after OpEx. However, this analysis from Rob Hanna of Quantifiable Edges shows that August OpEx has shown an unusually poor record of returns. So the bulls shouldn’t expect any help from OpEx week.

Looking beyond this week, the trading outlook is starting to look constructive. The perennially bullish strategist Tom Lee had turned tactically cautious about a month ago, citing the unusual condition where stock volatility had fallen bond volatility, which tended to result in short-term stock market weakness.

Here is what he said in a tweet today:

Here is what I am watching. The SPX traded sideways for about three weeks starting in mid-July when it first broke out to new ATHs. Pullbacks were shallow and the worst correction was halted at the 20 day moving average (dma) and the middle of the Bollinger Band (BB). The SPX is now testing its 20 dma and mid BB support again. In addition, the VIX Index (bottom panel) is very close to the top of its BB, which has often acted as resistance and a short-term buy signal in the past.

My inner trader is currently partially long the market. Should the VIX Index penetrate its upper BB on a closing basis, which may not may not happen, he is prepared to add to his long position. In any case, downside risk is relatively limited here as any corrective action should see strong support at the 2120 breakout point.

Disclosure: Long SPXL

Jackson Hole preview: Fun with statistics

Posted by Cam Hui - August 16, 2016

As we await the Fed`s annual Jackson Hole symposium on August 25-27, Bloomberg highlighted a research paper by Fed economist Jeremy Nalewaik. Nalewaik found that inflation and inflationary expectations had tracked each other well but started to diverge in the mid 1990’s.

This paper is important to the future of Fed policy, as it pushes the Fed towards a lower for longer view where inflationary potential is far lower than previously expected:

“Movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations,” Nalewaik wrote.

He cites as a potential explanation for this a hypothesis offered in a 2000 paper co-authored by Yellen’s husband, Nobel prize-winner George Akerlof, who wrote that “when inflation is low, it may be at most a marginal factor in wage and price decisions, and decision-makers may ignore it entirely.”

Akerlof’s and Nalewaik’s research jibe nicely with ideas that St. Louis Fed President James Bullard has injected into the debate on the rate-setting Federal Open Market Committee this year.

If this paper becomes a major focus at the Jackson Hole meeting, then the Fed is likely to tilt towards a take-it-slow view on raising interest rates. However, I would argue that this analytical framework is highly sensitive to how the Fed picks its input variables. One wrong move could result in a policy error of major proportions.

The Fed’s framework in context

For newbies, the Fed`s primary framework for setting interest rates is the Phillips Curve, which postulates an inverse relationship between unemployment and inflation. Policy makers could make short-term trade-offs between having lower unemployment at the price of higher inflation, or vice versa (chart via Wikipedia).

The part where the rubber meets the road is more difficult for policy makers. Models are interesting, but what do you plug into the chart for the inflation axis? Do you use some measure of inflation, or inflationary expectations? If you use inflationary expectations, here is a video of former Fed Chair Ben Bernanke where he outlines the debate of whether inflationary expectations are anchored at about 2%, or if they’ve become unanchored to the downside. The answer is that he has no idea.

There is a faction within the Fed, led by the likes of Lael Brainard, who argues that inflationary expectations are at risk of becoming un-anchored to the downside. If that is indeed the case, then the logical policy response is to keep interest rates lower for much longer. The Nalewaik paper is supportive of that case.

Which variable do you pick?

Theoretical discussions like these are very interesting from an intellectual viewpoint. However, an erroneous conclusion based on measurement error could have a disastrous effect on policy. The first chart of this post compares inflationary expectations from the University of Michigan survey to Core PCE, which is the Fed’s preferred inflation metric. The Nalewaik paper also shows other metrics of inflationary expectations, which are lower than the University of Michigan survey. If we were to substitute either of these measures for inflationary expectations, the divergence would be far lower than shown in our first chart.

So why did Nalewaik use the University of Michigan survey as his expectations metric? He cites as his reason being that “inflation expectations of the general public appear much more likely than the other candidate series to have a causal effect on actual inflation”.

In most economic models, firms set prices of goods and services in real terms, and since deviations from the optimal real price are costly to the firm, firms take into account expected aggregate price inflation in their pricing decisions. So the inflation expectations of the individuals setting prices of goods and services (i.e. “price setters”) should drive actual inflation, according to these theories.

Unfortunately, long time series on the inflation expectations of price setters are not available. What is available, broadly speaking, are the inflation expectations of the general public (from the Michigan survey), the inflation expectations of professional forecasters (typically economists), and, more recently, measures of inflation compensation derived from financial instruments whose payouts are linked to inflation. Based on several a priori considerations, the inflation expectations of the general public appear much more likely than the other candidate series to have a causal effect on actual inflation.

Here is the same chart of Core PCE against the University of Michigan survey (red line) and market based inflationary expectations (black line). The divergence between Core PCE and the market based forecast doesn’t look as serious. Arguably, firms seeking to raise prices also look to signals from the capital markets that determine their cost of capital, instead of strictly based on operating conditions from the “inflation expectations of the general public”.

Just to confuse matters further, the chart below includes Core CPI as well as Core PCE as measures of actual inflation. Core CPI has been rising much stronger than Core PCE recently. So which is the correct inflation metric?

I have no answer to any of these questions. What these exercises do is to illustrate the sensitivity of inputs, as well as how the choice of different measures can have change policy by 180 degrees.

Here is the Atlanta Fed’s inflation dashboard, which illustrates the policy dilemma for the Fed’s policy makers. Most inflation metrics are elevated and the escalation in labor costs is signaling a possible return to cost-push inflation. On the other hand, inflationary expectations are extremely low by historical standards.

Here are the components of inflationary expectations. All metrics are low by historical standards, except for sticky price CPI.

Are you confused? I am.

Where does Yellen stand?

For investors, the crucial issue comes down to what Janet Yellen thinks. My simple rule of thumb is: what the Fed chair wants, the Fed chair gets. In this case, we have a number of clues from her past speeches.

In a speech on March 29, 2016, Yellen seems to be casting doubt about whether expectations are well anchored at 2%:

Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation’s “normal” behavior, and, furthermore, that a persistent failure to keep inflation under control–by letting it drift either too high or too low for too long–could cause expectations to once again become unmoored.

…Lately, however, there have been signs that inflation expectations may have drifted down. Market-based measures of longer-run inflation compensation have fallen markedly over the past year and half, although they have recently moved up modestly from their all-time lows. Similarly, the measure of longer-run inflation expectations reported in the University of Michigan Survey of Consumers has drifted down somewhat over the past few years and now stands at the lower end of the narrow range in which it has fluctuated since the late 1990s…

…Taken together, these results suggest that my baseline assumption of stable expectations is still justified. Nevertheless, the decline in some indicators has heightened the risk that this judgment could be wrong.

In addition, I recently highlighted an important essay by Ben Bernanke. The Bernanke essay outlined the evolution of the Fed’s estimates of long-term economic growth (y*), unemployment (u*) and interest rates (r*),

According to the table, the latest consensus estimate of equilibrium Fund Funds rate (r*) is 3.0%. However, a speech by Janet Yellen on June 6, 2016 indicated that she believed the “neutral rate” only needs to rise about 1% from current levels, which is far below the consensus:

One useful measure of the stance of policy is the deviation of the federal funds rate from a “neutral” value, defined as the level of the federal funds rate that would be neither expansionary nor contractionary if the economy was operating near potential. This neutral rate changes over time, and, at any given date, it depends on a constellation of underlying forces affecting the economy. At present, many estimates show the neutral rate to be quite low by historical standards–indeed, close to zero when measured in real, or inflation-adjusted, terms. The current actual value of the federal funds rate, also measured in real terms, is even lower, somewhere around minus 1 percent.

Taken together, Janet Yellen`s view of where Fed policy should be is definitely on the dovish side of the dove-hawk spectrum. I therefore reiterate my case for a market bubble. The combination of wrong-footed positioning by investors, a growth surprise and a Federal Reserve that is unlikely to “take away the punch bowl” anytime soon suggests that stock prices could rally to levels that are not in anyone’s spreadsheet (see my weekend post Party like it’s 1999, or 1995?).

