Breakout or fake out?

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less 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.

A global growth rebound

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

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

 

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

 

A tour around the world

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

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

 

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

 

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

 

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

 

Wage gains are starting to show signs of acceleration.

 

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

 

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

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

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

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

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

 

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

Europe: Green shoots of recovery

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

 

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

 

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

China: Don’t count on a hard landing

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

 

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

 

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

 

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

The week ahead: Cautionary flags everywhere

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

 

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

 

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

 

 

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

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

Disclosure: Long SPXL

Buy the shallow pullback

Posted by Cam Hui -

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

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

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

 

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

 

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

Let me expand on those points.

The growth rebound continues

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

 

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

 

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

 

Price momentum continues

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

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

 

My inner trader buys more

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

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

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

 

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

 

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

Disclosure: Long SPXL, TNA

Worried about US equities? Here’s an alternative!

Posted by Cam Hui -

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

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

Panic over Europe

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

 

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

 

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

 

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

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

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

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

  • The Italian constitutional referendum.
  • The French Presidential Election.
  • The European Union’s refugee deal with Turkey.
  • The Italian banking crisis.

Let me address those issues, one at a time.

A European political question

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

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

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

 

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

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

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

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

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

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

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

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

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

Italian banking crisis: Resolving tail-risk

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

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

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

 

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

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

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

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

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

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

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

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

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

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

 

Signs of market healing

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

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

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

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

 

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

 

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

 

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

 

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

 

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

 

Green shoots?

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

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

Get ready for the melt-up

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less 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.

A brighter tomorrow

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

  • Positioning: Investors have been caught leaning the wrong way. They are just starting to play catch-up, but sentiment remains overly skeptical.
  • Growth surprise: A US recovery has caught most people off-guard (though I in the minority when I was bullish during the market panic in January, see Buy! Blood is in the streets!).
  • Central bank accommodation: The Federal Reserve has been ultra-cautious in its policy of interest rate normalization, which is an enabling factor for equity price gains.
While I am starting to have concerns about equities on valuation grounds, the market is likely undergoing a blow-off phase where if participants hold their noses and buy, they could enjoy some truly bubbly profits.

A skeptical market

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

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

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

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

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

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

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

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

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

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

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

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

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

The growth surprise continues

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

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

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

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

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

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

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

A strong earnings outlook

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

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

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

A dovish Fed?

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

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

Throw caution to the wind?

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

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

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

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

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

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

The week ahead: Don’t short a dull market

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

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

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

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

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

Disclosure: Long TNA

Is Chinese growth stalling?

Posted by Cam Hui -

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

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

 

Here is LSR analyst Michelle Lam:

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

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

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

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

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

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

 

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

 

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

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

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

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

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

A new definition of Money

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

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

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

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

 

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

Assessing downside risk

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

 

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

A new monetary framework

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

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

 

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

 

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

Is the consolidation over?

Posted by Cam Hui -

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

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

 

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

Neutral, but not oversold

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

 

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

 

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

Buying the leadership

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

 

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

 

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

FOMC preview: How hawkish the tone?

Posted by Cam Hui -

As we approach another FOMC this week, much of the short-term tone of the market will depend on the Fed. In order to analyze what the Fed is likely to do, let`s begin with their mandate, which is price stability (fighting inflation) and full employment. In addition, the Fed has taken on a third objective of financial stability.

When I look at what`s happened since the Brexit vote, all signs point to a renewed path towards interest rate normalization. Therefore it would be unsurprising to see the FOMC statement take a more hawkish turn. Expect the post-meeting buzz to focus on one or two rate hikes for the remainder of 2016.

The Phillips Curve

As the Fed`s stated dual mandate aims for both inflation fighting and full employment, their analytical framework is the Phillips Curve, which postulates a short-term tradeoff between unemployment and inflation.

Cost-push inflation is starting to rise from a tight labor market This graph from Tim Duy shows the relationship of between unemployment and wage growth, which eventually pressures inflation. The behavior of these two variables in the current cycle hasn’t been very different from past cycles. With unemployment at sub 5% levels, rising wage growth (and therefore rising cost-push inflationary pressures) is to be expected.
 

 

A growth revival

For much of the winter, the Fed had been worried about an economic pause, or slowdown. In addition, instability from abroad, such as Brexit, added to concerns about global financial instability. Much of those worries are now receding.

We can think of the American economy can be divided into two parts, the industrial, or manufacturing, economy and the consumer economy, which is proxied by consumer spending and employment. The industrial economy appears to be undergoing a growth revival, as evidenced by the upside surprise of the Markit Manufacturing PMI (Purchasing Managers’ Index).
 

 

As for the consumer, Bloomberg highlighted analysis from Macquarie, which used the components of Atlantic Fed’s GDPNow, to show that Q2 personal consumer expenditure is expected to surge to 4.5% quarter-over-quarter. In other words, the consumer is back and spending!
 

 

In addition, initial jobless claims continue to make progress. Last week’s release of initial claims beat market expectations again and the 4-week average fell to a new cycle low. This figure is particularly important as it coincides with the survey period for the July Non-Farm Payroll report.
 

 

As monetary policy is believed to operate with a lag, the combination of calmer financial markets, progress in growth and employment are expected to prompt the FOMC to return to a course of interest rate normalization. Undoubtedly, there will the usual caveats about “data dependence”, but expect a September rate hike to be back on the table. At a minimum, the market will expect that the Fed will raise rates at least once this year.

What to watch for

For equity investors, there are two metrics to watch. The chart below of the Citigroup Economic Surprise Index, which measures whether macro indicators are beating or missing expectations, and the 10-year Treasury yield shows a widening gap between the two. We have seen a growth surprise in the past few weeks, but bond yields have barely budged. Will bond yields rise in response to the FOMC statement?
 

 

The second metric to monitor will be the evolution of the shape of the yield curve. A steepening yield curve, where the 10-2 year yield spread widens, is the bond market’s signal that it expects rising growth, while a flattening yield curve is an indication of falling growth expectations. Assuming that the language of the FOMC indicates a return to rate normalization, will the yield curve steepen or flatten?

As the chart below shows, the circled yield curve inversions, where the 10-year rate is below the 2-year rate, have tended to lead equity bear markets. While the yield curve has been flattening, it is a long way from an inverted state.
 

 

At times like these, equity investors should pay close attention to the message from the bond market.

In the 7th or 8th inning of the bull market

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less 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.

Value meets Growth and Momentum

No, I am not turning bearish on stocks despite the title of this post. However, the value side of my inner investor is starting to get a little nervous. The market has risen to a level that can be described as either fair value or slightly overvalued. In addition, the behavior of “smart” investors like insiders are also raising cautionary flags that serve as early warning signs of limited upside potential.

On the other hand, the US economy is undergoing a growth revival, which is helpful for higher stock prices. In addition, the market is experiencing powerful momentum in the form of a FOMO (Fear of Missing Out) rally that’s still in its early stages. The irrational exuberance scenario that I postulated two weeks ago (see How to get in on the ground floor of a market bubble) is becoming my base case. Under those circumstances, stock prices can rise further than anyone expects.

My preliminary conclusion is we are seeing the late stages of a market blow-off that will ultimately mark the top of the bull market that began in March 2009. We are in the 7th or 8th inning* of this bull and there are still gains to be made, but longer term investors should start to begin to exercise some caution.

* For readers unfamiliar with baseball, a normal game lasts 9 innings. If the score is tied after the 9th inning, then extra innings are played until a winner is determined.

The bull case

Let’s start with the bull case for stocks. I have been saying for several weeks that we are seeing the start of a growth surprise and that trend continues. Last week, we saw the latest Manufacturing PMI beat expectations and tell a story of an industrial growth revival.

Last week, we also saw more progress in initial jobless claims which also beat expectations. Last week’s release is particularly useful as it coincides with the survey period for the July Jobs Report.

We also saw a number of key metrics being released for housing last week, which is important as the sector is a leading indicator of economic growth – it’s virtually impossible to have a recession without housing and construction turning down. Housing starts and existing home sales both beat expectations, reflecting solid prospects for continued economic growth (click on links to comments from Bill McBride of Calculated Risk).

In fact, macro momentum was so strong last week that there were very few important indicators that missed expectations.

A solid earnings season

If we were to analyze the market from a bottom-up basis, the growth picture appears just as positive. The latest Earnings Season update from John Butters of Factset shows that both the EPS and sales beat rates are coming in slightly ahead of historical averages. More importantly, the Street is revising EPS upwards at a solid rate (chart annotations are mine).

From a growth investor’s viewpoint, these are all bullish signs.

FOMO rally = Momentum

Even as the market undergoes a growth surprise, the BoAML Fund Manager Survey (FMS), which is primarily a survey of global institutional fund managers, is suggestive that a FOMO stampede is just starting. Remember – institutions represent big and slow money and their moves tend to be slow but powerful.

The FMS shows that global institutions are still relatively defensively oriented. Cash levels are high.

Overall portfolio risk is well below average.

Equity allocations at about neutral (the lower than average portfolio risk can be explained by high cash levels).

Growth expectations are falling, despite emerging evidence of a US growth surprise.

Equity weights in the US has moved from an underweight to a slight overweight position in June, though readings are not excessively high. Managers are allocating more funds into US equities as the evidence of a growth surge emerges. The combination of an defensive portfolio orientation and positive US growth characteristics suggests that the shift into US equities leads me to believe that funds flows into the US market has a lot more room to run.

This buying stampede has created a price momentum tsunami. CNBC highlighted analysis from Ari Wald of Oppenheimer showing past instances of momentum breadth surges have led to much higher prices.

In short, funds were caught off-side and too defensively positioned. Now they`re buying anything that moves. As the chart below of high beta stocks vs. low volatility stocks shows, a FOMO rally has a long way to run before sentiment can be characterized as irrational exuberance.

Cautionary signs

Despite the bullish signals from Growth and Momentum, a number of cautionary signs are restraining me from getting wildly bullish. I wrote before that the combination of above average valuation (as measured by Morningstar’s fair value estimate) and insider selling (Barron’s) could pose bullish headwinds (see How worried should investors be about insider selling?).

Those conditions are appearing again. We are seeing mild (3%) overvaluation and several weeks of of insider selling. While this is not a perfect market timing signal, it does suggest that stock prices lack valuation support.

I would warn that this model is not designed for trading, but investing. During the episode in late 2014 and early 2015 when such a combination of condition existed, the signal persisted for several months and the market ground upwards before it corrected (chart from How worried should investors be about insider selling?).

Another risk that I have also pointed out in the past raised concerns about how a rising US Dollar squeezes the margins of large cap US multi-national companies. While the USD remains fairly flat on a YoY basis, the recent rally of the USD Index has moved it to test downtrend technical resistance. An upside breakout could be a signal of further strength, which would eventually pose headwinds for US equity fundamentals.

Another cause for concern the direction of bond yields. The chart below (via Ed Yardeni) shows the Citigroup Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations (red line), and the 10-year UST yield (blue line). These two indicators have tracked each other quite closely in the past. While ESI has surged in the past few weeks, 10-year yields have barely moved. How long before yields rise to catch up with ESI?

If Treasury yields were to rise, it would change the risk-reward relationship between stocks and bonds in the favor of bonds and put downward pressure on stock prices.

The ESI-bond yield relationship also begs the question of the Federal Reserve’s reaction function to higher growth, better employment and stabilizing markets. When will it resume its path of interest rate normalization? How many rate hikes will we see in 2016?

We should get better clarity when the FOMC releases its statement next week. The FOMC statement is expected to set the tone for the bond market and the USD, which could have profound implications for equity prices for the reasons I mentioned above.

The bull market in the late innings

For now, any Fed induced slowdown or recession is well in the future. Nevertheless, these are risks bear watching in the face of a mature economic cycle and mature late-stage stock market bull.

When I put it all together, the stock market is caught between a battle between Value. whose signals tend to be early, and Growth and Momentum. As the latter two factors can be very powerful in the late phase of a bull, this combination suggests that the bull market that began in 2009 can still have more room to run. If I had to make a guess about an SPX target, a rough estimate of 2400-2500 would be where this market ultimately tops out – and that figure is consistent with the upside target on a point and figure chart.

