The Brexit Pandora’s Box

Posted by Cam Hui -

For my (mainly) American friends, file this under “why you don’t understand Europe”:

The Vietnam War was a war that scarred the national psyche and dramatically changed the tone of American foreign policy for a generation. If you visit the Vietnam Memorial in Washington DC today, you will find roughly 58,000 names of fallen soldiers from that period. Now imagine if instead of losing 58,000 soldiers, the United States lost 2.5 million during the Vietnam War. For a country like the US of roughly 300 million people, that kind of casualty rate would mean that virtually every household in America would be touched by combat death, whether it’s a father, son, brother, uncle, friend or neighbor. Then 25-30 years later, which is roughly the span between the Vietnam War and 9/11, the country got involved in another conflict with a similar death toll.

Imagine the resulting national trauma.

That’s what happened to many European countries in the First and Second World Wars – and the losses quoted would be roughly what the equivalent losses are for the US on an equivalent per capita basis on par with many European countries. The Credit Suisse Global Investment Returns Handbook has documented the financial cost of a century of war in Europe. Here are the real returns to different asset classes in France over the last century. In addition to the human carnage, investors suffered devastating losses during those wars.
 

 

Here is the same analysis for Germany. In addition to the lives lost, many investors had to contend with the permanent loss of capital. Some of those “risk free” interest rates that may have been in financial models weren’t so free of risk anymore.
 

 

The UK fared a lot better as unfriendly foreign troops never set foot on its soil. On an inflation adjusted basis, its equity returns was an order of magnitude better than France or Germany.
 

 

For comparative purposes, here is the return record of US assets. Americans were fortunate to have escaped the two world wars with minimal financial damage. The Great Depression caused more equity damage than the wars. The terminal real value of equity investments was three times better than UK results.
 

 

So is it any surprise that at the end of the Second World War, the leadership of Western Europe surveyed the carnage and came to a conclusion that we can never do this again. Ever. Thus the Common Market, the EEC and later the EU were born. While it was originally structured as a free-trade agreement, the political intent was to bind the two main combatants, France and Germany, so tightly together so that a European war cannot happen again. The political goals of Europe has largely succeeded. Today, if Angela Merkel mobilized the Bundeswehr and told the troops that they were going to war against the French, the men would all laugh, have a beer and go home.

That is the miracle of Europe. Against the tail-risk of millions killed and cities devastated, the price of little squabbles about bailing out Greece seems like a minor price to pay.

The rise of the Euroskeptics

Today, the political glue that holds Europe together is starting to disintegrate. Regardless of what happens on Thursday, the Brexit referendum is a symptom of how a rising tide of nationalism across Europe is opening up a Pandora`s Box. This new Pandora’s Box is unraveling of the political consensus holding Europe together.

In a past post (see A history lesson, and why Europe should try to be more Canadian), I highlighted a column by Margaret Wente in the Globe and Mail about how those of us in Canada are different from Old World.

Our identity is not defined by blood, or by our sense of destiny. We have no concept of Volk. We’re just folks. We don’t care who you are or where you came from or who or what you worship, as long as you share our good Canadian bourgeois values. Don’t litter. Send your kids to school. Wear a poppy.

(For the uninitiated, the tradition in British Commonwealth countries is to wear a poppy on Remembrance Day, November 11, as a remembrance of the sacrifices made in past wars.) Those of us living in the New World tend not to be as tribal as the Old World – and tribalism is what the European Project is trying to minimize.

That’s all changing. The Brexit referendum is just one manifestation of renewed nationalism and tribalism in Europe. A recent report by Timbro, the Swedish research institute, documents the rise of authoritarian populism in Europe (and authoritarian populism is usually identified with Euroskepticism).

Never before have populist parties had as strong support throughout Europe as they do today. On average a fifth of all European voters now vote for a left-wing or right-wing populist party.

The voter demand for populism has increased steadily since the millennium shift all across Europe. No single country is clearly going against the stream. 2015 was the most successful year so far for populist parties and consistent polls show that right-wing populist parties have grown significantly as a result of the 2015 refugee crisis. So far this year left-wing or right-wing populist parties have been successful in parliamentary elections in Slovakia, Ireland, Serbia, and Cyprus, in a presidential election in Austria and in regional elections in Germany.

 

The news is full of the rise of Euroskeptic parties with authoritarian populist leanings (both left and right) headed by the likes of Le Pen (France), Wilders (The Netherlands), Orbán (Hungary), Grillo (Italy) and so on. As an example of the inroads made by these Euroskeptic protest movements, Beppe Grillo’s Five Star party’s candidate, Virginia Raggi, won the election as Rome’s first female mayor on the weekend.

Europe turns inward

The Pew Research Center recently surveyed Europeans and showed how their people are turning inward:
 

 

In foreign policy, even though they profess support of greater engagement and multilateralism, polling internals indicate that nationalism remains ascendant and appetite for compromising with allies is low.
 

 

The Brexit referendum is an example of how its people are turning inward. As this analysis of the demographic leanings in the vote demonstrates (via Ian Bremmer), Brexit is mainly an English initiative as Scotland, Northern Ireland and Wales tilt towards Remain while most of the Leave support comes from England (except for London).
 

 

Should the Leave side win, the most likely outcome would see Scotland holding another succession referendum, but this time succeeding, followed by possibly Northern Ireland and Wales. The United Kingdom would fragment into its basic unit of Volk, just as Europe is fragmenting.

How Europe can end

The disintegration of the European ideal is the greatest threat to European stability – through rising nationalism and tribalism. Problems like Cyprus, Greece, Spain and Italy can be fudged through the kinds of messy compromises that are typical of Europe. But if enough Euroskeptics take control of enough member states, the European Dream dies. The markets implicitly understand this risk. As the Brexit Leave side was gaining in the polls, it wasn’t the yield on the 10-year Gilt that was rising, but the spread on peripheral debt that was blowing out.

To be sure, no one is going to war if the Leave vote succeeds this week, but it creates a higher element of longer term tail-risk for the region. In a future post, I will detail one possible development that may create hope that Euroskepticism may be reaching its high tide mark.

How the S&P 500 can get to 2200 and beyond

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 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 bullish 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: Neutral
  • Trading model: Bearish

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.

Where’s the growth?

My last post (see Why you need to give the bull case a chance) elicited a considerable amount of comment. Most of the pushback I got on the equity bull case amounted to a question of, “Where’s the growth coming from?”

I recognize the concerns. As this chart from Factset shows, the equity market has had to endure five consecutive quarters of falling year-over-year EPS growth. How can anyone possibly be bullish under such circumstances?
 

 

In this post, I would like to explain my bull case for stocks, with an initial SPX target of 2200 and, depending on the Fed’s reaction function, up to 2400-2500.

Backward vs. forward growth

Looking backwards in the rear view mirror, I can sympathize with many of the growth concerns. The chart below shows YoY GDP growth (blue line) and ISM Manufacturing (red line). US economic growth decelerated for most of last year and suffered a mild industrial recession in Q4 2015 and Q1 2016, from which it appears to be starting to recover.
 

 

On a forward looking basis, the latest Atlanta Fed’s nowcast of Q2 GDP growth stands at 2.8%, which represents a robust recovery from the winter months.
 

 

Also on a forward looking basis, the bottom-up outlook for earnings looks brighter too. Based on this chart from Factset, I make the following observations (annotations are mine):

  • Stock prices had been range bound and sloppy because forward EPS was not growing (see box), but…
  • Forward EPS is rising again, which is bullish for equities, and…
  • If you decide to stay cautious and wait for forward EPS to break up out of the box, it may be too late as prices may have already moved by then. 

The stock market is forward looking, not backward looking. So don’t make the mistake of only looking in the rear view mirror.
 

 

I would also like to address the perennial bearish objection that Street analysts are terrible at calling turning points in the economy and therefore rising forward EPS mean nothing. Much of the recent earnings decline can be attributable to two factors, namely USD strength and the weakness in oil and other commodity prices. Arguably, they are the same macro factor as the direction of the USD is inversely correlated with commodity prices.

This chart of Q2 2016 EPS revisions by sector tells the story of YoY EPS growth. The worst hit sectors are the commodity producing sectors of Energy and Materials. In addition, downward estimate revisions in the Technology sector is mainly attributable to highly stock specific factors in three large cap stocks: AAPL, MSFT and IBM.
 

 

From a macro perspective, however, we can see that many of the earnings headwinds abating. The USD Index has stopped strengthening and it has been range bound for about a year. The bottom panel of the chart below shows the YoY rate of change in the USD, which has fallen to the zero line. A rising USD created an earnings headwind for exporters as the negative currency translation squeezed their operating margins. A flat USD on a YoY basis eliminates that headwind and should result in better earnings growth, starting in Q2 2016.
 

 

This chart of commodity prices, as measured by the CRB Index, tells a similar story. The CRB Index has stopped falling and it has rallied out of a downtrend. The rate of change chart also shows that prices are steadily getting “less bad”, which should be constructive for the earnings of companies in Energy and Mining.
 

 

So even if you believe that Street analysts are idiots and know nothing, there are definite macro forces that are supportive of better earnings growth in Q2 2016. An EPS growth projection of 5-10% is a reasonable assumption for the H2 2016. Assuming no changes in P/E multiples, this should result in a stock market advance of 5-10%, which makes an SPX target of 2200 quite feasible.

Analyzing the Fed’s reaction function

In order for SPX to rise significantly higher than 2200, we need P/E expansion. P/E expansion is a function of higher growth expectations, or a lower discount rate, or bond interest rate. The latter is highly dependent on the Fed’s reaction function to economic conditions.

First, some basics – the Federal Reserve has a dual mandate, price stability (fighting inflation) and maximizing employment. So let’s think like Fed bureaucrats and address how they think about their dual mandate. The Fed uses a Phillips Curve modeling framework, which states that policy makers can trade off unemployment and inflation rates in the short run (chart below via Wikipedia). In addition, they have stated that they are aiming for an inflation rate of 2% and they are watching labor markets to see how close the economy is to full employment.
 

 

Currently, core Personal Consumption Expenditure (PCE), the Fed’s preferred inflation rate metric, is creeping up towards the Fed’s 2% inflation target and wages are displaying the typical rising pattern seen in the latter stages of an economic expansion when labor markets get tight.
 

 

So the Fed should start to raise rates, right? Well, it depends. Take a detailed look at the Phillips Curve chart above. What does the Fed plug into the y-axis to measure inflation? Does it use a measure like core PCE, which is backward looking, or it does it use inflationary expectations?

Tim Duy recently detailed Janet Yellen’s inflation dilemma. In her latest speech, Fed Chair Yellen made many references to inflationary expectations:

Uncertainty concerning the outlook for inflation also reflects, in part, uncertainty about the behavior of those inflation expectations that are relevant to price setting. For two decades, inflation has been relatively stable, reacting less persistently than before to temporary factors like a recession or a swing in oil prices. The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

Here is the problem. In past cycles, inflationary expectations had risen as the economic expansion matured. In this cycle, inflationary expectations have been falling. Here is a chart (via Tim Duy) of survey based inflationary expectations.
 

 

Here are the inflationary expectations as determined by the bond market, which is also falling.
 

 

The Fed pays a lot of attention to inflationary expectations because if expectations start to rise uncontrollably, it faces a risk of runaway inflation. Today, it has the opposite problem, inflationary expectations are falling.

More upside before the market top?

Street analysts spend a lot of time trying to figure out what the Fed will do next. By contrast, I spend more time trying to determine the Fed’s reaction function to data development. So here’s the tricky part of forecasting interest rates. Assuming that the economy stays on its current path of slow and steady growth, employment continues to rise and so does current inflation metrics such as core PCE and wage growth. On the other hand, inflationary expectations stay muted. What does the Fed do?

An educated guess (and it’s only a guess) is the Fed stays on hold longer than the market expects while the internal debate rages as to whether inflationary expectations are becoming un-anchored to the downside. In practice, we may see a single rate hike in December after the election. This do-nothing policy would eventually reach a tipping point at some time in the future, but that’s a problem for later.

This scenario leaves the door open for greater P/E expansion this year as it becomes evident that growth is returning and the Fed remains dovish. That’s how the SPX can get to 2400-2500, as growth expectations ramp up later this year and the rate environment stays benign.

The Brexit wildcard

Any market analysis today would be incomplete without addressing the elephant in the room, the Brexit referendum later in the week. There are all sorts of opinions about what might happen under Brexit, from benign (Warren Buffett) to dire (Bank of England). Markets would undoubtedly become highly volatile should the UK vote to leave the EU.

Opinion polls in the past few weeks show that the Leave camp has been steadily gaining ground, but several polls released this weekend shows a substantial swing in Remain’s favor. The polling firm BMG recently provided a fascinating window on the science of polling. Business Insider reported that a (pre-Jo Cox killing) BMG telephone poll had given Remain a 7 point lead, while a separate BMG online poll indicated a 10 point lead for Leave. What gives?

The discrepancy can be explained by the methodology detailed on the BMG website. Simply put, Remain supporters are difficult to reach and BMG’s polling results show that when the pollster persists in calling target respondents who don’t answer the phone, polling results change. The Remain lead rises dramatically after the second call, then falls back and steadies after the third call.
 

 

For some context of why this is important, most pollsters had missed the move towards the Conservatives in the last UK general election. The few who called it right tried very hard to poll these “hard to reach” voters. So getting a complete picture is critical to getting the right forecast.

Viewing the Brexit referendum through another lens, I could put on my market technician’s hat and assert that price gives us all the information we need. The bookmakers, who are putting actual money on the line, are giving the Remain side about 66% chance of succeeding. More importantly, momentum is currently in Remain’s favor. The Oddschecker site shows that Remain odds are shortening (blue) while Leave odds are rising (pink).
 

 

If these results hold up, then expect a relief rally to start when the referendum results become known.

The week ahead

In an earlier post last week (see The VIX tail wagging the SPX dog), I noted that the VIX Index, which is a measure of fear, had surged above its upper Bollinger Band (BB), but the market decline was fairly mild relative to other VIX spike episodes. The general level of anxiety is probably attributable to the Brexit referendum, as GBP (Pound Sterling) volatility had leaked into the VIX.

The bottom panel of the chart below shows the short-term VIX (VSTX) has inverted against the three month VIX (VXV), which is an indication of short-term market fear and GBP volatility hedgers coming into the equity market. In addition, the VIX upper BB ride is becoming a template of a stock market bottoming process. In the past, the market had bounced when the VIX Index rose above its upper BB, rallied and then fallen back about a week later to test the previous low.
 

 

The rally and re-test is consistent with the pattern observed by Rob Hanna at Quantifiable Edges of 5-day declines that remain above their 20-day lows (Day 0 = last Thursday). If history is any guide, then market strength should top out on Monday or Tuesday.
 

 

My inner investor remains constructive on stocks. The latest update from Barron’s of insider trading activity shows that this group of “smart investors” are buying again after spending several weeks at a neutral reading. This data point is mildly supportive of the bull case and suggests that, at a minimum, downside risk is limited.
 

 

My inner trader took profits and covered his short position, albeit a little early, and he is waiting for an opportune entry point on the long side next week.

Disclosure: No trading positions

Why you need to give the bull case a chance

Posted by Cam Hui -

Maybe it’s me, or my imagination? Even before the latest round of market weakness, most of the feedback and sentiment on my social media feed has tended to bear bearish. I saw a fair number of calls for SPX to eventually test its February lows at about 1820, but I haven’t seen a lot of forecasts for breakouts to new highs. The recent year-end projection by respected former Value Line research director Sam Eisenstadt of 2220 only represents only modest upside from current levels, but I don’t see a lot of enthusiasm for that call.

The WSJ recently call this The Most Pessimistic Bull Market in History, as investors have only embraced it in the most reluctant way:

Instead of chasing growth and profits, investors this year have bought into safety—in a big way. Only two of the 10 top-level sectors which make up the market have reached new highs this year, and they are the antithesis of exuberance: utilities and consumer staples.

This may be merely a failure of imagination. As in 2007, the bubble pushing up the market may be elsewhere. Back then, valuations weren’t outrageous, but excess in credit created unsustainable profits. This time the most obvious froth is in the government-bond markets. German 10-year bunds on Friday yielded a mere €270 a year on a €1 million investment ($1.1 million), enough to fuel your BMW 7-Series a couple of times with enough left over for a currywurst and a beer. Japan’s yields are negative for bonds maturing out to early 2031, while U.S. 10-year Treasurys on Monday closed at a new 52-week low.