Party like it’s 1999, or 1995?

Posted by Cam Hui - August 14, 2016

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 research outlined in our post Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The latest signals of each model are as follows:

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

How close are we to a market top?

I am used to getting abused for my market views, but the abuse is starting to turn into agreement – and that’s a cautionary flag. I haven’t always been a bull, here is a summary of my major market calls since January 2015.

When I was cautious in the first half of 2015, I got hate mail (see Why I am bearish (and what would change my mind)). When the market corrected in August/September 2015 and I was constructive on stocks, I got hate mail (see Relax, have a glass of wine and Why this is not the start of a bear market). When I turned bullish in January 2016 at the height of the market panic, a lot of people thought I was an idiot (see Buy! Blood is in the Streets). When I reiterated my bullish views as the market moved sideways in June before the big breakout, there was much skepticism that stock prices could go much higher (see How the S&P 500 can get to 2200 and beyond).

Now that the broad market averages are seeing new all-time highs, market psychology has shifted from skepticism to grudging acceptance of the bull case. This got me worried. Am I becoming consensus and part of the crowd? Does this mean that the market is about top out?

For some perspective on this question, the Dow, SPX and NASDAQ all made simultaneous new highs last Thursday. The last time this happened was December 31, 1999, which was shortly before the ultimate top in March 2000, indicating that the market may be in a high risk zone. On the other hand, Ryan Detrick highlighted analysis showing simultaneous new highs in all three indices tend to be bullish.

Coincidental new highs is reflective of bullish price momentum, Detrick pointed out that the market saw a total of 25 simultaneous new highs in 1995.

So should we party like it’s 1995, which was a sustained bull move, or late 1999, which marked a blow-off top?

I believe that the answer depends on the timing of a recession caused bear market, which is a function of the Federal Reserve’s reaction to economic and market developments.

A shift in psychology

Last week, Marc Faber issued a warning for a market crash. Had he made the call six months ago, there would have been widespread acceptance in social media. Today, it was met with ridicule. Value Walk pointed out how wrong Faber had been over the years and the regularity of his “crash” calls.

Jon Boorman went further and outlined the history of doomster Chicken Little warnings about the stock market.

Intermediate term sentiment is starting to shift bullishly from an extreme bearish reading, but there are few signs of a crowded long. (Note that I distinguish between intermediate term sentiment metrics, which measure investor psychology, and short-term sentiment, which measure short-term trader psychology). My conclusion is based on the analysis of three distinct groups, namely individuals, investment advisors, and institutions.

Among individual investors, the TD-Ameritrade IMX, which measures investor bullishness, has been declining since early 2015. More importantly, it fell in July even as stock prices advanced to all-time highs. This signals a continued lack of enthusiasm for stocks.

Sentiment surveys are one thing, but indicators like IMX measure what people are actually doing with their money. The WSJ reports that fund flows confirm the cautiousness shown by IMX as the difference between stock and bond fund flows are at panic levels last seen at the 2009 market bottom. This is hardly a case of rampant bullishness.

Rydex funds flows data, which also shows what people are doing with their money, is also telling a similar story of a lack of bullishness. With the market touching all-time highs, sentiment has retreated from a mild bearish reading to neutral.

On the other hand, investment advisor psychology has been improving. The latest NAAIM survey of RIAs show bullishness at highly elevated levels, but weekly swings in NAAIM sentiment can be volatile and fickle. A recent Eaton-Vance survey of advisors was more revealing about the evolution of advisor sentiment. As the chart below shows, growth, or greed, is starting to rise, but volatility concerns, or fear, is still elevated.

Global institutions, which represents the really slow and big money, are also gradually shifting back toward risky assets like stocks from an underweight position. The latest BoAML Fund Manager Survey shows global institution cash levels are still high, indicating an overly defensive posture.

US equity weights had been below normal and institutions are just starting to buy. They are nowhere near a crowded long extreme.

In summary, investors are getting less bearish, but current readings are the not typical signs that are found at a market top.

Growth rebound continues

In addition, growth expectations continue to rise. As per this chart from Factset, trailing 12-month EPS is starting to recover, indicating that the earnings recession that began last winter is over. Bears should also take note of how prices tend to lag trailing EPS (chart annotations are mine).

More importantly, the forward outlook is upbeat. By contrast to the above trailing EPS chart, note from the chart below how prices are roughly coincidental with forward 12-month EPS. The latest Q2 Earnings Season is nearly over and the EPS and revenue beat rates are slightly ahead of historical averages. Corporate negative guidance is below historical norms and forward 12-month EPS continues to rise, which reflect ongoing Street optimism.

What can derail this bull move?

The combination of an under-invested investment community, a positive growth surprise, and rising bullish momentum in investor psychology all suggest that there is room for stock prices to advance further. So what can derail this bull market?

Just to be clear, by “derail” I don’t mean a correction, but a bear market where stock prices fall and continue falling. Classic bear markets of this sort began in 2007, 2000, 1990, 1982 and 1974. The common thread to these bear markets is they either preceded or coincided with economic recessions.

Georg Vrba, who has done tremendous work in recession forecasting, recently reviewed his models and concluded that a recession is at least a year away. Here are the recession triggers that he is watching;

Accordingly, the changes to the model’s parameters which may be instrumental in bringing on a new recession are:

decrease of the 10-yr Note Yield

decrease of the Unemployment Rate

increase of the Fed Funds Rate

increase of the Inflation Rate (CPI)

It is unlikely that that the 10-yr Note Yield and the Unemployment Rate will decrease much from their current levels. So it would appear that an increase of the Fed Funds Rate and/or Inflation Rate will be the most likely cause to shove the economy into recession.

When does the Fed take away the punch bowl?

Reading between the lines, all of Vrba’s indicators are tied to the Federal Reserve’s reaction to economic developments. New Deal democrat has made the case, to which I agree, that the economy is in the late cycle of an expansion. The labor market is tightening, which should induce cost-push inflation. But with few signs of rising inflation or even renewed inflationary expectations, when does the Fed react to take away the punch bowl just as the party warms up? When it does, will the rate normalization process be ahead or behind the inflation curve? How will the market react?

Those are all very good questions. An important essay by former Fed chair Ben Bernanke shed some light on the Fed’s reaction function. The chart below shows how the Fed’s expectations of economic growth (y*), unemployment (u*), and the Fed Fund rate (r*) has evolved over the years.

The key to understanding the Fed is to see growth expectations (y*) has fallen from the 2.3-2.5% range in 2012 to 1.8-2.0% in 2016. Both unemployment rate and interest rate expectations have been falling because growth expectations have been falling. Growth expectations were falling because of the abysmal productivity record. Here is Bernanke:

Estimates of potential output growth (y*) have declined primarily for two reasons. [1] First, potential growth depends importantly on the pace of growth of productivity (output per hour). [2] Unfortunately, productivity growth has repeatedly disappointed expectations during this recovery. For example, in 2009, leading scholars were predicting productivity growth in the coming years of about 2 percent per annum; in fact, growth in output per hour worked has recently been closer to half a percent per year. It’s possible that productivity may recover, of course, but if it doesn’t, then potential growth rates in the future will be lower than had been expected earlier.Second, although Fed forecasters have been too optimistic about output growth in recent years, they have also been, interestingly, too pessimistic about unemployment, which has fallen faster than expected despite the slow rise in GDP. Generally, the unemployment rate tends to fall when output is growing faster than its potential—a basic macroeconomic relationship known as Okun’s Law. [3] The observed combination of slow output growth and rapid unemployment declines can be consistent with Okun’s Law only if growth in potential output has been lower than thought.

It’s all about productivity

In other words, it’s all about productivity. In fact, the hand wringing over falling productivity has become so bad that Morgan Stanley downgraded long-term global productivity growth to a miniscule 1.25% (via FT Alphaville).

What if the Fed and the market are wrong on productivity? A recent Bloomberg story indicated that productivity may be ready to shoot higher because of a tight labor market.

Like anything else, the cost of labor gets higher as it gets more scarce. This dynamic should incent businesses to start spending more on capital, rather than continuing to bid up wages, in order to boost production. Capital deepening, in turn, is a key driver of productivity: when workers have more/better/newer equipment, they’re generally able to produce more output per hour.