As for the question of the timing of a market peak, we can get some clues from this Morgan Stanley analysis of the the high yield credit cycle (via Value Walk). Based on this analysis, we might see the top of the cycle about a year from now. By contrast, an analysis using the Presidential Cycle would see a cyclical market top in early 2017. So a rough guess would see the time frame for a market top in 6-12 months.

(Chart notes: Horizontal axis is in years, Spd Peak = Spread Peak).

The bull market isn’t dead, but it`s aging. It is now starting the manic phase where price is overshooting fair value. I am now paying more attention to technical analysis to watch for the signs of a top.

The week ahead

I don’t have much to add to my mid-week tactical market comment (see When will the bulls take a breather?). Bullish momentum appears to be waning. Even perennially bullish strategist Tom Lee at Fundstrat has turned tactically cautious. He pointed out that equity volatility (VIX) has fallen below bond volatility and such episodes have historically seen an average SPX loss of -1.3% in the next 20 trading days 68% of the time.

In addition, the latest Commitment of Traders data shows crowded long positions by futures speculators in the NASDAQ 100, S+P 400 and the Dow. The combination of these readings all point to limited upside potential in the near-term.

Though the stock market can continue to grind upwards and make marginal new highs, the more likely outcome is a 1-2 week period of sideways consolidation or minor pullback.

Even though he is getting a little nervous, my inner investor remains bullish and fully invested. My inner trader remains in cash after coming back from vacation. Next week will see potential volatility in the form of the heavyweight AAPL earnings report and the FOMC meeting. My inner trader is inclined to believe that the prudent course of action is to stay on the sidelines. He is waiting for signs that the market’s overbought condition has been alleviated before making a commitment to the long side.

Disclosure: No trading positions

The Trump Arbitrage Trade

Posted by Cam Hui -

The reaction to Donald Trump`s speech to the Republican convention has been highly bifurcated. Mainstream media and analysts mostly reacted with horror and raised cautionary notes about his campaign of fear (see The New York Times and The Economist), while social media lit up with “I would totally vote for this guy” messages.
 

 

To be sure, Trump’s speech was extremely dark in tone for the presidential candidate of any major party. Here are some key excerpts that painted a picture of a failing America:

Homicides last year increased by 17% in America’s fifty largest cities. That’s the largest increase in 25 years. In our nation’s capital, killings have risen by 50 percent. They are up nearly 60% in nearby Baltimore…

The number of police officers killed in the line of duty has risen by almost 50% compared to this point last year. Nearly 180,000 illegal immigrants with criminal records, ordered deported from our country, are tonight roaming free to threaten peaceful citizens.

The number of new illegal immigrant families who have crossed the border so far this year already exceeds the entire total from 2015. They are being released by the tens of thousands into our communities with no regard for the impact on public safety or resources…

Household incomes are down more than $4,000 since the year 2000. Our manufacturing trade deficit has reached an all-time high – nearly $800 billion in a single year. The budget is no better.

President Obama has doubled our national debt to more than $19 trillion, and growing. Yet, what do we have to show for it? Our roads and bridges are falling apart, our airports are in Third World condition, and forty-three million Americans are on food stamps…

Not only have our citizens endured domestic disaster, but they have lived through one international humiliation after another. We all remember the images of our sailors being forced to their knees by their Iranian captors at gunpoint…

In Libya, our consulate – the symbol of American prestige around the globe – was brought down in flames. America is far less safe – and the world is far less stable – than when Obama made the decision to put Hillary Clinton in charge of America’s foreign policy.

Never mind the pundits who fact checked Trump and pointed out the distortions. If you are a believer in the Trump message and you weren’t sure if he will win, what would you do with your portfolio?

The answer is to buy gold. That viewpoint sets up the Trump Arbitrage: If you believe in Trump’s assessment of America, you would buy gold. If you thought that things aren’t as bad as the Trump view, you would buy stocks. You would buy hope – and innovation.

The Trump Arbitrage trade is either gold, or stocks. Here is the gold vs. equities pair trade, which remains largely range-bound for most of this year.
 

 

Here is how I would evaluate the Trump Arbitrage Trade.

Evaluating the Trump Arbitrage Trade

I could tell you that you would be late to the party in “buying” Trump, as COT data shows that hedge funds are in a crowded long in gold futures (via Hedgopia).
 

 

I could also tell you that while the recent past (Q1 growth) has been subpar, the American economy is undergoing a growth rebound. The Citigroup Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations, has been surging. That’s an indication of a growth surprise that’s probably not priced in by the equity market yet.
 

 

I could also tell you that the stock market has hit all-time highs and the US Dollar is rallying again. Does this look like the picture of a weak America?
 

 

You may choose to support Donald Trump and express your support at the ballot box, but a bet on his vision of a failing America would likely hit you in the wallet.

When will the bulls take a breather?

Posted by Cam Hui -

Mid-week market update: As stock prices have recovered strongly off the Brexit panic bottom to make a new all-time high, there are numerous signs that the market is ready to take a breather. In all likelihood, a period of sideways consolidation or minor pullback is on the horizon.
 

 

Traders in a crowded long

Short-term sentiment measures have moved from extreme pessimism to a wildly bullish, though intermediate term sentiment is still supportive of further highs. Mark Hulbert reported that his survey of NASDAQ stock market timers (HNNSI) jumped from -55.6% (a net short reading) after the surprise Brexit result to 77.8%, which is an astounding change of 130% in the space of only three weeks.

The latest TickerSense Blogger Sentiment Survey is also reflective of this turnaround in trader sentiment. Bullish sentiment has surged to highs not seen since October 2012.
 

 

I have tended to discount the value of opinion polls because opinions can change very quickly and I have place greater weight on sentiment metrics where traders are playing with real money. Data from the option market, where hedgers and speculators are putting actual money on the line, confirms the crowded long narrative. Babak, aka Trader’s Narrative, highlighted a normalized CBOE put/call ratio measure, which is also showing a high level of complacency.
 

 

As well, the term structure of the VIX Index, where the 1-month VIX (VIX) is showing a substantial discount to the 3-month VIX (VXV) is also telling a similar story of bullish complacency.
 

 

In addition, the Ned Davis Research ETF Speculation Index, which measures the ratio of leveraged long ETFs to short ETFs, recently flashed a sell signal. While sell signals have historically been not to be as effective as buy signals, this is another sign that the risk-reward ratio is not skewed in favor of the bulls.
 

 

Wobbly breadth

Putting it all together, sentiment models are pointing to a period of near-term market weakness or consolidation. For me, the clincher came from Trader Followers, who monitors Twitter breadth. As the chart below shows, Twitter breadth (top panel) has staged an upside breakout, which is intermediate term bullish. However, the bullish stock breadth (green line, second panel) is starting to roll over, which is a warning sign that momentum is petering out.
 

 

My inner trader remains in cash. He is waiting to see how the likely period of consolidation or pullback, which should be shallow, to play out before going long.

Disclosure: No trading positions

Demographic Apocalypse Now?

Posted by Cam Hui -

When I was a boy, I can remember the Zero Population Growth (ZPG) movement, which was a response to the Club of Rome‘s Limits to Growth Mathusian thesis of “the world has limited resources, but human population is rising exponentially and therefore ecological disaster looms”. Somewhere along the way, birth rates fell in response to global industrialization, rising incomes and changing incentive structures. In an agrarian society, children are potential units of production. They can be put to work in the fields and support you in your old age. In an industrialized society, children are cost centers. It was no wonder that birth rates fell as the emerging market economies boomed.

Today, ZPG has been realized (and more). Human global population will stabilize and shrink some time in the 21st Century. In fact, global population is about to reach an inflection point in the not too distant future as the number of old people will soon exceed the number of young children (via Business Insider):
 

 

A demographic shift like this raises all sorts of questions. For investors, it brings into the question of future returns as Baby Boomer demand for retirement income starts to dominate capital market returns and strain government retirement benefits. For policy makers worldwide, the issues are how to fund retirement benefits, as well as how to structure policies to transition to an aging society.

The looming retirement crisis

John Mauldin addressed many of these issues in his essay Welcome to the Pale Grey Dot. The world is indeed aging and it will cause a retirement crisis. The only question is one of timing.
 

 

Mauldin, who has preached a gloom-and-doom message for as long as I can remember, painted a dire picture of what is likely to happen in retirement:

I’ve said this before, but it’s worth repeating: “retirement” is a new concept. For most of human history, people worked as long as they were physically able and died soon thereafter. And in much of the world that is still the case. Traditionally, the intervening period between no longer being able to work and dying was longer for people who had large families to care for them – which is one reason fertility rates were so high.

This state of affairs began to change in the 19th century when the advent of mechanized agriculture began to allow a farmer to feed his own family and still have food to sell. The work time of farm families was somewhat freed up, and more time could be devoted to helping the elderly to live longer.

At some point, supporting retirees went from being a family responsibility to a task shared between family and society. Governments created programs like Social Security in the US that guaranteed some minimal income to older folks. Businesses did the same with pension plans. Families were still the backstop, though, along with whatever savings retirees had accumulated.

For a century or so, this three-legged stool worked fairly well. People who reached retirement age could stop working and lean on some combination of (a) their family (mainly their children), (b) their own savings or pensions, and (c) government

Now that’s starting to change. By choosing to have fewer children, we unwittingly sawed one leg off that three-legged retirement stool. It’s hard to depend on descendents who don’t exist.

Worse, the other two legs are starting to crumble, too. Defined-benefit pensions are rare in the private sector and unstable for government retirees. Individual investors tend to lose their money in market crashes and are often lucky just to break even. Even government plans like Social Security are in increasingly questionable shape.

Matthew Tracey and Joachim Fels at Pimco have a more sanguine view in their essay 70 is the new 65. They argue that the traditional way of thinking about dependency ratios, like this chart below, is all wrong.
 

 

Instead, they calculate a modified dependency ratio based on a re-defined “peak savers” and the saving activity of seniors as they age, as life expectancy have risen. Based on these calculations, the demographic cliff is delayed by about ten years.
 

 

An asset-liability framework

I believe that the focus by Mauldin, Pimco and many other analysts on the coming demographic cliff is overly myopic as it only shines the spotlight on the social liability side of the equation. If we view the problem using an asset-liability framework, the bigger question is how society as a whole responds to an aging population.

  1. How can society generate sufficient wealth and growth to provide for its swelling number of seniors? The problem about rates of return on invested pension assets and pension funding ratios are issues of how to split the inter-generational pie.  That question will become a matter of social debate that likely gets decided at the ballot box. Unless the pie is big enough and growing fast enough, nothing matters.
  2. Equally important and related to my previous point about the size of the pie: How will businesses respond in the face of a shrinking global labor pool?

We can get some clues from Japan, which is an advanced industrial society with the oldest population profile. Matthew Klein at FT Alphaville documented the two ways that Japan has responded to its aging population profile. First of all, employment rates went up, which was no surprise:

They enlarged their labor force, as female participation rose. As an aside, labor force enlargement could also be accomplished through higher immigration, but Japan did not go down that road.
 

 

In a separate FT Alphaville post, Klein demonstrated that the US could also enlarge its labor force through better female participation. Just look at the gulf in female participation rate between American and Canadian workers. Bloomberg also reported that an increasing number of Americans plan to work until 70, which also raises the size of the work force.
 

 

In addition, Japanese corporations invested – a lot. True, the Japanese household savings rate collapsed just as its demographic profile predicted.
 

 

But the current account soared, as Japanese corporations raised their savings rate and invested overseas.
 

 

Demographic Apocalypse Not Yet – even in aging Japan.

The robots take over?

The Japanese experience brings up an important point about capital and labor. Duncan Weldon, writing in Medium, recently asked “How does capital respond to a labor shortage?”

An article in the Wall Street Journal last week got me thinking again about of the bigger medium term questions in macroeconomics. Namely, what should we be worrying about more: not enough workers or not enough jobs?