Josh Brown also pointed out that stock market investors have become chicken-bulls (my term, not his), as the two most popular ETFs for equity flows have been low-volatility funds, USMV and SPLV:

The popularity of these two ETFs is perfectly emblematic of the mood these days among financial advisors and their clients. And if you know anyone in the ETF business, they’ll tell you that the principal determiners of flows are in this order: 1) recent performance 2) whether or not advisors have been sold on them and 3) recent performance. ETFs do not sell themselves and retail do-it-yourselfers are not the drivers of AUM flows – only advisors can really move the ETF needle. The iShares product probably has an edge on SPLV because it’s based on an MSCI index, which is what many advisors use as a benchmark in their performance reporting.

That’s where the “chicken-bull” part comes in:

A collective financial advisor decision was made in the aftermath of August – “Okay, we’ll stay in, but we can’t take the full volatility of the stock market anymore.”

You can only imagine the calls that were coming in – “Is this it? Here we go again!”

To which the advisors’ response was something along the lines of “Don’t worry, I have an idea…” The iShares and PowerShares wholesalers did their work well.

Seeing this fund grow to $12.5 billion, having taken in a third of that in the first four months of this year, tells you everything you need to know about current sentiment. Advisors are tacitly accepting that they must be in US stocks, but because of the angst of their clients, they’re offering them exposure through a vehicle that purports to offer “minimum” volatility.

That’s not the sort of investor behavior and psychology that happens at market tops. While a bull case where the SPX rises to 2400-2500 is my base case scenario, it is well within my range of possibilities. Until the investing public starts to get wildly enthusiastic about a 2400-2500 SPX target, it’s hard to see how this market tops out.

 Let me make two cases for a 2400-2500 bull market. One is fundamental, the other is technical.

The valuation bull case

An analysis by Calamos Investments recently made the point that the stock market isn’t very overvalued. They compared the forward P/E ratio of the market and market sectors in 1992 and today. 1992 was chosen because no one could argue that the market was overvalued then, as it was just the start of the great market run that culminated in the NASDAQ Bubble.

As you read this analysis, don’t forget that interest rates were considerably higher than they are today. Arguably, today’s low rate environment deserves a higher P/E multiple.
 

 

As the table below shows, the current market forward P/E multiple of 16.4 is modestly above the 1992 multiple of 14.3. An examination of the biggest differences in P/E multiples reveals that they are Energy, which is understandable because its earnings have been devastated by the oil crash, Consumer Staples and Utilities (annotations are mine).
 

 

Wait! What? Where are the excesses in this market? Staples and Utilities are defensive sectors. You mean that investors are paying up for defensive exposure (see the WSJ and Josh Brown above)?

In the past, market tops have been marked by wild bullishness about some hot sector, such as Financial, Technology, Gold, Energy and so on. Does a market led by defensive low-volatilaty leadership look like the psychology of a market top?

The VLT Momentum buy signal

The other bullish signal comes from the VLT Momentum Indicator, which is a momentum signal using long-term monthly data developed by Coppock. I am indebted to Leuthold Group who alerted me to the potential setup in May. Indeed, SPX closed above 2062 in May, which triggered a VLT Momentum Indicator buy signal.
 

 

Tom McClellan also wrote about the buy signal, but based on the DJIA instead of SPX:
 

 

This Bloomberg story went into greater detail about the work by Leuthold Weeden Capital and outlined the past record of this buy signal.
 

 

If history is any guide, a one-year SPX target of 2500 is well within reach using the median return of about 22% after past VLT Momentum Indicator buy signals. These days, a 2200 target would be considered mildly aggressive and price targets of 2500 is virtually unheard of.

In conclusion, market psychology is still overly bearish. Until I see more of the public getting more enthusiastic and piling into stocks with an eye towards 2400, 2500 or even talk about 3000, it’s hard to see how this market can make a cyclical top.

The VIX tail wagging the SPX dog

Posted by Cam Hui -

Mid-week market update: What’s going on with the VIX Index? The VIX, which measures implied option volatility and a useful measure of “fear”, spiked dramatically on Monday. While SPX did fall, the magnitude of the decline didn’t match past VIX spikes. It prompted this tweet from Ryan Detrick:
 

 

Rob Hanna at Quantifiable Edges also observed that the combination of a VIX spike of this magnitude is unmatched by the shallowness of the fall in stock prices.

 

As you can see from the chart below, the VIX Index spent the second day above its Bollinger Band (BB), which has marked regions of limited downside risk in the past. On the other hand, the bottom panel shows the 10-day rate of change of the VIX Index, and such events have often foreshadowed further SPX weakness (see vertical lines).
 

 

What’s going on? My analysis suggests that we are seeing the case of the VIX tail wagging the SPX dog.

Unusual levels of fear

These levels of fear shown by the VIX Index is unusual in many ways as the VIX spike has been unconfirmed by other metrics. The Fear and Greed Index has retreated from an overbought, or “greedy”, reading to neutral. Normally, these kinds of VIX moves have tended to correspond to oversold levels, which are not in evidence.
 

 

Macro Man recently suggested that Brexit referendum anxiety has spilled over from the currency option market to the more liquid VIX Index. While that explanation undoubtedly has some elements of truth, it remains unsatisfactory.

If the market is indeed trying to hedge against Brexit event risk, then we should expect that the VIX term structure to have become inverted at some point. If you are trying to hedge event risk, then you hedge the event. In that case, the demand for near-term protection (VIX) should be higher than the demand for longer term protection (3-month VIX, or VXV). As the chart below shows, while the VIX/VXV ratio has risen, it hasn’t inverted in the last few weeks nor is it anywhere near an inverted state.
 

 

Historical studies

In more practical terms, how can someone trade this anomaly in the VIX?

One way of addressing this puzzle is to examine the historical precedence. An alert reader highlighted analysis from Rob Hanna at Quantifiable Edges showing what the market has done after a sharp drop from an intermediate term high. The results look bullish out to a five-day time horizon.
 

 

Separately, I went back to 1990 and looked at what happened after sharp VIX spikes. The VIX spike on Monday was 3.9 points, or 23%. The chart below depicts the median market action before and after the VIX spike, which shows that the study found sufficient number of instances to denote statistical significance. As the chart shows, the magnitude of SPX weakness one and two days before the VIX spike was nearly half of past episodes. Depending on how we defined the VIX spike, either by the absolute point rise or in percentage terms, the market tended to rally after the spike and then fall back. This suggests a scenario of a rally, followed by a decline to test either the previous lows or find some support level before rising again.
 

 

If history is any guide, then expect some market supportive noises out of the FOMC tomorrow, especially during the post-meeting press conference. The market would then rally into Friday and then fall into the Brexit referendum next week.

That’s when event risk comes into play. If the UK votes to stay in the EU, then the bears can expect a rip-your-face-off relief rally. If, on the other hand, the Leave forces prevail, then the bottom could be much lower than anyone expects.

For now, my inner is inclined to step aside in light of the FOMC wildcard, but if events unfold as planned, then he plans on entering a modest short SPX position near the close on Friday in anticipation of further angst about the Brexit vote. Anyone who plans on trading this event will need the discipline to pre-define his risk and pain threshold. And he have to be prepared to be nimble.

Good luck.

Buy the dip!

Posted by Cam Hui -

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on 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 bullish 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: Neutral
  • Trading model: Bearish

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.

Here comes the June swoon

The market seem to be following the script that I laid out last week (see Get ready for a market of maximum frustration). I wrote that I remained bullish into year-end, but the short-term outlook was corrective. From a very short-term trading perspective, however, the tendency for the market to rise in the face of bad news like the Jobs Report, indicated that stocks needed to move higher before correcting.

The market did climb the proverbial Wall of Worry until mid-week before weakening (see my mid-week comment Adventures in Option-Land). As the market ground higher last week, I could see the bears starting to capitulate and sentiment gauges becoming more bullish, the major indices topped on on Wednesday. The market narrative then changed to focus on the deteriorating macro outlook. Indeed, the Citigroup Economic Surprise Index, which measures whether macro data is beating or missing consensus estimates (gold line in chart), is turning down again.
 

 

It’s time for stocks to pay the macro piper. However, these indications of weakness are temporary. Once the growth fears clear, stock prices should recover and push to new highs later this year.

The recession calls

Recently, we have seen several recession calls from the Street. First, there was the news of rising recession risk from the JP Morgan model.
 

 

Albert Edwards also issued another one of his imminent recession alerts (via Business Insider):

In the aftermath of the latest, weaker than expected, nonfarm payroll data, economists are certainly more worried. The excellent folks at Advisor Perspectives highlight the Fed’s Labour Market Conditions Index as suggesting a recession is imminent (the cumulative peak is an average of 9 months ahead of the start of recession and we are now four months beyond a peak. For investors who think copper still has some predictive power, its recent move is disturbing.

 

 

As Edwards has tended to be a permabear, I am not going to dignify his recession call with a rebuttal (see this Business Insider account of how he predicted doom and an SPX target of 400 in 2011).

A more serious warning came from David Rosenberg, who was freaking out over the dismal May Jobs Report (via Business Insider):

This is the biggest “miss” by the economics community since December 2013, and the worst headline since September 2010 when the Fed was more preoccupied with its next round of quantitative easing than with raising the funds rate.

Not just that, but there were downward revisions to the prior two months totaling 59,000 – something we have not seen since June of last year.

Look at the pattern; +233,000 in February, +186,000 in March, +123,000 in April and +38,000 in May. Detect a pattern here (he asks wryly)?

He went on to sound the recession alarm:

I don’t want to alarm anyone but the facts are the facts, and the fact here is simply that this is precisely the sort of rundown we saw in November 1969, May 1974, December 1979, October 1989, November 2000 and May 2007.

Each one of these periods presaged a recession just a few months later – the average being five months.

Counterpoint: A job market at full employment

Most of the recession calls were based on the awful Jobs Report, which may be problematical as it focuses on a single metric and can be said to be cherry picking data. Nevertheless, there were a number of Street analysts who interpreted the poor employment picture as a labor market at or near full employment, or the non-accelerating inflation rate of unemployment (NAIRU), which is good news. These analysts include Liz Ann Sonders of Charles Schwab, Ethan Harris at BoAML and Torsten Sløk at Deutsche Bank (via Business Insider). Just click on each of the links to see the full details of their analysis.

Remember, an economic recession represents broad-based weakness on many fronts, not just a single indicator. So it’s important to look for confirmation of weakness from other macro variables.

Consider, for example, initial claims as a proxy for the employment picture and how it has behaved along with the yield curve, which has been a sure-fire recession indicator in the past. As the chart below shows, recessions have followed occasions when initial claims (blue line) has bottomed out and started to rise. Initial claims are now at an all-time low. If the labor market is indeed deteriorating, then initial claims should start to rise soon. Further analysis showed that lows in claims have coincided with periods of yield curve inversion (circled). Only once in the days of the tight monetary policy era of the Volcker Fed in late 1970s, has the yield curve continued to invert after the bottom in initial claims. Currently, the yield curve, regardless of how it’s measured (2/10 or 5/25), is not inverted. This divergence casts doubt about whether a recession is imminent.
 

 

I have also plotted initial claims against ISM Manufacturing and ISM Services, which are also indicators of economic strength and weakness. As ISM readings above 50 are considered to be expansionary and below 50 contractionary, I normalized ISM by subtracted 50 to make the zero line as the delineation between expansion and contraction. As the chart shows, ISM has tended to flash more recessionary signals, some of which were false (see circled past divergences). Currently, ISM Manufacturing dipped into contractionary territory and started rising again, while ISM Services, though weak, is still in expansionary mode. This is another divergence that argues against a recession call based on the employment picture.
 

 

The JOLTS report was helpfully released last week, which provided another window into the labor market. If the job market is so bad, can someone tell me why job openings are rising and layoffs are falling?
 

 

Why are job openings rising while hiring is falling?
 

 

The more likely explanation is a skills gap, as explained by the Beveridge curve (via Sober Look).
 

 

Indeed, the Atlanta Fed’s Wage growth tracker shows a median wage increase of 3.4%, which is well above the Fed’s 2% inflation target. Wage hikes above the inflation rate (and inflation target) seems to be a sign of a tight labor market.
 

 

This analysis leads me to conclude to side with the labor market at full employment, or NAIRU, camp. In the past, labor markets at NAIRU have coincided with rising inflationary pressures. Indeed, Eric Burroughs pointed out that regional Fed inflation metrics have started to creep up and they are nearing the Fed’s 2% inflation target.
 

 

A market friendly Fed

Despite these signs of rising inflationary pressures, the WSJ pointed out that the latest University of Michigan survey showed that long-term inflationary expectations fell to an all-time low. This latest data point will undoubtedly create further debate within the FOMC, about whether inflationary expectations are becoming unanchored to the downside (see my post What I learned about Fed policy this week about Ben Bernanke`s comments about the Phillips Curve). As the debate continues over the next few months, the FOMC is likely to stay on hold until these issues are resolved.

In the meantime, the latest speech from Janet Yellen pushed probability of the next rate hike, which I define at the as being above 50% as a threshold, out to December.
 

 

At the same time, growth is returning despite the recession scare. New Deal democrat‘s weekly assessment of high frequency economic releases is projecting a return to economic growth in the months ahead:

When all but one of the few negatives are among coincident indicators and both long and short leading indicators are uniformly positive to neutral, we should expect improvement in the months ahead.

In addition, the Street is projecting more growth. The latest update from John Butters of Factset shows that forward EPS estimates are rising again after a brief growth hiccup.
 

 

An easy Fed and more growth – what more can the stock market ask for?

Dueling gurus

The markets may also have been spooked by the WSJ article about how George Soros was stepping back into his firm and his bearish stance, citing the his concerns over China and Europe as reasons for his negative outlook.

While Soros is unquestionably an investment legend, his calls have not always been infallible. This Bloomberg article details some of his most recent hits and misses over the last few years. The WSJ article also prompted reminders of how many times journalists have published “Soros is bearish” stories in the past.
 

 

The moral of this story: Investing is a business with a low signal-to-noise ratio. Even gurus can be wrong.

By contrast, Mark Hulbert highlighted the views of another investment guru, retired Value Line research director Sam Eisenstadt, whose market forecasts have tended to be far more right than wrong – and the consistency of his forecasts are statistically significant, which is a test that few market analysts can pass. Hulbert went on to detail that the last Eisenstadt forecast, which was made in December, called for an SPX target of 2050 by the end of June:

Though the last six months are just one data point, his model has been more right than wrong over the last half-century, according to results of statistical tests that Eisenstadt has shared with me.

Eisenstadt’s latest SPX target for year-end 2016 is 2220, which represents a modest gain from current levels and it is at the lower end of my estimate of 2200 to 2400 for the index. The Eisenstadt forecast is also consistent with the daily SPX point and figure upside objective of 2219.
 

 

A mild pullback

Last week, my inner trader believed that the prudent course of action was to start scaling out of his long positions near the highs (see Adventures in Option-Land), which he did, and keep tight stops. He flipped from his remaining long position to a short on Friday (see tweet here).

Looking to the week ahead, most of the downside damage may have already been done if the historical June trading pattern depicted by Jeff Hirsch repeats itself. There will be two key events in June with unpredictable binary outcomes, namely the FOMC meeting next week and the Brexit referendum on June 23. If I were to take a wild-eyed guess (and remember it’s only a guess), the trading pattern identified by Hirsch is consistent with a scenario of a positive surprise at the FOMC meeting, followed by a declined caused market anxiety over the Brexit referendum and a relief rally based on a Remain outcome. Barring any big surprises from the FOMC meeting, the most likely scenario is a sloppy range-bound market until the Brexit question gets resolved.
 

 

From a technical perspective, the latest breadth readings from IndexIndicators show that the market is rapidly approaching a minor oversold condition based on the net 20-day highs-lows.
 

 

…and % of stocks above the 10 dma. These readings are supportive of the thesis that the correction may be nearly over.
 

 

My mild pullback scenario calls for an initial target level of about 50 on the Fear and Greed Index, which has retreated rapidly from an overbought reading.
 

 

My inner investor thinks that this is all noise and he is preparing to add to his equity positions next week should the market significantly weaken. My inner trader is intensely watching the market action and he is preparing to take profit and cover his short position should readings become oversold. In all likelihood, the SPX decline will stop at support at about the 50 day moving average level of 2076.
 

