Bulls and bears wait for Godot

Posted by Cam Hui -

Mid-week market update: Several readers wrote me this week with similar comments, which went something like, “I concur with your bullish fundamental reasoning, but the stock market is trading little ‘heavy’ and I am concerned.” I agree 100%. Despite the bullish fundamental and technical tailwinds (see Six reasons why I am still bullish), the market hasn’t been able to break out of the narrow range since the upside breakout in July to new all-time highs.
 

 

Ryan Detrick at LPL Financial characterized this market as a “historic holding pattern”:

What has happened the past four months is truly historic, in that nothing has happened. For equities to trade in this tight of a range near all-time highs is extremely rare and we probably have the election to thank for it, as big money would rather wait until the results before making any moves.

From a technical viewpoint, neither the bulls nor the bears have been able to muster sufficient strength to break this market out of the narrow range. For both sides, they might have well been the characters Vladimir and Estragon in a production of Waiting for Godot. Nevertheless, there are plenty of reasons to be bullish on equities on an intermediate term basis.

Upside breakouts are bullish

The point and figure chart is one way of filtering out the noise of the sideways consolidation since the breakout to all-time highs in July. As this weekly point and figure chart shows, the narrow trading range resolves itself as just an upside breakout. Moreover, the ability of the market to hold above its breakout level is considered to be bullish.
 

 

Monthly MACD buy signal still in force

I recently featured this monthly chart of the Wilshire 5000. In the past, the market has performed well whenever MACD has moved from negative to positive (bottom panel), which it did at the end of September. Despite the sloppy market action in October, MACD remains positive and the MACD buy signal is still in force.
 

 

Risk appetite is holding up

A key measure of market internals is the performance of risk appetite. As the chart below shows, the relative performance of high beta vs. low volatility (top panel), and small caps vs. large caps (bottom panel) remain in relative uptrends.
 

 

In addition, the credit markets are telling a similar story. The chart below shows that US high yield, or junk bonds, are outperforming their duration-equivalent Treasuries and therefore displaying a positive divergence in risk appetite.
 

 

Is it the election?

Ryan Detrick postulated that the sloppiness of market action could be attributable to the upcoming US election. The election is nearly in sight. Sean Emory recently outlined his historical analysis of market performance seven days before the election. In the past, the stock market has performed well before the election and poorly afterwards.
 

 

The seven day windows begins this Friday, October 28, 2016. This seasonal tailwind will be an opportunity for the bulls to show what they can do. It will be the bears turn afterwards.

At a minimum, I would be extremely cautious about being short the market over the next few days.

Disclosure: Long SPXL, TNA

Silver linings in Europe’s political dark clouds

Posted by Cam Hui -

As the American elections approach their final denouement in two weeks, it’s time to look ahead to a number of political dark clouds forming in Europe. FT Alphaville recently highlighted research from Barclay’s showing the collapse in support of establishment parties around the world.

 

The support for anti-establishment and protest parties and candidates have been on the rise – and these individuals represent threats to upset the current political status quo. After the US election in November, we have to look forward to the Italian referendum on December 4, the start of Brexit negotiations in early/mid 2017, the French election, and the German election. All of these events have the potential to tear Europe apart.

I believe that fears over the political disintegration in Europe may be overblown. Arguably, we could be seeing a near-term peak in the support of the protest vote in 2016 and 2017.

The pain in Spain

The first piece of good news came from Spain. After 10 months of impasse, the opposition PSOE abstained in a vote to allow Mariano Rajoy’s PP to form a minority government. Spain had undergone two elections in the last year and was at risk of a third one in the face of deadlocked electoral results, but this compromise allowed the country to have some form of political direction again. Even without a government, Spanish GDP growth was outperforming the euro area:

 

But the deficit is still above target and action is needed to bring it under control. This could not be done without a government in place.

 

Score this as a narrow win for the establishment.

The Italian referendum

Next up, we have the potential disruption caused by the Italian constitutional referendum, which is scheduled for December 4. Italian PM Matteo Renzi called for a national vote to reform the constitution in order to make Italy more governable. This way, his and future governments can minimize the endless political deadlocks that Italy has experienced in the post-war era. Rezni further raised the stakes by stating that he would quit if the “No” vote prevailed, which would open the door to the Euroskeptic Five Star Movement coming to power. Such an electoral failure has the potential to throw the Eurozone into another crisis (think Greece magnified by ten). The combination of a wobbly Italian banking system and an anti-establishment populist party will undoubtedly spook the markets. HSBC has sketched out the possible outcomes of the referendum with this chart (via Daily Express):

 

The latest betting odds from Ladbrokes shows an implied probabilities of “No” at 54% and “Yes” at 46%. The outlook appears bleak.

Peak populism?

However, the future may not be as dire as it seems. Even if Renzi were to lose the referendum, the Five Star Movement may not form the next government. In the past few years, we have either seen a collapse in the anti-establishment vote as a country approaches the brink (Le Pen in France, Trump in the US), or the failure of reform programs put forth by Euroskeptic parties.

For example, consider the experience of SYRIZA in Greece. SYRIZA was elected twice in consecutive elections on an anti-European platform. The (then) new government underwent some difficult negotiations with the Eurogroup. During the course of the discussion, Prime Minister Alexis Tsipras gambled and called a disastrous referendum on European proposals. He won his mandate to say “no” to Europe, but eventually backed down and acquiesced to even more unfavorable terms than what was originally offered. Despite these setbacks, Greece did not leave the euro, and the world did not end.

Europe made an example of Greece. Undoubtedly other Europeans were watching.

In Italy, the Five Star Movement (M5S) made some surprising gains in local elections as its candidates won the mayoral race in Turin and Rome. Even then, the party ran into trouble. Here is the BBC`s account:

Five Star’s newly elected mayor of Rome, 38-year-old lawyer Virginia Raggi, finds herself in trouble.

She has picked an environment chief, Paola Muraro, who is currently under investigation for her 12-year period as a consultant for the city’s waste company. And sorting out Rome’s rubbish collection is one of the city’s most important jobs.

What’ is worse is this: At first Ms Raggi denied knowing about the criminal investigation. Weeks later she admitted that Ms Muraro had, in fact, told her about it in July.

Deny-and-then-admit is a damaging political combination.

The episode strikes at the heart of the Five Star Movement’s reputation.

M5S made its name through its anti-corruption promises. Now, it finds itself bogged down in the same ground as other Italian political parties routinely accused of mismanagement and corruption.