As such, Nordea Markets Chief FX Strategist Martin Enlund drew attention to the relationship of a tightening labor market eventually leading to higher productivity.

“If labour scarcity rises – and/or labour quality weakens, this greater cost-of-hiring (of L) is the same as a relative drop in the cost of real capital (K),” he wrote. “A growing capital stock would be consistent with greater productivity growth.”

Renaissance Macro Research Head of U.S. Economics Neil Dutta previously published a version of this chart shortly after the publication of productivity statistics for the fourth quarter 2015.

“If the deep recession is a reason that productivity is weak, running the economy at full employment can yield benefits in the longer run,” he added. “Full employment brings higher costs. Thus, firms have more of an incentive to find efficiencies.”

In other words, productivity has been weak because of slack in the labor market and labor has been cheap. As the economy moves towards full employment, it will push companies to spend more on capital, or plant and equipment, to replace labor. Higher investments will eventually push up productivity.

Imagine the following scenario. The Fed has mistakenly believed that the long-run growth rate is falling because of a secular decline in productivity. In fact, the slowdown in productivity is cyclical, not secular. The labor market tightens and wages rise, which induces cost-push inflation. By the time the Fed realizes what is happening, it finds itself behind the curve and will have to tighten interest rates hard – hard enough to send the economy into a recession.

The scenario I just outlined has many moving parts. When does productivity start to show signs of recovery? When does inflation start to rear its head? How long before the market realizes that the Fed is behind the curve?

The answer to those questions will tell us whether it’s 1995 or 1999. A slow reacting Fed has the potential to produce a market bubble and push stock prices to unreal levels, followed by a Marc Faber style crash. A faster reacting Fed can dampen inflationary expectations and maintain the economy’s expansion longer.

Watch the Fed. Watch the speeches coming out of the Jackson Hole retreat this year. Watch the yield curve. Is it steepening, which shows that the bond market expects rising growth, or flattening, which signals weaker growth.

The week ahead: Buy the dip!

In my last mid-week market update, I highlighted analysis from SDJ10304 showing that when the VIX Index fell below its lower Bollinger Band (BB) and the BB was narrow, SPX median returns were flat for one and two weeks (see Be patient). These conditions occurred a week ago Friday and the market seems to be behaving in accordance to historical norms. The one-week SPX return was a whopping +0.05%.

There are reasons to be optimistic. Twitter breadth, as measured by Trade Followers, is positive as the breadth of bullish stocks has been trending up.

The high yield, or junk bond, market is also behaving well. This is another sign that broad market risk appetite is healthy, which is ultimately bullish for stock prices.

The market appears to be undergoing a high level consolidation after the upside breakout to new highs. The most likely resolution of the narrow trading range of the last week is likely to be an upside breakout to further new highs.

My inner investor remains comfortably invested with an overweight position in equities. My inner trader holds a partial long position in SPX. He will be watching for any signs of weakness next week as a buying opportunity.

Disclosure: Long SPXL

Be patient

Posted by Cam Hui - August 10, 2016

Mid-week market update: Is this the pullback and correction that I’ve been anticipating? If so, how far can it go?

Be patient.

Take a look at this weekly point and figure SPX chart. Is there any doubt that the intermediate term outlook is bullish?

While my inner investor remains bullish based on the intermediate term trend, my inner trader is cautiously bullish and not all-in as there may be some near-term choppiness ahead.

The message from the VIX Index

First of all, I want to address the recent article by Mark Hulbert showing that the level of the level of the VIX has nothing to do with future market returns.

I agree 100% with that analysis. As the market has been trading in a very narrow range, realized volatility is shrinking and therefore it is no surprise that implied volatility (VIX) would fall as well. However, there is information when the VIX Index moves too quickly by either spiking or cratering, as defined by its relationship to its Bollinger Bands (BB).

The chart below shows the three-year history of the VIX Index. In the past, the market has either stalled or staged minor pullbacks whenever it has fallen below its lower BB (blue vertical lines). The index breached its lower BB last Friday.

What if the BB band narrows because of reduced volatility? The bottom panel of the above chart shows the BB width and it has fallen to very low levels. As this analysis from SDJ10304 shows, past instances of VIX lower BB breaches combined with BB width under 20 have produced flat to negative returns.

To fully appreciate the statistics from the above analysis, you have to be a bit of a math geek. Please note that the forward 1, 5, and 10 day median returns are flat, while the average returns over the same periods are negative. In addition, the % higher statistic over 1, 5 and 10 days are all 50%. That indicates that the typical returns after such trigger events (VIX below BB and lower BB width) tend to be flat, but there were instances where the market tanked so much that they pulled down the average return figures.

In other words, expect market returns to be flat but risk is skewed to the downside for this week and next.

This conclusion is also supported by the Bloomberg report that large speculators (read: hedge funds) are in a crowded short on VIX Index futures.

These conditions set up the possibility of a short-term volatility spike in the near future. As volatility tends to be inversely correlated to stock prices, it also suggests that the stock market may suffer a near-term setback soon.

Given the positive fundamental tailwinds behind stock prices (see my weekend post Breakout, or fake out?), I expect that downside risk is likely to be limited. If the SPX were to weaken further, it will have to test three levels of support. The first support will be mid-BB, or the 20 day moving average (dma) at 2170; the second support will be the lower BB, which is currently 2156; and the third and major support level is the 50 dma and breakout level of 2120.

My inner trader took some partial profits from his long positions last week but he remains cautiously bullish. He is awaiting either signs of further weakness or an upside breakout to new highs before adding to his long positions.

Disclosure: Long SPXL

Brexit: Fantasy vs. reality

Posted by Cam Hui - August 9, 2016

I am seeing an unusual level of rising anxiety over the political implications of Brexit. Last week, Stratfor published a report entitled “Brexit: The First of Many Referendum Threats to the EU”, which detailed the threats of additional referendums to the future of Europe.

Jim Rogers, writing in the Daily Reckoning, also painted a dire picture of the world after Brexit:

Are we at a point right now where it feels like it’s accelerating. People all over are very unhappy about what’s going on. If you read history, there are a lot of similarities between now and the 1920s and ’30s. That’s when fascism and communism broke out in much of the world. And a lot of the same issues are popping up again.

Brexit could be a triggering moment. This is another step in an ongoing deterioration of events. It’s also an important turning point because it now means the central banks are going to print even more money. That may prop the markets up in the short term…

The European Union as we know it is not going to survive. Not as we know it. Britain voted to leave, and France could very well be next. Why France? One of the main reasons is because the French economy is softer than the German economy. At least in Germany people are still earning money and making a living, despite all the recent turmoil. In France, the same malaise that’s settling over the U.S. and other places is settling in. And it’s going to spread.

There is no place to hide with what’s coming. I’m not saying it’s coming this year, or even the next. I can’t give a specific date. But imbalances are building up to such a degree, they just can’t continue much longer.

In addition, Philippe Legrain fretted about Brexit opening the door to European disintegration in an essay in Project Syndicate.

I beg to differ. In fact, the Brexit experience has made Europe stronger, not weaker.

Brexiteer fantasies

I recognize that the desire for Brexit is mainly emotional and not economic. Bloomberg reports that a survey by the U.K.-based Centre for Macroeconomics shows that the main reasons that voters favored Brexit were not economic. Simply put, Project Fear did not work to scare voters to believe that the UK would be far worse off under Brexit than inside the EU.

In the wake of the vote, we get silliness from the hard core Brexiteers such as this petition to remove French words from British passports.

The sentiment is reminiscent of a Monty Pythonesque caricature of the English-French relations here:

…when a simple search in Google shows that even the word “passport” has French roots.

Then I came upon this fantasy of trying to re-create parts of British Commonwealth with CANZUK:

If that is why the British are leaving, the natural question is: are there any countries out there with similar values and similar income levels with whom the British have greater cultural and constitutional similarity? That is obviously a question that answers itself: Canada, Australia and New Zealand are closer to Britain, constitutionally and culturally, than anywhere in Europe. And their income levels are fairly similar: in 2014, the U.K. had a GDP per capita of about US$46,000, versus US$44,000 for New Zealand, US$50,000 for Canada and Australia a little higher at US$62,000.