On the one hand, the world is undergoing a demographic transition and the one off impact of China’s entry into the global economy may have run it’s course.

If I had to pick one graph to show “what’s happening in the world right now”, this one would be pretty high up my list:

 

 

Weldon found the answer in how Arizona businesses responded to a labor shortage. The answer was automation:

The WSJ article that helped clarify my own thinking was on Arizona and the impact of a multi-year crackdown on illegal immigration. The state provides a neat case study of what happens when a labour shortage develops.

At first glance the numbers appear to back up the Goodhart-Nangle argument:

 As the Arizona economy recovered, a worker shortage began surfacing in industries relying on immigrants, documented or not. Wages rose about 15% for Arizona farmworkers and about 10% for construction between 2010 and 2014, according to the Bureau of Labor Statistics. Some employers say their need for workers has increased since then, leading them to boost wages more rapidly and crimping their ability to expand.

But faced with a shortage of workers and rising costs, capital responds. The labour market doesn’t operate in vacuum.

Here’s how on Arizona pepper farmer has responded:

He says mechanization is his future. He continues to pour time and money into a laser-guided device to remove stems from peppers, which pickers now do by hand in the field. Another farmer in the area developed a mechanical carrot harvester.

Mr. Knorr says he is willing to pay $20 an hour to operators of harvesters and other machines, compared with about $13 an hour for field hands.

Take away cheap labour and business models that rely on it existing will adapt or die. The way to adapt is to investment in labour-saving technology.

Even Foxconn has followed this well-trodden path by firing 60,000 Chinese workers and replacing them with robots (via the BBC):

In a statement to the BBC, Foxconn Technology Group confirmed that it was automating “many of the manufacturing tasks associated with our operations” but denied that it meant long-term job losses.

“We are applying robotics engineering and other innovative manufacturing technologies to replace repetitive tasks previously done by employees, and through training, also enable our employees to focus on higher value-added elements in the manufacturing process, such as research and development, process control and quality control.

“We will continue to harness automation and manpower in our manufacturing operations, and we expect to maintain our significant workforce in China.”

Since September 2014, 505 factories across Dongguan, in the Guangdong province, have invested 4.2bn yuan (£430m) in robots, aiming to replace thousands of workers.

Demographics Apocalypse Not Yet,

A global inequality reversal?

So far, the trends I have outlined so far is already known. Businesses are responding to a labor shortage by investing in automation. Aggregate output will not fall. Society will be able to take care of its seniors. How it re-distributes the fruits of automation is another question that will have to get decided at a level that’s beyond my pay grade.

This brings up another, but more speculative point. Branko Milanovic pioneered a study showing how global inequality has changed over the last thirty years. Much of the gains from globalization and offshoring accrued to the middle class in the emerging market (EM) economies and the very rich of the world, because it was the top 1% that directed and reaped the fruits of globalization. The losers were the people in the subsistence economies, because those economies were not sophisticated enough to participate in the global labor rate arbitrage, and the middle class in the developed market (DM) economies.
 

 

Just look at how global income distribution has improved since 1988:
 

 

…and how poverty rates have plummeted.
 

 

As the world gets older and businesses respond with more automation, especially in an inter-connected world where technologies like 3D printing become more ubiquitous. Consider this article by James Fallow, writing in The Atlantic, about the Maker Movement, which has become a grassroots movement of (currently) artisans creating flexible manufacturing in the United States:

“This would not have been possible ten years ago,” Venkat Venkatakrishnan, the CEO of a unique and famous maker space called FirstBuild, told me in Louisville earlier this year. FirstBuild is unique because it was created by GE, as a subsidiary of its appliance division and as a deliberate effort to bring the nimble maker spirit to its design process.

“What has changed is that the maker movement has figured out a group of technologies and tools which enable us to manufacture in low volume,” Venkat (as he is known) said. Big manufacturers like GE built their business on high-volume, factory-scale, very high-stakes production, where each new product means a bet of tens of millions of dollars. FirstBuild is mean to explore smaller, faster, more customizable options.

“Now you can get a circuit board mill for $8,000. If you are looking for a circuit board for an appliance, earlier the only chance of getting it was from China. Today I can make boards here and ship them out quickly. Similarly with laser cutters—not big ones but small ones, where I can cut metal right here. It’s a huge advantage, and these things did not exist ten years from now. In those days you couldn’t hack the kind of creative solutions we are seeing now.”

Such a revolution in 3D printing and specialized manufacturing would shorten the supply chains in both distance and number of nodes. It also suggests a reversal in the labor arbitrage advantage that has benefited the EM countries in the last 30 years and the start of reshoring back to the developed markets.

If that becomes the case, global inequality is likely to increase over the next 30 years, which will be a headwind for EM investors, while the winners will be the technology leaders who stay at the top. This also would be a welcome development for the embattled middle class in the developed market economies, which has seen populism and tribalism rise, especially in Europe (see The Brexit Pandora’s Box).

To be sure, not all EM countries will lose under such an arrangement as trade patterns would shift from global to regional in nature. The countries that can offer the combination of low labor rates and proximity to markets, such as Mexico (NAFTA bloc), Eastern Europe (EU), China and South Korea (Asia) are likely to become the comparative winners within the EM economies.

All systems flashing green for the bulls, but…

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less 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.

The all-time-highs explained

Regular readers know that I have been bullish on stocks for quite some time. It was therefore gratifying to see the stock market catapult to new all-time-highs. Just in case you were wondering why stock prices have been rallying in the face of Brexit uncertainty, the blogger Jesse Livermore pretty much nailed the reason with this tweet:
 

 

I also suggested last week that the market was on the verge of a growth surprise (see How to get in on the ground floor of a market bubble). The combination of an equity market friendly policy environment and positive growth surprises are acting to push stock prices higher.

Signs of renewed growth are everywhere

Indeed, we saw more data indicating robust US economic growth as industrial production and retail sales, which represent both the manufacturing and consuming parts of the economy, came in above expectations. Here is industrial production, which has recovered from its winter swoon:
 

 

June retail sales indicated that the American consumer remains healthy:
 

 

Other signs of a rebound are everywhere. NFIB small business optimism rose again in June, which contributed to a better growth tone for the economy.
 

 

As a result of these developments, we have seen a surge in the Citigroup Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations.
 

 

As well, the yield curve is steepening again, which is the bond market’s way of signaling higher growth.
 

 

Bottom-up analysis is also confirming the top-down view of economic strength. The latest earnings data update from John Butters of Factset shows that forward EPS continues to rise – which is another sign of positive fundamental momentum (annotations in red are mine).
 

 

So far, all systems are flashing green for the bulls…

Cyclical sectors come back to life

The behavior of the market is also an important clue to market analysis.The bull case was bolstered when the SPX upside breakout to new all-time-highs was accompanied by leadership from cyclical stocks, which confirms my growth surprise thesis.

The renewed growth momentum seems to be global in nature. China is behaving well again, as the Shanghai stock market and the stock markets of its major Asian trading partners have all rallied above their respective 50 day moving averages (dma).
 

 

Commodity prices, and in particular the more cyclically sensitive industrial metals complex, are also important barometers of Chinese growth. Commodities have been in well-defined uptrends, which is a bullish sign especially in light of headwinds posed by the strong USD, which tends to be inversely correlated to commodities.
 

 

In addition, cyclical sectors and industries have also been showing signs of relative strength – which is another positive.
 

 

Bullish technical outlook

When I look at the market from a chartist’s viewpoint, the intermediate term picture looks bullish as well. The SPX staged an upside breakout through resistance and technicians can use such breakouts to measure the upside target for the index. When I apply a point and figure charting technique (using a 0.5% box and 3 point reversal), I get an upside target of roughly 2500.
 

 

The upside breakout in equities was also accomplished with strong momentum. Mark Hulbert highlighted analysis from Dan Sullivan indicating that the market has flashed a rare momentum buy signal that has occurred only 13 times since 1949. Such episodes have historically resolved themselves bullishly.
 

 

What more could the bulls ask for?

Near-term caution

Despite all of the bullish backdrop, some caution is warranted as sentiment models suggest that the current advance is extended and the near-term risk-rewards is not necessarily skewed upwards. The latest NAAIM survey indicate that RIAs are in a crowded long. Historically, such conditions have resolved themselves with short-term pullbacks.
 

 

The 10 dma of the CBOE put/call ratio shows a high level of complacency, which has also led to consolidation or correction in the past (marked by the dotted red lines).
 

 

Similarly, the CNN Money Fear and Greed Index is flashing a very “greedy” reading.
 

 

My inner investor has been comfortably bullish on stocks for quite some time and he is riding out his position of an overweight position in equities. My inner trader has been in cash because he believed that it would be prudent to step to the sidelines as he was on vacation for the last couple of weeks. He will be back in the saddle next week and he will be waiting to get on stocks on any pullback, which is expected to be relatively shallow.

Disclosure: No trading positions

How much “runway” does China have left?

Posted by Cam Hui -

As we await China’s Q2 GDP report in the face of sharply lower trade figures, it’s useful to ponder once again the China tail-risk question. For years, analysts have been warning about impending doom in China because of the growing mountain of unsustainable debt (see Kyle Bass, Jim Chanos, Andy Xie and George Soros).

 

In the past, every time China has gotten to the edge of a hard landing, Beijing has confound the bears by kicking the can down the road and forestalling a crisis. That kind of “extend and pretend” strategy is perfectly viable if the road is long enough, but the key question for investors is, “How long is the road?”

A debt crisis in 2-3 years?

The answer according to Michael Pettis, experienced China watcher who has more or less called every turn in China for the last decade, is three years. In his latest blog post, Pettis made a number of optimistic assumptions about China’s debt load and believes that they are likely to experience a debt crisis within a 2-3 year time frame:

[E]ven 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 went on to model China’s debt trajectory under a number of assumptions. The base case is no rebalancing with GDP continuing at a 6-7% pace. Under that scenario, debt grows at 12-14% per annum and debt to GDP rises by 25% in 2020 and debt growth rises to 15-18%.

 

Pettis went on to vary the assumptions in his growth model. He managed to get debt growth under control if GDP growth slowed to a 3-4% rate while transferring 3-4% of GDP to the household sector. The idea is to shift growth from State-owned Enterprises (SOEs) to private Small and Medium Enterprises (SME). But how plausible is that

 

Under such a scenario, the idea is to shift the engine of growth from State-owned Enterprises (SOEs) to private Small and Medium Enterprises (SMEs). While overall growth levels would slow, this kind of rebalancing would make the debt load trajectory more sustainable. But how realistic are those assumptions?

Notwithstanding the fact that 3-4% GDP growth would be regarded by many as a “hard landing” for China, government transfers of 3-4% to the household and private sector would be extremely difficult to achieve politically. It would necessitate the wholesale financial suicide of Communist Party cadres who are running many SOEs. Moreover, it would mean a transformation of the banking culture:

The point is that banking systems do not allocate credit on the basis of a set of well-understood rules that can easily be manipulated or redirected. The credit allocation process is the outcome of a complex set of institutions that are at least as much political as economic in nature. To transform this process requires a long and difficult transformation of these political institutions.

It would also require, in China’s case, the creation almost from nothing of a credit culture, replacing a banking culture in which loan officers paid very little attention to credit risk because money was mostly lent directly or indirectly to government or government-related entities (most or all of which enjoyed implicit or explicit guarantees). Beijing would have to transform this banking culture into one that is driven by the credit evaluation of businesses that are often not very transparent and that operate in complex systems of ownership. But it is not easy to build a credit culture, and it is a virtual certainty that any attempt to do so quickly will, very soon after it began, generate large amounts of NPLs.

I don’t hold much hope for this kind of rebalancing at such a substantial level. Tom Orlik recently highlighted the latest investment data, which showed that most of the investment growth was coming from SOEs and not private businesses.

 

Not your father’s EM crisis

Still, a Chinese hard landing won’t be anything like the kinds of emerging market crises in the past. While the absolute level of external debt of just under USD 1 trillion appears to be large, you have to view that amount in a context. Global equity markets suffered USD 2 trillion in losses on the day after the Brexit decision. In addition, China has an enormous reserves and enjoys a current account surplus to service that debt. Moreover, some of the recent “capital flight” went to pay down USD denominated debt, which will likely turn out to be a prudent move.