Here is The Economist’s Intelligence Unit on the political headwinds faced by M5S:

The Raggi administration has had a difficult start. The formation of the city government was delayed owing to disagreements within M5S regarding appointments, with the national leadership of the movement seen to impose its will in the end. The capital’s citizens have high expectations of Ms Raggi, so even though she only came into office at the end of June, their patience might run out quickly if she is not seen to be solving problems. Intense media attention on the continued build-up of uncollected rubbish on the streets of the city has not helped. According to one opinion poll by a market researcher, Winpoll, for the Huffington Post, an online news source, in early August, 41% of those surveyed in Rome viewed Ms Raggi’s performance as positive and 59% did not.

Ms Raggi will be keen to avoid the fate of Federico Pizzarotti, the mayor of Parma and M5S’s first leader of a major municipality. In 2012 Mr Pizzarotti came into office under similar circumstances to Ms Raggi: Parma had been chronically mismanaged by previous administrations and was on the verge of a municipal debt crisis. The M5S mayor, previously an IT consultant with no experience in government, quickly became a symbol for Mr Grillo and his party. However, despite implementing a number of reforms and making headway towards improving Parma’s accounts, Mr Pizzarotti eventually fell out with Mr Grillo and Mr Casaleggio. Owing in part to his investigation for allegedly abusing his office, Mr Pizzarotti was expelled from M5S in May 2016. He currently remains in office and denies any wrongdoing. Given the higher profile of Ms Raggi’s role, M5S’s national leaders will be keen to avoid airing any tensions with her administration so publicly. A perception that Ms Raggi has done too little to change Rome, like Mr Pizzarotti in Parma, could eventually be damaging for M5S at the next general election, but in our view it is unlikely that any missteps will be enough to benefit Mr Renzi and the PD before the referendum.

Like SYRIZA, M5S has demonstrated a spotty record in actually being able to govern once it’s in power. The experience in Rome and Parma could be viewed with skepticism by the Italian electorate should Renzi lose the referendum and fresh elections are called.

Brexit chaos: pour encourager les autres

For the ultimate in the success of the protest vote, we have to look not further than the mess called Brexit. In the wake of the referendum, prime minister Theresa May has signaled a “hard Brexit” in her recent speech to the Conservative Party faithful:

Whether people like it or not, the country voted to leave the EU. And that means we are going to leave the EU. We are going to be a fully-independent, sovereign country, a country that is no longer part of a political union with supranational institutions that can override national parliaments and courts. And that means we are going, once more, to have the freedom to make our own decisions on a whole host of different matters, from how we label our food to the way in which we choose to control immigration.

European directives will be replaced by British law:

The final thing I want to say about the process of withdrawal is the most important. And that is that we will soon put before Parliament a Great Repeal Bill, which will remove from the statute book – once and for all – the European Communities Act.

This historic Bill – which will be included in the next Queen’s Speech – will mean that the 1972 Act, the legislation that gives direct effect to all EU law in Britain, will no longer apply from the date upon which we formally leave the European Union. And its effect will be clear. Our laws will be made not in Brussels but in Westminster. The judges interpreting those laws will sit not in Luxembourg but in courts in this country. The authority of EU law in Britain will end.

As we repeal the European Communities Act, we will convert the ‘acquis’ – that is, the body of existing EU law – into British law. When the Great Repeal Bill is given Royal Assent, Parliament will be free – subject to international agreements and treaties with other countries and the EU on matters such as trade – to amend, repeal and improve any law it chooses. But by converting the acquis into British law, we will give businesses and workers maximum certainty as we leave the European Union. The same rules and laws will apply to them after Brexit as they did before. Any changes in the law will have to be subject to full scrutiny and proper Parliamentary debate. And let me be absolutely clear: existing workers’ legal rights will continue to be guaranteed in law – and they will be guaranteed as long as I am Prime Minister.

Bloomberg set out a chart of the relationships between European countries and their obligations. Under Theresa May’s vision for Britain, the UK start from the beginning and it be totally out of any and all treaty obligations with Europe.

 

Is it any wonder why the markets got spooked? In the wake of those statements, Nicola Sturgeon of SNP has called for another Scottish independence referendum in the event of a “hard Brexit”. In case anyone thought that the UK could easily conclude a successful trade agreement with the EU, the failure of the Canada-EU free trade agreement (CETA) over Wallonia objections represents a cautionary tale of how difficult trade deals are to negotiate. As a final insult, the lead EU negotiator has called for the talks to be conducted in French.

Forget a “hard Brexit”, Politico reported that a “dirty Brexit” is on the table after the latest European Council meeting;

At just after 1:30 a.m., Tusk appeared, bleary eyed, to explain the silence. “There will be no negotiations until Article 50 is triggered by the U.K., so we did not discuss Brexit,” he said.

Yet he couldn’t resist setting out the EU’s equally hardline position — no restrictions on free movement of people as well as goods, capital and services within Europe’s single market. “The basic principles and rules, namely the single market and the indivisibility of the four freedoms, will remain our firm stance.”

In other words: say what you like about taking back control of immigration, May, we hold all the cards in this negotiation.

Behind the scenes, EU officials have been given equally firm instructions.

Senior diplomats have been told to prepare for the possibility of no agreement being struck at all after two years of talks, two EU diplomats told POLITICO. On Thursday, David Davis, the Brexit Secretary, said that without a deal, the British economy could fall off a “cliff edge.”

If Europe wanted to make an example of Greece, it intended to make a even greater example of the UK, pour encourager les autres.

Is the European electorate watching?

Back from the brink

As chaos reigns, there are ways for both the Italian and British governments to claw their way out of the holes that they find themselves in. The WSJ reported that Matteo Renzi’s government approved a budget that raised its deficit targets, in defiance of EU guidelines:

Italy’s government on Saturday approved a 2017 budget plan that aims to avert tax increases as Prime Minister Matteo Renzi faces increasing pressure ahead of a national referendum over constitutional changes…

With the plan approved Saturday, the Italian government raised its budget deficit target to 2.4% of gross domestic product this year and to 2.3% in 2017, from its previous targets of 2.3% and 2.0% respectively, which could bring Italy into conflict with European Union rules aimed at reining in member states’ deficits.

Megan Greene interpret this move as typical European brinkmanship. Renzi is in effect telling Europe, “Either deal with me, or you’ll be dealing with the Five Star Movement next.”