Sorry, the British Empire is long gone and the Commonwealth is as effective today as la francophonie. The old supply chains, which are the key elements of Commonwealth-based trade links, have atrophied and disappeared. The world has moved on since the 1950s and 1960s. Canada’s main trade focus is on North America. Australia and New Zealand’s main customers are in Asia.

CANZUK countries occupy very different parts of the world and trade volumes between each other is relatively low by global standards. The synergies from a free-trade pact would therefore be relatively low. In addition, the share of global GDP of these countries only amount to 8% (h/t Jereon Blokland for chart).

Why even bother?

The reality: Devil is in the details

For readers who are unfamiliar with the Brexit process, here is a useful FAQ and guide from the BBC. Needless to say, there is much that needs to be done and many details that have to be ironed out. The latest government actions show that the UK is utterly unprepared for the tasks ahead. Here are just some of the obstacles it faces:

Pending litigation challenging the Brexit process;
The threat of Scottish succession;
As the government faces a bewildering array of demands from the 27 other European states…
The negotiation team isn’t even in place. HM Treasury is advertising to fill the post of Director General, Financial Services. This is a trade negotiator whose task is “defining and negotiating our new relationship with the EU in the field of financial services”.

Trade negotiations are, by their nature, detailed and intricate. Agreements can’t be slapped together overnight. Here is a real-life example to consider.

Recently, the province of British Columbia slapped on a 15% tax on real estate for any non-resident buyer as a way to alleviate the price pressure in Vancouver (see CBC story). A Toronto lawyer responded with an Op-Ed entitled “B.C. just violated NAFTA with its foreign property tax — and we could all pay for it“. He contended that NAFTA requires Canada to treat the citizens of the other signatories, namely the United States and Mexico, the same way as it treats Canadians. Slapping a tax on foreign purchasers of Canadian real estate amounted to a treaty violation. Canada also has trade agreements with numerous other countries with similar provisions as well and the tax would also violate those treaties.

There was much buzz on social media on this topic, until an alert reader pointed out that Canadian trade negotiators had already addressed that particular issue.

With any agreement, the devil is in the details. Unless you think these things through very carefully, you don’t know what could trip you up in the future.

Pour encourager les autres

It is therefore no surprise that as Europeans woke up and realized the implications of Brexit, Euroskeptic support fell dramatically (via Reuters):

In an IFOP poll taken between June 28 and July 6, a few days after Britain’s vote to leave the EU, support for EU membership jumped to 81 percent in Germany, a 19 point increase from the last time the question was asked in November 2014.

In France, support surged by 10 points to 67 percent. In both countries, that was the highest level of support since at least December 2010, when IFOP started asking the question.

“Brexit shocked people in the EU,” Francois Kraus, head of the political and current affairs service at IFOP, told Reuters on Wednesday.

“Seeing the Eurosceptics’ dream come true must have triggered a reaction in people who usually criticise the EU and blame it for decisions such as austerity measures.

“But when people realise the real implications of an exit, there’s new-found support for the European project,” he said.

In the euro zone’s third-largest economy, Italy, support also rose 4 points, to 59 percent, the highest since June 2012. In Spain, some 81 percent of those polled said EU membership was a good thing, a 9 point increase in 2-1/2 years.

People in other major European countries were not keen to follow Britain’s example and hold referendums on EU membership: a majority of people in Germany, France, Italy, Spain and Poland, said they were against such votes.

Should a referendum be held, all five countries would vote to remain in the EU, with majorities of at least 63 percent.

When British Admiral John Byng failed in his mission to relieve the French blockade of Minorca during the Seven Years War, he was court martialed for negligence and shot by firing squad “pour encourager les autres“. Along the same lines, the Bexit vote acted to discourage other Euroskeptics from going down the same road. That’s why I believe that the Brexit vote lessened the political risk to Europe, contrary to the claims by Stratfor, Jim Rogers and others.

The real lesson of Brexit disarray and the difficulties of the process is to serve as a lesson for Euroskeptics: pour encourager les autres.

Breakout or fake out?

Posted by Cam Hui - August 7, 2016

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 research outlined in our post Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The latest signals of each model are as follows:

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

A global growth rebound

The SPX broke out to another all-time high on Friday in response to the positive surprise from the Employment Report. The upside breakout followed a false breakdown out of a narrow trading during the same week. The key question for traders is, “Is this an honest-to-goodness breakout, or just a fake out?”

Indeed, there is an intermediate term bullish case to be made. I’ve been writing for the past few weeks about how the combination of overly defensively oriented investors and a US growth surprise is leading to a FOMO (Fear of Missing Out) rally in US equities. Now it seems that the growth surprise is spreading around the world. As the chart below shows, the Global Purchasing Managers Index (PMI) is turning up, which is a positive sign for global growth.

On the other hand, short-term technical indicators are flashing signals of extreme caution. The market appears to gotten ahead of itself and a pullback may be in order before stock prices can rise sustainably. The chart below from Sentiment Trader shows that sentiment is at an optimistic extreme, which is a worrisome sign (annotations in red are mine).

A tour around the world

As an overview of the intermediate term bull case, I would like to take a quick whirlwind tour around to world to see how each region’s growth outlook is progressing. My analytical framework is based on dividing the world into three trade blocs, centered around the US, Europe and China.

Let`s start our tour around the world with the US economy. Remember hand wringing over the recent disappointing Q2 GDP report? Friday’s July Employment Report has dispelled much of the anxiety over stalling growth. The headline job gains of 255K blew past Street expectations of 180K. The internals were equally positive, which was nicely summarized by this tweet from Urban Carmel.

Average weekly hours showed solid gains and it’s now at or above the levels seen at the peak of the last cycle. Note that average manufacturing weekly hours (red line) is a component of the Leading Economic Indicators and its strength is a positive sign for future growth.

The participation rate continues to rise as discouraged workers re-entered the work force, indicating further momentum in employment.

Temporary jobs, which is a leading employment indicator, started to stall out last December but it`s on the rise again. This is a positive for future employment gains.

Wage gains are starting to show signs of acceleration.

Putting this all together, we have the underpinnings of a healthy consumer who is ready to spend. On the industrial side of the economy, the upward trend in ISM is pointing a capital expenditure revival in the near future, even though the latest ISM Manufacturing survey missed market expectations.

There is also cause for optimism on the capex front, Bill McBride of Calculated Risk pointed out that much of the drop-off in non-residential investment came from the energy sector and it was actually positive, ex-energy.

The BEA reported that investment in non-residential structures decreased at a 7.9% annual pace in Q1. However most of the decline was due to less investment in petroleum exploration. Investment in petroleum and natural gas exploration declined from a $62.4 billion annual rate in Q1 to a $50.2 billion annual rate in Q2 – and is down from $106 billion in Q2 2015 (declined more than 50%).

Excluding petroleum, non-residential investment in structures increased at a 5.5% annual rate in Q2.

These upbeat views of the American economy are consistent with the analysis from New Deal democrat, who monitors high frequency economic releases and splits them into coincidental, short leading and long leading indicators. NDD had found that both the short and long leading indicator are positive, while coincident indicators have been a bit wobbly. Based on these results, I would expect more signs of economic improvement in the near future.

Equity investors should also be encouraged from a bottom-up perspective as corporate earnings expectations are still marching upwards. The latest update from John Butters of Factset shows that with Q2 Earnings Season is nearly over, the earnings and sales beat rates are roughly in line with historical experience. What management has been saying in their quarterly conference calls has been relatively upbeat, as the negative guidance rate is below average. Consequently, forward 12-month EPS is climbing, which reflect continued Street optimism.

In summary, there is no shortage of bullish news in the US.

Europe: Green shoots of recovery

Across the Atlantic, Europe has been the sick man of the world, but there are signs of recovery. The latest Markit PMI shows a picture of steady growth.

Digging further, the employment component of PMI is turning up strongly, which is a cause for optimism.

While it is the laggard, Europe is starting to look like an emergent turnaround story.