Should we see a crash, most of the non-performing loans (NPLs) will be denominated in CNY. Should Beijing opt to save the banking system, as well as parts of the shadow banking system, most of the costs will be borne by the household sector in the form of renewed financial repression. Under such a scenario, the cost would be a prolonged period of slow growth.

The threat to the global financial system of a China hard landing or crash is therefore relatively low. Still, USD 1 trillion is still a lot of money and there is always the possibility that some banks get caught up with excess exposure to China, but the likelihood of another Lehman Moment won’t be as high as it was in 2008.

The shadow banking system time bomb

Just because the global economy is largely insulated from a Chinese hard landing, a RMB denominated NPL blow-up in China won’t be pleasant. HSBC (via Business Insider) detailed the rapid growth of the shadow banking system, in the form of off balance sheet wealth management products (WMP) and WMPs will amount to one-third of retail funding in (you guessed it) two years:

If Wealth Management Products (WMPs) continue to expand at their current rate, in two years’ time as much as a third of the retail funding activities in China’s banking system will take place off balance sheet. That will make it even harder for regulators to estimate risk in the banking sector and to monitor linkages between the country’s shadow banking activities, capital markets and the real economy.

WMPs lack transparency. While the authorities have taken steps to rein in their growth, WMPs are sucking the liquidity out of the Chinese financial system because they offer higher rates of return, but with opaque risk.

The WMP problem is now so huge that it’s starting to suck up cash lying around in the Chinese economy like a horde of locusts. Economists use “M2” to describe the part of an economy’s money supply that includes cash, checking deposits and what is known as “near money” — extremely liquid assets like savings deposits, money market mutual funds and other time deposits.

HSBC points out that M2 growth has settled in around 12%-15% a year over the last few years. It was 20% while the economy was growing faster. WMPs, HSBC analysts estimate, are growing much faster than that.

“What that means, quite simply, is that money is flowing into WMPs faster than the pace at which it is being created, implying that liquidity is being sucked in from the real economy,” the analysts wrote. “In our opinion, the sustainability of such a situation is questionable, and this is potentially one of the key factors that could trigger a systemic risk event down the road.”

 

Political tail-risk

The risk of political upheaval would rise should the Chinese financial system blow up as Beijing loses control of the banking system. Branko Milanovic is the academic who produced the landmark study on inequality that outlined how global inequality had fallen but local (within country) inequality had risen, especially in the developed market economies.

 

Milanovic recently talked to Forbes Asia and here is what he had to say about China:

The legitimacy of the Chinese government depends, to a large extent, on the delivery of a very high rate of growth. Increasing inequality was acceptable when everyone was getting better off. Now inequality could become a political issue, particularly because incomes have been acquired by corruption and political connections. That may be true in other places too, but China does not have the political process to allow new parties and leaders to come into power. So that’s the danger inequality poses for political stability in China.

Milanovic expanded on this point in a recent post on his blog:

[A] similar process of rising populism in China seems difficult to explain because it is accompanied not by a declining but by a rising middle class. The modernization theory leads us to believe that the rising share of the middle class should propel democratization. In effect, this is what we have observed over the past 40 years, from the Carnation Revolution to Portugal to the fall of Communism or the spread of democracy in South Korea and Taiwan and in all of Latin America.

Could China be an exception to this “regularity”? It is the same question probably that the Communist party leaders ask themselves. If they answer it in the affirmative, they would be throwing in the towel in a fight to maintain their rule. Since they seem unwilling to do so, and are becoming aware that the ideology of “GDPism”, founded on an infinite growth of real incomes by close to double-digit numbers, cannot be maintained, they have tried to move the public opinion in the direction of populism, whether of mild Maoist or of soft nationalist kind. Neither of these two tendencies is yet strong enough or sufficiently poisonous, but the potential to crank it up if needed is there. Thus, in the Chinese case, the rising tide of populism is not caused by an economic failure but on the contrary by economic success which is making the maintenance of the old political system more difficult, or is incompatible with it. This is a contradiction between the development of the forces of production and inadequacy of the superstructure that every Marxist would easily recognize.

Now imagine a crisis in China stemming from the confluence of a pending disruptive debt adjustment and rising middle-class incomes that puts pressure on democratization. The markets wouldn’t like that at all.

I am not trying to be alarmist and the intent of this post is most emphatically not an  “OMG, sell everything” warning. If China were to get hit with some minor crisis today, the PBoC has sufficient resources to kick the can down the road for another year, but that road is getting shorter.

Investor need to watch for the trigger for the onset of a crisis. Don’t over-react, yet.

A dangerously extended market, or a FOMO rally?

Posted by Cam Hui -

Mid-week market update: The SPX has staged an upside breakout to new all-time highs and indicators are looking overbought. Now the key question for traders is whether current conditions represent an extended market that`s ripe for a pullback, or does do these conditions represent a “good” overbought condition that accompanies a momentum surge, which leads to […]

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If machines are human, would you let one marry your daughter?*

Posted by Cam Hui -

Several months ago, the internet was all abuzz over the victory of Google’s AlphaGo program beating Go grandmaster Lee Sedol (see story here). As the game of Go is a computationally and mathematically complicated game and the number of variations in the game is an order of magnitude higher than chess, it was a great victory for the kinds of “deep learning” artificial intelligence (AI) techniques pioneered by Google’s Deep Mind team.

Indeed, there have been great strides by AI research teams in the fields of pattern recognition and natural language processing. As an example, the Washington Post chronicled a startup called Viv designed to be a natural language AI bot that can order you pizza, among other tasks:

In an ordinary conference room in this city of start-ups, a group of engineers sat down to order pizza in an entirely new way.

“Get me a pizza from Pizz’a Chicago near my office,” one of the engineers said into his smartphone. It was their first real test of Viv, the artificial-intelligence technology that the team had been quietly building for more than a year. Everyone was a little nervous. Then, a text from Viv piped up: “Would you like toppings with that?”

The engineers, eight in all, started jumping in: “Pepperoni.” “Half cheese.” “Caesar salad.” Emboldened by the result, they peppered Viv with more commands: Add more toppings. Remove toppings. Change medium size to large.

About 40 minutes later — and after a few hiccups when Viv confused the office address — a Pizz’a Chicago driver showed up with four made-to-order pizzas.

The engineers erupted in cheers as the pizzas arrived. They had ordered pizza, from start to finish, without placing a single phone call and without doing a Google search — without any typing at all, actually. Moreover, they did it without downloading an app from Domino’s or Grubhub.

Invasion of the stock bots

There have been also great strides in the application of AI in finance as well. The WSJ reported that Nasdaq is using AI systems to try and detect financial crime:

Nasdaq Inc. is trying to identify would-be white-collar criminals by using artificial intelligence systems originally built to track terrorists and sex traffickers. The exchange is testing systems that analyze data about trading activity against what traders say on their corporate chat and email accounts, in an effort to spot potential insider trading, market manipulation and other crimes faster and more accurately than current surveillance systems can.

Parsing the chatter of traders in the time before, during and after transactions – and matching those findings with trading data — provides “holistic surveillance,” said Bill Nosal, vice president of business development for market technology at Nasdaq. “This can show what was happening in the trader’s head,” Mr. Nosal said.

Asia Nikkei reported that Nomura is experimenting with AI driven HFT:

In the age of ultra-high-frequency trading, financial institutions are turning to artificial intelligence to improve their stock trading performance and boost profit.

One such company is Japan’s leading brokerage house Nomura Securities. The company has been pursuing one goal: to simulate the insights of experienced stock traders with the help of computers. After years of research, Nomura is set to introduce a new stock trading system for institutional investors in May.

The new system stores vast amounts of price and trading data in its computer. By tapping into this reservoir of information, it will make assessments — for example, it may determine that current market conditions are similar to a moment two weeks ago — and predict how share prices will be trending a few minutes down the line.

Goldman Sachs is reported venturing into AI assisted trading of macro-economic data (via Singapore Strait Times):

When Mr Daniel Nadler woke on Nov 6, he had just enough time to pour himself a glass of orange juice and open his laptop before the Bureau of Labour Statistics released its monthly report on the US job situation at 8.30am. He sat at the kitchen table in his apartment in Chelsea, nervously refreshing his Web browser as the software of his company, Kensho, scraped the data from the bureau’s website. Within two minutes, an automated Kensho analysis popped up on his screen: a brief overview, followed by 13 exhibits predicting the performance of investments based on their past response to similar job reports.

Mr Nadler couldn’t have double- checked all this analysis if he wanted to. It was based on thousands of numbers drawn from dozens of databases. He just wanted to make sure that Kensho had pulled the right number – the overall growth in American payrolls – from the report. It was the least he could do, given that within minutes Kensho’s analysis would be made available to employees at Goldman Sachs.

The analysis isn`t just restricted to macro data, but macro events such as predicting the market reaction to events like wars:

Kensho’s main customers at Goldman so far have been the salespeople who work on the high-ceiling trading floors. In recent months, they have used the software to respond to incoming phone calls from investors who buy and sell energy stocks and commodities, wondering how they should position their portfolios in response to, for instance, flare-ups in the Syrian civil war. In the old days, the salespeople could draw on their own knowledge of recent events and how markets responded. For a particularly valuable client, the sales representative might have called a research analyst within Goldman to run a more complete study.

Now a salesperson can just click an icon and access the Kensho interface, which consists of a simple black search bar. Mr Nadler showed me how the process worked on his laptop. Type in the word “Syria”, and several groups of events related to the country’s civil war appear. Among the top event groups are “Advances Against ISIS”, which includes 25 past events, and “Major ISIS Advances and Brutal Atrocities”, with 105 events.

Back on the trading desk, after picking out one group of events – the 27 incidents of “Escalations in the Syrian civil war”, say – a sales trader can pick from a series of drop-down menus that narrow the search to a specific time period and a specific set of investments. The broadest set includes the world’s 40 or so major assets, including German stocks and a few varieties of crude oil. They can then click on the green Generate Study button, and a few minutes later they’ll have a new page full of charts.

Stories like these can easily be extrapolated to an invasion of stock bots, all trading against each other and wiping out humans in finance. How realistic is this scenario of automated trading bots taking over the markets?

The uniqueness of alpha

I believe I can offer a unique perspective to this question, as I spent most of my investment career as a quant trying to gain an edge over human analysts, While there will always be great strides in automation, the machines will have great difficulty taking over for a number of reasons:

  • Generating alpha is a highly creative activity
  • Generating alpha is an activity with a low signal-to-noise ratio 
  • There is no unique underlying model of what drives markets
  • There are problems with transparency, ethics and compliance

The uniqueness of creativity

In a recent post, James Kwak derided the cookie-cutter approach to education that turns out engineers and analysts, who wind up engaged in groupthink:

Just this week, the president of Queen’s University in Belfast said this (explaining why students will no longer be able to concentrate in sociology or anthropology):

Society doesn’t need a 21-year-old who is a sixth century historian. It needs a 21-year-old who really understands how to analyse things, understands the tenets of leadership and contributing to society, who is a thinker and someone who has the potential to help society drive forward.

That’s the new conventional wisdom: we need “leaders” who can “help society drive forward,” whatever that means.

By contrast, Kwak pointed to David Silbersweig’s defense of a liberal arts education:

If you can get through a one-sentence paragraph of Kant, holding all of its ideas and clauses in juxtaposition in your mind, you can think through most anything. If you can extract, and abstract, underlying assumptions or superordinate principles, or reason through to the implications of arguments, you can identify and address issues in a myriad of fields.

I certainly agree. And I also agree that society needs people with a broad range of intellectual perspectives. This is the kind of thing you would expect me to agree with. I majored in social studies and got a Ph.D. in French intellectual history, of all things (and one of my fields for my orals was philosophy). But there’s an important caveat, which I’ll get to.