 

Meanwhile, Canadian political scientist David Welch speculated that Theresa May’s latest initiatives are setting up the Brexiteers to fail:

Ms. May opposed Brexit before the referendum and has given no indication that she has since converted to the cause. Like any savvy politician, she cannot simply ignore the express will of the voters, but she knows as well as anyone that Brexit would be bad for Britain – and particularly bad for Theresa May. She has no interest in going down in history as a footnote to David Cameron’s folly, the overseer of Britain’s diminution, and possibly even the person who destroyed the United Kingdom, if Scottish voters prove sufficiently unhappy with the best deal London can strike with Brussels to vote to leave Britain and remain in the EU.

If Ms. May is preparing the groundwork to stay, she is doing it brilliantly. By stretching out the timetable as far as possible without raising anyone’s suspicions, she has given ample time to let Brexit buyer’s remorse gel. Bankers and major foreign investors such as Nissan have begun to signal their readiness to leave. Local councils are beginning to tally EU funds they will lose. Scottish nationalists are stirring.

Meanwhile, Ms. May has set up key Tory Brexit supporters to fail by giving them thankless cabinet assignments: Boris Johnson (Foreign Secretary), David Davis (EU Exit Secretary) and Liam Fox (International Trade). As time passes, it will become increasingly clear that none can hope to deliver what they promised the voters in June.

Don’t be surprised in March if, instead of triggering Article 50, Ms. May calls a snap election asking for a mandate to be released from her Brexit obligation. Striking a stateswomanlike pose, she could persuasively argue there is no good Brexit deal to be had and that Brexit voters, sold a bill of goods by the likes of UKIP’s Nigel Farage, voted in June on the basis of incomplete and inaccurate information and have a right to sober second thought. She could avoid the risk of a second referendum by correctly noting that a general election is the traditional means by which British governments seek mandates from the electorate. And she may be able to offer up a sweetener in the form of a “better deal” from Brussels than Mr. Cameron was able to muster.

The scenarios that I have laid out are highly speculative, but they are typical of the sturm und drang of European theatre. (That’s why the actors in this theatrical performance involved are politicians – they play politics.)

In the end, the worst case analysis may not be that dire. In fact, this may be precisely the sort of catharsis that the European electorate needs to see that anti-establishment and Euroskeptic parties may not offer the solutions they truly desire. In fact, those roads lead to disasters like the SYRIZA capitulation and Brexit chaos.

In the meantime, Markit reported that its Eurozone Composite PMI rose to a 10-month high and beat market expectations. Growth is surprising to the upside.

 

The European elites have everything under control (for now). All is right in the world.

When does the Fed remove the punch bowl?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

How will the Fed fight the next war?

In my last post (see A sentimental embrace of risk), I showed that risk appetite was starting to perk up. Investor interest is rising in both the reflation and cyclical investment themes. So far, this risk-on thesis is showing solid fundamental underpinnings.

The bearish strategists at Goldman Sachs and HSBC who had forecasted a disappointing Q3 earnings season have so far been wrong (see Q3 earnings season: Stud or dud?). With 23% of SPX companies having reported earnings, John Butters of Factset observed that both the EPS and sales beat are well above their 5-year historical averages. As a result, Street optimism continues to improve as forward 12-month EPS rose another 0.16% in the week (chart annotations are mine).

 

The stock market is on pace to rally on the back of a growth revival and the end of the earnings recession that began in late 2014. This party is just starting to going. The only question is when the Fed will act to take away the punch bowl. This issue is becoming a crucial question for investors, as speeches from Yellen and Fischer last week may indicate that the Fed is signaling the start of a shift in thinking of how it fights the next war, persistent low growth.

The reflation trade bandwagon is rolling

I have been writing about the reflation trade for several months (see How the SP 500 can get to 2200 and beyond published on June 19, 2016). Last week, it seemed that the whole market was jumping into the reflation and risk-on trade.

BAML strategist Michael Hartnett made the long-term case for buying hard assets because their relative value had gotten out of whack (charts via Zero Hedge).

 

Commodity prices have become extremely cheap on a multi-decade basis.

 

Momentum is turning positive for the reflation trade. The BAML Funds Flow report showed that clients were starting to rotate away from defensive assets and yield plays into cyclical and inflation hedge vehicles.

 

Inflationary pressures building

The market consensus is starting to shift in favor of an inflationary revival. Frederik Ducrozet noted that the return of inflationary expectations is occurring across major developed markets, with the UK in the lead, followed by the US and the eurozone.

 

Deutsche Bank pointed out that US inflation is trending upwards, no matter how it’s measured (chart via Marketwatch).

 

AllianceBernstein got into the act and asked if it is too late to catch the emerging market rally. The short answer is, “No”.

 

The latest update from the Fed’s Beige Book shows either “modest or moderate expansion” accompanied by “tight” labor markets, which is another signal of steady growth. In the chart below, I have calculated the number of times in a rolling 12-month period when the annualized monthly core PCE inflation rate has exceeded 2%. In the past, the Fed has begun a tightening cycle whenever the count reached six. The only exception occurred in 2011, when this metric hit the six-month tripwire as Europe underwent its Greek debt crisis. The latest reading is five – we are not far away from another tightening cycle.

 

Even if the Fed were to raise rate, initial interest rate hikes tend to be stock market bullish, as market participants tend to focus more on the positive effects of rising growth expectations rather than the negative effects of rate increases. That scenario is starting to play out today. Scott Grannis pointed out that chemical activity tends to lead industrial production. Currently, chemical activity is on an upswing and industrial production should follow shortly.

 

Grannis also observed that swap spreads are not signaling any signs of high systemic risk, indicating a benign equity backdrop.

I’ve long argued that swap spreads are excellent indicators of systemic risk and financial market health. When swap spreads are 40 bps or less, it’s a sign that financial markets are liquid and systemic risk is very low. (See a longer explanation for the meaning of swap spreads here.) U.S. 2-yr swap spreads are just about perfect at current levels. Eurozone spreads are trading at the high end of what might be termed a “normal” range, but that probably reflects the fact that conditions in Europe are not as stable as they are here. In any event, swap spreads today are far less than what they have been during times of great economic stress and anxiety. Today’s level of swap spreads is symptomatic of healthy liquidity conditions and an economy with relatively low systemic risk, and that adds up to a bulwark against recession.