China: Don’t count on a hard landing

China’s economy statistics are notoriously unreliable and can be made up, so I have learned to rely on more indirect means of measuring Chinese growth. Here are the two ways that I use. One way is to monitor the stock markets of China’s major Asian trading partners, whose sensitivity to Chinese growth is shown in the chart below (via Bloomberg):

The charts of the “Greater China” stock markets are shown below. All markets, except one, are above their 50 day moving averages (dma). The only exception is Singapore, which is testing its 50 dma support.

Another way to measure the health of Chinese growth is through the price of industrial metals. The chart below shows that industrial metals are in a solid uptrend, even net of currency effects.

While I have expressed concerns about the longer term growth outlook for China (see How much “runway” does China have left?), the prospect of a hard landing is not in its immediate future.

The week ahead: Cautionary flags everywhere

Looking to the week ahead, however, short-term cautionary flags are popping up everywhere. The chart below shows the SPX A-D Line (top panel), SPX (middle panel) and the relative performance of a high beta ETF (SPHB) against a low volatility ETF (SPLV) as a measure of risk appetite (bottom panel). As the chart shows, the SPX A-D Line (top panel) also did not confirm Friday’s upside breakout with a new high. In addition, risk appetite has not been able to break out of the relative downtrend and therefore constitutes another non-confirmation signal.

I also tweeted the following warning on Friday. The VIX Index had fallen below its Bollinger Band in the course of Friday’s market rally. Past instances (marked by vertical lines) have tended to resolve themselves with either consolidations or minor pullbacks.

Dana Lyons pointed out last week that inverse ETF volume is historically low, which is a sign of trader complacency that can lead to short-term corrective action. As the sample size is low (N=5), so take this analysis with a grain of salt.

My inner investor remains upbeat on the US stock market and he has an overweight position in equities. Any corrections that occur are likely to be mild and he is unconcerned about minor squiggles in stock prices.

My inner trader has been very bullish, but he took some partial profits Friday by selling his high-beta small cap ETF. While he remains constructive on equities, the short-term risk-reward ratio has deteriorated sufficiently to take some chips off the table. Should the market weaken in the days ahead, he anticipates that he will be buying again.

Disclosure: Long SPXL

Buy the shallow pullback

Posted by Cam Hui - August 3, 2016

Mid-week market update: After spending over two weeks in a narrow trading range, the SPX broke down out of that range yesterday and tested technical support at the 20 day moving average (dma), which was also the mid-Bollinger Band mark. At the height of the decline, the index had fallen 1% and the market was flashing short-term oversold signals.

When the market steadied soon after the open on Wednesday, I tweeted:

It appeared that the market had successfully tested 20 dma support:

In addition, short-term breadth measures (via IndexIndicators) had retreated to oversold levels that a bounce was likely.

Those conclusions are based on the combination of an intermediate term backdrop of economic and fundamental growth and powerful price momentum. Under such circumstances, market pullbacks are likely to be shallow and further all-time highs would probably follow soon afterwards.

Let me expand on those points.

The growth rebound continues

I have been writing about a US growth surprise for several weeks. It seems that the growth rebound is becoming global. Gavyn Davies noted that their “Fulcrum nowcasts for global economic activity have identified a broad pick-up in growth in many major regions, both in the advanced economies and the emerging markets”.

Ned Davis Research came to a similar conclusion and saw the hints of a H2 global rebound.

The bond market is also getting excited about growth. The 10-2 year yield curve is steepening. A widening spread between the 10-year and 2-year UST yields is a sign that the bond market is discounting high growth.

Price momentum continues

The fundamental and macro backdrop for the surge in equity prices since the Brexit panic bottom has been a combination of a growth surprise, which I have documented above, and wrong-footed positioning, where both institutions and individuals were collectively caught off-side with overly defensively oriented portfolios. Viewed through a technical analysis lens, the market is benefiting from a powerful surge of price momentum as a result of investors playing catch-up. Such episodes have tended to resolve themselves bullishly in the past.

There have been many studies on intermediate term momentum surges, so I won’t repeat all of them. This study from Nautilus Research is just one example, which suggests further price gains ahead on a multi-week and month time frame.

My inner trader buys more

Against a bullish intermediate term fundamental and technical backdrop, the narrow consolidation after the bullish price surge off the Brexit panic low should therefore be interpreted as a pause. Barring significant macro or political surprises, the intermediate path of resistance is up and pullbacks are likely to be shallow. Chris Ciovacco recently wrote about the bullish implications of an index holding above its breakout point, which is roughly the 2120 level for SPX:

Any breakout can fail, but as noted above, the current set of breakouts have already passed the textbook window for a typical failed breakout. Could the breakouts still fail? Sure they could. However, as long as the SP 500 can hold above the 2,100 to 2,135 range, the higher the odds equities have more upside. If the S&P 500 cannot hold 2,100, we will be giving our growth-oriented positions a shorter leash.

Here is Ned Davis Research with a study of market action after narrow consolidations. If history is any guide, 6-12 month returns after such episodes tend to be above average.

Fast forward to today. The SPX has broken down out of a narrow trading range yesterday (Tuesday). Support has been found at the 20 dma. Both short-term and intermediate term (1-2 week) trading indicators show the market touched oversold or near oversold levels.

My inner trader, who is already partially long the market, believes that these conditions represent a low-risk entry point for additional commitments to the long side. Downside risk should be limited to the breakout point at about 2120, which is also the level of the 50 dma, while upside potential suggests a rally to new all-time highs.

Disclosure: Long SPXL, TNA

Worried about US equities? Here’s an alternative!

Posted by Cam Hui - August 1, 2016

I have a suggestion for value oriented investors who are uncomfortable with my market blow-off thesis for US equities (see How to get in on the ground floor of a market bubble and Get ready for the melt-up). What about buying Europe?

Valuation metrics for European stocks are certainly cheaper. The SP 500 trades at a price to book ratio of 2.7 and forward P/E 18.4. By contrast, FTSE Europe trades at a P/B of 1.6 and forward P/E of 15.9 and the Euro Stoxx 50 trades at a P/B of 1.3 and forward P/E of 13.5.

Panic over Europe

To be sure, an unusual level of anxiety about Europe has arisen lately. This can be illustrated by the latest BoAML Fund Manager Survey. When asked about the biggest driver for equity prices for the next six months, the unexpected answer was “European risk premium”. As the chart below shows, the issue was not on anyone’s radar screen in the previous month (chart annotation mine).

The FMS also showed that institutional managers were fleeing eurozone equities in droves:

…and they had already sold down their UK equity position to very low levels.

The panicked reaction over Europe is consistent with the anecdotal evidence gathered by Andrew Garthwaite of Credit Suisse when he made the rounds of institutional accounts in the US, Europe and South Africa:

Capitulation on Europe. Many US clients believed Brexit meant the end of the euro (with Italian constitutional referendum being the next key event). Outflows are close to record highs, valuations are back to Greek crisis lows on P/E relatives yet earnings and economic momentum are showing signs of relative stability.

He went out to detail the main concerns of US clients:

Most US clients believe there will be another flare up of the European political/economic crisis. The Brexit vote reminded investors of the fundamental shortcoming of the euro: a monetary union without a fiscal, political union or proper banking union (only 0.8% of deposits will be commonly insured by 2024). The particular areas of concern were:

The Italian constitutional referendum.

The French Presidential Election.

The European Union’s refugee deal with Turkey.

The Italian banking crisis.

Let me address those issues, one at a time.

A European political question

If there is anything that I’ve learned in the past few years with the progression of European crises, such as Greece, Cyprus and Brexit, it`s that Europeans are very good at coming together to eliminate tail-risk, usually by socializing the cost. Americans who view European through the prism of a US political and financial framework often don`t realize what is said publicly is mostly theatre in order to strike a bargain about how the socialization burden is shared. The real negotiations occur behind closed doors and through back channels that most of us never see.

The first three concerns voiced by American institutional investors (Italian referendum, French election, Turkey refugee deal) are mainly political in nature. They in effect raise questions about the centrifugal forces that are tearing apart Europe.

On the surface, those threats appear very real, but those risks are overblown. A Eurobarometer survey done in April (pre-Brexit) shows that when push comes to shove, most Europeans self-identify as European, rather than as members of their own country. The UK was a glaring exception and, even there, Brexit is showing how messy the process of standing apart from Europe is.