 

Disclosure: Long SPXU

What I learned about Fed policy this week

Posted by Cam Hui -

Rather than indulge in instant analysis, I wanted to give myself a few days to reflect on Janet Yellen’s speech on Monday (see full transcript). In doing so, I learned a number of things about Fed policy that I didn’t know before:

  • How much does the Fed want to raise before it considers rates to be “normalized”
  • What it means to allow the economy to run a little “hot” because of slack in the labor markets
  • What the hurdles are to next raise rates
  • From Ben Bernanke: The debate over how to implement the Phillips Curve in monetary policy

Normalization = 1% rate hike

One of my big surprises was what Yellen considered to be the “neutral” Fed Funds rate. My estimate of the Taylor Rule target based on various inputs had put the “neutral” rate north of 3%, but Yellen thinks that rates only have to rise by about 1% to get to neutral:

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

This statement is an indication of the dovishness of the Yellen Fed.

No inflation “overshoot”

On the other hand, investors shouldn’t take the Fed’s dovishness for granted. Despite all of the Fedspeak about how they are willing to let the economy run a little “hot” (read: tolerate higher inflation) because of slack in the labor market, the Fed is not willing to overshoot its inflation target and approach its 2% target from above. Yellen stated that monetary policy operates with a lag and therefore she is unwilling to risk an inflationary overshoot:

I continue to believe that it will be appropriate to gradually reduce the degree of monetary policy accommodation, provided that labor market conditions strengthen further and inflation continues to make progress toward our 2 percent objective. Because monetary policy affects the economy with a lag, steps to withdraw this monetary accommodation ought to be initiated before the FOMC’s goals are fully reached.

Hurdles for the next rate hike

In her speech, Yellen sounded optimistic about the trajectory of economic growth, but she went on to set up some tests in light of the softness evidence in the last Employment Report:

Over the past few months, financial conditions have recovered significantly and many of the risks from abroad have diminished, although some risks remain. In addition, consumer spending appears to have rebounded, providing some reassurance that overall growth has indeed picked up as expected. Unfortunately, as I noted earlier, new questions about the economic outlook have been raised by the recent labor market data. Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015? Does the latest reading on the unemployment rate indicate that we are essentially back to full employment, or does relatively subdued wage growth signal that more slack remains? My colleagues and I will be wrestling with these and other related questions going forward.

Tim Duy thinks that the Fed will need a couple months of solid data before committing to a rate hike, which suggests that July is off the table:

The May employment report killed the chances of a rate hike in June. And it was weak enough that July no longer looks likely as well. I had thought that, assuming a solid May number they would set the stage for a July hike. That seems unlikely now; they will probably need two months of good numbers to overcome the May hit. The data might bounce in the direction of July, to be sure. Hence Fed officials won’t want to take July off the table just yet, so expect, in particular, the more hawkish elements of the FOMC to keep up the tough talk.

The Phillips Curve debate

Finally, an insight came from an unusual source, Ben Bernanke, about how the Fed is wrestling with the Phillips Curve. In a Brookings Institute round table, Bernanke was asked the question, “Is the Phillips Curve dead?” (click this link for the short video).

For newbies, the Phillips Curve describes an inverse relationship between inflation and unemployment. In the short run, policy makers can trade off between two evils, inflation and unemployment.

Bernanke said that, despite all of its flaws, the Phillips Curve is still a good guide for monetary policy. However, there is some debate over what to put in the “inflation” axis for the Phillips Curve, actual inflation, or inflationary expectations? If they were to use inflationary expectations, the question becomes where expectations are anchored.

Here is a chart of forward inflationary expectations, which has been falling. If inflationary expectations are anchored at the widely telegraphed Fed target of 2%, then the current trajectory of monetary policy makes sense. If, as the likes of Lael Brainard have argued in the past, the risk that inflationary expectations are becoming unanchored to the downside, then Fed policy needs to be easier.
 

 

Here is a chart of employee compensation as a % of GDP (blue line) and core PCE (red line). Notwithstanding the downward drift in employee compensation over the past few decades, past upticks in employee compensation have coincided with upward pressure in core PCE. These episodes have tended to occur in the late stages of economic expansions, which were arrested by monetary policy tightening which usually resulted in recessions.
 

 

So is the latest rise in employee compensation a typical cyclical effect which should be met with a response by tighter monetary policy? Should the softness in the May Employment Report persist, I would expect that debate between the hawks and the doves in the Fed to heat up.

I plan to have more thoughts on how to read the huge miss in the May Employment Report in my next post.

Adventures in Option-Land

Posted by Cam Hui -

Mid-week market update: I like to monitor the option market from a sentiment modeling perspective because, unlike surveys which can swing all over the place, the option market is a forum where people are putting real money on the line.

Even as the stock market has been slowly grinding upwards, the option market has been showing signs of skepticism. As the chart below indicates:

  • The market is overbought on RSI-5 and nearing an overbought condition on RSI-14, but…
  • The VIX Index, aka the Fear Index, has been rising for the last few days; and
  • The VIX term structure has also been indicating higher fear levels in the same time frame.

 

 

At the same time, standard measures of overbought/oversold and sentiment models, such as the CNN Money Fear and Greed Index, is showing a high level of greed, which is contrarian bearish.

 

 

What’s going on? Is this just a sign that the stock market is climbing the proverbial Wall of Worry?

 

An overbought market

Jason Goepfert recently provided some context to the current movement in the VIX Index. As the chart below shows, the market has tended to pause and pull back after both SPX and VIX have advanced together.

 

 

As well, Urban Carmel pointed out that the Fear and Greed Index tends to be a bit early in calling short-term tops, but risk/reward is tilted to the downside.

 

 

Currently, other short-term measures like this one from IndexIndicators are at overbought levels where pullbacks have occurred.

 

 

My inner trader believes that while the stock market can continue to grind a bit higher and possibly make a new all-time high, the prudent course of action is to start scaling out of profitable long positions. At the same time, he will keep tight trailing stop orders on his remaining long SPX longs as he is mindful of the old Wall Street adage: “Bulls make money. Bears make money. Pigs just get slaughtered.”

Disclosure: Long SPXL

Technical analysis meets macro

Posted by Cam Hui -

I present for your consideration the following mystery chart. Would you rate this as a “buy”, “hold” or “sell”? Your answer will tell you something about your global macro-economic outlook and the likelihood of an equity bear market in the near future.
 

 

Scroll down for the answer…
 

 

 

 

 

 

 

 

 

 

 

 

 

Any of the recessionistas who ranked the above chart “buy” might want to read this post carefully, including everyone who jumped on the JP Morgan rising recession risk bandwagon and David Rosenberg’s abrupt bearish turn.
 

 

Mystery revealed

I am indebted to Joe Wiesenthal, who tweeted the following macro insight from Citi. The mystery chart is the relative return of the Russell 1000 Value Index against the SP 500. Value stocks have become the market leadership in the past few months. According to Citi, the Value style appears to be positively correlated with global growth and a risk-on environment.
 

 

 

Indeed, an examination of the over and underweight of the Russell 1000 Value Index against SPX shows the main overweight positions are in Financials and Energy while the main underweight positions are in Consumer Cyclical and Technology. It is therefore no surprise for Citi to come to the conclusion that a Value exposure represents a bet on Oil, Interest Rates, Commodities and Credit.
 

 

Incidentally, if you were wondering why an overweight position in Financial stocks represent a bet on growth, the chart below shows that the relative performance of Financials is correlated with the shape of the yield curve, as measured by the 10 year UST yield – 2 year UST yield (green line).
 

 

There may be a correlation vs. causation problem going on here. That’s because the shape of the yield curve has also been correlated with banking interest rate margins.
 

 

For the recessionistas: If you really believe that a recession is just around the corner and you ranked the mystery chart pattern as a “buy”, would you be more comfortable with shorting it instead?

Distilling the “pure” Value effect

Despite the Citi analysis, an exposure to the Value style isn’t just a strict exposure to better growth and a risk-on environment. We can see a better view of the “true” effects of Value by analyzing the sector exposure of small cap value stocks. The chart below shows the over and under-weight positions of the SP 600 Small Cap Value Index against the SP 600, using the same +10% to -10% over and underweight Y-axis of the previous chart. By this metric, there are very few significant sector bets in small cap value stocks, with the exception of an underweight position in Healthcare.
 

 

However, the relative return pattern of large and small cap value stocks are roughly the same. The relative performance of small cap value bottomed earlier than large cap value, though they both turned up at about the same time.
 

 

In conclusion, while the recent positive performance of the Value style is undoubtedly affected by the macro exposures identified by Citi, the relative returns of small cap Value suggests that the recent Value outperformance is positive net of sector and macro effects.

Get ready for a market of maximum frustration

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 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 bullish 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: Neutral
  • 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.

A June swoon before SPX 2400?

Well, that Jobs Report certainly changed the tone of the market! The massive disappointment of Friday’s Employment Report, combined with other weak macro data such as ISM services, is setting up for a choppy market of maximum frustration. I am seeing cross-currents that could be treacherous for both bulls and bears. Here is my market outlook for differing horizons:

  • Medium term (6-12 month time horizon) bullish: The disappointing Employment Report gave the FOMC doves to stay cautious and push out its schedule of interest rate normalization. When combined with a picture of a steadily growing US economy, it gives room for the SPX to reach the 2400-2500 area late this year before the market tops out for this cycle (see my previous posts How the SP 500 could get to 2400 this year and The roadmap to a market top).
  • Short term (1-2 months) bearish: On the other hand, the massive Non-Farm Payroll (NFP) miss, along with weakness in forward EPS, is setting up for a growth scare that is likely to spook the markets.
  • Trading (1 day to 1 week) bullish: The inability for equity prices to fall in the face of bad news suggests that the bears are exhausted. It therefore sets up the market for a rip-your-face-off rally should there be any sign of positive news.
The stage is set, pick your poison. Be careful – even a slight timing mistake could turn a trading profit into a loss.

Anatomy of a market top

Last week, I laid out the broad macro-economic outline of how the stock market might make a cyclical top for this cycle (see The roadmap to a market top):

In his post, New Deal democrat laid out a very sensible checklist for anyone watching for the next recession (comments in parentheses are mine):

  1. Interest rates continue to fail to make new lows. (Check: he means short rates).
  2. House prices and stock prices stop meaningfully appreciating. (Stocks, yes. Houses, not yet but it could be soon as sales lead prices – and sales have stalled).
  3. Inflation picks up to 2% or more as energy prices begin to go up again. (Check: see Core CPI).
  4. Maybe – the Fed raises rates in response to increased CPI readings, perhaps enough to invert the yield curve. (Yield curve is not inverted, but see the risks in my post Three steps and a stumble).
  5. Corporate lending stalls, housing turns down, and consumer spending begins to turn down, resulting in a recession.

We are somewhere between phase 3 and 4, but the question remains one of timing. Last week, it appeared that the Fed was ready to raise rates by a quarter point in either June or July, with another hike in December. Today, June is off the table, though July remains a possibility. I had penciled in 5-10% EPS growth for the remainder of the year, a dovish Fed could accommodate some P/E expansion, which puts a 2400-2500 SPX target within reach this year. Without the Fed, the best the index could do would be 5-10%, or 2200-2300.

From a technical viewpoint, the 2200-2400 target is roughly in line with the range obtained from point and figure charting. Using daily price data, this technique indicated a price objective of 2175 based on the double-top breakout on May 27, 2016.
 

 

Using weekly data, the upside objective is 2418 should the index stage an upside breakout, which hasn’t occurred yet.
 

 

Weakening growth expectations

However, the dramatic NFP miss on Friday has totally changed the conversation. The question has stopped being about whether a 2200 or 2400 target is appropriate, but what the downside risk is. To put some perspective on how bad the Jobs Report was, Bloomberg pointed out that this was the worst release since 2010.
 

 

The downward revisions of previous months didn’t help matters either. Even worse, temporary employment (blue line below), which is a leading employment indicator, continued to weaken. The report screamed “pre-recession”, but when will the market react to that possibility?
 

 

There are reasons not to panic and over-react. NFP is a noisy number. The trends in Janet Yellen’s labor market dashboard are still moving in the direction of continued improvements in wages and labor market conditions.
 

 

Nevertheless, The combination of disappointment in a number of other measures such as the Jobs Report, ISM services and consumer confidence has spiked the recession odds in JP Morgan`s model to 36% (via Business Insider):

JP Morgan’s proprietary model that gauges the risk of a recession starting over the next 12 months also hit its highest mark since the financial crisis on Friday. Most of this was on the back of lackluster economic data.

“With the rally in risk markets over the last month, our models based on financial market pricing now see a recession risk moderately below our model based on macroeconomic data,” wrote JP Morgan economist Jesse Edgerton.

“Since last week, we have seen disappointments in the Dallas Fed measures of manufacturing and nonmanufacturing sentiment, the ISM nonmanufacturing index, and the Conference Board measure of consumer confidence.”

 

 

I am not inclined to panic in the face of this news as recession risk models with a longer term track record, such as Georg Vrba`s work on unemployment, is not signaling recession – and neither is his Business Cycle Index.
 

 

New Deal democrat agrees that recession risk is low in his weekly assessment of high frequency economic indicators. The economy is weak, but his short and long leading indicators are nowhere near recessionary levels.

[T]here is very little in the high frequency data that is outright negative. In fact, the long leading indicators are about as positive as I have ever seen them. With the Fed presumably on hold again after Friday’s jobs report, perhaps the broad US$ will also fall back from negative to neutral. Taking the K.I.S.S. approach of simply looking at the Index of Leading Indicators, they have been basically flat since last summer — implying an economy limping along but not falling into outright recession this year.

The Street turns cautious

Coincidentally, the Street’s analyst sentiment is turning down. The bottom-up driven forward 12-month EPS metric is falling, which will likely create headwinds for equity prices. The latest data from John Butters of Factset shows that forward EPS fell -0.29% (my estimate) last week.
 

 

Still, any correction stemming from a growth scare may be milder than the January/February episode. Factset also reported that Q2 EPS estimates have been flat for the last few weeks, which is a positive sign. Brian Gilmartin attributed the flattening earnings estimates to better growth in energy and materials, which is a bullish sign for late cycle cyclical stocks.
 

 

I view the lack of downward estimate revisions constructively because EPS estimates for any single period, whether annual or quarterly, have shown a tendency to start high and fall. Just take a look at the historical record from Ed Yardeni. Flat revisions is the new up.
 

 

So where does that leave us? How real is this growth scare? I would make the case that any slowdown is temporary and a data blip. Consider the latest Fed Beige Book report, which showed modest expansion:

Economic activity in April through mid-May increased at a moderate pace in the San Francisco District, while modest growth was reported by Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, and Minneapolis. Chicago noted that the pace of growth slowed, as did Kansas City. Dallas reported that economic activity grew marginally, while New York characterized activity as generally flat since the last report. Several Districts noted that contacts had generally optimistic outlooks, with firms expecting growth either to continue at its current pace or to increase.

Labor markets were reportedly tightening, which does not square with the downbeat Jobs Report:

Employment grew modestly since the last report, but tight labor markets were widely noted; wages grew modestly, and price pressure grew slightly in most Districts.

In addition, the latest ISM report showed New Orders at above 55 for three months running, which is hardly a recessionary signal. In fact, ISM New Orders can be seen as a sign that the shallow industrial recession that began late last year has ended.
 

 

In fact, the surge in new orders to inventory ratio is suggestive of a 2H growth spurt, not a slowdown.
 

 

Further, the USD fell in reaction to the NFP Report surprise, which is supportive of equity strength. A strong USD had been squeezing the operating margins of multi-national stocks. Conversely, a weak Dollar should therefore provide an earnings tailwind. Given the reaction on Friday, it would be no surprise to see the USD Index eventually retreat and test support at about the 93 level.
 

 

The Fed`s reaction

Bloomberg reported that Cleveland Fed President Loretta Mester, who is the first Fed official to speak after the Jobs Report, stated that the Fed should stay the course on interest rate normalization and dismissed the weak jobs number as a possible data blip. Jon Hilsenrath of the WSJ summarized the likely Fed reaction to the NFP Report as taking a June rate hike off the table, but July remains a possibility.

I interpret current conditions as the early signs of a temporary growth scare. Investors shouldn’t freak out, however, as a bear market is unlikely to begin from current levels. First of all, the US economy remains robust and the growth scare is probably just a data blip. However, should the economy start to truly weaken, the Fed has the capability to put its rate normalization on hold and possibly even begin easing with another QE program. A more plausible bear market scenario is a Fed policy miscalculation that over-tightens monetary policy which plunges the US and global economy into a recession. For that to happen, we need more growth – and more inflation to fuel the Fed’s determination to raise rates. Near-term equity market weakness is therefore likely to be short-lived and should be viewed as a buying opportunity.