 

Earnings growth, which is a key driver of equity prices, looks solid. Factset pointed out that EPS growth would be positive in four of the last five quarters on an ex-energy basis.

 

Q3 will likely the inflection point for YoY EPS growth. As the chart below shows, oil prices are no longer a drag on Energy sector earnings. Freed of this headwind, YoY earnings growth should turn positive in Q3 and accelerate into Q4 and next year.

 

Barron’s reported that insiders are continuing to buy equities, which suggest that the intermediate term outlook for stocks is still bullish.

 

For investors who want to participate in the reflation and cyclical revival themes, the chart of relative returns below shows that the sector leadership is in technology and semiconductors. It maybe too early to buy inflation hedge plays like energy and mining as they are still showing relative consolidation patterns.

 

A cyclical market top in 2017?

My base case scenario has called for the stock market to rally in response to a growth revival. In response to rising growth and inflationary pressures, the Fed then begins an interest rate tightening cycle. Eventually, rising rates slow the economy down sufficiently to tank the growth outlook and stock prices. The fragility of foreign economies, particularly in China and Europe, have the potential to drag the world into another synchronized global recession and a significant equity bear market.

Ambrose Evans-Pritchard recently painted an Apocalyptic outcome where rising US interest rates topples the global economy:

The risk of a US recession next year is rising fast. The Federal Reserve has no margin for error.

Liquidity is suddenly drying up. Early warning indicators from US ‘flow of funds’ data point to an incipient squeeze, the long-feared capitulation after five successive quarters of declining corporate profits.

Yet the Fed is methodically draining money through ‘reverse repos’ regardless. It has set the course for a rise in interest rates in December and seems to be on automatic pilot…

If allowed to happen, it will be a deeply frightening experience, rocking the global system to its foundations. The Bank for International Settlements estimates that 60pc of the world economy is locked into the US currency system, and that debts denominated in dollars outside US jurisdiction have ballooned to $9.8 trillion.

The world has never before been so leveraged to dollar borrowing costs. BIS data show that debt ratios in both rich countries and emerging markets are roughly 35 percentage points of GDP higher than they were at the onset of the Lehman crisis.

This time China cannot come to the rescue. Beijing has already pushed credit beyond safe limits to almost $30 trillion. Fitch Ratings suspects that bad loans in the Chinese banking system are ten times the official claim.

The current arguments over Brexit would seem irrelevant in such circumstances, both because the City would be drawn into the flames and because the eurozone would face its own a shattering ordeal. Even a hint of coming trauma would detonate a crisis in Italy.

A shift in Fed policy?

That dire scenario may not happen. That’s because the Fed might stretch its rate normalization process far more than anyone expects. Two key speeches from Fed officials gave important clues about how Fed policy might be changing.

The first speech was Janet Yellen’s “high-pressure economy” speech on October 14, 2016. Her discussion of “hysteresis” sounds remarkably similar to Larry Summers’ concerns about secular stagnation:

The idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy–an effect commonly referred to as hysteresis–is not new; for example, the possibility was discussed back in the mid-1980s with regard to the performance of European labor markets. But interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand. With regard to the U.S. experience, one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to several developments that likely occurred as a result of the deep recession and slow recovery. In particular, the study finds that in the wake of the crisis, the United States experienced a modest reduction in labor supply as a result of reduced immigration and a fall in labor force participation beyond what can be explained by cyclical conditions and demographic factors, as well as a marked slowdown in the estimated trend growth rate of labor productivity. The latter likely reflects an unusually slow pace of business capital accumulation since the crisis and, more conjecturally, the sharp decline in spending on research and development and the very slow pace of new firm formation in recent years.

Yellen indicated that one possible solution would be to run a “high-pressure economy”, where policy is looser and more inflationary as a cyclical counterweight to the secular forces of low demand:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

The “high-pressure economy” proposal is really a rehash of Yellen’s advocacy of optimal control theory, which she outlined in a November 13, 2012 speech:

To derive a path for the federal funds rate consistent with the Committee’s enunciated longer-run goals and balanced approach, I assume that monetary policy aims to minimize the deviations of inflation from 2 percent and the deviations of the unemployment rate from 6 percent, with equal weight on both objectives. In computing the best, or “optimal policy,” path for the federal funds rate to achieve these objectives, I will assume that the public fully anticipates that the FOMC will follow this optimal plan and is able to assess its effect on the economy.

The blue lines with triangles labeled “Optimal policy” show the resulting paths. The optimal policy to implement this “balanced approach” to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016, about two quarters longer than in the illustrative baseline, and keeping the federal funds rate below the baseline path through 2018. This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the Committee’s 2 percent objective for several years.

 

 

While the “high pressure economy” issue was posed as a research question by Yellen and therefore not a statement of an official shift in Fed policy, last week’s speech by the more hawkish Stanley Fischer was a surprise. Fischer has long been an advocate of higher rates. Indeed, he signaled his hawkishness by stating that the Federal Reserve is “very close” to its employment and inflation targets (see Reuters story). In the same speech, Fischer explored the problem of persistently low interest rates. He began by worrying out loud that the Fed may be running out of bullets in the next downturn when interest rates are so low, but added that raising rates may not be as simple as it looks:

Notwithstanding the increase in the federal funds rate last December, the federal funds rate remains at a very low level. Policy rates of many other major central banks are lower still–even negative in some cases, even in countries long famous for their conservative monetary policies. Long-term interest rates in many countries are also remarkably low, suggesting that participants in financial markets expect policy rates to remain depressed for years to come. My main objective today will be to present a quantitative assessment of some possible factors behind low interest rates–and also of factors that could contribute to higher interest rates in the future.

Now, I am sure that the reaction of many of you may be, “Well, if you and your Fed colleagues dislike low interest rates, why not just go ahead and raise them? You are the Federal Reserve, after all.” One of my goals today is to convince you that it is not that simple, and that changes in factors over which the Federal Reserve has little influence–such as technological innovation and demographics–are important factors contributing to both short- and long-term interest rates being so low at present.

Fischer went on to explore the problem of persistent low growth, otherwise known as hysteresis, or a low r*:

There are at least three reasons why we should be concerned about such low interest rates. First, and most worrying, is the possibility that low long-term interest rates are a signal that the economy’s long-run growth prospects are dim. Later, I will go into more detail on the link between economic growth and interest rates. One theme that will emerge is that depressed long-term growth prospects put sustained downward pressure on interest rates. To the extent that low long-term interest rates tell us that the outlook for economic growth is poor, all of us should be very concerned, for–as we all know–economic growth lies at the heart of our nation’s, and the world’s, future prosperity.