Unlike, say, learning Java, it isn’t easy to specify exactly what you learn in the humanities that turns out to be useful later. You do a lot of reading and writing, but of course those are things you knew how to do before going to college. You may learn how to check out boxes of documents at the archives, but that turns out not to be so useful unless you stay in academic research.

One thing I think I learned was dealing with ambiguity. In fields like social studies and history, you rarely find explanations of the world that are unequivocally correct. You don’t even have the pretense, which many economists labor under, that there is an unequivocally correct explanation out there, and you are just trying to find it. As a result, one thing I became pretty good at was using words fill to gaps—manufacturing connections and relationships between different phenomena. This, it turns out, is a very useful skill in the business world where, to tell an old consulting joke, two data points are a trend and three data points are proof. The ability to come up with a story that is convincing—and that very well may be true—based on limited information can be worth a lot in the business world.

In other words, a liberal arts education teaches you how to think critically and deal with ambiguity. Those are not the same skill set you acquire while going through engineering or business school. In my personal experience, it is the combination of critical thinking skills and hard analytical skills that are the ingredients for individual success.

Contrast the above picture with this account of the problem of Chinese university students studying in the West. These students came from an educational system that emphasizes rote learning, which can produce students with off-the-charts SAT scores who aspire to professions like engineering and accountancy, but they tend to be lacking in critical thinking skills.

There is no shortage of complaints to be addressed. Problems facing Chinese students overseas – a lack of social integration, poor English, weak critical thinking and a tendency to produce poorly referenced essays that land them in hot water for plagiarism – are well documented.

A recent Wall Street Journal investigation painted a bleak picture. On the one hand, it found Chinese students so surrounded by their compatriots that the most English they spoke all day was to order a burrito. On the other, academics were frustrated by having to modify their lectures and complained that Chinese students often lacked analytical or writing skills.

Is the Asian model the way to “produce leaders with the potential to help society drive forward”?

The challenge of ambiguous markets

Now think about the kind of ambiguity that the markets represent and how the practice of professional investing has evolved in, say, Warren Buffett’s lifetime. In the 1950s and 1960s, investors were mainly stock pickers. You learned to be a good security analyst. The dream, at the time, was to find the next IBM, or the next Xerox.

The 1970s saw a revolution in the paradigms of investing. Markets were said to be efficient. The Capital Asset Pricing Theory postulated that investors only had one dial on his portfolio. It’s called “beta”. If the investor was bullish on stocks, he raised the portfolio beta. If he was bearish, he lowered it. At the same time, numerous researchers found “anomalies” in the efficient market hypothesis, such as the low P/E effect, the low P/B effect, the small cap effect and so on. Thus, value investing was born – just as the Nifty Fifty growth-at-any-price stock bubble blew up in the 1974-75 bear market and ushered in a period where the new value investing style became dominant.

The 1980s ushered in the era of international diversification. Back then, what self respecting American investor would have even dreamed of putting money in strange places like *gasp* Japan? In addition, investors paid far more attention to the idea of making the capital structure more effective. You could lower your cost of capital, i.e. make the assets sweat more, by varying the debt to equity ratio. Boring, stable companies with low debt became restructuring targets – and the Leveraged Buyout (LBO) binge began.

Investing fashion changed again in the 1990s as the internet craze took hold of the markets. The emphasis turned to growth and growth potential. Valuation didn’t matter, neither did cash flow – until it all blew up in March 2000.

I could go on, but you get the idea. There is no central unifying theme behind what makes stocks go up or down. Regimes change. Paradigms change. Themes evolve. The late Peter Bernstein summarized the evolution of academic research this way in his book, Capital Ideas Evolving:

Before Harry Markowitz’s 1952 essay on portfolio selection, there was no genuine theory of portfolio construction — there were just rules of thumb and folklore. It was Markowitz who first made risk the centerpiece of portfolio management by focusing on what investing is all about: investing is a bet on an unknown future. Before Bill Sharpe’s articulation of the Capital Asset Pricing Model in 1964, there was no genuine theory of asset pricing in which risk plays a pivotal role — there were just rules of thumb and folklore. Before Franco Modigliani and Merton Miller’s work in 1958, there was no genuine theory of corporate finance and no understanding of what “equilibrium” means in financial markets — there were just rules of thumb and folklore. Before Eugene Fama set forth the principles of the Efficient Market Hypothesis in 1965, there was no theory to explain why the market is so hard to beat. There was not even recognition that such a possibility might exist. Before Fischer Black, Myron Scholes, and Robert Merton confronted both the valuation and the essential nature of derivative securities in the early 1970s, there was no theory of option pricing — there were just rules of thumb and folklore.

The academic creators of these models were not taken by surprise by difficulties with empirical testing. The underlying assumptions are artificial in many instances, which means their straightforward application to the solution of real-time investment problems is often impossible. The academics knew as well as anyone that the real world is different from what they were defining. But they were in search of a deeper and more systematic understanding of how markets work, of how investors interact with one another, and of the dominant role of risk in the whole process of investing. They were well aware that their theories were not a finished work. They were building a jumping-off point, a beginning of exploration, and, as each step led to the next, they began to search for an integrated structure to simultaneously explain the performance of markets and to solve the investor’s dilemma in trading off risk against return. That structure is still evolving.

If ideas about finance are constantly evolving, then how do you build an AI algo for all seasons under these circumstances? The FT reported that even quants are questioning AI’s place in finance:

Popular AI approaches such as machine learning can be used by computers to learn and develop autonomously. For example, a machine learning algorithm can learn to play and master a computer game such as Super Mario independently, at first playing the arcade classic randomly but quickly figuring out how the controls work and how to get to the end of the level.

There is therefore widespread enthusiasm over the potential of unleashing machine learning algos to find fleeting but profitable patterns in the vast sea of data.

“I think of algos as little children that can scale tremendously. And you can teach them to read millions of books at the same time,” says Brad Betts, a former Nasa computer scientist working in BlackRock’s San Francisco-based Scientific Active Equity arm.

Yet scepticism, even among many quants, is still pervasive. They see areas such as machine learning and deep learning — the latter underpinned DeepMind’s Go exploits — merely as extensions or enhancements of techniques that have for long been in use.

“Lots of people use techniques that could be called machine learning for decades,” argues Robert Hillman, head of Neuron Capital. “There’s a huge difference between image recognition and using AI in markets. Will this be a paradigm change for investing? I don’t think so . . . It’s not a fundamental change, it’s an efficiency improvement.”

Mr Kirk points out that most common AI approaches are focused on pattern recognition, such as telling the difference between a cat and a dog in an image. But markets are dominated by noise and chaos, the patterns are harder to find.

“As a geek I’m super-excited about AlphaGo, but it’s a big leap from beating a game with clearly defined rules and objectives and investing,” he says.

Even quants that are cautiously optimistic on the future of AI in investing warn of many pitfalls. Algorithms that may look ingenious and backtest superbly against historical data have a nasty habit of unravelling when confronted with unforgivingly fickle financial markets.

Finance quants suffer from what I call “physics envy” in wishing that their models are as precise as the kinds of models found in the hard sciences such as physics and chemistry. The fundamental problem is that investing has what engineers call a low signal-to-noise ratio (see my previous post A cautionary tale for quants and system traders). As the above FT article pointed out, even Isaac Newton, who was one of the greatest scientific and mathematical geniuses of his time, lost a fortune in the markets:

Isaac Newton may have been one of the finest minds of all time, but he turned out to be a miserable investor. “I can calculate the motions of the heavenly bodies, but not the madness of people,” he lamented after losing a fortune in the South Sea bubble.

Ethics, compliance and transparency

Notwithstanding the implementation issues of AI trading algos, which I predict will work spectacularly until one day they blow up because of a regime change, what is to stop Terminator-Skynet bots from dominating finance in the meantime?

There is the problem of ethics and compliance. Bloomberg reported that Google is struggling with these challenges when trying to build intelligent machines:

The report describes some of the problems robot designers may face in the future, and lists some techniques for building software that the smart machines can’t subvert. The challenge is the open-ended nature of intelligence, and the puzzle is akin to one faced by regulators in other areas, like the financial system; how do you design rules to let entities achieve their goals in a system you regulate, without being able to subvert your rules, or be unnecessarily constricted by them?

For example, if you have a cleaning robot (and OpenAI aims to build such a machine), how do you make sure that your rewards don’t give it an incentive to cheat, the researchers wonder. Reward it for cleaning up a room and it might respond by sweeping dirt under the rug so it’s out of sight, or it might learn to turn off its cameras, preventing it from seeing any mess, and thereby giving it a reward. Counter these tactics by giving it an additional reward for using cleaning products and it might evolve into a system that uses bleach far too liberally because it’s rewarded for doing so. Correct that by making its reward for using cleaning products tied to the apparent cleanliness of its environment and the robot may eventually subvert that as well, hacking its own system to make itself think it deserves a reward regardless.

Izabella Kaminska at FT Alphaville demonstrated another version of this problem in a recent post:
 

 

It was a fake jury summons that put an algo on trial:

It’s a fake jury summons to Southwark Crown Court for the trial of a theoretical rogue algorithm called Superdebthunterbot. It was, of course, just a bit performance art, the brainchild of Goldsmiths College artist Helen Knowles.

But it was also a wonderful exercise in what might happen if a free-thinking evolutionary algorithm, hatched to maximise the efficiency of bad debt collection, took any means possible to meet its objectives.

In this case Superdebthunterbot had supposedly encouraged indebted students — through digital marketing trickery — to sign-up for unregulated medical trials in a bid to raise the cash they owed to the debt collection agency.

It was emphasised to the jury that whilst a human programmer had engineered the algorithm, it was not he who had concocted the plan to use such a strategy for debt collection. It was not the programmer who was on trial, but the algorithm. And the question being asked was whether the algorithm — echoing Asimov’s laws of Robotics — had a duty of care to the individuals it was dealing with.

Kaminska asked a very valid question. What happens when one of these algos starts to harm human beings? Who pays? Who is liable?

It’s all very well using AI to make trading strategies more effective, but we have to acknowledge that if these AIs are being designed without a duty of care for the humans in it, they will have no qualms about exploiting or manipulating humans to ensure the assets they’re trading perform in a way that they can control. After all, any asset class is ultimately tied to the human behaviours which underpin them, meaning it’s only if the humans can be gamed, manipulated or their behaviours controlled, that the AIs can predict asset movements accurately enough to be able to collect outsized returns from each other.

Ultimately, it may be the lawyers and compliance officers to puts the brakes on any runaway AI train. One of the basic due diligence techniques for hiring an investment manager are the 3Ps:

  • Performance: What was the performance and what was the risk profile of the manager, or strategy?
  • Philosophy: What makes you think you have an alpha?
  • Process: How do you implement your philosophy?

An deep learning AI-bot that evolves will have a philosophy and process that will be virtually impossible to describe because of its evolving nature. With “normal” human based investment processes, an investment manager can describe what went wrong if the strategy underperforms and explain why they are either staying the course or making changes to address the problem. An AI-based process suffers from the problem of a lack of transparency. It will be a far more difficult conversation with the client when portfolio performance blows up to say, “I don’t know, the AI bot did it.”

Ironically, it may ultimately be the fear of legal liability of trustees that will ultimately restrain the growth of AI in finance.

* The title was inspired by an old science fiction short story entitled “If all men were brothers, would you let one marry your sister?“

How to get in on the ground floor of a market bubble

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less 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.

A nascent bubble

Cullen Roche wrote an article last week in Marketwatch making the case that the US equity and real estate market is ripe for the formation of a market bubble.

What’s even more interesting is that this environment appears (at least in my view) to be ripe for a financial-asset bubble. That is, as weakness abroad drives yields lower in the U.S., stocks and real estate look increasingly attractive. Stocks have clearly benefited from this “reach for yield,” as have certain types of higher-risk bonds.

Indeed, as government bond yields turn negative around the world, US Treasury assets seem to be the only yield game in town. Investors are rewarded with the additional bonus of steady US growth. Stocks should benefit as falling UST yields translate into P/E expansion.
 