Traders: Don’t get too bearish just yet

While my inner investor remains constructive on stocks, my inner trader is a nervous wreck. You can read the tone of a market by how it responds to news. When the disappointing NFP news hit the tape, the stock market fell about 1% on the day, but recovered to close at -0.3%. This kind of market action is a sign of bearish exhaustion. There are just too many bears, so it may be too early for traders to get bearish just yet.

There are many ways to measure market sentiment, but for the purposes of this exercise, I’ll ignore the surveys and stick to the indicators where traders and investors have real money on the line – and those indicators are tilted bearishly. Willie Delwiche noted that fund flows have shown a high demand for “safety”, as investors have been pouring money into bond funds:
 

 

…while pulling money out of stock funds:
 

 

Jason Goepfert documented the crowded short position of small futures traders, which is contrarian bullish.
 

 

Rydex data also shows that sentiment has been getting more cautious and nearing a crowded short condition. Current circumstances are unusual as investor sentiment has been getting more bearish as the stock market advanced, while similar past similar readings (see vertical lines) have been seen during periods of market weakness.
 

 

Bullish internals

In addition, a number of technical internals are bullish. The SPX Advance-Decline Line made an all-time high last week. While that does not mean that stock price can`t pull back, it does suggest that any correction is likely to be shallow.
 

 

Barron’s also featured analysis from Jason Goepfert of SentimentTrader which indicated the current backdrop of positive price momentum after the February low is bullish:

Through May, the SP 500 logged three straight months of gains since its 12-month low in February. That’s an encouraging sign for the rest of the year, if the experience of May 2009 holds true. That was the last time the market rose for three consecutive months after a 12-month low. Then, the market gained 16.8% in the following nine months and was up by more than 46% some two years later.

This insight comes courtesy of Jason Goepfert, founder, president, and chief number cruncher at SentimenTrader, which tracks sentiment measures to glean insights from the market’s action.

Examining data beginning in 1928, Goepfert notes that in 12 out of 14 years in which the SP 500 posted three consecutive months of gains following a 12-month low, the market rallied for the next three months. If the fourth month rose as well, future gains in the months ahead were even better, except for 1930 and 1940, periods of extended losses. In 2009, the fourth month neither advanced nor retreated but stayed flat, and yet the market never looked back.

Goepfert sees parallels between now and 1953, when stocks underwent a minor correction after a multiyear bull market. Then, as now, the advance/decline line hovered near its all-time high and market breadth was strong. Mimicking 1953 would be the best of all scenarios: The SP rose 24.7% in the nine months following the three-month signal and went on to return 83.8% two years out.

As well, the behavior of high-beta small cap stocks is signaling a pending risk-on environment, not a correction. As the chart below shows, both the SP 600 and Russell 2000 are breaking out of cup and saucer formations and their relative return charts are displaying the classic signs of saucer bottoms (ht Greg Harmon). I recognize that the charts can reverse and fake out even the best traders, but do many major pullbacks start with sentiment, breadth and high-beta small caps behaving in this way?
 

 

My inner investor remains constructive on stocks. The talk of minor pullbacks is just noise. A June swoon is well within the realm of possibility but he is prepared to buy on weakness.

My inner trader is nervously staying long the market for now and tightening up his trailing stops as market strength could reverse itself at any time. On the other hand, he would not be surprised to see the SPX test the top of its resistance zone and fake out all the bulls and bears before reversing direction. He will also be watching for the VIX Index (bottom panel) test its lower Bollinger Band, which would be indicative an overbought condition and a sell signal.
 

 

Just don’t ask me what the downside target is in a correction. I have no idea. My inner trader will be grateful if he manages to make the right directional call in a timely fashion in this potentially volatile environment.

Disclosure: Long SPXL

Should China emulate America? Or the other way around?

Posted by Cam Hui -

For your weekend contemplation: This post isn’t about how the American and Chinese economies may converge, but about the potential development path of capital markets and regulatory regimes. CNBC recently reported that Charles Schwab and the Shanghai Advanced Institute of Finance conducted a survey of Chinese stock investors and found out the reason the Chinese all appeared to be punters and gamblers. First and foremost, they didn’t start that way and only a small minority were in it for a quick profit:

Having surveyed 450 investors, only 13 percent invest for short-term purposes, such as turning a quick profit or generating enough cash to make a major purchase, while 87 percent invest as a means to improve their standard of living, retire or their children’s education, the study found.

But the Chinese market is not very mature and the investor base isn’t very sophisticated:

The lack of a mature bond market, long-term products on the market and professional financial advisors were major challenges, the authors explained.

“While the incomes and expectations of China’s emerging affluent have risen, China’s financial services sector has not kept pace…Unlike upper-middle class investors abroad, most Chinese investors chart their financial futures without assistance from financial service professionals,” the authors said.

As a result, Chinese often don’t understand the content of their investments and the risks they carry, the study noted, pointing to WMPs as an example. Detailed information isn’t always provided to customers and this lack of transparency is intentional since most WMPs are concentrated in China’s increasingly troubled industrial sector, the study said.

The combination of the lack of a professional institutional investor base (think Singapore’s sovereign wealth fund) and the lack of hard information about the markets, individual investors adopt behavior that looks like gambling:

Emerging affluent investors only invest 20 percent of their total assets in stocks due to market turbulence and aggressive government intervention forces. Because of this tiny allocation, Chinese tend to time the market, which isn’t usually a winning strategy for the average retail investor, the study noted.

“Speculative inclinations among investors are further reinforced by the disconnect between China’s stock markets and its real economic situation,” it said, revealing that only one-fifth of China’s industrial companies are listed on its A-share markets, while almost no emerging technology companies are represented.

“When a stock market fails to reflect the circumstances of the broader economy, rumor-driven speculation gains an upper-hand over strategic decision-making.”

Moreover, the incentive system of the advisors and salesman selling these investors are skewed towards sales, instead of doing the right thing for the client:

Because advisors tend to generate the majority of their revenues through sales commissions, they often sell products without regard for their clients’ needs, doing little to educate investors, according to the study.

During my tenure as an international equity portfolio manager, I observed similar kinds of punter and gambler mentality in many Asian markets. Unlike the American, European and even Japanese markets, whose trading are dominated by a local institutional investor base who tend to be more sophisticated about equity analysis, macro-economic analysis, etc., most Asian markets tend to be dominated by retail investors, whose are less knowledgeable about markets and have trading mentalities. Even “well developed” equity markets whose culture are Chinese in character like Hong Kong and Taiwan have experienced wild swings in prices on high volume turnover that are the hallmark of trader dominated markets.

Is a “westernized” market the answer for China?

Sitting here from a perch in the West, it would be easy to feel smug about the lack of market sophistication in China and the kinds of western solutions that can be applied. Even in the United States, those kinds of approaches have been problematical. The WSJ reported that, despite the widely publicized cases of wrongdoing, few individuals have been prosecuted:

The Wall Street Journal examined 156 criminal and civil cases brought by the Justice Department, Securities and Exchange Commission and Commodity Futures Trading Commission against 10 of the largest Wall Street banks since 2009. In 81% of those cases, individual employees were neither identified nor charged. A total of 47 bank employees were charged in relation to the cases. One was a boardroom-level executive, the Journal’s analysis found.

The analysis shows not only the rarity of proceedings brought against individual bank employees, but also the difficulty authorities have had winning cases they do bring.

As well, consider the resistance over the Department of Labor’s proposal for the adoption of a fiduciary standard for investment advisors (see comment above about Chinese “advisors” selling product without regard to client needs). To be sure, not all bankers are evil and many people in the industry try to do the right thing and put their clients first:

Over the years the Department of Labor spent developing and then reworking the fiduciary rule, Assistant Secretary Phyllis Borzi and her colleagues regularly received support from a surprising quarter – people who work for some of the companies that most vehemently fought it.

“Wherever I would go, people would come up to me, wearing name tags of companies that were wildly opposed to what we were doing, and they would say, ‘You go, girl,’ ” Borzi told an audience at an Institute for the Fiduciary Standard event this week. “And that kept us going.”

Like China, the incentive system has been skewed the wrong way and, as Greg Mankiw famously put it, people respond to incentives:

She emphasized that the industry’s conflict-of-interest problems come not from the people who work in it, but from the structure of the system itself.

“It isn’t,” she said, “a case of bad people giving advice. It’s that people who wanted to do the right thing by their clients were trapped in a bad system, in a system that was characterized by misalignments of the interest of the investor and the interest of the adviser.”

Should America emulate China, or China America?

I spent about half of the time in my professional career on the buy side (as an institutional investor) and half on the sell side (brokerage firm). The principal focus of my sell side career has been on institutional investors.

Here is what I found disturbing about that experience, as the fiduciary standard is arguably not relevant when dealing with institutional investors, who are trained investment professionals. Here is what I have observed first-hand:

  • Salesman and traders who knowingly sell junk to clients with the justification that, “They’re all big boys and they know the risks. It’s all in the disclosure documents.”
  • One salesman, a CFA charterholder himself, derided a negative research report that I wrote as the “CFA way of doing things” because it interfered with a product that he was selling. (Sorry, I thought I should adhere to the CFA code of ethics).
  • An investment banker who actively hid the fact from his firm’s research arm that the CEO of a company that the firm had IPO’ed had a criminal record.
Going back to today’s Hong Kong and China, consider this Bloomberg account of the stock recommendations of the brokerage firm Emperor Capital Group, which had a “buy” rating on every one of the companies it covered:

The unit of Emperor Capital Group Ltd. issued buy recommendations on every one of the 173 companies it reported covering from April 2015 through May 16. Its target prices, which the company says forecast trading levels within weeks, predicted gains of 25 percent on average. They are frequently the most bullish among analysts who cover the same stocks and list their calls with Bloomberg, including those based on the standard 12-month horizon.

The picks ended up being so wrong during the past year’s rout of Chinese and Hong Kong stocks that shorting every one would have resulted in gains of about 6 percent after just four weeks and almost 13 percent if all were held through last week.

Emperor’s record highlights the perils of equity trading for new retail investors flooding markets in China and Hong Kong. Individuals piled into stocks as the Shanghai Composite Index recorded one of its best rallies ever and policy makers relaxed restrictions on mainland and Hong Kong citizens trading in each other’s markets. Emperor, which caters to such traders, said its revenue increased 64 percent in the year ending March 31 thanks in part to big increases in brokerage fees and margin-lending interest payments.

 

 

Their price targets tended to be *ahem* aggressive, but every single stock went down in the end.
 

 

Emperor got paid well, but where are the customers’ yachts?

Emperor’s latest earnings statement, released May 18 for the six months ending March 31, reported another 20 percent increase in brokerage revenue from a year earlier. Revenue from margin loans and other lending rose 141 percent to HK$373 million. At the end of the period, the company was holding HK$13 billion worth of securities as collateral for margin loans.

These are the sorts of shenanigans that happen when the sell side is not held to a a fiduciary standard. I would also add that most people that I have met in the industry try to do the right thing for their clients, but the sales incentive system is designed to encourage them to cut corners. What’s more, the ones who “do the wrong thing” have in many cases gotten paid obscene bonuses for many years, sometimes decades, before reality finally caught up with them.

Finance: A force for good?

So, I ask the question: Should China try to emulate America, or should America try to emulate China? Is it too much to ask to require investment advisors to put their clients first and be held to the same standard as doctors and lawyers? Or should the US give in to the lobbyist who characterize regulators as “nuns with guns“?

Speaking at the 69th CFA Institute Annual Conference, psychologist Daniel Goleman stated that he believes that the investment industry has a long-term problem with trust. Instead of railing about excessive regulation, finance can be positioned as a force for good:

Goleman noted that trust — or the lack thereof — remains a challenge for the industry. According to the 2016 Edelman Trust Barometer, financial services ranked dead last vis-à-vis other business sectors, with a 51% trust rating. While there undoubtedly remains a deficit, the good news is that public faith in financial services increased 8% since the 2012 survey. Still, more needs to be done to restore trust levels.

“Trust is an essential,” Goleman said. “Trust is actually part of the commodity that finance needs in order to operate well.”

What the financial industry needs, he added, is “a strategic pivot to look at what we’re doing in finance for society, for the greater good.”

Otherwise, we know what has happened in the Chinese markets.

5 technical reasons to be bullish on stocks

Posted by Cam Hui -

Mid-week market update: As the US equity market consolidates its gains near resistance and all-time highs, I remain constructive on stock prices for the following five reasons:

  • Momentum is positive
  • Breadth is positive
  • Bullish support from overseas markets
  • Greed is fading, which is supportive of further gains
  • Overbought conditions are fading (ditto)

Momentum is positive

I recently highlighted this tweet from Leuthold Group and the SPX has indeed closed May above the key 2062 level. If history is any guide, stock prices should move higher from here.
 

 

Breadth is positive

The chart below shows the SPX A-D Line hit another all-time high yesterday (data has not been updated to Wednesday at pixel time). The SPX A-D Line is an apple-to-apples comparison and doesn’t have the problems of what is in the NYSE Composite when technicians analyze market breadth with the NYSE A-D Line,
 

 

Bullish support from overseas markets

It is always useful to see if an advance or retreat is confirmed by other markets, which is another way of analyzing market breadth, but on a global basis. That’s called inter-market analysis, or cross-asset analysis. The picture from overseas is also supportive of further gains, European markets are in rally mode. The FTSE 100 above its 200 dma and just testing its 50 dma support.
 

 

The Euro STOXX 50 is rising as well. While it has cleared its 50 dma, it has yet to breach its 200 dma.
 

 

The Chinese market and the markets of its major Asian trading partners are showing signs of healing. All Asian markets are in minor uptrends and the Shanghai market rallied above a key resistance level two days ago.
 

 

Greed is fading

The option market is showing indications that complacency and greed are fading. The VIX Index has risen above its 20 dma, indicating rising fear, and the term structure of the VIX, as measured by the VIX to VXV (3-month VIX) is also signaling rising fear, or falling greed.
 

 

Overbought readings are fading

Intermediate term (1-3 week time horizon) breadth metrics are not overbought and the market has room to move higher given the positive breadth and momentum backdrop. This chart from IndexIndicators of the net 20-day highs-lows shows that the market is starting to retreat from a minor overbought condition, which gives it more room to advance.
 

 

The combination of these indicators do not mean that stock prices will necessarily rocket up tomorrow, or even this week. There are a number of binary events that could be a source of volatility this week, such as the Employment Report and Janet Yellen’s speech this Friday.

Nevertheless, trading and investing is a matter of playing the odds – and the odds are tilted in favor of the bulls right now.

Disclosure: Long SPXL

The roadmap to a market top

Posted by Cam Hui -

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on 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 bullish 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: Neutral
  • 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.

Not turning bearish yet

No, my inner investor isn’t turning bearish, but I believe it is prudent to be thinking about how a market top develops. The bull market that began in 2009 is getting mature and I am getting starting to watch for signs that a market top is developing. My analytical framework is as follows:

  • Macro-economic analysis: I am grateful for the work by New Deal democrat in his recent post A roadmap to the next recession. This chart from Gene Epstein at Barron’s shows the risks to equities should economic growth stall and roll over. While stock prices can fall and correct at any time, the most severe declines have been associated with recessions.
 

 

  • Growth and valuation: I think of stocks in terms of the two components of the PE ratio. First, how much is E like to grow? Second, will the P/E ratio expand or contract? The big question in the current environment is the intersection of growing E as the Fed embarks on a tightening cycle. How will stock prices respond as earnings rise, but higher interest rates puts downward pressure on the P/E ratio?

A roadmap to the next recession

In his post, New Deal democrat laid out a very sensible checklist for anyone watching for the next recession (comments in parentheses are mine):

  1. Interest rates continue to fail to make new lows. (Check: he means short rates).
  2. House prices and stock prices stop meaningfully appreciating. (Stocks, yes. Houses, not yet but it could be soon as sales lead prices – and sales have stalled).
  3. Inflation picks up to 2% or more as energy prices begin to go up again. (Check: see Core CPI).
  4. Maybe – the Fed raises rates in response to increased CPI readings, perhaps enough to invert the yield curve. (Yield curve is not inverted, but see the risks in my post Three steps and a stumble).
  5. Corporate lending stalls, housing turns down, and consumer spending begins to turn down, resulting in a recession.
We are roughly between stages 3 and 4 of this process as the Fed is itching to raise rates. We have seen a coordinated campaign by numerous Fed speakers correcting the market`s perception about the trajectory of rate hikes for the rest of this year. The June meeting is “live”, with the usual caveats about “data dependency”. Don’t be surprised if there are two more rate hikes this year. CNBC reported that Janet Yellen did nothing on Friday to contradict the other Fed officials and said that a rate hike was probably appropriate in the next few months, 
CME Fedwatch is currently showing a 28% chance of a hike in the overnight rate at the June FOMC meeting:

 

 

…and a 60.7% chance that rates will be more than the current 0.5% by the July meeting:

 

 

Mission accomplished. Fed speakers have done their job. The market now believes that the FOMC will likely stay steady in June, which makes sense in light of the risks from the Brexit referendum, but hike by a quarter point in July.