WTF? Did Fischer really say that? Is Fischer moving closer to Yellen’s position? Is this a signal that the Fed is starting to pivot towards a persistent low growth scenario, which would mean lower rates for longer?

I have no idea. As investors, however, we need to pay attention to how the Fed’s reaction function is evolving (or not). This is about anticipating how the Fed fights the next war. Investors who make the right call on that question should be able to profit handsomely.

For now, my base case scenario is still based on the standard central banker cyclical response of rate normalization. However, I am allowing for the possibility that rates could stay low for much longer than anyone expects. The latter case translates into an extended bull market for inflation hedge sectors and assets.

We should get a much better idea of the evolution of Fed policy in early 2017.

The week ahead: Don’t be short

Looking to the week ahead, the combination of a better than expected Q3 earnings season, positive seasonality, and a mildly oversold condition are creating bullish tailwinds for stock prices. Last week was October option expiry. As Jeff Hirsch pointed out, October OpEx tends to see volatile swings but a positive market bias. The SPX rose 0.4% last week, which is typical of the market action in Hirsch’s historical studies.

At a minimum, traders should be wary about going short. I pointed out last week that the market is entering a period of positive seasonality (via Callum Thomas).

 

With SPX returns still negative for October, the potential for a rebound is high. Mark Hulbert observed that the rebound from October lows to the end of the following month, namely November, is the best of the year. Score another point for positive seasonality.

 

However, other historical studies are showing mixed results. On one hand, Jeff Hirsch indicated that the week after October OpEx, which is next week, has tended to see a positive market bias.

 

On the other hand, Hirsch pointed out in a separate post that the market tends to be weak two weeks before the election, which is also next week, and strong thereafter.

 

Selected short-term sentiment models are showing mildly oversold readings, though the market could get more oversold. The Fear and Greed Index is one such example.

 

Rydex funds flows are showing a similar condition where the market has bottomed in the past. However, fear levels could go higher.

 

I have also found decent buy signals whenever NAAIM exposure falls to the bottom of its Bollinger Band. Current readings show that we are very close to a buy signal.

 

The chart below of the NYSE McClellan Summation Index is showing an oversold condition. In the past, such readings have tended to see limited downside risk for the market.

 

In the meantime, the market remains range bound since its July upside breakout. While it has retreated to test the 2120 breakout turned support level several times, that support has held.

 

I have no idea of what might happen next week, but a combination of bullish trend of earnings and sales beats, positive seasonality, and supportive sentiment readings makes me leery about being short the market. Both my inner investor and trader are bullishly positioned.

Disclosure: Long SPXL, TNA

An sentimental embrace of risk

Posted by Cam Hui -

Mid-week market update: When traders refer to “institutions” in the context of sentiment analysis, often the impression is that institutions represent some monolithic entity. Nothing could be further from the truth. I tend to analyze institutional sentiment by segmenting them into four distinct groups, each with their own data sources:

  • US institutions, whose sentiment can be measured by Barron’s semi-annual Big Money Poll
  • Foreign and global institutions, as measured by the BAML Fund Manager Survey (FMS), which is conducted on a monthly basis;
  • RIAs, as measured by the NAAIM survey, conducted weekly; and
  • Hedge funds, as measured by option data and the CFTC futures Commitment of Traders data, though hedge funds are partly represented in the BAML FMS sample.

Each group is different and they can behave differently. The first three tend to represent slow but big money, while hedge funds represent the fast and high turnover money.

The differing groups of institutions don’t always agree. Today, however, the US and global institutions all seem to have formed similar views. Institutional investors are bearish on bonds and they are becoming increasingly bullish on stocks, based on a belief that growth is improving.

Under these circumstances, the key question for traders and investors is whether they should jump on bullish equity bandwagon or be contrarian and fade the institutional purchases.

How the surveys are different

Before answer that question, I would first like to examine the data and discuss the pros and cons of each data set. Barron`s Big Money Poll is conducted every six months and the survey is done on a sample of US-based managers. While the survey frequency may not necessarily be to our liking, institutional money is slow money and therefore a semi-annual survey is not necessarily a problem because of the relatively low turnover of this investor group. The main shortcoming of the Barron’s poll is it provides only a snapshot of respondent attitudes, with little history of responses. As an example, we can see that managers are tilted bullishly, but how does that compare to its own history?

 

The BAML FMS is conducted monthly and the sample size is broader and it is composed of managers with a global outlook. There are many non-US managers in that survey. The questions tend to cover global issues and not just US domestic ones. A comparison of the responses between the Barron’s Big Money Poll and the BAML FMS can be revealing as foreign and US managers don’t always agree. Unlike the Barron’s poll, the BAML FMS does provide a history of responses, which can be useful as it gives us an idea of whether managers are in a crowded long or short position. However, the published questions are not always consistent from one month to the next. As an example, the September report showed the equity positioning of hedge funds was an extreme. What happened next? The October report gives no details.

 

By contrast, the NAAIM survey is conducted on a weekly basis and the sample are RIAs who manage retail accounts. The NAAIM survey only asks a single bull vs. bear question and lacks the depth of the other surveys, which asks questions about macro-economic issues and asset and sector preferences. As the chart below shows, the NAAIM data (bottom panel) has tended to be more useful as a buy signal when RIAs are panicked (vertical blues lines) than as sell signals when RIAs are complacent (grey areas). Currently, RIAs have been ramping up their equity exposure from the January market bottom but readings are not extreme yet.

 

Bond bears

The one characteristic that stands out from both the Barron’s and BAML surveys is a high degree of bond market bearishness. I have seen some analysts point to the high level of cash from the BAML FMS as a sign of cash on the sidelines waiting to go into the stock market, but that is a misinterpretation of the data.

 

Even though cash levels are high, equities are roughly at neutral weight.

 

Cash is high because funds have come out of the bond market.

 

We are seeing a similar level of caution in the Barron’s Big Money Poll.

 

Better growth ahead

In effect, institutions are becoming more cautious on the bond market in anticipation of Fed action to raise rates because of a better growth outlook,

 

Barron’s is showing a similar response.

 

Rising risk appetite

Managers are starting to raise their risk appetite because of their better growth outlook. Overall positioning shows an underweight in risky assets.