 

Roche continued:

But we haven’t seen the big boom in real estate yet (with the exception of, maybe, San Francisco). But could we be there? I am not certain, but here in Southern California the chatter is starting to get a little crazy again. As rents rise rapidly and future returns on stocks and bonds just don’t look that great, many people are turning to real estate.

The other day I was talking to one of the most rational and intelligent guys I have ever known. I was talking about all of this and how absurdly low mortgage rates are. He said: “Yes, that’s why you buy a house in today’s market and then go out and buy another one.” Now, this is an Ivy League econ PhD talking here, not your average stripper circa 2006 from “The Big Short.”

When rational people start saying irrational things, my ears perk up. And it makes me wonder (still) if we’re not on the precipice of something that looks a lot more like 1999 than 2008. Add it all together and it makes you wonder: Are we ripe for a big financial-market bubble, thanks in large part to foreign economic weakness? It might seem paradoxical, but don’t discount that risk.

While a market bubble is not my base case scenario and I don’t like to bet on market bubbles because the thesis depends on the Greater Fool Theory of investing, what Roche says deserves some consideration. I would like to expand on the points made and explore how a bubble could form based on the following factors:

  • Better than expected growth
  • Skeptical sentiment turning into greedy sentiment
  • A market friendly Federal Reserve

The return of growth

The blowout June Jobs Report on Friday was certainly a shocker and may have signaled a more positive environment for US growth. Several days before the results were released, Jim Paulsen of Wells Capital Management made the case that stock prices were due to perk up because of better than expected growth. The Bloomberg US Economic Surprise Index, which measures whether economic releases were missing or beating expectations, was on the rise.
 

 

The rebound has also been confirmed by the Citigroup Economic Surprise Index:
 

 

Paulsen also found that when growth surprised on the upside, equities enjoyed a favorable environment of higher returns and lower risk, as measured by volatility (annotations in red are mine).
 

 

Burt White of LPL Financial confirmed Paulsen’s findings when he found that improvements in the ISM Manufacturing Index tends to lead earnings growth by six months.
 

 

Expectations about EPS growth has so far been confirmed by the latest readings from Factset (annotations in red are mine).
 

 

How foreign money could pour into US assets

When I couple the research from Paulsen and White with the observation that the US is becoming an island of growth and stability in an uncertain world, we have a potential setup for a mad rush for US financial assets, though the WSJ reported that a recent study by the National Association of Realtors indicate that non-US buyer interest is receding, not increasing. On the other hand, portfolio flows are supported by the fact that US equities have been steadily outperforming global equities for many years..
 

 

The latest BoAML Fund Manager Survey shows that global asset managers are underweight US equities.
 

 

…though they are roughly neutral weight equities in general.

 

 

In short, these factors combine to create pent-up demand for US stocks from overseas.

From skepticism to irrational exuberance?

The start of an asset bubble begins with a rational reason for rising prices, such as funds flow demand from foreigners for growth and stability. It first feeds on disbelief and ends with rising greed and irrational exuberance.

Right now, there is considerable skepticism about the upside potential of US equities. Josh Brown had pointed out that investors were being “chicken bulls” (my term, not his) by reluctantly putting money to work in stocks by buying low-volatility funds and ETFs, which are considered to be low risk. If there is a bubble forming right now, it seems to be occurring in Utilities as the forward P/E of this slow-growth but defensive sector trades at a premium to the market (via Marketwatch):
 

 

Dana Lyons pointed out that when Utilities outperform, it tends to be positive for DJIA returns.
 

 

Urban Carmel also noted that funds flows continues to be negative for equities and positive for bonds, which is hardly the picture of unbridled greed and irrational exuberance,
 

 

The IPO market has been moribund, which is another indication that there are few excesses in the market.
 

 

At an anecdotal level, I am still encountering a lot of bearish objections as I made my bull case in the last few months. Virtually all of these comments show heightened fear that either a major bear market or a market crash is just around the corner. For some context on downside risk, Business Insider reports that the Citi Bear Market checklist is not flashing any major cautionary signs.

Citi’s Bear Market checklist consists of a series of 18 factors that would signal the beginning of a sustained stock market downturn. Included in this group are measures such as earnings per share valuations, the US Treasury yield curve, growth in the number of IPOs, and more.

At this point, the checklist has only 3 factors in dangerous “red” territory and one in cautious “yellow” territory, for a total score of 3.5 out of 18. By comparison, the checklist hit 17 of the 18 before the 2000 crash and 13.5 before the financial crisis sell-off.

 

In summary, long-term sentiment metrics are supportive of higher stock prices and bubble blowing.

Central banks as enablers

The Fed is another actor that could contribute to bubble formation. The minutes of the June FOMC meeting indicated that the Yellen et al wanted to adopt a wait and see attitude on monetary policy normalization as the May Jobs Report was extraordinarily weak. Despite the blowout jobs growth exhibited by the June report, the Fed will undoubtedly want to wait a few months to look through the data volatility before making a definitive decision on interest rates. In all likelihood, the strength in the labor market will continue as Gallup`s Good Job Rate has also registered a new high.
 

 

The chart below (via Michael McDonough) shows the evolution of Fed Funds expectations, pre-May Jobs Report, pre-Brexit vote, pre-June Jobs Report and Post-Jobs Report. Even though the probability of rate hikes jumped after the blowout June report on Friday, the market is still not expecting a rate hike until well into 2017.
 

 

A dovish Fed can therefore be another factor contributing to the formation of a US equity market bubble. While I am not saying that an asset bubble is a sure thing, as there are many moving parts to this story, the potential is certainly there for a bubble to form, especially when the ECB, the BoJ and SNB drive yields into the red and USD assets become increasingly attractive to non-US investors.

The week ahead

Looking to the week ahead, you can tell a lot about the short-term direction of a market by the way it responds to news. I believed that the Brexit panic and sell-off would take several weeks to resolve itself with a W-shaped bottom in stock prices (see Brexit panic: A gift from the market gods?), but I was wrong. Even before the good news presented by the June Jobs Report, stock prices weren’t responding very much to bad news. The market ignored concerns over the political disarray within the British establishment in the wake of the Brexit vote. It also proceeded to shrugged off worries about the stability of the Italian banking system.

Sentiment readings from Rydex data, which measures what retail traders are doing with their money rather than opinion surveys, show that the public is still tilted towards bearish positions. This suggests that a growth surprise will likely catch the bears off-guard and the test of technical resistance at the SPX all-time highs will be resolved bullishly in the near future.
 

 

Breadth indicators are also supportive of high stock prices. The SPX Advance-Decline Line has already made an all-time high, which is a positive divergence.
 

 

However, very short-term indicators with a 1-3 day time horizon such as this one from IndexIndicators of % of stocks above their 10 dma are showing an overbought reading, which points to a temporary pullback or consolidation early next week.
 

 

On the other hand, longer term trading indicators such as the net 20-day highs-lows suggests that this advance has more room to run on a 1-2 week time frame.
 

 

Under these circumstances, a buy the dip strategy would be appropriate for both investors and traders who missed the initial rally.

Upside targets

I began this week`s analysis by postulating what would happen should stocks get caught up in a market bubble. One of the key questions is, “What`s the upside potential on a move like this?”

Let`s begin with a non-bubble analytical framework. Jim Paulsen recently appeared on CNBC and gave a relatively modest SPX target of 2200 before year-end. That 2200 figure is also consistent with the year-end forecast of former Value Line research director Sam Eisenstadt. So call 2200 the non-bubble “rational” target for December.

On the other hand, bubbles are “irrational” and they can run much further than anyone expects. Should a non-US buying stampede materialize, I will be watching for contra indications that the party may be coming to an end. As an example, the shape of the yield curve has historically been a good indicator of recessions and bear markets. While the yield curve is flattening right now, it is nowhere near inversion.
 

 

My inner investor has been bullishly positioned for quite some time and he is carefully watching the above chart for a sell signal. My inner trader thought that it was prudent for him to step aside as he started a two-week holiday last week. Some time ago, we caught our daughter hiding under the covers listening to *gasp* Puccini (all parents should have such problems). We have therefore undertaken an operatic tour of Europe this summer. Here I am atop the Eiffel Tower.,,
 

 

…and at the British Museum in London:
 

 

My inner trader was itching to put on a long position early in the week had he not been going on holiday. Had he missed the move, he would be watching for a pullback next week to buy the market. However, he is staying in cash as he doesn’t have the time to be tactically watching the markets while on holiday.

Disclosure: No trading positions

An NFP preview: When will the Fed raise rates again?

Posted by Cam Hui -

In the wake of the Brexit shock, Fed governor Jerome Powell was the first Fed speaker to give a speech, which gives some clue to the direction to Fed policy. While what the Fed does near-term is important to traders, the longer term thinking is important to investors as the definition of the Fed’s reaction function to events will affect the timing of rate hikes, the next recession and the next bear market.

Brexit risks

The Powell speech laid out two main concerns of the Federal Reserve. One was the global risks posed by Brexit:

These global risks have now shifted even further to the downside, with last week’s referendum on the United Kingdom’s status in the European Union. The Brexit vote has the potential to create new headwinds for economies around the world, including our own. The risks to the global outlook were somewhat elevated even prior to the referendum, and the vote has introduced new uncertainties. We have said that the Federal Reserve is carefully monitoring developments in global financial markets, in cooperation with other central banks. We are prepared to provide dollar liquidity through our existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for our economy. Although financial conditions have tightened since the vote, markets have been functioning in an orderly manner. And the U.S. financial sector is strong and resilient. As our recent stress tests show, our largest financial institutions continue to build their capital and strengthen their balance sheets.

It is far too early to judge the effects of the Brexit vote. As the global outlook evolves, it will be important to assess the implications for the U.S. economy, and for the stance of policy appropriate to foster continued progress toward our objectives of maximum employment and price stability.

Dallas Fed President Robert Kaplan took a similar wait-and-see cautious tone in a Bloomberg interview last week:

Federal Reserve Bank of Dallas President Robert Kaplan said Britain’s vote to exit the European Union could slow growth and the most significant question raised by the decision lies in potential spillover effects as other countries ponder their own place in Europe.

“Is there contagion? What does Ireland do? What does Scotland do? What do other EU countries do?” Kaplan told Bloomberg in an interview Thursday in Washington. “In this case, political and economic are intersecting. And it will take a significant amount of time to see how all that unfolds.”

The Fed’s leading dove, Lael Brainard, had been hammering away on the theme of global linkages. Here is her speech from October, 2015:

Downgrades to foreign growth affect the U.S. outlook through several channels. First, weak growth abroad reduces demand for U.S. exports. Second, the expected divergence in U.S. growth increases demand for U.S. assets, putting upward pressure on the dollar, which, in turn, weighs on net exports. The estimated effect of dollar appreciation on net exports has been shown to be substantial and to persist for several years.6 Weak demand weighs on global commodity prices, which, together with the effects on the dollar, restrains U.S. inflation. Finally, the anticipation of weaker global growth can make market participants more attuned to downside risks, which can reduce prices for risky assets, both abroad and in the United States–as we saw in late August–with attendant effects on consumption and investment.

Brainard thinks that the global economy is fragile. Even though all may seem well in the United States, weak non-US growth will eventually pull down US growth:

Consider two possible scenarios. First, many observers have suggested that the economy will soon begin to strain available resources without some monetary tightening. Because monetary policy acts with a lag, in this scenario, high rates of resource utilization may lead to a large buildup of inflationary pressures, a rise in inflation expectations and persistent inflation in excess of our 2 percent target. However, we have well-tested tools to address such a situation and plenty of policy room in which to use them. Moreover, the persistently deflationary international environment, the gradual pace of increases in U.S. resource utilization, the estimated small effect of resource utilization on inflation, the likely low level of neutral interest rates, and the persistence of inflation below our 2 percent target suggests this risk remains modest. Financial markets appear to agree, as five-year inflation compensation is well below 2 percent.

Now, take the alternative risk: that the underlying momentum of the domestic economy is not strong enough to resist the deflationary pull of the international environment. A further step-down in global demand growth and a further strengthening in the dollar could increase the already sizable negative effect of the global environment on U.S. demand, pushing U.S. growth back to, or below, potential. Progress toward full employment and 2 percent inflation would stall or reverse. With limited ability to ease policy, it would be more difficult to move the economy back on track.