The growth outlook

The second leg of my analytical framework is the growth outlook. Indeed, growth is returning after the recession scare in January and February. John Butters of Factset shows that forward EPS estimates continue to rise, as optimism is returning to the Street.
 

 

The Citigroup Economic Surprise Index (gold line), which measures whether economic data is beating or missing expectations, is on the rise again.
 

 

The big question is what happens to stock prices. During past rate hike cycles, equities have been able to shake off the first few rate hikes and rally in the face of tight monetary policy. The reason can be attributable to the positive effects of strong growth overcoming the negative effects of a rise in interest rates. A post by Jeroen Blokland indicates that history shows that Fed rate hikes have led to better returns by commodities and global equities.

The chart below shows the 10-2 year yield spread (in black, as a measure of the yield curve), the gold to bond price ratio (green, as a measure of inflationary expectations) and the Dow Jones Industrial Average (bottom panel). I chose the DJIA as an indicator because it contained relatively few technology stocks and therefore had fewer distortions from the NASDAQ Bubble of the late 1990s. In the past, when inflationary pressures (green line) ticked up, the Fed responded by raising rates and eventually inverting the yield curve. Stock prices were flat to up during those inflationary uptick episodes (marked by the red rectangles) for the reasons I mentioned above.
 

 

We are entering a similar period where inflationary expectations are starting to rise again. Based on past historical experience, stock prices should see new highs before rolling over into a bear market as the Fed over-tightens the economy into the recession.

Conventional analysis suggests that the next US recession should be fairly mild, as there have been few excesses built up in the current cycle. But the Great Financial Crisis taught us that the world is highly inter-connected. The main risks to the market and the economy comes from outside US borders. Europe is by no means fixed and European bank balance sheets are still very stretched. China`s challenges with its white elephant infrastructure and debt overhang are well known. So what happens when the US economic locomotive slows down and the American consumer stops spending?

The WSJ reported that Ed Yardeni believes that the rest of the world is far more sensitive to a Fed rate hike than the American economy. Just take a look at the correlation (don`t say causation) between the Treasury yield curve and global industrial production.
 

 

Here is the Treasury yield curve and global trade.
 

 

I can easily imagine a scenario where a slowing US economy puts the brakes on global trade and industrial production, which exposes the problems in China and European bank leverage. The aftermath would not be a pretty picture.

The road ahead

I do not write for Zero Hedge and this is not meant to scare anybody. So far, all we have is a “this will not end well” investment story. The trigger has not been pulled yet and growth is still holding up.

In a more bullish scenario that I had written about before, I postulated a similar roadmap, but with a more dovish Fed that was willing to hold its fire until the December meeting (see How the SP 500 could get to 2400 this year). Nevertheless, much of the analysis I wrote for that post still holds true. Earnings could rise another 5-10% from current levels as energy and commodity prices “`less bad”. Assuming no change in the P/E ratio, this would translate to a 5-10% rise in stock prices, which puts an upside SPX target of 2200-2300 for this year.

The unknowns are how Federal Reserve policy affects the yield curve and the US Dollar. USD weakness has provided a tailwind for stock and commodity prices, but the recent bout of strength could reverse many of those gains. A strong greenback puts downward pressure on the earnings of multi-nationals doing business outside US borders and further USD strength would exacerbate the negative effects of interest rate hikes.
 

 

Analysis from Factset shows that the sectors with the greatest foreign sales exposure are Technology, followed by cyclically sensitive sectors like Energy, Materials and Industrial companies. In effect, USD weakness is a pro-cyclical factor, or a double-edged sword, affecting stock prices.
 

 

The near-term market outlook

For now, the short and intermediate term stock market outlooks are still bullish. Sentiment readings are neutral to bearish, which means neutral to contrarian bullish for stocks. My inner trader is encouraged by the continual bearish tilt in sentiment despite the strong rally last week.
 

 

Michael Harnett of BoAML indicated that their global fund flows model is getting very close to a buy signal (via Marketwatch):
 

 

Momentum is still positive and Leuhold Group wrote it was getting close to a buy signal should the SPX close May above 2062 (it currently stands at 2099). The pending Leuthold Group signal is consistent with my thesis that the market can make new highs in 2016.
 

 

The message from the credit markets is also supportive of higher stock prices. The chart below of the prices of US junk bond and emerging market bond against their duration equivalent US Treasury benchmarks shows a pattern of higher lows and higher highs, which is reflective of improving risk appetite.
 

 

Even the market reaction on Friday to Janet Yellen’s comments was revealing. It first weakened as Yellen indicated that a rate hike was just around the corner. It then shrugged off the bearish content and rallied to new recovery highs. This was a sign that the bulls have control of the tape.
 

 

My inner trader flipped from bearish to bullish last week (see The correction is (probably) over). My inner investor remains bullish on stocks, but he is carefully monitoring the recession indicators in the Ultimate Market Timing Model (see Building the ultimate market timing model) for signs that the Fed is engineering a recession in 2017.

Disclosure: Long SPXL

$50 oil! What’s next?

Posted by Cam Hui -

As the oil price touched $50, there has been a growing paradigm shift, a sort of “this time is different”, consensus forming about the long-term outlook for oil prices. Amy Myers Jaffe of UC Davis recently addressed the 69th CFA Institute Conference and made the following bearish points about the long run trajectory of oil prices:

  • Demand: Global demand growth is set to slow, flatten and perhaps fall as countries start to adopt alternative energy sources. Indeed, Bloomberg recently reported that there are more people employed in renewable energy in China than oil and gas. Similarly, solar power related employment has surpassed employment related to coal and oil and gas combined in the United States.\
  • Supply: The fracking revolution is a revolution. For the first time in history, advances in engineering has allowed us to extract oil and gas from oil bearing rock, which means that any geology that formerly produced oil, such as Pennsylvania, is has the potential to produce oil again. Jaffe did not, however, address the cost question and said in so many words that these are engineering problems, which can be solved over time.
In effect, don`t expect much more upside in the price of oil.
Independent of Jaffe’s analysis, Bloomberg Gadfly column by Liam Denning used similar assumptions about oil prices and suggested a strategy by the Big Oil companies is in order:

Like OPEC, they [Big Oil] assumed the value of their reserves of this finite, critical commodity would, more or less, keep rising over time. So a barrel not produced today, even if it cost a lot to find or acquire, is effectively money in the bank. This is why the majors obsess over their reserves replacement ratio, measuring how many new barrels come in to replace the ones they pump out.

Now, the upcoming Saudi Aramco IPO raises one troubling possibility: That the assumption of endlessly rising reserve value may no longer hold true.

A flurry of paradigm-shifting announcements out of Saudi Arabia came soon after a speech in October by BP’s chief economist. He posited that the shale boom undercut the notion of peak oil supply, while efforts to curb carbon emissions raised the possibility of peak demand.

Denning went on to suggest that the upcoming partial privatization of up to 5% of Saudi Aramco representing a Saudi strategic shift to produce at any price, rather than to bank the oil in the ground because it is becoming a commodity with diminishing value.

Saudi Arabia’s sudden desire to sell shares in its national champion and generally shift the entire economy away from its oil addiction suggests it at least entertains those possibilities. It also provides a rationale to maximize production at any price, rather than risk barrels being left worthless in the ground.

Shale boom + carbon emissions curb = Peak Oil demand. It’s time to change the thinking on the management of this resource and sell it as fast as possible because some of those assets will become stranded in the future. Call it the Hot Potato Theory of oil.

Hot Potato Theory = This time is different

How plausible is the Hot Potato Theory? Notwithstanding the current market conditions, take a look at this multi-decade chart of oil supply and demand from Yardeni Research. Past history shows that demand has kept on growing.
 

 

Going back to 1987, oil demand has risen more or less steadily with minor interruptions from recessions. One of the underlying assumptions of the Hot Potato Theory calls for demand to start rolling over.
 

 

A bet against rising oil demand is a bet against emerging market economic growth. In the short term (1-3 years), it would mean halting EM growth in its tracks.
 

 

If we were to make the assumption that energy demand in the EM countries is going to start flattening out, much as they have in the developed countries, more development translate to greater industrialization and higher energy usage intensity. While China is an outlier in its inefficient use and its energy intensity will likely start to flatten out and eventually fall, we also have to consider the developmental cycle in other EM economies. A bet on near-term falling or flattening demand is still a bet that EM growth slows dramatically. Such a scenario implies tanking EM growth and, in all likelihood, a prolonged global recession.
 

 

As oil prices have fallen, Barron`s reported that Boeing has warned that airlines are becoming less concerned over fuel economy. So expect a very bump ride if you expect a demand dropoff in the near future.

To summarize, a bet on flattening or falling oil demand is a “this time is different” bet, at least in the 1-3 year time frame. While history has seen earth shattering transformations in technology and behavior, a “this time is different” is one of the most dangerous bets that an investor can make.

To be sure, there is far more supply on the market. The chart below depicts the rise of oil production from US tight oil and, to a lessor extent, Russia in the last few years. The appearance of this new supply has upset the old order. Moreover, the Saudi desire to pump at all costs and maintain market share is probably linked to its rivalry with Iran, rather than any calculated attempt at economic maximization.
 

 

The political risk of restructuring

Saudi Arabia`s deputy crown prince Mohammed bin Salman recently unveiled its Vision 2030 restructuring plan to great fanfare. The plan is full of McKinsey slogans, but short on details and it received with great skepticism (see an example here from FT Alphaville). Moreover, Vision 2030 contained many ambitious objectives like this one that contained prescriptions on how to diversify the economy, where evidently neither the Saudis nor their McKinsey consultants were aware of Michael Porter’s work on industry clusters in The Competitive Advantage of Nations:

Our aim is to localize over 50 percent of military equipment spending by 2030. We have already begun developing less complex industries such as those providing spare parts, armored vehicles and basic ammunition. We will expand this initiative to higher value and more complex equipment such as military aircraft. We will build an integrated national network of services and supporting industries that will improve our self-sufficiency and strengthen our defense exports, both regionally and internationally.

In fact, the Saudi reliance on McKinsey is reminiscent of Miachiavelli`s warning about mercenaries. Simply put, mercenaries just want your money, but you can’t count on their loyalty when the going gets tough:

Mercenaries and auxiliaries are useless and dangerous; and if one [a prince] holds his state based on these arms, he will stand neither firm nor safe; for they are disunited, ambitious and without discipline, unfaithful, valiant before friends, cowardly before enemies; they have neither the fear of God nor fidelity to men, and destruction is deferred only so long as the attack is; for in peace one is robbed by them, and in war by the enemy. The fact is, they have no other attraction or reason for keeping the field than a trifle of stipend, which is not sufficient to make them willing to die for you. They are ready enough to be your soldiers whilst you do not make war, but if war comes they take themselves off or run from the foe; which I should have little trouble to prove, for the ruin of Italy has been caused by nothing else than by resting all her hopes for many years on mercenaries, and although they formerly made some display and appeared valiant amongst themselves, yet when the foreigners came they showed what they were.

We have seen instances in the past where countries and local authorities have tried various schemes to pivot and get lessen their economy’s reliance on natural resources as a source of growth. Most have failed. The greatest success was been the Norwegian sovereign wealth fund, which took oil revenues and invested the proceeds outside Norway as a way of avoiding local boondoggles – which is not a feature of the Saudi plan.

The new fracking technology will likely put a ceiling on the price of oil for some time, while oil prices may not be sustainable at $30-50, higher prices will be met by marginal production, which can be started by the shut-in US tight oil in relatively short order. These price ceiling constraints implies that the Saudi budget will be under considerable pressure for some time.

Such an environment creates serious tail-risk over the next 5-10 years as political discontent is likely to rise, not just in Saudi Arabia, but in many oil producing countries. As an example, Nigeria is already experiencing supply problems due to a local insurgency (via Bloomberg):

It’s hard to see any long-term let-up given Nigeria’s record on fixing this problem. The previous wave of discontent, which hit a peak in 2009, only came to an end when President Yar’Adua offered amnesty, training programs and monthly cash payments to nearly 30,000 militants, at a yearly cost of about $500 million. Some leaders of the Movement for the Emancipation of the Niger Delta (MEND), the militant group, got lucrative security contracts.

But the failure to properly address local grievances means it was only a matter of time before another wave of angry young men took up the fight for a better deal for southern Nigeria. The crisis has been hastened by new president Muhammadu Buhari’s termination of the ex-militants’ security contracts and his seeking the arrest of former MEND leaders.

The Avengers now say they want independence for the Niger River delta.

And it’s not as if Nigeria’s oil woes are limited to the militants. Exxon had to declare force majeure on Qua Iboe exports after a drilling platform ran aground and ruptured a pipeline, while Shell did similar with Bonny Light exports after a leak from a pipeline feeding the terminal.

 

 

Stratfor recently featured a report on the jihadist threat in Saudi Arabia, which comes from the dual threat of IS and Al Qaeda. In effect, Saudi Arabia faces the tail-risk of becoming a failed state should the Kingdom fail to properly manage the intersection of falling oil revenues and the expectations of its citizens. A report by Global Risk Insights added more color with an even more pessimistic view:

With the strain on its finances from the oil price trough and its military campaigns abroad, Saudi Arabia is in a weakened condition. The basis of its internal control is its enormous capacity to pay for popular support through the maintenance of a generous welfare state.

The likelihood of increasing economic hardship (25% of the population now lives in poverty, with youth unemployment at 30%) and Shia retribution for ISIS-orchestrated attacks, together with continued cooperation with Iran and the US in the fight against ISIS and the House of Saud’s failure to protect Sunnis in Yemen and Syria, means that the ability of a challenger, such as ISIS, to make a successful bid to displace the leadership role of the House of Saud is high.

Recent reports of discontent and instability within House of Saud itself further enhance the opportunity for a challenger to succeed.

The House of Saud is facing its most trying challenge since its conflict with the Ottomans 200 years ago, and the implications are enormous.

The country will likely go through a bloody transition with conflict amongst Salafi factions, between Salafis and other Sunni groups, and between these groups and Shias. Conflict will continue until one of those groups emerges victorious or, more likely, the country is divided between them.

The problem isn`t just limited to Saudi Arabia. This chart shows oil exports as a percentage of GDP (via WEF). The list is headed by Kuwait, followed by Libya. Saudi Arabia is third on the list.
 

 

This chart shows the reliance on fuel as a percentage of merchandise exports, which includes commodities such as natural gas and coal. Saudi Arabia is 11th on the list.
 

 

A recent Bloomberg story detailed the struggles of Alaska governor Bill Walker of managing the State`s collapsing oil revenues against the expectations of its residents used to receiving dividend checks. Many countries at the top of the above list don’t have the same kind of governance structures present in modern western democracies. If Alaska is having trouble managing its budget and expectations, then what’s the political tail-risk in these other countries?

The near-term path for oil prices

The IEA projections show that oil supply and demand is likely to come into better balance late this year, which should help prices rise.
 

 

A recent Goldman Sachs research report (via Business Insider) postulates a much flatter cost curve for oil production because of ever improving tight oil technology, whose production can be shut-in and restarted quickly, and the desire of OPEC countries to maintain market share.
 

 

If we are to accept the Goldman thesis about an equilibrium price at or about current levels because of a new and flatter cost curve, these prices are below the minimum budget breakeven for many oil producing countries and the risk of sudden price spikes from geopolitical disruption rises. At a minimum, it would suggest an unstable equilibrium, with prices in the $40-60 range punctuated by spikes from more frequent supply disruptions.
 

 

So much for the Hot Potato Theory for the next few years. Tactically, however, the intersection of $50 oil and the recent WSJ article “The New Oil Traders: Moms and Millennials“, which detailed the story of apparently inexperienced day and swing traders gravitating toward leveraged crude oil ETFs suggests that the latest strength in crude prices may be overdone. A more prudent course of action for investors would hold a core position, buy the dips and lighten up on rallies.

Disclosure: Long SU

The correction is (probably) over

Posted by Cam Hui -

Mid-week market update: About two weeks ago, my inner trader turned cautious on the US stock market (see my tweet and subsequent post Tactically taking profits in the commodity and reflation trade). I had cited as reasons the weakness from China, the commodity markets and, later, Europe (see Waiting for the storm to pass), which was based on inter-market and cross-asset analysis. (Though my inner investor remained constructive on stocks.)