In the wake of the Brexit vote, the results have scared the living daylights out of many euroskeptics. Sentiment shifted to a greater pro-European tone (via Reuters):

In an IFOP poll taken between June 28 and July 6, a few days after Britain’s vote to leave the EU, support for EU membership jumped to 81 percent in Germany, a 19 point increase from the last time the question was asked in November 2014.

In France, support surged by 10 points to 67 percent. In both countries, that was the highest level of support since at least December 2010, when IFOP started asking the question.

“Brexit shocked people in the EU,” Francois Kraus, head of the political and current affairs service at IFOP, told Reuters on Wednesday.

“Seeing the Eurosceptics’ dream come true must have triggered a reaction in people who usually criticise the EU and blame it for decisions such as austerity measures.

In the euro zone’s third-largest economy, Italy, support also rose 4 points, to 59 percent, the highest since June 2012. In Spain, some 81 percent of those polled said EU membership was a good thing, a 9 point increase in 2-1/2 years.

People in other major European countries were not keen to follow Britain’s example and hold referendums on EU membership: a majority of people in Germany, France, Italy, Spain and Poland, said they were against such votes.

Should a referendum be held, all five countries would vote to remain in the EU, with majorities of at least 63 percent.

In light of these results, the risks that the Italian referendum would result in “Quitaly” or the anti-establishment and euroskeptic Marine Le Pen becoming the next French president are fading.

Italian banking crisis: Resolving tail-risk

Then, we have the Italian banking crisis. The Italian banking system is simply burdened with too much non-performing loans (NPL). Here is how FT Alphaville explained it:

A full recap of said banking sector and its estimated €200bn of gross non-performing loans would, according to JPM, “require up to €40 billion (less than 2.5% of GDP)”.

While the NPL shortfalls in Italy are serious, the chart below puts the problem into some context. The problems in Ireland and Greece are even worse, but no one is panicking over those countries.

Under the new European banking rules, a sovereign can recapitalize its banks only if the creditors take a hit. Here is JP Morgan, via FT Alphaville:

According to the new rules, any government funding is conditional on pre-emptive burden sharing, which amounts to wiping out/haircutting private investors’ stakes in the banks’ capital (equity, subordinated and senior debt). In our view, such an approach would be extremely risky and ill advised, and the likely burden sharing of retail-held bonds would send shock waves across the domestic depositor base.

The problem is, much of the Italian banking paper is owned by Italian households and forcing haircuts would send the economy into a tailspin. As Italy represents the third largest economy in the eurozone, an economic problem has become a political problem. Cue the theatre and the endless European bargaining. Here is JPM again:

Article 32 of the BRRD explicitly foresees some exception to the bail-in rules in the case of systemic risk. It is hard to argue that the Italian case does not raise systemic risk, in our view. Furthermore, the high NPLs burden is a legacy rather than a recent problem, and we expect that this would receive further recognition by the relevant authorities (the European Commission and the ECB) in due time.

Ultimately, an adequate solution to the Italian banking woes only involves manageable financial commitments, in our view. A solution is rather a matter of political will, which in turn revolves around the German stance on the policy response to the Brexit shock. So far, Germany has shown an intransigent position, but we believe that rising fears about the systemic implications of a self-inflicted Italian banking crisis will trigger a rethink. As discussed, the details on the treatment of retail investors are important, and collateral damage should be avoided.

I don’t know how this “crisis” will end up, but the level of burden sharing within the eurozone is manageable. The eurozone agreed to a new €86 billion rescue program for Greece last year, so what’s a commitment of up to €40 billion for the third largest economy in the euro?

Indeed, Banca Monte dei Paschi di Siena, which is the bank with the worst balance sheet, cobbled together a rescue package on Friday. While more work needs to be done, tail-risk from Italian banking is fading fast (via the WSJ):

The bank said it plans to unload €9.2 billion ($10.3 billion) in net nonperforming loans to Atlante—a fund orchestrated by the government and financed by Italian banks, insurers and pension funds—and other investors.

Monte dei Paschi will also raise up to €5 billion in fresh capital—or nearly six times its market capitalization—to rebuild its capital cushion. The bank said it still has to win approval from regulators, including the European Central Bank.

The latest EBA stress test showed that Banca Monte dei Paschi di Siena is in the worst shape of any eurozone bank and would see its Tier 1 capital go negative in the stress test adverse scenario. Allied Irish Bank was next and saw its Tier 1 capital go below the critical 4.5% threshold in the same scenario.

Signs of market healing

Once you take away the tail-risk, the “European risk premium” problem raised in the BoAML FMS is far more benign. Already, we are seeing signs of healing in the markets. Remember CoCo bonds? Bloomberg details how they’ve recovered:

It’s been a roller coaster six months for investors in bank debt. At the beginning of the year, the market for contingent convertible bonds, known as CoCos, seized up, imperiling the post-crisis effort to resolve banks without recourse to taxpayer funds.

Fears over Deutsche Bank AG’s ability to pay a coupon on its Tier 1 securities fed the market’s perception that issuers across the board might struggle to service interest payments, thanks to regulatory changes towards the bank capital regime. That caused a market maelstrom in February. The primary market for such hybrid securities froze, and debt prices tumbled.

Since then the market has rebounded sharply, despite the U.K.’s vote to leave the European Union and the upcoming EU-wide bank stress tests, which have prompted fresh concerns over the health of some Italian banks. Amid regulatory changes seen as friendly to investors in hybrid securities, and Deutsche’s uninterrupted coupon payments, an index for the high-risk, high-reward securities is now up 3 percent this year, having gained as much as 15 percent from the February low.

In the absence of tail-risk, European equities look very intriguing as an investment. Andrew Garthwaite highlighted the fact that consensus estimate revisions in Europe are outpacing US revisions.

As a point of reference, Factset reports that US estimate revisions are rising and both earnings and sales beat rates are above their 5-year averages this earnings season.

Jeroen Blokland pointed out how eurozone GDP growth is beating US GDP growth, though the Q2 GDP was depressed by an anomalous inventory adjustment (see the discussion in my previous post Get ready for the melt-up).

Blockland also highlighted the disparity in performance between US and eurozone GDP and equities. Spot the divergence in this chart:

We are seeing signs of a possible bottom in relative performance in eurozone equities. The chart below shows the relative performances of the Euro STOXX 50 (black) and SPX (green) against the MSCI All-Country World Index (note all are in USD so currency effects are included). While US stocks has been in a steady relative uptrend, eurozone equities have been underperforming for close to a year, but they have started to turn around.

Green shoots?

In conclusion, the combination of diminished tail-risk, better fundamental outlook for Europe and market action are all cautious signs of green shoots for the European stock market. The washed-out nature of European equities therefore makes them an intriguing alternative for value investors. The additional catalysts of receding tail-risk and positive growth outlook also lowers the risk that European stocks represent a value trap. In fact, European equity investors have the best of all worlds when compared to US equity investors. Valuations are cheaper and so is growth.

For investors who can’t stomach my Greater Fool market blow-off thesis for US equities, European equities could represent a recovering value play that has the potential to outperform US equity assets in the next 6-12 months.

Get ready for the melt-up

Posted by Cam Hui - July 31, 2016

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 research outlined in our post Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The latest signals of each model are as follows:

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

A brighter tomorrow

No, the “brighter tomorrow” of the title does not refer to the better future promised by American politicians during this election season, but the brighter future for equity prices over the next 6-12 months. It appears that the market bubble scenario that I outlined a few weeks ago is well on its way to becoming a reality (see How to get in on the ground floor of a market bubble). The following factors are combining to create an environment that could see the market melt-up:

Positioning: Investors have been caught leaning the wrong way. They are just starting to play catch-up, but sentiment remains overly skeptical.
Growth surprise: A US recovery has caught most people off-guard (though I in the minority when I was bullish during the market panic in January, see Buy! Blood is in the streets!).
Central bank accommodation: The Federal Reserve has been ultra-cautious in its policy of interest rate normalization, which is an enabling factor for equity price gains.

While I am starting to have concerns about equities on valuation grounds, the market is likely undergoing a blow-off phase where if participants hold their noses and buy, they could enjoy some truly bubbly profits.