By contrast, vice-chair Stanley Fischer sounded a more hawkish tone in a CNBC interview:

“First of all, the U.S. economy since the very bad data we got in May on employment has done pretty well. Most of the incoming data looked good,” Fischer said. “Now, you can’t make a whole story out of a month and a half of data, but this is looking better than a tad before.”

He added, “Our primary obligation, it’s set out in the law, is to do what’s right for the American economy. Of course we take what happens abroad into account because it affects the American economy. … We’ll base what we do on what’s happening in the United States and what we think will happen.”

Based on the tone of the latest Fedspeak, it doesn’t sound like the Fed has fully bought into the Brainard “linkages” risk thesis just yet. For now, the world is still mesmerized by Brexit risk. If we use the Russia/LTCM crisis as a template, the Fed had been in a mild tightening cycle when the crisis hit. It responded with several rate cuts and began normalizing rates about nine months later. The chart below shows the Fed Funds target (in blue) along with the Russell 1000 (red) as an indication of the market response during that period.
 

 

The Russia/LTCM crisis is my base case scenario for the timing of the Fed’s rate normalization policy, though the rate cut part is in doubt as the markets appeared to have normalized very quickly. However, the wildcard is the question of how the Fed interprets the ongoing developments in the labor market.

Full employment?

The other focus of the Powell speech as employment and inflation. This is particularly relevant as we await the June Jobs Report on Friday morning to see if the weakness seen in May was an aberration.

After several years of improving labor market conditions, recent data have been sending mixed signals on the level of momentum in the economy. Business investment has weakened, even outside the energy sector. Growth in gross domestic product (GDP) is estimated to have slowed to a rate of only 1-1/4 percent on an annualized basis over the fourth quarter of last year and the first quarter of this year. Incoming data do point to a rebound. For example, the Atlanta Fed’s GDPNow model, which bases its projection on a range of incoming monthly data, estimates growth of 2.6 percent in the second quarter. In contrast, the labor market data, especially the monthly increase in payroll jobs, after displaying considerable strength for several years right through the first quarter of 2016, weakened significantly in April and May. While I would not want to make too much of two monthly observations, the strength of the labor market has been a key feature of the recovery, allowing us to look through quarterly fluctuations in GDP growth. So the possible loss of momentum in job growth is worrisome.

Wait! Did he say “weak business investment”? I pointed out on the weekend that analysis from Factset shows that capex was still growing at a healthy rate on an ex-energy and finance basis (green line):
 

 

The difference between the Powell comment about “weak business investment” and above chart illustrates the main policy risk as we await the June Jobs Report. The Fed may be mis-interpreting incoming data as weakness, when the economy is actually strengthening. In that case, we may see lower for longer in the short run, only to be followed by a realization that Fed policy is behind the curve and the response of a series of rapid rate hikes that pulls the US and global economy into recession.

As an example, one of the concerns raised by the weak May Jobs Report was that the unemployment rate had dropped, but for the bad reason that the participation rate had fallen. Here is what Janet Yellen said in her Congressional testimony about the participation rate (see WSJ video).

  • The Labor Participation Rate (LPR) has been falling for some time because of demographics
  • Weak labor markets has also pushed up LPR because discouraged workers leave the work force
  • LPR has been flat recently, which Yellen interpreted positively as signs of cyclical gains
Indeed, the signs of these cyclical gains are everywhere. Consider this chart of the unemployment level (in blue), hires (red) and job openings (green). As unemployment has fallen, the hires and job openings lines have crossed, indicating a tightening job market.

 

 

Initial claims have fallen to all-time lows, even adjusted for population.

 

 

Small business surveys are showing that the employers are experiencing more difficulty in finding workers.

 

 

The tightness in the job market translate to wage pressure. The Atlanta Fed reported that job leavers are getting better increases than those who stay (via Business Insider).

 

 

At some point, all these wage increases will translate into cost-push inflation. The Fed is at risk of falling behind the inflation curve as labor compensation (blue line) ticks up in a typical late expansion cycle fashion.

 

 

Already, the Atlanta Fed’s wage growth tracker is indicating wage growth at 3.5%. How much cost-push inflation can you take, Dr. Yellen?
 

 

The end game

Let’s fast forward to Friday morning and the June Jobs Report has been released. If headline employment growth is roughly in line with expectations, then the likelihood of a Fed hike in the spring or summer of 2017 becomes a more reasonable expectation. But what happens if employment comes in on Friday below expectations again and these “weak” reports continue for the next few months?

I have laid out the case that there is little slack in the labor market. Should we see weaker than expected employment growth, it’s a sign of a full employment economy, not economic weakness. Under those circumstances, I expect that the debate will rage within the Fed over differing interpretations over the coming months as rates stay on hold while the Brexit risk premium fades.

Despite her dovish reputation, Yellen has rejected Evans Rule 2.0 (don’t hike until you see inflation at 2%) and stated that she doesn’t want to approach the Fed’s 2% inflation target from above:

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

Assuming that the Brexit crisis blows over, one of the greatest market risks as we approach the spring and summer of 2017 is the Fed stays on hold too long and then recognizes belatedly that it is behind the inflation fighting curve. It will then have to respond with a series of staccato rate hikes that plunge the global economy into recession.

How to beat Wall Street analysts at their own earnings game

Posted by Cam Hui -

In the past few months, I have received a lot of feedback and criticism over my use of forward 12-month EPS estimates, such as the chart below that appeared in last weekend`s post (see Brexit panic: A gift from the market gods?). I would like to clarify why this form of analysis matters and this is a valuable technique to beat Wall Street analysts at their own Earnings Game.

 

Here is we know about Street estimates.

Earnings estimates do matter

Earnings do matter to markets. Expectations matter. If you don’t think that they don’t, just remember all the speculation, jockeying and positioning before and after the earnings reports of traders’ favorite stocks such as FANG and tell me otherwise.

Analysts are wrong

As shown by this chart from Yardeni Research, Street EPS estimates are notoriously inaccurate and overly optimistic. EPS estimates for any single fiscal year or quarter tend start high and they decline over time. In fact, you will find a huge gulf between aggregated bottom-up estimates and top-down estimates from Street strategists. It’s not unusual at all to find bottom-up estimates amounting to GDP growth + 10%, which is wildly optimistic.

So the next time someone (like Zero Hedge) tells you that earnings for any single fiscal quarter or year for stocks are falling, remember this chart. Earnings estimates have a natural tendency to fall over time because of excess optimism and declining estimates are not necessarily a bearish sign for the stock market.
 

 

As analysts’ projections become more realistic over time and they lower their earnings estimates, another force comes into play to raise the error rate. Corporate management plays games with the Street to lower expectations and so that companies can beat consensus estimates at announcement time. The latest Factset report shows that the average 5-year EPS beat rate for EPS is 67% and the average 5-year sales beat rate is 56%.

That’s why the sales beat rate is more important than the EPS beat rate these days.

Estimate revision = Fundamental momentum

The way to correct for Street estimation error is to monitor the direction of change in analyst estimates and this technique is known as estimate revision modeling. Technical analysts are familiar with the concept of price momentum. Estimate revision is a form of fundamental momentum.

There are several ways of calculating EPS estimate revision. One is to use a diffusion model by observing the number of upward revisions against downward revisions without regard to the magnitude of the change. Another wrinkle for the quantitative analyst is whether to focus on FY1 estimates or FY2 estimates. For example, if the fiscal year ends in December and we are analyzing estimates in October, FY1 estimates really amount to only Q4 estimates as the first three quarters are already known. In that case, what’s more important to the stock’s outlook, FY1 or FY2?

I have tested a number of different approaches to measure EPS expectations. The most stable method is to calculate a rolling forward 12-month EPS by blending FY1 and FY2 estimates together. This constant forward EPS technique corrects for the problem of overly optimistic estimation problem because the forward bias is constant.

By monitoring how forward EPS changes, we can observe changes in fundamental sales and earnings momentum. That’s because not all analysts change their estimates at the same time and not all investors, institutional in particular, respond to estimate changes at the same time. Different Street analysts publish reports on the same company at different times. If there is a shift in the underlying fundamentals of the business, EPS and sales estimates will see a similar shift as analysts jump on the bandwagon – and that bandwagon effect is a form of fundamental momentum in expectations.

Now compare and contrast the Yardeni chart above with my original Factset chart of forward EPS and price. The relationship between forward EPS and price is far more stable and less prone to estimation error. The chart shows that forward EPS is roughly coincidental or slightly lags price. In fact, price is the far more noisy data series and, if you believe in fundamentals haven’t changed, earnings can be a better guide to the long-term equity return outlook.
 

 

Modeling drawbacks

No model is perfect and there are a number of disadvantages to this approach.

First, estimate revisions are inherently noisy. If you monitor them on a daily or weekly basis, the changes appear to be microscopic – but that’s not a bug, it’s a feature. At an individual stock level, I have had some success with generating buy and sell signals stocks with extremes in estimate revisions as a way of spotting the rolling bandwagon that I mentioned before. This fundamental momentum effect has diminished somewhat since the advent of Rule FD as corporate management has become increasingly reluctant to speak to analysts between earnings announcements, but it can nevertheless be an effective stock picking technique. (Don’t ask me to generate lists of buys and sells based on this model as that level of company level data detail is not available to me.)

At an aggregate level, we can smooth out some of the noise by looking at trends. By observing how Street sentiment is changing towards the market and at sector levels, we can see whether sentiment is improving or deteriorating. As trends tend to be persistent, we can also profit from the trend, or bandwagon effect, from a top-down viewpoint.

Another drawback of using estimate revision is the Street is notoriously bad at turning points in the market. For that, I have tended to rely on other models based on macro-economic, technical and sentiment analysis to spot turning points.

Nothing is perfect, but applying an estimate revision analytical framework to forward 12-month EPS estimates remains a valuable tool for both bottom-up and top-down market analysis.

Brexit panic: A gift from the market gods?

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Neutral
  • Trading model: Bullish

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

A gift from the market gods?

Now that Mr. Market has decided that Brexit has been “fixed”, it’s time for a sober second analytical look at the impact of this historic decision by the UK electorate on the US equity market.

The knee-jerk market sell-off appears to be a gift from the market gods to investors. The economic impact of the event on the American economy seems to be relatively minimal. Risk premiums have risen in response as the world is witnessing a repeat of the usual European theatre, whose last major production was staged during the Greek crisis of 2011.

The view from this side of the Atlantic

Pre-Brexit, here is the US macro picture looks good. The industrial side of the economy, which had been in the doldrums, is showing signs of recovery:
 

 

There has been a lot of recent hand wringing over weakness in capital expenditures. However, this report from Factset shows that capital expenditures ex-energy and finance (green line) has been steadily rising.
 

 

The American consumer, who has been a pillar of strength throughout this recovery, continues to be strong. The latest consumer confidence release beat expectations and it`s on the rise again.
 

 

The bottom-up picture of the stock market is constructive. John Butters of Factset also reported that the negative to positive earnings guidance ratio has improved from last quarter and it`s slightly better than its five-year average.
 

 

Equally encouraging is Factset‘s latest flash of post-Brexit earnings estimate revisions. Forward EPS is continuing to grind upward (annotations in red are mine).
 

 

Brexit impact: A slight positive

From my reading, the projected long-term impact of Brexit on the US economy is positive to neutral. Former IMF chief economist Simon Johnson thinks that America gains while Europe loses under Brexit (via Marketwatch):

In geopolitical and economic terms, the U.S. is potentially the biggest winner from the disintegration of the EU. The U.S. rose to global predominance as Europeans fought one another and their empires declined. The post-1945 U.S. role was challenged first by the Soviet Union, which, for a time, posed a real technological challenge. Today, Russia has a small — and shrinking — economy and a population in decline…

Prosperity is based on people and ideas. Who can attract the most talented people, educate them and their children, and give as many individuals as possible the opportunity to work productively? The U.S. has some serious problems, but absorbing immigrants and encouraging creativity have been among its main strengths for more than 200 years.