 

We can see similar hints of rising risk appetite from the Barron’s Big Money Poll. Barron’s reported that bullishness increased from record low levels, which suggests that managers are far from a crowded long position [emphasis added]: “Our latest poll finds 45% of respondents bullish or very bullish about the market’s outlook through the middle of 2017, up from the spring poll’s record-low tally of 38%.”

The BAML FMS shows that managers are slightly underweight in US equities.

 

The magnitude of the bullishness in the Barron’s survey appears to be relatively modest. Managers believe that the SPX will only appreciate 7% to June 2017 and a further 3% to December 2017. A one-year expected return of 10% on the stock market doesn’t seem like wild bullishness.

 

If we get an upside growth surprise, the potential for a FOMO melt-up is high (see Q3 earnings season: Stud or dud?). Equity weights within balanced portfolios are still low by historical standards.

 

Hedge funds and individuals

No review of sentiment models would be complete without an understanding of hedge fund and individual investor positioning. The picture on the fast money is mixed. On one hand, COT data from Hedgopia shows that large speculators, or hedge funds, have moved from a net long to net short position in SPX futures.

 

On the other hand, large speculators remain in a crowded long in high-beta NASDAQ futures.

 

Option sentiment isn’t giving a clear picture either. The term structure of the VIX is showing a neutral reading, somewhere between extreme fear and complacency.

 

Individual investors and traders appear to be similarly confused. Both the AAII and Rydex are in neutral, with a slight bearish tilt, which is contrarian bullish. These readings could be interpreted bullishly given the market is very close to its all-time highs.

 

The TD-Ameritrade Investor Movement Index, which surveys the aggregate actions of its account holders, shows a pattern similar to NAAIM. Individual investors have been buying the market since the January bottom, but readings are not at an extreme level yet.

 

Investment conclusions

Sentiment analysis is showing that investors of all stripes are starting to embrace the idea of renewed growth. Risk appetite is growing, but portfolio positioning are nowhere near crowded long extremes yet. The fast money traders have been quick to jump on the developing bullishness, but have pulled back their exposure a bit as the market has consolidated sideways.

We are in a holding pattern, but if the positive macro momentum were to continue, there is plenty of room on the bullish bandwagon.

 

Disclosure: Long SPXL, TNA

Q3 earnings season: Stud or dud?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Is the earnings recession over?

Regular readers will know that I have been bullish on stocks for the last few months. My forecast has called for an equity rally into year-end and beyond. Last week, a couple of Street strategists have turned cautious on the stock market. I would therefore like to examine the bear cases that they present.

Bloomberg reported that Goldman Sachs strategist David Kostin set an SPX year-end target of 2100. The main reason for the bearish call is earnings disappointment.

“Variables that determine earnings surprises – changes in U.S. economic growth, interest rates, oil price, the dollar, and EPS [earnings per share] revisions – suggest a below-average share of firms will report positive earnings per share surprises (43 percent vs. 46 percent),” he writes in a note to clients. ” We see a weak third-quarter reporting season coupled with negative fourth-quarter EPS revisions pushing stocks 2 percent lower to our year-end target of 2,100.”

 

 

Bloomberg also reported that HSBC strategist Ben Laidler also sounded a cautious note, based on valuation and likely earnings disappointment:

“We think markets are pretty vulnerable. You have earnings expectations which are pretty high, you have valuations which are pretty high,” he said. “You look around the world, the level of economic-policy uncertainty is very, very high — I think that is a dangerous combination right now.”

As I will show, at the core is the bull vs. bear debate is whether the earnings recession ended in Q3 2016.

How expensive are stocks?

First, I would like to address the issue of market valuation, which HSBC analyst Ben Laidler raised. How cheap or expensive is the stock market?

The indirect evidence does not suggest that the market is expensive. The latest update of insider activity from Barron’s shows that this group of “smart investors” have been steadily buying in the last few weeks. While insider trading data is noisy and readings can be volatile from week to week, it’s difficult to reconcile the idea of smart money buying an expensive market.

 

John Butters at Factset reported this week that the SPX trailing P/E ratio is 19.4. At first glance, that appears to be well above the historical average and that P/E ratio has only been exceeded by the market P/E during the Tech Bubble of the late 1990s. However, inverting the P/E ratio to an earnings yield of 5.2%. With the 10-year Treasury yield at 1.8%, there is a certain element of TINA (There Is No Alternative to stocks) that is supportive of the equity bull case.

 

What if interest rates were to rise? Wouldn’t that make stocks less attractive? Analysis from JPM Asset Management shows that when 10-year rates are below 5%, stock price movements are positively correlated with changes in interest rates.

 

Other historical studies have shown that stock prices tend to rise even when the Fed first starts a rate hike cycle. That’s because the Fed raises interest rates to cool down an economy that’s growing to quickly. The market initially focuses on the positive effects of better growth, rather than the negative effects of higher interest rates.

In the current environment where the Fed is about to raise rates, the equity valuation vulnerability issue becomes a question of whether better earnings growth can overcome the negative effects of a likely December rate hike. Is the earnings recession over? Can stocks continue to rise in anticipation of better earnings?

The earnings recession in context

To put the recent earnings recession into context, the latest Factset report shows that trailing 12-month EPS peaked in late 2014, along with the oil price, and they have been falling ever since (annotations in red are mine).

 

The bear case

The bear case rests mainly on deceleration macro data. The Atlanta Fed’s nowcast of Q3 GDP growth has fallen to 1.9%. The NY Fed`s nowcast stands at 2.3%. Both figures are considerably lower than the levels seen in late August when the nowcasts were in the 3.0-3.5% range.

 

At the same time, New Deal democrat`s monitor of high frequency economic data shows that the economy is starting to wobble. While long leading indicator remain strong, short leading indicators are starting to weaken, and coincident indicators are mixed. While the persistent mixed readings in the coincident indicators are reflective of the mild industrial recession, the deterioration in short leading indicators is more disturbing. NDD concluded:

A great deal depends on whether the recent lows in interest rates translate into an increase in the new housing market. This coming week we will get housing permits and starts, which assume even more importance that usual, especially as mortgage applications – positive for now – nevertheless look like they are getting ready to roll over.

In other words, don’t panic, but watch for more developments.

The bull case

While the bear case for equities stems from top-down macro analysis, much of the bull case can be attributable to bottom-up derived fundamentals. The latest Q3 estimate of YoY EPS growth is -1.8%, but Q3 may be the bottom for earnings growth (annotations in red are mine).