Since then, the SPX weakened to test an important technical support at 2040, which represents the neckline of a potential head and shoulders formation. (As all good technicians know, a head and shoulders formation isn’t complete until the neckline is broken.) While the market did break 2040 last week on an intra-day basis, neckline support held. In addition, the NASDAQ Composite confirmed the strength today by staging an upside breakout through resistance.
 

 

At the time of the bearish trading call, I said that I would turn bullish if:

  • The US stock market got oversold and sentiment models flashed a crowded short reading; o
  • The stock markets improved in Europe or Asia.
Let’s consider what has happened since then.

The bull case

The SPX has made a round-trip and rallied above its 50 day moving average (dma).  Despite all the global concerns over slowing growth in China, Brexit and Fed policy, the bears were never able to push the index down past 2040. These combination of a lack of bearish momentum and today`s recovery can be interpreted as the bulls seizing control of the tape.

Rob Hanna at Quantifiable Edges found a historical bullish pattern based on the recent consolidation action that suggests a positive bias going out to two weeks.
 

 

As well, the UK market rallied dramatically through both its 50 and 200 dma, which was likely a reaction to the latest polls showing that the Remain camp is gaining ground in the upcoming Brexit referendum. Regardless of the explanation, such exhibitions of positive momentum is bullish and indication of that possible relief rally is just starting.

 

 

Commodity prices have shown a mixed picture. On one hand, the CRB Index, which is more heavily weighted in energy, remains in an uptrend because of the strength in oil prices.

 

 

On the other hand, the cyclically sensitive industrial metals are still struggling:
 

 

Another positive cyclical development has been the dramatic rally in the semiconductor stocks, which staged a marginal upside breakout from resistance on an absolute (top panel) and relative (bottom panel) basis. While these stocks appear to be extended in the short term, their turnaround is a positive signal for the global growth outlook.
 

 

The bear case

Despite these bullish developments, it would be difficult to declare that blue skies and clear sailing are ahead for the bulls. First and foremost, the market is signaling that problems with China are ongoing. The chart below of the stock markets of China’s major Asian trading partners have not turned up, with the exception of Australia, which is trading above its 50 dma, and Taiwan, whose sudden recovery is semiconductor related (see above).

 

 

In addition, the USD strength is problematical for stock bulls. The USD is inversely correlated to commodity prices and it would difficult to see how both USD and commodity prices, which is an important barometer of global cyclicality, could rise at the same time. In addition, a strong USD will put downward pressure on the profit margins of US multi-nationals and therefore depress the earnings growth outlook.

 

 

As well, the yield curve is continuing to flatten (for further explanations see Three steps and a stumble? and Yield curve: Correlation vs. causation edition). A flattening yield curve could be interpreted as a signal of decelerating economic growth, which would be a worrisome sign.

 

 

Bear case getting less bad

How can we resolve the apparent contradiction of signals of better growth (improving US and European stock markets, commodity prices and better semiconductor industry outlook) with equally compelling indications of slowing growth (weak China and Asian stock markets, strong USD and flattening yield curve)?

The bear case getting less bad. This is mostly all about the Fed. The price action of the USD and the flattening yield curve can be explained by the sudden hawkish Fedspeak in the last couple of weeks after the dovish tone from the last FOMC statement. Tim Duy summarized the disagreement within the FOMC as a debate over whether the economy faces inflationary pressures from the employment picture, as the decline in the unemployment rate has stalled because the participation rate is rising again:

To me then, it appears that by raising rates now the Fed is risking falling short on its employment mandate at a time when the price mandate is also challenged. And falling short on the employment mandate now suggests an economy with sufficient slack to prevent reaching that price mandate. And that is without considering neither the balance of risks to the outlook nor the possibility that escaping the zero bound requires approaching the inflation target from above rather than below. Consequently, it seems that the case for a rate hike in June should be quite weak.

I would think that Federal Reserve Chair Janet Yellen should also find it quite weak. But the minutes of the April FOMC meeting and recent Fedspeak indicate that a large number of monetary policymakers find the case for a rate hike quite compelling. Given her past concerns regarding underemployment, I would have expected Yellen to lean stronger in the opposite direction. But I don’t know that she is in fact leaning against the logic driving a rate hike. I am hoping we learn as much via her upcoming speaking engagements.

Hopefully, we should get greater clarity about the direction of Fed policy when Janet Yellen speaks on June 6. My guess is that Yellen, who was trained as a labor economist, tilts towards the side of the doves and the Fed Policy Loop begins yet again.
 

 

From my inner trader’s perspective, the improvement in tone in stock prices represents an unconfirmed signal of strength. Things are getting less bad – and that`s bullish. Should the market hold the breakout points (SPX 50 dma, FTSE 100 50 and 200 dma, etc.) tomorrow on a closing, he will cover his current short position and reverse to the long side. This brief correction is probably over.

Disclosure: Long SPXU

Yield curve: Correlation vs. causation edition

Posted by Cam Hui -

Further to my last post (see Three steps and a stumble?), I would like to clear up some misconceptions about how I interpret the yield curve and its investment implications. Much of the confusion revolves around the idea of correlation vs. causation. Yield curve inversions don’t cause anything. Yield curve inversions are a signal (correlation) of certain effects that have important investment implications.

In this post, I will address the following topics:

  • Yield curve and recessions
  • Yield curve and credit conditions
  • Yield curve and equity bear markets

The yield curve and recessions

First of all, I do agree with New Deal Democrat that the yield curve is not signaling recession right now. As the chart of the 10-2 year Treasury yield shows, this spread has inverted (gone negative) before every one of the last five recessions, with no false positives. But the spread has been bouncing around 0.9-1.0% and therefore it is not forecasting a recession.
 

 

Incidentally, the choice of 30-5 (blue line) or 10-2 (red line) year spreads make little difference to our conclusions:
 

 

When will the yield curve actually invert and signal recession? I have no idea. Tim Duy thinks that the yield curve will continue to flatten because the Fed is in a tightening cycle:

So why is the curve flattening? My story is this: The yield curve flattens whenever the Fed is in a tightening cycle. And the Fed most assuredly remains in a tightening cycle. They have not backed off their fundamental story that rates are headed higher. They see normalized interest rates on the short end as well above the current yield on the long-end. This seems entirely inconsistent with signals from the bond market and the global zero interest rate environment. In my opinion, the Fed continues to send signal that they intend to error on the side of excessively tight monetary policy.

For the yield curve to steepen, the Fed needs to signal that it is more “relaxed” about rising inflation:

To expect the curve to steepen at this juncture, I think at a minimum you need the Fed to more aggressively commit to approaching the inflation target from above. You need to overshoot. That I think would be essentially an easing at this point. Chicago Federal Reserve President Charles Evans is already there. I think that Federal Reserve Chair Janet Yellen is getting there, but can’t say it.

And even then, I don’t know that approaching the target from above is enough. The dominance of the dollar in international finance means the Fed has a preeminent role in fostering global financial stability. A 2 percent US inflation target may not be consistent with global financial stability. And if not consistent with global financial stability, then not with US financial stability and thus not solid US economic performance. Which means if the Fed is the world’s central bank, they need to adopt an inflation target consistent with maintaining global growth. That might be higher than 2 percent. And they aren’t going down that road without a long and nasty fight.

Remember, an inverted yield curve doesn’t cause recessions. Inverted yield curves are market signals of tight monetary policy that causes recessions.

The yield curve and credit conditions

Additionally, I did not mean to imply in my last post that a flattening yield curves causes credit availability to dry up. A flattening yield curve an indicator of monetary policy, which the financial system interprets to become more prudent in its lending standards.
 

 

The yield curve and bear markets

Finally, some readers pointed to the analysis from Urban Carmel, which showed a loose connection between flattening yield curves and equity bear markets.
 

 

For a slightly different perspective, here is the 10-2 yield spread (blue line) against the Russell 1000 (red line). Yield curve inversions (blue circles) have signaled recessions in the past. The stock market has experienced bear markets in anticipation of recessions (red circles). Arguably, the NASDAQ top of 2000 and its subsequent crash had sufficient economic impact that it caused a recession.
 

 

The two are related but inverted yield curves don’t cause bear markets, stocks go down in anticipation of recessions.In general, the macro-economic sequence goes something like this. The Fed tightens monetary policy, which causes the yield curve to flatten and eventually invert. The inversion is an indicator that monetary policy is so tight that a recession is more or less inevitable. The stock market reacts to the prospect of a slowing economy and recession and falls.

Got that? The shape of the yield curve is only a market indicator. It doesn’t “cause” anything to happen. Correlation does not equal causation.

Three steps and a stumble?

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 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 bullish 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: Neutral
  • Trading model: Bearish

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.

Some good news and bad news

The market action last week played out roughly as I expected. Stock prices were choppy and displayed a series of lower highs and lower lows, though the technically important 2040 support neckline of the head and shoulders pattern did not break decisively (see Waiting for the storm to pass). The short-term trend remains down and key intermediate term indicators has not reach oversold levels, as measured by the NYSE McClellan Oscillator (NYMO) breaching the -80 level and VIX Index moving above its Bollinger Band, which suggests that the current corrective action isn’t finished.
 

 

There was some good news and bad news as stocks declined. As I have pointed out before, the simplest way of thinking of stocks is through the two components of the P/E ratio. First, is the E rising? The good news came from the latest round of macro data releases showed upbeat figures from industrial production and housing. That, combined with a rising CPI, paints a picture of a US economy with robust Q2 growth.

As well, John Butters of Factset reported that forward 12-month EPS continues to climb, which is reflective of improving optimism from the Street (chart annotations in red and estimated revision are mine). Score a couple of points for the bulls.
 

 

The less certain news comes from an evaluation of the likely direction of the P/E multiple. The inverse of P/E, or E/P, is a function of interest rates and expectations of future growth (which is why growth stocks trade at high P/E multiples). The decidedly hawkish tone from the Fed officials and the FOMC minutes spoiled the party for the bulls.

One of the wildcards of my generally bullish outlook for equities has depended on a relatively dovish Fed. The big question is whether the Fed is continuing on the Fed policy loop of stop-start hawk-dove cycle, or if it’s actually serious about embarking on a policy of rate normalization.
 

 

The fragile economy

While the following does not represent my base case projection, I would like to explore the possibility of the bearish three steps and a stumble scenario, which follows the old trading adage of three Fed tightening moves will tend to lead to a stock market stumble. This scenario is becoming a real possibility as the US economy is still in a fragile state.

The fragility of the current economic expansion was highlighted by a WSJ interview with Steven Blitz, chief economist at ITG Investment Research. Blitz is no Zero Hedge doomster, but he assigned a 60% chance of probability of recession in the next 12 months, largely because of possible policy error:

My 60% probability really means to convey a sense that the economy is nearing a point where policy mistakes can kick it into recession. A lot of data appear to be more middle or end-of-cycle in their behavior. This means to me that the economy is more susceptible to a policy mistake. The Federal Reserve really needs to be careful and more recent statements from [Chairwoman Janet] Yellen suggest they are.

Blitz went on to outline his bearish scenario:

Understand the Fed tightening began after QE3 ended, and the forward market started pricing an aggressive forward trajectory for Fed policy, aggressive for this economy. Media focuses on the funds rate, but forward pricing matters most. Forwards determine the Treasury yields against which mortgages, corporate borrowing, and dividends are priced. As an increasingly aggressive Fed policy tack was priced in, capital markets reacted as they always do once the Fed starts in this direction—the 2s/10s yield curve flattened, equity markets weakened, and economic growth began to decelerate, which continued into the first quarter.

In other words, don`t focus on the Fed Funds rate, focus on forward rates and the yield curve because the market prices risk off forward rates. Indeed, the market implied policy rates rose and the forward curve steepened after the release of the minutes of the April FOMC meeting. The green line in the chart below shows the implied policy rates after the release of the minutes, while the yellow line shows what they were a week ago.
 

 

Another indicator of bond market expectations, namely the 2/10 yield curve (2 year vs. 10 year UST yield spread), has been a very accurate recession forecaster in the past as it has inverted (short yield trading above long yield) 100% of the time ahead of the past five past slowdowns. The good news so far is the 2/10 yield curve is nowhere near an inverted state yet.
 

 

As Blitz pointed out, the financial system takes signals from forward rates and the yield curve. As the chart below shows, a flattening yield curve (red line) has led to tightening credit standards (black and blue lines) in the past two cycles. In the current cycle, lending standards are starting to tighten already, in line with the flattening yield curve.
 

 

The chart below from Tobias Levkovitch at Citi shows that tightening credit conditions lead business loan volumes by about 18 months. In effect, Federal Reserve actions are already starting to withdraw the financial oxygen needed for firms to invest and expand. It just goes to show how sensitive the economy can be to shifts in monetary policy. It`s not just the quarter point rate hike that matters, but the side-effects of the rising rates that affect this fragile economy.
 

 

Another indication of the fragility of the US economy comes from the Fed report on the Economic Well-Being of U.S. Households in 2014, published in May 2015. Of the people earning $40-100K, which is a moderately well-off segment of the population, 44% reported they couldn’t come up with $400 in an emergency. The more astonishing detail of the survey showed that 27% of those making $100K or more couldn’t either. That`s a lot of people living from one paycheck to another.

Right now, there is no need to panic just yet, as the 10-2 year yield spread has been bouncing around between 90-100 basis points and nowhere close to a negative reading (inversion), which has been a warning sign of a recession. However, the chart below shows that the yield on the 2-year Treasury rose about 0.5% between late 2014 and late 2015. During the same period, the 10-2 year spread flattened by about 1%. Moreover, the 10-year yield fell about 0.5% and the yield curve flattened by about 0.5% in the same period since the December 2015 quarter point rate hike, which is reflective of the bond market’s judgement of a weakening economy. If that pattern were to repeat itself, the yield curve could invert or come either very close to inversion after two quarter point rate hikes.
 

 

Three steps and a stumble could be just around the corner.

What the Fed is more likely to do

Having outlined the dire bearish scenario, whose probability I would guesstimate at 15-20%, here is what I think is far more likely to happen.

First, the FOMC is likely to stand pat in June. The Yellen Fed has made a big deal about communication policy. It has had a history of not wanting to surprise the markets. If the Fed wanted to make sure that the market understood the June meeting is “live”, they certainly took action to “correct” market perceptions last week.

Still, the probability of a June rate hike is still relatively low. The latest reading from the CME Group Fedwatch tool shows an implied probability of 26% of a June rate hike. If they are serious about raising rates in June, watch for continued Fedspeak to raise that probability to at least 50-60%. We are not there yet.
 

 

Tim Duy had a more nuanced interpretation of the FOMC minutes as a tug-of-war between the doves and hawks within the FOMC:

There are two clear views here: One group feels the economy is near full employment, while another sees room for further improvement. The former group will want more hikes sooner, the latter fewer hikes later. Federal Reserve Chair Janet Yellen should be taking a side in this critical debate and thus driving the direction of policy. Watch for her to provide guidance on this and inflation when she speaks on June 6.

As well, the Fed officials have indicated that the USD is an important barometer for its monetary policy. A rising dollar has the dual effect of tightening monetary policy for the Fed and it could be viewed as a sign of secular stagnation, as there is much concern at the Fed over the ability of other major central banks like the BoJ and ECB to escape the deflation trap. As the USD Index has recently bounced off an important support level and started rally, its continued strength would be a factor for FOMC decision makers to put a rate hike on hold.
 

 

Reading between the lines, many of the more hawkish “participants” quoted in the FOMC minutes are the regional Fed Presidents, not all of whom vote. On the other hand, the voting bloc within the FOMC, which are tilted towards the Fed governors, tend to be more cautious and dovish. As Janet Yellen has voiced concerns about global financial instability, I would be utterly shocked if the FOMC voted to raise rates just days ahead of the Brexit referendum at its June meeting. One way to resolve the hawk-dove dilemma would be to stay on hold in June, but prepare the market for a July rate hike if there is no Brexit.

An even more dovish interpretation would be the Fed stays in the hawk-dove stop-start cycle, but without taking actual action, at least until the December meeting.
 

 

Stay tuned and watch how the Fed Fund probabilities evolve.

Waiting for capitulation

In the meantime, my inner trader is waiting for further weakness and signs of capitulation and oversold conditions before fully covering his short position. The readings on short and intermediate term sentiment models can be described as either neutral or slightly bearish, but not at extremes. The CNN Money Fear and Greed Index is one example out of many.
 

