Page 78 – Humble Student of the Markets

Is a recession just around the corner?

Posted by Cam Hui - September 18, 2016

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

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

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

The latest signals of each model are as follows:

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

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

My answer to Northy

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

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

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

Torturing the data until it talks

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

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

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

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

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

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

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

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

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

Be data dependent

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

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

Recession Watch

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

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

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

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

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

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

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

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

Residential real private investment: Aside from the 1981 “double-dip,” and 1948, it has always peaked at least one year before the next recession.

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

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

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

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

Nothing to worry about (yet)

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

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

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

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

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

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

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

The week ahead: Not enough fear?

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

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

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

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

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

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

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

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

Disclosure: Long SPXL, TNA

Bottom spotting

Posted by Cam Hui - September 14, 2016

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

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

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

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

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

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

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

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

Zweig Breadth Thrust setup

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

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

Trifecta Bottom Spotting Model

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

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

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

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

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

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

…and stocks above their 200 dma.

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

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

Where are we now?

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

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

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

Disclosure: Long SPXL, TNA

Rate hike vs. rate hike cycle

Posted by Cam Hui - September 12, 2016

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

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

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

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

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

The Hamilton checklist

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment implications

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

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

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

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

Macro weakness: Just a flesh wound?

Posted by Cam Hui - September 11, 2016

The latest signals of each model are as follows:

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

Weak macro = Weak stock market?

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

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

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

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

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

Macro disappointment spooks the market

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

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

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

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

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

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

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

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

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

The coincident indicators remain mixed…

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

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

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

Bottom-up growth still robust

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

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

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

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

Strong technical breadth underpins the market

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

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

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL, TNA

Why a crowded VIX short isn’t equity bearish

Posted by Cam Hui - September 7, 2016

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

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

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

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

An option math primer

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

Time to option expiry (longer = higher call option price)
Risk-free rate (higher rates = higher call option price)
Difference between current price and exercise price (higher difference of market price – strike price = lower call option price)
Volatility (higher volatility = higher call option price)

Of all the inputs cited, the only value that is not directly observable is volatility. Everything else being equal, it is the implied volatility that determines the price of an option.From the observed price of an option, we can back out the implied volatility. The CBOE publishes several implied option volatility estimates based on an at-the-money option with different expiry dates:

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

Term structure arbitrage

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

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

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

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

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

When does volatility spike?

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

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

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

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

Oh wait…

Disclosure: Long SPXL, TNA

Thanks, but I’m not that good!

Posted by Cam Hui - September 5, 2016

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

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

Thanks, but I’m not that good.

Teaching my readers how to fish

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

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

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

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

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

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

A terrific call, or terrible call?

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

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

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

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

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

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

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

Stay bullish for the rest of 2016

Posted by Cam Hui - September 4, 2016

The latest signals of each model are as follows:

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

Stay focused on the big picture

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

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

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

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

Macro: Growth upturn continues

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

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

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

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

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

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

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

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

These are not signs of stalling growth.

Technical: Bullish momentum

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

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

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

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

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

Investors still skeptical

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

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

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

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

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

Turbulence in 2017?

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

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

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

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

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

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

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

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

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

How the Fed can trigger a bear market

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

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

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

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

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

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

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

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

The week ahead

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

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

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

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

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

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

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

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

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

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

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

Disclosure: Long TNA, SPXL

Three key macro factors to watch in today`s market

Posted by Cam Hui - August 31, 2016

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

[Please see Bloomberg story for chart]

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

The yield curve

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

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

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

It’s the exchange rate, stupid!

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

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

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

Small caps and growth expectations

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

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

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

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

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

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

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

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

A possible Non-Farm Payroll surprise?

Posted by Cam Hui - August 30, 2016

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

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

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

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

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

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

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

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

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

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

How bad could a Chinese banking crisis get?

Posted by Cam Hui - August 29, 2016

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

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

Not your father’s emerging market debt crisis

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

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

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

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

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

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

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

Damage of collapsing trade

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

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

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

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

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

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

A scenario, not a forecast

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

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

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

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

The roadmap to a 2017 market top

Posted by Cam Hui - August 27, 2016

The latest signals of each model are as follows:

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

A 2017 market top?

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

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

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

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

Why I am a bull

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

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

Profit expectations are rising, also from depressed levels.

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

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

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

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

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

Timing the market peak

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

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

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

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

Lurking bears

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Upside potential of 10-20%

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

The week ahead: All eyes on the Jobs Report

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

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

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

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

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

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

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

Disclosure: Long SPXL

Showdown at Jackson Hole? Forget it!

Posted by Cam Hui - August 25, 2016

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

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

Three camps at the Fed

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

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

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

So we are close to our targets.

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

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

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

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

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

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

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

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

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

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

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

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

Please tell us how you really feel, Larry.

No sign of a policy shift

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

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

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

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

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

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

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

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

The market catches round number-itis

Posted by Cam Hui - August 24, 2016

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

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

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

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

Macro momentum: Too far too fast

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

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

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

A crowded long

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

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

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

Deteriorating breadth

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

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

Choppiness ahead

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

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

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

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

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

Disclosure: Long SPXL

A second chance on Europe

Posted by Cam Hui - August 23, 2016

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

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

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

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

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

Fears are abating

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

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

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

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

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

Posted by Cam Hui - August 21, 2016

The latest signals of each model are as follows:

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

The message from inter-market analysis

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

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

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

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

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

A reflationary rebound

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

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

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

Here is the New Zealand Dollar:

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

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

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

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

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

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

Rising commodity inflation = ?

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

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

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

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

Commodity inflation “transitory”?

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

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

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

The Fed’s delicate balance

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

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

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

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

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

The week ahead: Round number-itis?

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

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

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

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

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

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

Disclosure: Long SPXL

Waiting for the consolidation to end

Posted by Cam Hui - August 17, 2016

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

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

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

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

Sideways action until Friday?

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

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

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

Here is what he said in a tweet today:

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

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

Disclosure: Long SPXL

Jackson Hole preview: Fun with statistics

Posted by Cam Hui - August 16, 2016

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

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

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

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

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

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

The Fed’s framework in context

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

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

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

Which variable do you pick?

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

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

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

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

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

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

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

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

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

Are you confused? I am.

Where does Yellen stand?

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

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

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

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

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

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

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

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

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

Party like it’s 1999, or 1995?

Posted by Cam Hui - August 14, 2016

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

The latest signals of each model are as follows:

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

How close are we to a market top?

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

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

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

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

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

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

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

A shift in psychology

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

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

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

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

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

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

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

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

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

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

Growth rebound continues

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

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

What can derail this bull move?

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

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

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

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

decrease of the 10-yr Note Yield

decrease of the Unemployment Rate

increase of the Fed Funds Rate

increase of the Inflation Rate (CPI)

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

When does the Fed take away the punch bowl?

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

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

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

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

It’s all about productivity

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

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

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

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

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

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

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

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

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

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

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

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

The week ahead: Buy the dip!

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

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

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

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

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

Disclosure: Long SPXL

Be patient

Posted by Cam Hui - August 10, 2016

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

Be patient.

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

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

The message from the VIX Index

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

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

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

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

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

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

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

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

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

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

Disclosure: Long SPXL

Brexit: Fantasy vs. reality

Posted by Cam Hui - August 9, 2016

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

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

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

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

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

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

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

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

Brexiteer fantasies

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

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

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

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

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

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

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

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

Why even bother?

The reality: Devil is in the details

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

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

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

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

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

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

Pour encourager les autres

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

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

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

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

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

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

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

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

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

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

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