A skeptical market

Intermediate-term sentiment models are showing a high level of skepticism despite the SPX bouncing around in a narrow range within 1% of its all-time high. The groupings of sentiment can be divided into four categories, of which three are flashing contrarian bullish signals:

Retail: Neutral to mildly bearish, indicating skepticism about the rally to all-time highs
Advisors: Very bullish, all-in
Institutions: Still cautious
Hedge funds (fast money): Bearish

Let’s start with the retail investor and trader. With the market touching all-time highs, can someone please explain to me why Rydex fund flows are tilted towards a mildly bearish reading and AAII sentiment is neutral? Moreover, why does AAII bullish sentiment (bottom panel) fall after only a couple weeks of sideways consolidation? Are individuals that skittish?

Urban Carmel also pointed out that last week’s mutual fund and ETF flows resumed their defensive tone again. Market tops tend to be characterized by buying stampedes, not switches from equity into bond funds.

To be sure, the NAAIM survey of RIA sentiment shows that advisors are extremely bullish, but the historical record shows that past crowded long readings have not been very good contrarian sell signals.

As for institutional sentiment, I detailed last week how the BoAML Fund Manager Survey (FMS) showed global institutions were neutrally weighted equities and they were madly buying US stocks, which set up the potential for a FOMO (Fear Of Missing Out) rally (see In the 7th or 8th inning of the bull market).

Additional anecdotal evidence of excessive institutional cautiousness came from Andrew Garthwaite of Credit Suisse. Garthwaite had turned cautious on equities last December, but when he made the rounds of institutions in the US, Europe and South Africa, he found that institutional accounts were on the whole even more bearish that he was.

Clients are close to being as bearish on equities as we can remember. Clients do not find equity valuations attractive enough to compensate for the macro, political, earnings and business model risks. We think that clients are too pessimistic. The ERP is marginally cheap (on our model) while bonds, credit and real estate look abnormally expensive. Liquidity and positioning are also supportive of equities.

He also found that a lot of people were grumpy and lost because of subpar returns.

We have come across almost no one who seems to have outperformed or made decent returns this year. Data from Morningstar suggests, for example, that in the year to July 1st, just 29 out of 242 funds in the Investment Association UK All Companies sector beat the performance of the FTSE All Share. Moreover, the Dow Jones Credit Suisse Long/Short equity index, which tracks hedge fund performance, fell by 5% year-to-date. In passing, we have never had so many client meetings starting with statements such as ‘we are totally lost’.

In effect, institutions were bearish and got caught offside by the post-Brexit risk-on environment. Garthwaite, who had been bearish, concluded that it was time to turn contrarian bullish for the following reasons:

The lack of an alternative (“government bonds, corporate bonds and real estate appear very expensive in most parts of the world” and “the riskless return on bonds is in our view becoming returnless risk, driving investors into other instruments”);
Positioning (“the non-financial corporate sector in the US has bought $2.6trn of US equity since the market low in Q1 2009… or c.15.0% of market cap… while households have sold c.$62bn and institutions have sold by c.$1.1trn of equities over the same period”);
Excess liquidity is still strong; and
We might (just might) actually get an easier fiscal policy (fiscal QE is mentioned) at some point.

With individuals and institutions off-side on their positioning in the face of a growth surprise, the potential for a FOMO melt-up is high.

The growth surprise continues

Early last week, Bill McBride at Calculated Risk wrote a post called The Future is still Bright. In that post, he outlined the macro conditions that are still supportive of growth. McBride cited the following positive factors for US economic growth:

Progress in residential construction and housing starts, which are the best leading indicator for the economy;
State and local governments have stopped shedding jobs and they’re starting to hire again, which is positive for employment;
A better outlook for the US federal deficit;
The end of household deleveraging as debt service ratios hover near record lows. Household debt is rising again, which fuels consumer spending;
Positive labor force demographics, as the prime working age group is rising again; and
Improving life expectancy.

Near-term, the Q2 GDP miss that was announced Friday morning was a blemish to my growth surprise scenario. Headline Q2 GDP came in at an anemic 1.2%, which was a huge miss compared to the consensus 2.6% expectation.

However, an analysis of the internals show that Q2 GDP wasn’t that bad. Most of the miss can be attributable to a negative inventory adjustment, while consumption remains extremely strong.

Here is how Bespoke broke down the components of the Q2 GDP report (annotations in red are mine):

More importantly, final demand was healthy (via Justin Wolfers).

Despite the disappointing headline Q2 GDP figure, the growth story appears to be intact. The one silver lining of the GDP miss has been the weakness in the US Dollar. USD strength had posed a headwind to corporate earnings growth and the USD Index had neared a key resistance level a week ago. The combination of a no-surprise FOMC statement and a weak GDP report resulted in currency weakness, which alleviated my concerns about the of USD strength on the economy.

A strong earnings outlook

Switching focus from top-down macro economic analysis to bottom-up company analysis, the latest update from John Butters of Factset shows earnings internals are also healthy. With 63% of the SPX having reported, both earnings and sales beat rates are slightly above their historical averages. Moreover, forward EPS continues to rise, which reflects continuing optimism from the Street.

The upside surprise to the operating outlook didn’t just catch investors by surprise, it caught some CEOs by surprise as well. The latest summary of earnings calls from Avondale summarized the outlook as getting less bad, which formed the basis for “the surprise”.

This Week’s Post: No One Ever Called This Expansion
Although there are a lot of reasons to be more optimistic about the global economy, CEOs this week found plenty of reasons to be pessimistic too. Even the companies that felt like they were executing well cited a slow economic backdrop, with “anemic” growth. At least it is growth though, and +1 feels good when you were running at -2 before.

A dovish Fed?

The combination of overly bearish sentiment and growth surprise form a sufficient basis for a risk-on melt-up in equity prices. Add to that mix a cautious Federal Reserve as it embarks on a tightening cycle and we have additional fuel for a bull run. In the wake of the disappointing Q2 GDP report, Fed Fund futures of a rate hike this year has dropped to 37.3%.

The instant reaction in the wake of the GDP report may be overly dovish and we should wait for more Fedspeak to get a better understanding of Fed policy. Nevertheless, the scenario of a Federal Reserve that declines to take away the punch bowl as the party gets out of hand is becoming a definite possibility. Such a policy response sets the ground for a market blow-off later this year, before Yellen et al step in to addresses the excesses created by an overly dovish policy.

Throw caution to the wind?

I am not alone in postulating a stock market mania, BCA Research recently speculated about a blow-off in global equities, citing the following possible catalysts:

First, the character of the equity market advance may shift and a rotation out of defensives and into cyclicals could transpire. Since the previous market peak, defensive stocks have handily outperformed due to the drubbing in global bond yields. As the global bond bull market goes on hiatus at least for a while – a view that BCA’s Global Investment Strategy service has posited – defensive sectors may feel the heat.

Second, investors’ perceptions of improving global growth may be enough to move the needle in the still extremely oversold and under-owned cyclical sectors.

Third, there appears to be ample sidelined cash to flow back into stocks if a bear capitulation occurs and investors throw in the towel in order to participate in an advance.

BCA Research concluded that while a market blow-off may be possible, “further equity strength should be characterized as a high-risk, liquidity-driven overshoot phase in global stocks”. I agree. Valuations are getting stretched. The latest Factset data shows forward P/E nearing a new high, which is disconcerting for value oriented investors (chart annotations are mine).

Despite these reservations, the combination of a growth surprise, wrong-footed market positioning and a market-friendly Fed may mean that it`s time to throw caution to the wind and get set for a “high-risk, liquidity-driven overshoot” in stock prices.

The week ahead: Don’t short a dull market

As the market continues to consolidate sideways, I will be tactically watching whether the SPX can break out of its trading range. In addition, I am monitoring the relative performance of the High beta ETF/Low volatility ETF pair as a measure of risk appetite (bottom panel). Should that pair break up through its relative downtrend, the risk-on upside could be substantial.

In all likelihood, the trader’s adage of “don’t short a dull market” will hold true in the current circumstances. Nautilus Research found that, historically, such periods of tight consolidations have resolved themselves to the upside.

Rob Hanna at Quantifiable Edges found a similar effect when he studied past market behavior of tight consolidation after new highs.