 

Rydex and AAII sentiment data are also showing similar readings – slightly bearish, but nowhere near a crowded short.
 

 

The latest update of insider activity from Barron’s shows a constructive reading. A minor retreat in stock prices has produced to a neutral to slightly bullish reading from this group of “smart investors”.
 

 

More conventional measures of breadth from IndexIndicators show that the net 20-day highs-lows, which is an intermediate term (2-3 week) trading indicator, is not oversold.
 

 

As the current bout of market weakness began overseas, European markets are not oversold either:
 

 

 

While it was not meant to be primarily used in this fashion, but the Zweig Breadth Thrust Indicator falling below 0.40 has also shown itself to be a pretty good oversold signal in the past. Note that the oversold condition is only the setup for the ZBT signal and the market has to stage an upward momentum thrust for the ZBT signal to be triggered (see A possible, but rare bull market signal). As the chart below shows, the ZBT Indicator is getting close, but it is not oversold yet.
 

 

From a trader’s perspective, the bears still have control of the tape as momentum is still pointed downwards. The hourly SPX chart below shows that the market remains below key resistance levels, such as the 50 hour moving average and a couple of downtrend lines. The inability of the market to convincingly rise above its 50 hour MA and its weakness on Friday generated a very short-term sell signal on RSI-5.
 

 

Until we either see an oversold and capitulation extreme or significant improvements in the overseas stock markets and commodity markets, my inner trader is inclined to stay with his short position.

When I lengthen my time horizon, my inner investor is still constructive on stocks. Rising forward EPS is a sign of supportive growth fundamentals and while sentiment is not at bearish extremes, the lack of bullish enthusiasm during the rally off the February bottom suggests that equity downside risk is limited right now.

Disclosure: Long SPXU

A cautionary tale for quants and systems traders

Posted by Cam Hui -

How would you feel if the average doctor was right 55% of the time? What if a “superstar” doctor, the one whose new patient waiting list stretched out for 1-2 years, was right 60-70% of the time?

That’s how thing work in investing. A “good” quantitative factor, or system, is often acceptable if it has a 55% success rate. If you get a 65% success rate, you are a superstar. Some systems have success rates of less than 50%, but the average value of their wins dwarf the average value of their losses.

Finance quants are often said to suffer science envy. They employ scientific techniques to find alpha, but they do it in an environment where the signal-to-noise ratio is very low. Let`s not kid ourselves, we know what day traders, swing traders and system traders really do.
 

 

By contrast, the signal-to-noise in the sciences tend to be higher. Viewed in isolation, that can be a cautionary tale for all quant researchers and systems traders who think that they may have found their path to riches.

The trouble with science

The signal-to-noise ratio in the sciences may not be as high as idealized. A recent article in FiveThirtyEight shows that science has serious problems of its own:

If you follow the headlines, your confidence in science may have taken a hit lately. Peer review? More like self-review. An investigation in November uncovered a scam in which researchers were rubber-stamping their own work, circumventing peer review at five high-profile publishers. Scientific journals? Not exactly a badge of legitimacy, given that the International Journal of Advanced Computer Technology recently accepted for publication a paper titled “Get Me Off Your Fucking Mailing List,” whose text was nothing more than those seven words, repeated over and over for 10 pages. Two other journals allowed an engineer posing as Maggie Simpson and Edna Krabappel to publish a paper, “Fuzzy, Homogeneous Configurations.” Revolutionary findings? Possibly fabricated. In May, a couple of University of California, Berkeley, grad students discovered irregularities in Michael LaCour’s influential paper suggesting that an in-person conversation with a gay person could change how people felt about same-sex marriage. The journal Science retracted the paper shortly after, when LaCour’s co-author could find no record of the data.Taken together, headlines like these might suggest that science is a shady enterprise that spits out a bunch of dressed-up nonsense. But I’ve spent months investigating the problems hounding science, and I’ve learned that the headline-grabbing cases of misconduct and fraud are mere distractions. The state of our science is strong, but it’s plagued by a universal problem: Science is hard — really fucking hard.

In most cases, scientific researchers are not out to perpetrate fraud, but they have a bias towards positive results. Negative results doesn’t get you published. No one pats you on the back because you didn’t find the cure for cancer. No papers, or few papers, translates to no academic tenure.

Moreover, different perspectives and different approaches can yield different conclusions. Consider the following study where a researcher asked other research teams to study the question of whether soccer referee rulings are affected by a player`s skin color. Even though the different teams were all given the same data set, they reached a variety of conclusions:

Nosek’s team invited researchers to take part in a crowdsourcing data analysis project. The setup was simple. Participants were all given the same data set and prompt: Do soccer referees give more red cards to dark-skinned players than light-skinned ones? They were then asked to submit their analytical approach for feedback from other teams before diving into the analysis.

Twenty-nine teams with a total of 61 analysts took part. The researchers used a wide variety of methods, ranging — for those of you interested in the methodological gore — from simple linear regression techniques to complex multilevel regressions and Bayesian approaches. They also made different decisions about which secondary variables to use in their analyses.

Despite analyzing the same data, the researchers got a variety of results. Twenty teams concluded that soccer referees gave more red cards to dark-skinned players, and nine teams found no significant relationship between skin color and red cards.

 

 

What`s the signal-to-noise ratio in this study?

The variability in results wasn’t due to fraud or sloppy work. These were highly competent analysts who were motivated to find the truth, said Eric Luis Uhlmann, a psychologist at the Insead business school in Singapore and one of the project leaders. Even the most skilled researchers must make subjective choices that have a huge impact on the result they find.

But these disparate results don’t mean that studies can’t inch us toward truth. “On the one hand, our study shows that results are heavily reliant on analytic choices,” Uhlmann told me. “On the other hand, it also suggests there’s athere there. It’s hard to look at that data and say there’s no bias against dark-skinned players.” Similarly, most of the permutations you could test in the study of politics and the economy produced, at best, only weak effects, which suggests that if there’s a relationship between the number of Democrats or Republicans in office and the economy, it’s not a strong one.

The important lesson here is that a single analysis is not sufficient to find a definitive answer. Every result is a temporary truth, one that’s subject to change when someone else comes along to build, test and analyze anew.

Even the most earnest researcher have to make choices about the metrics of what determines success. The analytical choices that they make have direct effects on the conclusions of their study.

I don`t know

The problem is even more acute for finance researchers. Not only are they burdened with a high signal-to-noise ratio, their analytical biases will often lead them down the wrong path. That’s why models that perform well in backtests, or for short periods, suddenly blow up for no apparent reason.

While we all try our best, Charlie Biello wrote that the best three words that an investment analyst can say are “I don’t know”:

I

Don’t

Know

These three words, almost never uttered in this business, are far and away the most critical to long-term investment success.

Why?

Because the future and markets are unpredictable, and having the humility to admit that is very hard for us to do. We’re simply not wired that way and instead suffer from the behavioral bias of overconfidence. Which is to say we overestimate our own abilities when it comes to sports, trading, driving or anything else.

Which is the better indicator?

I am not here to pick on Biello, as I have the utmost respect for his work, but consider this example relating to the prize winning paper that he co-authored with Michael Gayed where they found a significant relationship between the lumber/gold ratio and stock prices:

The unique combination of Lumber and Gold is an intermarket relationship that has been anticipatory of future economic activity and risk appetite across asset classes outside of commodities. We find that when Lumber is leading Gold over the prior 13 weeks, expansionary conditions predominate and volatility tends to fall going forward. Such an environment is favorable to taking more risk in a portfolio or “playing offense.” We also find that when Gold is leading Lumber over the prior 13 weeks, contractionary conditions predominate and volatility tends to rise. In this environment, it pays to manage risk in a portfolio or “play defense.”

Here is a chart of the lumber/gold ratio (red line) against the stock/bond ratio (grey area bars) as a risk-on/risk-off measure. The bottom panel shows the rolling 52-week correlation between the two variables, which has been consistently high and positive over the last 10 years. As the lumber/gold ratio is starting to turn up, can we interpret this development as a bullish signal for stocks and risky assets?
 

 

Here is the same chart, using the copper/gold ratio. Both copper and lumber can be considered to be measures of economic cyclicality. The copper/gold ratio has a longer history and the rolling 52-week correlation is very similar to the one from the lumber/gold chart above.
 

 

While the lumber/gold ratio has turned up and flashed a bullish signal, the copper/gold ratio continues to decline and can be interpreted bearishly. Which indicator is right? Which one should we believe?

I don’t know.

Another way to reconcile these two charts is to theorize that lumber prices are more affected by US housing demand, while copper prices are more global and currently more affected by Chinese demand. While lumber is signaling a US rebound, copper is signaling further deceleration in Chinese growth.

Is that interpretation correct? If we were to accept that premise, what is the most likely path for stock prices?

I’m not sure.

Think of this story a cautionary tale for all quantitative researchers and systems traders. Just when you think that you found the Holy Grail of investing or trading, you will be wrong in some way. Treat your results with skepticism. Diversify your models, as any single model or indicator will be wrong.

Be humble before the market gods, or they will make you humble in the end.

What’s spooking the stock market?

Posted by Cam Hui -

Mid-week market update: No, it isn’t just a more hawkish Federal Reserve that’s spooking the stock market. Stock prices were been falling before Fedspeak and the latest FOMC minutes sounded a more hawkish tone. The SPX staged a successful test of its 2040 neckline support of its head and shoulders pattern today. In fact, today`s action could be interpreted constructively as it is experiencing a minor positive divergence on RSI-5.
 

 

Don`t blame the Fed. Market weakness is a symptom, not the cause of the retreat.

I turned more cautious on the stock market last week because of growing market fears of a slowdown in China (see Tactically taking profits on the commodity and reflation trade). There seems to be a bifurcation starting to occur in the global economy. The US macro picture looks fine as the American economy is motoring along, as evidenced by the latest news of the April rebound in industrial production. Outside the US, the picture looks far less rosy.

The latest BoAML Fund Manager Survey revealed the top two tail-risks on fund managers’ minds were Brexit and China, which did not appear as a source of concern in the previous month’s survey. It’s no wonder that the markets are getting spooked.
 

 

Here’s how I am preparing myself and how I would watch for the turn upwards, should it come.

Waiting for the turn in China

I’ve written enough about China that I am not going to repeat myself (see A better way to trade the China slowdown). The two main market signals over Chinese growth concerns come from the weak performance of the Chinese stocks and the stock indices of China’s major Asian trading partners. All indices, except for Australia, are below their 50 day moving averages (dma).
 

 

As well, the cyclically sensitive industrial metal complex has also not performed well, which is another sign of decelerating Chinese growth.
 

 

I am monitoring these two charts for signs of stabilization and improvement before trying to call a turn in China.

Rising Brexit risks

Then, there are the Brexit risks, which had been lurking in the background for the past few months. It wasn’t until I turned my sights to the UK that I realized the high level of angst in Britain. Gavyn Davies documented that the nowcast of growth estimates had cratered from 2.5% to roughly 0% today.
 

 

Davies wrote that the most likely explanation for the slowdown is concerns over Brexit:

Since this has occurred at a time when there has been no similar decline in the advanced economies as a bloc, it seems that the drop has been driven by something specific to the UK. The only obvious candidate for this is uncertainty surrounding Brexit, leading to postponment of investment and consumption decisions.

He went on to state that the nowcast is showing a 40% chance of a UK recession:

The nowcast model, which of course does not take account of the specific circumstances surrounding the referendum, already estimates that there is a 40 per cent likelihood of a recession in the UK in the next 12 months. This probability could rise further if uncertainty is maintained at high levels before or after referendum day.

It is now wonder that the FTSE 100 has struggled and fallen below both its 50 and 200 day moving averages.
 

 

Across the English Channel, the Euro STOXX 50 has also been weak in sympathy despite the encouraging signs of a eurozone growth revival. A recent Fitch report, however, indicated that Ireland, the Netherlands, Malta and Cyprus to be the most vulnerable eurozone countries to a Brexit event.
 

 

While the latest polls are all over the place, bookmaker odds show a solid lead for the Remain side.
 

 

I have no idea of how the China macro outlook is going to develop in the next few months, but if the bettors are correct, then we are likely to see a huge relief rally should the Remain side prevail in the June 23 Referendum. These conditions also suggests that global markets will be choppy and stay unsettled until the Brexit referendum is resolved in late June.

Prepare yourself accordingly.

A better way to trade the China slowdown

Posted by Cam Hui -

China has been undergoing a series of stop-start growth spurts mini-cycles, courtesy of credit driven stimulus programs (chart via RBS):
 

 

The size of the latest Q1 financing induced boom was extraordinary, as it hinted at panic by the authorities. For some perspective, credit expansion in Q1 2016 was somewhere between the GDP of Indonesia and Mexico:
 

 

Much of the extra liquidity sloshing around the system has created a great ball of money that has bounced around from one asset class to another, such as property, stocks and commodities.

Coming off a sugar high

I have written about the market fears of China slowdown before (see Tactically taking profits in the commodity and reflation trade), the data coming from last weekend seems to confirm that the sugar high of credit driven stimulus is starting to wear off (via Bloomberg):

The April readings marked a sharp swing in fortunes, especially in new credit: where March saw aggregate financing jump by more than all economists had forecast, April’s number undershot all 26 predictions. Such gyrations — long a feature of the nation’s stock market — add to the challenge for policy makers and foreign investors seeking to get a read on an economy caught in a multi-year slowdown and struggling to stabilize.

Total social financing plummeted to levels not seen since 2013 (Deutsche Bank via Business Insider):
 

 

Things got so bad that the PBoC felt compelled to reassure the markets that it would continue to support the economy through monetary policy (via Bloomberg):

China’s central bank reassured investors that monetary policy will continue to support the economy after a sharp slowdown in new credit last month, and said the lending slump was temporary.

The deceleration in the growth of new yuan loans in April was mainly due to a pick-up in a program to swap high-cost local government debt for cheaper municipal bonds, the People’s Bank of China said in a statement on its website on Saturday. No less than 350 billion yuan ($53.6 billion) of such swaps were conducted last month, while aggregating financing growth was affected partly by a decrease in corporate bond issuance, according to the central bank.

Comrade Xi speaks: Enough is enough!

The screeching halt in credit driven stimulus appears to have come from the top, as a recent article in state-owned People’s Daily quoted an unnamed “authoritative figure” (read: high level official) stating that China should expect an L-shaped growth path. Further, credit driven growth was the “original sin” that leads to market risks (via Xinhua):

China’s economy will follow an L-shaped path as downward pressures weigh and new growth momentum has yet to pick up, the People’s Daily on Monday quoted an “authoritative figure” as saying in an exclusive interview.

The country’s economic growth, which slowed to its lowest level after the global financial crisis, will not see a U-shaped or a V-shaped rebound, but follow an L-shaped path going forward, the source said.

The People’s Daily, flagship newspaper of the ruling Communist Party of China, did not disclose the name of the source, but the term “authoritative figure” is usually used for high-level officials.

The source said China’s economic growth has been stable and “within expectations,” but warned of emerging problems such as a real estate bubble, industrial overcapacity, rising non-performing loans, local government debt and financial market risks.

High leverage is the “original sin” that leads to risks in the market for foreign exchange, stocks, bonds, real estate and bank credit, the person was cited as saying.

According to the authoritative figure, the country should make deleveraging a priority, and the “fantasy” of stimulating the economy through monetary easing should be dropped. The country needs to be proactive in dealing with rising bad loans, rather than hiding them.

In addition, the South China Morning Post reported that Xin Jinping lectured party cadres in January about misguided perceptions about the intent of supply side reforms. Chinese supply side reform is not intended to be in the Reagan/Thatcher mold, but structural reform of “cutting capacity, reducing inventory, cutting leverage, lowering costs, and strengthening the weak links” (translation: don’t borrow to make and build so much stuff that no one wants):

Xi said some Chinese officials did not understand the point of supply-side reform.

“I highlighted the issue of supply-side structural reform at last year’s central economic work conference, and it triggered heated debate, with fairly good endorsement from the international community and various sides at home,” Xi said.

“But some comrades told me that they didn’t fully understand supply-side reform … I need to talk about this issue again.”

Xi said the concept could be implemented by “cutting capacity, reducing inventory, cutting leverage, lowering costs, and strengthening the weak links”.

“Our supply-side reform, to say it in a complete way, is supply-side structural reform, and that’s my original wording used at the central economic work conference,” Xi said.

“The word ‘structural’ is very important, you can shorten it as ‘supply-side reform’, but please don’t forget the word ‘structural’.”

The key problem for the Chinese economy was “on the supply side”, though China could not afford to completely neglect managing demand.