 

John Butters pointed out that a meagre -1.8% YoY growth estimate is not such a big hurdle. If results came in line with the beat rate results seen in a typical earnings season, it would be enough for EPS to return to positive YoY growth:

Over the past four years on average, actual earnings reported by S+P 500 companies have exceeded estimated earnings by 4.3%. During this same time frame, 68% of companies in the S+P 500 have reported actual EPS above the mean EPS estimates on average. As a result, from the end of the quarter through the end of the earnings season, the earnings growth rate has typically increased by 2.9 percentage points on average (over the past four years) due to the number and magnitude of upside earnings surprises.

If this average increase is applied to the estimated earnings decline at the end of Q3 (September 30) of -2.0%, the actual earnings growth rate for the quarter would be 0.9% (-2.0% + 2.9% = 0.9%). If the index does report growth in earnings for Q3 2016, it will mark the first time the index has recorded year-over-year growth in earnings since Q1 2015 (0.5%).

Much of the earnings recession can be attributed to a higher USD and lower oil prices. The chart below shows the JPM Asset Management estimate of the effects of USD strength on SPX revenues over the last few years.

 

The USD has been roughly neutral on a YoY basis in Q3, so the negative effects of USD strength are gone.

 

Here is the JPM Asset Management’s estimates of the effects of lower energy prices on SPX earnings.

 

On a YoY basis, oil prices are flat to slightly positive (see bottom panel).

 

Here is a chart of natural gas prices. The YoY effect is even more positive than crude oil.

 

As those macro headwind abate, is it any surprise that forward 12-month EPS are being revised upwards? In addition, Thomson-Reuters reported that Q3 earnings guidance, or preannouncements, has come in more positively than the historical experience.

 

The bond market seems to agree with the assessment of higher growth. Despite the rise in 2-year yields in anticipation of a December rate hike, the 2/10 yield curve steepened, which is an indication that the bond market expects rising growth.

 

At the end of the day, the key to stock prices will be the report card from Q3 earnings season. Will it surprise us on the upside or downside? While the signs of macro weakness are worrisome, I find it difficult to believe that Q3 earnings season will disappoint without any indications from the troops on the ground. Company guidance has been more upbeat than usual, and Street analysts have not found signs of aggregate deterioration.

The early results from earnings season is encouraging for the bulls. Factset reports that with 7% of index components having reported, the earnings beat rate is 76% (vs. 5-year average of 67%). The sales beat rate came in at 62% (vs. 5-year average of 54%). Moreover, the Q4 negative guidance rate is only 67% (vs. 5-year average of 74%). However, these results are highly preliminary and we should get a better idea of how earnings season is progressing next Friday.

One possible explanation for the divergence between top-down and bottom-up data analysis is the macro bears are reacting to lagging signals of economic weakness. The Citigroup US Economic Surprise Index (ESI) measures whether high frequency economic releases are beating or missing expectations. As the ESI chart below shows (gold line), the index had been falling but it has recently stabilized, indicating the start of a possible turnaround.

 

What could go right

There is a possibility that the bears have become overly negative. They have focused too much on the downside risks to the economy. Jim Paulsen at Wells Fargo Asset Management recently asked the question, “What could go right?”

Here are the upside risks that he named (shown in bold, with my comments after each bolded point):

  • What if the global economy experiences a global bounce?
  • What if the US finally adds a little leverage? These charts of the household finances (via JPM Asset Management) shows that the consumer has repaired her balance sheet and could be ready to spend again.

 

 

  • What if US productivity bounces?
  • What if the US gets a capital spending cycle?
  • What if monetary velocity bounces?
  • What if US housing has a surprising second half run? Bill McBride at Calculated Risk, who closely monitors the housing industry, sees no recession on the horizon in 2017 or 2018. Data from JPM Asset Management shows that housing is extremely affordable right now. With consumer finances in good shape, the potential for continued growth from the housing sector is high.

 

 

  • What is there’s a retail rush to stocks? The latest TD-Ameritrade Investor Movement Index indicates that retail investors are warming up to equities again, though readings are nowhere near extreme levels.

 

 

  • What if animal spirits finally show up? The chart below shows the relative performance of high beta stocks relative to low volatility stocks as a measure of risk appetite. While risk appetite has only begun to recover, the recovery is incomplete and we are nowhere near levels that signal investor euphoria.

 

 

Paulsen cautioned that it may be too early to get

We are impressed by how much potential still exist relative to how little most expect from the balance of this recovery. Since the recovery has proved disappointing for so many years, the expectations bar is extraordinarily low. The disconnect between recovery potential and expectations could be powerfully profitable. Earnings growth has been negative for two years and even a modest improvement in earnings may be perceived as a great relief. Global economic growth has been so bad for so long it really doesn’t need to quicken to impress. If it simply synchronized, it would feel different and much improved relative to any other time in this recovery. A bounce in productivity, an upturn in capital spending or improved housing activity would definitely surprise and inspire.

Then there are the real shockers. What if money velocity started rising and boosted business sales like never before in this recovery? What if the household and/or the business sector decided to take their recently retrofitted and markedly improved balance sheets out for a leveraged test drive? How about if the public finally tires of the bond market and allocates some funds back toward the stock market? Finally, what if confidence ultimately goes beyond just calming after the 2008 crisis and actually jumps to levels that embolden some true animal spirit behaviors?

To be clear, the best of this bull market is already behind us. Total returns during the balance of this recovery are not likely to be as good as we have already enjoyed. However, it is looking more and more like the current recovery will prove to be the longest ever in U.S. history and experiencing some perfect days along the way seems probable.

Don’t get bearish too soon. While the probability of any single bullish factor occurring is small, there are lots of lurking positive surprises out that that could rip your face off if you are short the market.

The week ahead: OpEx week

Looking to the week ahead, we are approaching a seasonally positive option expiry week in October. I wrote about Rob Hanna’s historical analysis of OpEx by month (see Six reasons why I am still bullish). Jeff Hirsch at Trader’s Almanac also studied October OpEx and found the first day has a bullish bias, and so does OpEx week and the week after OpEx.

 

Callum Thomas pointed out that the market is starting its seasonally strong period of the year.

 

The market successfully tested support at 2120 last week. It ended Friday oversold and exhibiting bullish divergences on RSI-5 and RSI-14.