My inner investor has been comfortably bullish on stocks for some time. My inner trader took an initial position in small cap stocks on Thursday in the belief that small caps would serve as high beta leadership for a potential advance.

Should the market break out to the upside, he plans on adding to his long position. Should it break down, downside risk is likely to be limited, first at its 20 dma, which is rising quickly and closed on Friday at 2159. Additional secondary support exists at the breakout level of 2120.

Disclosure: Long TNA

Is Chinese growth stalling?

Posted by Cam Hui - July 28, 2016

I have long had much respect for the folks at Lombard Street Research (LSR) for their unusual non-consensus calls. Back in the days of the Tech Bubble when everyone was focused on the likes of Cisco Systems, Lucent, Nokia and other technology darlings, they had said “watch China” as the next engine of growth. That turned out to be the Big Call that made me forever remember them.

It was therefore with great interest when a Bloomberg story came across my desk indicating that LSR believed that China may be in a liquidity trap. While Chinese M1 growth has been picking up sharply, LSR`s estimate of the growth the broad money M3 has been slowing, which led to the conclusion of a possible liquidity trap.

Here is LSR analyst Michelle Lam:

In a research note published on Monday, she writes: “Over the past two quarters, the PBOC has injected liquidity in excess of capital outflows. But our measure of broad money, which is the best indicator of overall monetary conditions, has deteriorated on a year-on-year basis, and fell below its level in 2013-14 and the government’s target.”

Lombard’s ‘M3’ calculation uses the official, so-called ‘M2′ measure, which is a broader measure of money than what’s known as M1, since it includes time deposits as well as cash and current deposits. In order to calculate M3, Lam adds in deposits that are excluded from mere M2, in addition to banks’ stock of bonds, and foreign liabilities.

The monetary picture is complicated further by the fact narrow money growth, or M1, has continued to soar in recent months, diverging with broad money growth.

Lam reckons the private sector is becoming increasingly unresponsive to M1 growth, with it either hoarding liquidity in deposits or deploying it to repair balance sheets.

“The divergence between narrow and broad money growth just highlights how difficult it has become for Beijing to generate growth by throwing money at firms that are unwilling to invest. Stimulus has boosted growth but has few second-round effects, and money is just not being passed around,” she says.

Indeed, LSR`s estimates of Chinese GDP growth has rebounded and now holds steady at about 6%:

…but growth was propped up by the same-old-same-old investment by State Owned Enterprises (black line) while the private sector (white line) has pulled back:

The latest round of debt-fueled investment driven growth have led many analysts to wonder how long Beijing can continue to play the game of artificially boosting growth as it faces diminishing returns to each yuan of stimulus (via Reuters):

Analysts say that determination has come at the cost of a damngerous rise in debt, which is six times less effective at generating growth than a few years ago.

“The amount of debt that China has taken in the last 5-7 years is unprecedented,” said Morgan Stanley’s head of emerging markets, Ruchir Sharma, at a book launch in Singapore. “No developing country in history has taken on as much debt as China has taken on on a marginal basis.”

While Beijing can take comfort that loose money and more deficit spending are averting a more painful slowdown, the rapidly diminishing returns from such stimulus policies, coupled with rising defaults and non-performing loans, are creating what Sharma calls “fertile (ground) for some accident to happen”.

From 2003 to 2008, when annual growth averaged more than 11 percent, it took just one yuan of extra credit to generate one yuan of GDP growth, according to Morgan Stanley calculations.

A new definition of Money

While these developments are worrisome, let me my two cents worth to the data. As someone of Chinese extraction, I can personally attest to the fact that there is a special affinity in Chinese culture to property investment.

The Chinese attitude towards property and the behavior around property is foreign to western culture. As the property bubble grew over the years and analysts wrung their hands over vacant see-through buildings (and therefore billions and billions in non-performing loans), there was a mitigating factor that the Chinese viewed real estate as a store of wealth – call it M3*. In fact, some preferred to leave apartments bought as investment vacant, much as a coin collector might view an un-circulated coin as more valuable. Moreover, the property tax regime encouraged this kind of investment behavior, as property taxes tended to be levied upon sale, rather than as a “wealth tax” for city services as they are in the west.

This attitude towards real estate can also be seen in banking practices. Rather than lend on the ability to service cash flow, as is practiced in the west, Chinese lenders tend to lend on asset value. That’s because accounting statements can be fudged, but asset values are *ahem* solid.

Callum Thomas documented the Chinese attitude towards investment preferences. As the chart below shows, bank deposits and WMP have tended to take the lead, largely because of the minimal investment size required. However, property (orange line) has held steady at about 15% over time.

I would therefore argue that in China, property is a form of money. In light of LSR’s liquidity trap thesis, monitoring what happens to property as money growth (M3* = M3 + real estate) is an important concept in determining the future path of the Chinese economy.

Assessing downside risk

Recently, alarm bells have been ringing over the outlook for China again. Goldman Sachs recently warned that China`s augmented fiscal deficit has ballooned to 15% of GDP.

These signs of sputtering growth and an economy that is becoming less responsive to official stimulus are worrisome signs. These are indications consistent with the Michael Pettis thesis that China has about two years left before it must face some painful adjustments (see How much “runway” does China have left?).

A new monetary framework

The big macro question then becomes, “Is China on the edge of another crisis?” To answer that question, the combination of LSR’s liquidity trap thesis and my observations about property as a form of money leads me to believe that M3* will be an important tool to measure the outlook for China.

So what’s happening to Chinese property? Callum Thomas recently highlighted the continued improvement in Chinese real estate prices. Apocalypse later, right?

Not so fast! Dissecting the property market data further, Tom Orlik found that Tier 1 prices were starting to wobble, but the other cities were enjoying health gains. While the real estate market appears to be healthy on the surface, the weakness in Tier 1 cities is something that needs to be watched carefully.

Tactically speaking, my conclusion is, “So far, so good.” Despite the apparent liquidity trap, the risk of imminent risk of collapse is minimal at the moment. However, the health of the Chinese property market will have to be watched carefully in the future.

Is the consolidation over?

Posted by Cam Hui - July 27, 2016

Mid-week market update: After the stock market rally off the panic Brexit bottom that took SPX to new all-time highs, the market has been in a tight trading range for the last 10 trading days.

As the chart below shows, the 5-day RSI, which is a useful short-term trading indicator,flashed a sell signal several days ago as it retreated from an overbought reading into neutral territory. This “should” have pushed the index down further, especially with the slightly hawkish tone from the Fed today. The logical initial support level is the mid-Bollinger Band, or 20 day moving average (dma), which is rising quickly but current stands at 2140. The next support would the the breakout level at about 2120.

However, the slightly hawkish statement from the FOMC was not enough to push the market below the tight consolidation range. A market with a weaker tone would have fallen to at least test the initial support level, but it hasn’t. The key question for traders is, “Is this consolidation or corrective period over?”

Neutral, but not oversold

My initial conclusion is that, in light of the powerful intermediate-term bullish momentum, the risk-reward is improving for the bulls. This chart from IndexIndicators shows that short-term breadth has retreated from overbought to neutral, but it’s not oversold.

The intermediate-term (1-2 week time frame) net 20-day highs-lows also tell a similar story of a retreat to neutral levels.

In light of the powerful breadth thrust that launched this rally, these readings indicate that the market could bottom out at current levels. While stock prices could pull back further, the market’s resiliency in the face of a hawkish Fed, where a September rate hike is back on the table, indicates a more favorable risk-reward ratio for the bulls.

Buying the leadership

For bullish traders, I can offer a couple of suggestions. I have been following a couple of groups that has been leading the market for the past few months that may be interesting long candidates. First, there are the small cap stocks, which has been recovering nicely since their bottom in February. The chart below shows the relative performance of the two major small cap indices against large caps and the both show similar patterns of market leadership.

In addition, Health Care stocks have also displayed a consistent pattern of leadership since mid-March. The strength in this sector appears to be global, as the bottom panel shows that this sector has also become market leaders in Europe as well.

My inner trader will therefore be dipping his toe in the water on the long side within the next couple of days, likely in one or both of these groups. Stay tuned!