China could not rely on “stimulating domestic demand to address structural problems such as overcapacity”, he said.

“The problem in China is not about insufficient demand or lack of demand, in fact, demands in China have changed, but supplies haven’t changed accordingly,” Xi said.

He gave the example of Chinese consumers shopping overseas for daily products such as electric rice cookers, toilet covers, milk powder and even baby bottles to show that domestic supply did not match domestic demand.

More importantly, Xi acknowledged that China faces big problems as it is “big but not strong”, which is evocative of Mao’s characterization of America as a “paper tiger“ during the era of the Vietnam War:

Xi said while China was the second-biggest economy in the world, its economy was “big but not strong” and faced “outstanding problems of unwieldiness, puffiness and weakness”.

“The main symptom is limited innovation, and that’s the Achilles’ heel of China’s [macro] economy,” Xi said.

A separate SCMP article hinted that the “authoritative figure” quoted was none other than Comrade Xi himself:

Yes, the “authoritative person” was Xi, judging from three revealing words in the interview: “kai men hong,” which literally means “open the door to see red lucky sight,” referring to a good start.

“Our economy is seeing unexpected new problems,” the person in the interview said. “It cannot be described with simple concepts like kai men hong … Our economic trend is not U-shaped and absolutely not V-shaped. It is L-shaped. It is not going away in a year or two.”

Take that as a resounding slap on the face for Politburo Standing Committee member and Vice Premier Zhang Gaoli, who is in charge of the economy. In a public conference in late March, Zhang said: “From the numbers, I expect kai men hong in the first quarter. This year we tackle the difficulties. Next year will be blue sky and gentle water.”

Now, who but Xi could have trashed the vice premier’s sunny projections so bluntly? The president is eager to push through his “supply-side structural reform,” trimming excess production capacity to free up resources for the right goods and services.

 

 

After all the anti-corruption purges, which are still ongoing, Xi is asserting his political power in a strongest way with the use of cultural revolution era terms:

“Some cadres have been changing positions on major policies, paying lip service to the decision of the central leadership. We ask cadres not to make groundless comments against the central leadership. This does not mean they cannot air opinions or cannot criticize. But one should not contradict the central leadership on important political issues.

“There are careerists and conspirators in our party undermining the party’s governance … We must respond resolutely to eliminate the problem.”

During one of the darkest periods of Chinese history, words like careerists and conspirators used to be reserved for leaders such as Lin Bao, the successor-designate of Mao Zhedong who allegedly tried to kill Mao.

Xi gave the speech to graft fighters in January. Whatever the rationale of publishing the speech four months later, the message is clear: Fall in line, or else.

Investment implications

Here is my takeaway of what Xi wants:

  • There will be no more wild credit driven growth.
  • He accepts the inevitability a slower growth path, as the economy is resilient enough to deal with a growth slowdown.
  • Xi wants to restructure the economy to more sustainable growth through the household sector and by moving up the value chain, i.e. more quality and less quantity.
Under these circumstances, the reversal of Q1 credit driven growth is unlikely to be followed by the usual stop-start mini-cycle. What Comrade Xi wants, Comrade Xi gets. Instead, he is looking for better quality growth.

For traders and investors, it will harder to forecast the near-term trajectory of Chinese growth. However, there is a far more risk-controlled way of trading the longer term China growth slowdown, namely the theme of re-balancing growth away from credit (finance) to the consumer.

This re-balancing theme brings up a couple of pairs trade opportunities, where an investor or trader buys a position and shorts an offsetting one. The conceptual pair trade is a long consumer China vs. a short finance China trade. I have been watching two possible pairs for quite some time as ways of playing this theme:

  1. Long PGJ-short FXI: PGJ is more heavily weighted in technology stocks, which are more sensitive to consumer spending, whereas FXI is more heavily weighted in finance.
  2. Long CHIQ-short CHIX: This is a more direct but less liquid play, where CHIQ is the consumer China ETF and CHIX is the finance China ETF.
Here is a chart of the two pairs (PGJ-FXI in black, CHIQ-CHIX in green). All of these ETFs are US-listed and trade in USD. If you would like to follow along at home, use this link for a real-time update.

 

 

For Xi, it is good to be the undisputed top dog in a command economy, as you can get what you want. For investors and traders, these pair trades represent reasonably risk-controlled ways of trading China by playing along with Comrade Xi`s edicts.

Waiting for the storm to pass

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 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 bullish 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: Neutral
  • Trading model: Bearish

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.

Don’t panic, it’s only a correction

My last blog post created a bit of a stir among readers as I was inundated with questions (see Tactically taking profits in the commodity and reflation trade). To reiterate, I made a trading call to get more cautious based on a developing slowdown coming from China, which was signaled by falling commodity and Asian stock prices.

At worst, this growth scare will result in nothing more than a minor US equity correction. The intermediate term outlook remains bullish. How would you feel about equity prices if I told you:

  • Earnings are continuing to recover
  • Fed policy is dovish and equity friendly
Put simply, stock prices depend on two factors. The first is earnings, or the E in the P/E ratio – and earnings are growing. The second is the P/E multiple, which is a function of the outlook for interest rates and future growth, both of which are showing equity friendly tendencies.

Investors just have to wait out the storm.

The earnings recession is over

Business Insider featured an article last week with the headline “The earnings recession is over”:

Deutsche Bank’s Binky Chadha argues that the worst is over and earnings growth is coming back.

Like, right now.

“Time for a significant inflection,” Chadha writes. “The 5 drivers imply a combined boost of 8.2% to Q2 SP 500 earnings; after -6.3% in Q1 to slightly positive growth of +1.9%. The bottom-up consensus presently sees only a modest turn, to -4.7%.

Adding: “The differential between our top-down arithmetic and the bottom-up consensus suggests downgrades should stop and indeed they have paused recently and eventually lead to upgrades or positive surprises.”

 

Indeed, the latest update from John Butters of Factset confirms Chadha’s thesis, as forward EPS are continuing to rise. With Q1 Earnings Season almost over, the EPS beat rate was above historical norms, though the sales beat rate fell short. In a separate note with bullish overtones, Michael Amenda at Factset pointed out that EPS beats came mainly from margin expansion, which is a reflection of better operating metrics, and not financially engineered share buybacks.
 

 

Chadha’s projection of roughly 8% YoY EPS growth at year-end is well within my estimate of 5-10% capital appreciation from EPS growth (see How the SP 500 could get to 2400 this year). A tweet from Urban Carmel indicated that revenues ex-energy reached a new high. As commodity prices have recovered some of their losses, a “less bad” result can easily translate to EPS and sales gains for the overall index.
 

 

Tack on another 5-15% in the form of P/E multiple expansion from a dovish Fed and the growth surprise projected by Chadha, the SPX target of 2400-2500 is well within reach this year.

An equity friendly Fed

Binyamin Appelbaum of the NY Times recently conducted a long and revealing interview with New York Fed President Bill Dudley (see the full interview here). Dudley is an important member of the Yellen-Fischer-Dudley triumvirate at the Fed and therefore his remarks are well worth considering. Here is a summary, which I made in conjunction with Gavyn Davies’ interpretation:

  • Dudley thinks that the benchmark GDP growth rate is 2%. Anything above that is inflationary, but the Fed is willing to allow the economy to run a little “hot” in order to get to full employment.
  • The economy will get “hot” as GDP growth rises above 2%, which should drive down the unemployment rate and push the economy closer to full employment.
  • He is reassured by the fact that core inflation has remained about 1.6% while the dollar and oil have been operating to reduce inflation in recent quarters.
  • Dudley is not worried about the downward drift in inflationary expectations. He is more concerned about declining inflationary expectations in the Eurozone and Japan, where he believes that monetary policy has been less successful than it has been in the US.
  • There is no sign of concern that the US may be dragged into secular stagnation by events abroad. For him, the main signal of this happening would be a rising dollar.
  • Recession risks are low because the Fed does not have to be pre-emptive and because he cannot see any major shocks at home or abroad. Moreover, there doesn’t seem to be the kinds of excesses that get unwound during typical recessions.
This was a revealing interview for a number of reasons. First, it detailed the sorts of concerns that the Fed has about deflationary effects from abroad. Moreover, it showed that they are watching the USD as a key barometer of secular stagnation.

Reading between the lines, the Fed is unlikely to raise rates in June. They will likely wait until September to make a decision. At that time, if they see GDP growth at 2% or more and unemployment ticking down, then it may be time to tap on the brakes.

Stalling employment growth

The employment picture may not improve as the FOMC expects, however. We are starting to see signs of weakness in employment growth. First, the Labor Market Conditions Index, which is a leading indicator of employment growth, is stalling. YoY growth went negative in January, which appears to be worrisome on the surface, but it recently rebounded to a “less bad” reading.
 

 

In addition, temporary hiring, which is another leading indicator of employment growth, is also decelerating. While we only have two full cycles of this data series, past instances of negative growth have preceded recessions. Current conditions are showing that temporary employment growth is starting to sputter, but readings are nowhere near the danger zone.
 

 

When I put these indicators together, it may be difficult for the Fed will find compelling reasons to raise rates based on jobs market conditions at the September meeting. Moreover, the FOMC is likely to be extra cautious as a rate hike just ahead of a presidential election could be seen as a political act. A move at the December meeting is far more likely.

So let’s recap the fundamental and macro picture. Equity earnings are recovering and likely to continue to rise (therefore the E in the P/E ratio will be growing). The Fed will probably to stay on hold, possibly until the December meeting and beyond, which is supportive of an expanding P/E ratio.

So stock investors have little to worry about.

The storm from abroad

For traders, it’s a totally different story altogether. I detailed in my last post my concerns about the market signals of slowing Chinese growth (see Tactically taking profits in the commodity and reflation trade). The Chinese economy is showing signs of slowing growth (via Reuters):

China’s investment, factory output and retail sales all grew more slowly than expected in April, adding to doubts about whether the world’s second-largest economy is stabilizing.

Growth in factory output cooled to 6 percent in April, the National Bureau of Statistics (NBS) said on Saturday, disappointing analysts who expected it to rise 6.5 percent on an annual basis after an increase of 6.8 percent the prior month.

China’s fixed-asset investment growth eased to 10.5 percent year-on-year in the January-April period, missing market expectations of 10.9 percent, and down from the first quarter’s 10.7 percent.

Fixed investment by private firms continued to slow, indicating private businesses remain skeptical of economic prospects. Investment by private firms rose 5.2 percent year-on-year in January-April, down from 5.7 percent growth in the first quarter.

“It appears that all the engines suddenly lost momentum, and growth outlook has turned soft as well,” Zhou Hao, economist at Commerzbank in Singapore, said in a research note.

“At the end of the day, we have acknowledge that China is still struggling.”

In response, the stock indices of China’s major Asian partners have all weakened below their 50 day moving averages (dma), except for Australia.
 

 

More importantly, industrial metal prices are breaking down, as they have fallen below both their 50 and 200 dma lines.
 

 

Crude oil prices are a bit firmer, as they may have been buoyed by supply disruptions from the Alberta wildfires, but how long can that last?
 

 

Nautilus Research found that the history of past oil rallies without the participation of copper has not been kind for crude prices,
 

 

European stock prices have also misbehaved, as both the FTSE 100 and Euro STOXX 50 have violated key moving average support levels.
 

 

A shallow correction

Despite these negative signals from cross-asset and inter-market analysis, I am expecting only a shallow correction. Breadth indicators remain supportive of the bull case and that is likely to put a floor on stock prices.
 

 

In addition, Leuthold Group highlighted their “Four on the Floor” breadth signal, where the DJ Transports, DJ Utilities, NYSE A-D Line and the DJ Corporate Bond Index are all above their 40-week moving averages. The historical experience after such signals have been equity bullish.
 

 

Sentiment models never got to a crowded long reading. Current sentiment conditions are best described as neutral and getting more bearish. The lack of a crowded long position at the start of the current market downdraft point to limited downside risk.
 

 

As well, an FT report indicated that outflows from equity funds are about $90b this year. This put equities “firmly” on track for their biggest year of redemptions since 2011, according to data provider EPFR.
 

 

Bear markets simply do not start with sentiment at such high levels of skepticism.

The “tell” from sector leadership

If the bulls were to make their stand at or about the current levels, then we need to see some signs of a healthy internal sector rotation. If resource extraction sectors such as Energy and Materials were to falter in their market leadership, then some other sectors need to step up and display superior relative strength, other than the defensive ones like Consumer Staples and Utilities.

I have been watching the Relative Rotation Graphs (RRG) for some clues of how sector leadership might change. RRG™ charts show you the relative strength and momentum for a group of stocks. Stocks with strong relative strength and momentum appear in the green Leading quadrant. As relative momentum fades, they typically move in a clockwise direction into the yellow Weakening quadrant. If relative strength then fades, they move clockwise into the red Lagging quadrant. Finally, when momentum starts to pick up again, they shift clockwise into the blue Improving quadrant.

As the RRG chart below shows, late cycle sector leadership (Energy, Materials and Industrials) is starting to falter. Possible up and coming sectors are the Financial and Consumer Discretionary stocks.
 

 

As a check on my RRG analysis of the US equity market, I looked at the RRG for European stocks, which shows a similar pattern. The same late cycle sectors are weakening. Financial stocks are improving, but Consumer Services and Consumer Goods remain weak.
 

 

The relative performance of Financial stocks is not encouraging. True, the sector is showing signs of recent positive relative momentum, but the relative returns of these stocks have been correlated with the shape of the yield curve. Unfortunately, the yield curve is flattening, which suggests limited relative upside for these stocks.
 

 

Here is the relative performance chart of Consumer Discretionary stocks. While the chart pattern appears to be constructive and the sector is showing positive relative momentum, it does face nearby overhead resistance. In addition, the nascent relative strength of the US Consumer Discretionary sector has not been confirmed in Europe. If a newly resurgent Consumer Discretionary sector is the best hope for the bulls, then it appears to be a slim hope.
 

 

For completeness, I have shown the relative performance of Technology stocks and the NASDAQ 100, the trader’s favorite group. While these stocks seem oversold could recover and turn upwards, my inner bull isn’t overly enthused about making a big bet on that outcome.
 

 

Waiting for a bottom to develop

My base case scenario calls for a correction within an intermediate uptrend for US stocks. The combination of positive fundamentals, breadth and supportive sentiment readings are all likely to put a floor on stock prices. However, market animal spirits are acting up and the near-term path of least resistance is down.

I am watching for some combination of the following to see that a market bottom has been reached:

  • Some signs of stabilization and improvement in:
    1. European equity markets
    2. Asian equity markets
    3. Commodity prices
  • Oversold extremes in US equities
  • Signs of a crowded short from sentiment models

None of those indications are in place today. As an example, the 10 day exponential moving average of the CBOE equity put/call ratio has spiked above 0.8. However, history shows (N=5) that 80% of the first occasion when the ema10 spiked above 0.8 (red vertical lines), the market has fallen further before finding a bottom in about 3-5 weeks.
 

 

The McClellan Summation Index (mid panel: common stock only, bottom panel: all stocks) tells a similar story. Momentum is starting to roll over and such episodes have tended to bottom out in about four weeks.
 

 

A 3-5 week period of market weakness is the most likely outcome. We will probably see some sort of retreat to technical support, followed by a rally and one or more re-tests of the lows before this correction is over.

The week ahead

Looking to the week ahead, the SPX is currently testing a head and shoulders neckline support line at about 2040. Should it break, the measured target is 1970-1980. However, there are also support areas at the 200 dma (2010) and a Fibonacci retracement level at 1997. I am also watching for a bottoming signal from the VIX Index. Past instances of VIX spikes above its Bollinger Band has marked oversold conditions where downside risk has been limited.
 

 

In addition, I am also monitoring my Trifecta Bottom Spotting Model, which is nowhere near to flashing a buy signal. Recall that this has been a terrific bottom spotting indicator with an 88% success rate.

Next week is option expiry week (OpEx), which has historically seen an upward bias in stock prices. However, analysis from Rob Hanna shows that May OpEx is one of the weaker periods, with gains and losses dead even at 50-50. The bulls should therefore expect no help from May OpEx (table annotations and the calculated summaries at the bottom are mine).
 

 

My inner investor remains long stocks, as he is unconcerned about minor corrections. The upside SPX potential of 17-22% (2400-2500) against downside risk of 2-4% (1970-2000) is a bet that he thinks is well worth taking.

By contrast, my inner trader is more focused on catching the smaller moves. He went short the market last week and he is waiting for the corrective storm to pass.

Disclosure: Long SPXU