 

Breadth readings from IndexIndicators show that the market is oversold on a short-term (1-2 day) basis:

 

…and on a longer term (1-2 weeks) time frame:

 

While oversold markets can get more oversold, the balance of probabilities favor a rally from current levels. Downside risk is likely to be limited from here. My inner investor is still positioned bullishly. My inner trader has been gradually adding to his long positions in anticipation of equity strength into year-end.

Disclosure: Long SPXL, TNA

Three reasons why this isn’t 1987

Posted by Cam Hui -

A scary analog has been floating around in the last few days. Citibank FX analyst Tom Fitzpatrick postulated that the current market looks an awful lot like 1987 (via Business Insider).

 

Murray Gunn at HSBC also issued a similar crash warning. Oh, puh-leez! I can think of at least three reasons why this isn’t 1987 (also recall The USD Apocalypse of September 30, 2016).

Breadth divergence

First of all, Andrew Thrasher pointed out that 1987 saw a negative breadth divergence.

 

That’s not the case today. In fact, the NYSE Advance-Decline Line recently made an all-time-high.

 

A hawkish Fed

In addition, the Crash of 1987 was preceded by three Fed rate hikes in rapid succession. It had raised rates at its August FOMC meeting and those actions were followed by two inter-meeting hikes in September. The monetary policy backdrop today is nothing like 1987.

 

Greed vs. fear

Those of us who were in the business in 1987 will also recall that the pre-Crash era was characterized by cheap tail-risk insurance. There were numerous traders who were willing to play the “pick up pennies in front of a steamroller” game by selling naked out-of-the-money put options on the stock market. We know what happened next.

Today, Bloomberg pointed out that cost of hedging downside risk with put options is at an all-time-high when compared to call options.

 

Market crash predictions certainly get the clicks, but investors and traders should think critically about such Apocalyptic stories.

 

Let’s get real. The conditions of today’s stock market is nothing like 1987. When the dust settles, remember what I said. If I am wrong, remember Fitzpatrick and Gunn with your Institutional Investor vote for best technical analyst.

Disclosure: Long SPXL, TNA

Six reasons why I am still bullish

Posted by Cam Hui -

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

 

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

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

Supportive breadth

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

 

Risk appetite remains healthy

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

 

Investor anxiety remains high

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

 

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

 

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

A friendly Fed

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

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

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

 

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

Growth expectations are healthy

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

 

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

 

Positive seasonality

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

 

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

Disclosure: Long SPXL, TNA

Peak robo?

Posted by Cam Hui -

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

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

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

 

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

Robo-advisor as fiduciary

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

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

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

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

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

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

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

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

 

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

 

Talking their book?

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

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

 

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

 

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

Co-opting the robo model

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

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

Buy Yom Kippur! SPX 2500 by Passover?

Posted by Cam Hui -

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

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

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

The latest signals of each model are as follows:

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

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

Positive seasonality ahead

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

 

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

 

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

The economy perks up

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Poised for a good Q3 earnings season

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

 

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

 

Reflation lives!

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

 

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

 

Risk appetite rising

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

 

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

 

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

 

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

 

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

 

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

 

Risk on! Let’s party!

S&P 500 at 2500?

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

 

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

 

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

The week ahead: Waiting for Yom Kippur

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

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

 

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

My September Non-Farm Payroll guess

Posted by Cam Hui -

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

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

 

A clue from initial claims

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

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

 

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

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

Posted by Cam Hui -

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

 

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

 

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

Will the real USD Index please stand up?

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

 

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

 

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

Signs of global reflation

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

 

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

 

Short term gold bearish

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

 

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

 

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

 

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

Dangerous over-valuation, or a New Era?

Posted by Cam Hui -

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

 

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

Decomposing the P/E ratio

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

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

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

 

Secular vs. cyclical effects

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

 

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

 

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

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

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

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

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

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

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

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

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

If Deutsche = Lehman, then Greek banks = ?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

It’s always something: Deutsche Bank edition

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

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

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

 

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

A banking primer

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

 

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

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

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

What happened to Deutsche Bank?

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

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

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

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

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

 

In addition, leverage is higher than other major banks.

 

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

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

 

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

 

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

 

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

 

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

In the absence of tail-risk…

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

 

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

 

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

 

Consumer confidence improved and beat Street expectations.

 

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

 

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

 

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

 

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

 

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

The week ahead: Bullish tone, but volatile

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

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

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

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

 

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

 

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

 

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

 

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

Disclosure: Long SPXL

The USD Apocalypse of September 30, 2016?

Posted by Cam Hui -

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

 

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

 

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

 

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

The investment record

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

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

 

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

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

Studies in market psychology: The Debate and Deutsche Bank

Posted by Cam Hui -

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

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

The “debate” market effect

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

 

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

 

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

 

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

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

 

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

 

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

Deutsche Bank: What now?

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

 

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

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

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

 

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

 

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

More choppiness ahead

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

 

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

Disclosure: Long SPXL

Some surefire stock winners under a Clinton presidency

Posted by Cam Hui -

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

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

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

“A muscular foreign policy”

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

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

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

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

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

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

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

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

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

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

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

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

Clinton vs. Trump: Charting the possible market reaction

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Reading the electoral tea leaves

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

 

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

 

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

 

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

Clinton vs. Trump

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

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

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

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

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

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

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

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

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

Here are some more examples from the New Yorker article:

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

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

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

I could go on, but you get the idea.

Clinton = Status quo

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

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

 

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

 

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

 

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

 

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

 

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

 

Bullish technical outlook

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

 

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

 

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

 

The Trump surprise

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

 

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

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

 

The week ahead: Be careful

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

 

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

 

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

 

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

 

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

 

Here is Nate Silver’s summary of the race:

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

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

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

Disclosure: Long SPXL

How the Fed could induce a bear market in 2017

Posted by Cam Hui -

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

 

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

A 2017 inflation surprise?

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

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

 

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

 

Accelerating inflation = Rising rates = Equity bearish

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

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

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

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

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

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

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

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

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

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

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

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

Back in the rut

Posted by Cam Hui -

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

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

 

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

 

I was wrong. Life is full of surprises.

A re-test of the highs?

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

 

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

 

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

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

Disclosure: Long SPXL, TNA

How China’s Great Ball of Money rolled into Canada

Posted by Cam Hui -

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

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

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

 

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

Peeking under the hood of Chinese fund flows

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

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

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

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

 

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

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

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

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

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

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

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

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

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

The music is still playing

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

 

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

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

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

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

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

 

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

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

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

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