Ben Bernanke thinks that most of the negative global effects come from a rising risk premium. As long as the market doesn’t get too caught up in excess fear, “the [American] economic recovery is unlikely to be derailed by the market turmoil”.

Globally, the Brexit shock is being transmitted mostly through financial markets, as investors sell off risky assets like stocks and flock to supposed safe havens like the dollar and the sovereign debt of the U.S., Germany, and Japan. Investors are perhaps more risk-averse than they otherwise would be because they know that advanced-economy central bankers have less space than in the past to ease monetary policy. Among the hardest hit countries is Japan, whose battle against deflation could be set back by the strengthening of the yen and the decline in Japanese equity prices. In the United States, the economic recovery is unlikely to be derailed by the market turmoil, so long as conditions in financial markets don’t get significantly worse: The strengthening of the dollar and the declines in U.S. equities are relatively moderate so far. Moreover, the decline in longer-term U.S. interest rates (including mortgage rates) partially offsets the tightening effects of the dollar and stocks on financial conditions. However, clearly the Fed and other U.S. policymakers will remain cautious until the effects of the British vote are better sorted out.

In the meantime, the Fed is staying cautious as rate hikes are put on hold. In fact, the market implied probability of a rate cut is higher than a rate hike until the December meeting.
 

 

In short, we have healthy US economic and equity earnings growth. We have a dovish Fed driving down bond yields. What more could a patient investor ask for? Was this market panic a gift from the market gods?

Cue the European drama

Meanwhile in Europe, the drama begins. We’ve seen different versions of this play before and it always ends the same way. The European Union has been through one crisis after another. Just as it seems Europe is about to go over a cliff, the eurocrats cobble together a fudge and kick the can down the road. Just ask the Greeks.

Yet this drama is no Shakespearean tragedy in which the main characters all die at the end. Instead, it should be better characterized as a farce in the manner of Molière.

The play begins with a crisis. The British populace has voted to leave the European Union. After the vote, no one has a plan. The Prime Minister resigns. The leader of the Opposition is under pressure from his own parliamentary caucus as most of the shadow cabinet have resigned (Telegraph). The Leave side has no plan and some of its leaders backtrack on previous promises made during the campaign (CNN, Mirror). Then, Boris Johnson, who was a major Leave campaigner and frontrunner to become PM, got knifed in the back by an ally and took himself out of the race to become PM (Bloomberg).

In Brussels, the European Commission wants to make an example of the British, in case any Euroskeptic parties in Europe think about leaving (chart via Ian Bremmer).
 

 

European Commission President Juncker has banned EU officials from discussing Brexit terms with British officials until an official Article 50 declaration has been delivered (RT). Angela Merkel tells British PM David Cameron that there is no turning back from Brexit (Bloomberg).

As the first act ends, pandemonium and hilarity ensues. A Cambridge economist shows up at a faculty meeting naked to protest Brexit and no one says a word – for two hours (Telegraph). Then we have the Revenge of Odin, as the English loses a Euro 2016 match by a score of 2-1 to Iceland, a team that’s coached by a dentist. As the curtain comes down, a chorus of Brexiteers are heard to disparage so-called “experts” who “claim” that if the other team scores more goals than yours, you’ve lost the game.

Farce? Even Molière couldn’t make this stuff up.

The story behind the drama

Despite all the drama so far, we know how this story ends. While it is true that Brussels is doing its utmost to halt the political contagion of Brexit, a Eurobarometer survey done in April shows that British attitudes are an exception in that they tend to self-identify by nationality rather than as European. Beneath the sensationalist headlines, the risk of political contagion is relatively low.
 

 

In the UK, signs of regret are emerging. I am seeing much discussion, legal analysis and trial balloons of how to either reverse the Brexit referendum vote, or achieve some form of Brexit-lite, in which the British relationship with Europe remains relatively unchanged.

In the weeks and months to come, there will be more threats and counter-threats. Sturm und Drang. Good news and bad news. Risk appetite will oscillate in response to the headline. Reading between the lines, the ultimate conclusion will be Brexit under a Brexit-lite model, if at all.

A settlement will be reached. Europe kicks the can down the road once again. Risk premiums fade and the markets stage a relief rally. (Just as Alexis Tsipras how well his referendum worked out.)

The week ahead

On Monday, I wrote that the US equity market was sufficiently oversold that a bounce was imminent (see Hitting the Brexit trifecta). The ensuring a reflex rally was so strong that, by Wednesday, I indicated that caution was warranted because both the bond and gold markets had not confirmed equity strength with retracement of their panic conditions (see How to trade the US election). I stand by those remarks.
 

 

Marc Chandler also sounded a tone of caution. Chandler is a currency strategist and therefore his comments related to Sterling, but his analysis is applicable to general risk appetite:

After plummeting 18.6 cents, mostly in a few hours after it became clear that the Brexit would carry the day, sterling has rallied four cents from the low set on Monday. We recognized that the magnitude of the drop left sterling technically over-extended, but we caution against suggests that the worst is behind us and that a durable low is in place. ..

t may take a few weeks before the shock feeds into economic reports. Expectations for a BOE rate cut as early as next month (July 14) have risen. From the high point last week to the low point at the start of this week, the implied yield of the September short-sterling (three-month deposit) fell 20 bp. They have recovered about five bp. Many economists are projecting a recession.

Sterling’s gains do not appear to reflect fundamental developments. Instead, we suggest the gains are driven by two considerations. First, is the money management of momentum traders. Once sterling stopped falling, short-term participants (fast-money) bought to take profits on short positions. Remember, in the futures market; speculators had were carrying one of the largest bearish bets on sterling on record (gross shorts = 93.7k contracts–each is for GBP65000). Second, institutional invests are adjusting portfolios and (currency) hedges ahead of the month- and quarter-end.

There are other short-term warnings that this market recovery is unlikely to be V-shaped, but W-shaped. Risk appetite in the junk bond and emerging market bond market are not confirming this advance, which is a sign that traders may want to fade equity market strength.
 

 

In the space of a week, the market has oscillated from an overbought reading to oversold and back to overbought again. This IndexIndicators chart of stocks above their 5 day moving average tells the story. At a minimum, expect a few days of consolidation before stocks can advance. A pullback would also be no surprise.
 

 

The hourly SPX shows RSI-5 at an extreme overbought level. Readings of over 90 are not sustainable and RSI-5 has flashed a sell signal after dropping below 70 from an overbought reading. In addition, RSI-14 is nearing a similar sell signal.
 

 

Nevertheless, the intermediate term outlook is constructive. The SPX Advance-Decline Line made another all-time high last week, which confirms the strength underlying this advance. I would caution, however, that breadth measures such as the A-D Line are intermediate term indicators and tell us little about short-term market action.
 

 

In addition, commodity prices, which is an important indicator of global cyclical strength, are rising despite the headwinds posed by the strong USD. I interpret this as a market signal of global reflation, which is positive for earnings growth.
 

 

My inner investor remains constructive on stocks and he is prepared to opportunistically increase his equity position on a pullback. The downdraft in stock prices was likely a gift from the market gods, but the problems haven`t totally disappeared and risk premiums have compressed too far too fast.

My inner trader is on holiday for the next two weeks. Even though regular blogging will continue, he believes that the prudent course of action is to stand aside during this volatile period.

Disclosure: No trading account positions

How to trade the US election

Posted by Cam Hui -

Mid-week market update: There isn’t much to say about the short-term stock market outlook, other than to acknowledge that a strong reflex rally is underway. As the markets are reacting in a highly emotional way, I have little to add other than to say that the market will be volatile. If you did jump on the buy signal issued on Monday night (see Hitting the Brexit trifecta), you might consider scaling out of your long positions as prices rise, especially as SPX rallies to test the underside of its 50 day moving average.
 

 

Brian Gilmartin pointed out that both the bond market and gold are not retracing the Brexit panic move the way stock prices are, which is a worrisome sign. I interpret these conditions as a bottoming process, where the market will bounce around in a range and re-test the lows before it can mount a sustainable rally.

Trading the US election

Now that the Brexit has been “fixed”, I turn to ways of trading the US presidential election this year. The last polls show that Hillary Clinton well ahead of Donald Trump and the Iowa Electronic Markets indicates that HRC has about a 70% chance of winning.
 

 

The analysis from FiveThirtyEight show similar levels of probability:
 

 

I have a couple of suggested trades to take advantage of either Clinton or Trump winning. As Clinton is currently in the lead, I will frame these trades as a “long” Clinton trade, but if you want to be “long” Trump, then all you have to do is put on the reverse trade by shorting instead of buying.

Buy defense stocks

Hillary Clinton has had a record as Secretary of State and she has shown a tendency to favor a far more assertive foreign policy than either Obama or her husband Bill. Here is The New York Times profile outlining the guide to her underlying foreign policy beliefs:

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

In short, expect Clinton to be far more hawkish, with echoes to past administrations under Reagan, Nixon and Kennedy:

In showing her stripes as a prospective commander in chief, Clinton will no doubt draw heavily upon her State Department experience — filtering the lessons she learned in Libya, Syria and Iraq into the sinewy worldview she has held since childhood. Last fall, in a series of policy speeches, Clinton began limning distinctions with the president on national security. She said the United States should consider sending more special-operations troops to Iraq than Obama had committed, to help the Iraqis and Kurds fight the Islamic State. She came out in favor of a partial no-fly zone over Syria. And she described the threat posed by ISIS to Americans in starker terms than he did. As is often the case with Clinton and Obama, the differences were less about direction than degree. She wasn’t calling for ground troops in the Middle East, any more than he was. Clinton insisted her plan was not a break with his, merely an “intensification and acceleration” of it.

In a speech she made as Secretary of State in 2010, Clinton used the “freedom of navigation” term in reference to the competing claims in the South China Sea, which is code that China is likely to see a far more muscular response from the United States as Beijing uses the artificial island strategy to stake and solidify its claims in the region:

The United States, like every nation, has a national interest in freedom of navigation, open access to Asia’s maritime commons, and respect for international law in the South China Sea. We share these interests not only with ASEAN members or ASEAN Regional Forum participants, but with other maritime nations and the broader international community.

The United States supports a collaborative diplomatic process by all claimants for resolving the various territorial disputes without coercion. We oppose the use or threat of force by any claimant. While the United States does not take sides on the competing territorial disputes over land features in the South China Sea, we believe claimants should pursue their territorial claims and accompanying rights to maritime space in accordance with the UN convention on the law of the sea. Consistent with customary international law, legitimate claims to maritime space in the South China Sea should be derived solely from legitimate claims to land features.

By contrast, Donald Trump shown himself to be far more isolationist as he has called for allies to foot a greater share of the budget for regional defense pacts. In other words, expect a friendly reception towards Pentagon spending from Clinton and don`t expect defense spending to rise very much under Trump.

In light of recent market volatility, using a risk-controlled way of betting on a Clinton win of buying defense stocks while shorting the market might be more advisable. There are two aerospace and defense ETFs, ITA and PPA, each with slightly different weightings, but their relative return patterns are fairly similar. As the charts below show, PPA is testing a relative resistance level while ITA has been a slight laggard and broken down through relative support.
 

 

Buy Mexico as the anti-Trump trade

Given Donald Trump’s rhetoric on trade, one way of playing a Trump win would be to short the Mexican Peso, or the Mexican stock market. If you believe that Clinton is more likely to win, do the opposite and buy Mexico instead.

The chart below shows the Mexican peso (MXN), which has been steadily falling against the USD. Unfortunately for investors who don’t have futures trading accounts, there is no MXN ETF as a direct play.
 

 

Another way of buying a Clinton win would be to either buy Mexican stocks, or to buy Mexican stocks (MXF) against a short position in the US (SPY). As the chart below shows, MXF has been weak on an absolute basis (top panel) and it has violated a double bottom on a relative basis (bottom panel).
 

 

Needless to say, you can also either directly short MXF or short MXF against buying SPY if you want to bet on a Trump win.