The market bottom 2-step: 1 forward, 1 back

Posted by Cam Hui -

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 seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” 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 this model has shown turnover rates of about 200% per month.

The signals of each model are as follows:

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

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 reversals continue

In the last few weeks, I have been highlighting the improving macro-economic and fundamental backdrop, while voicing concerns over the technical damage suffered by the stock market. I had concluded that the market was undergoing a W-shaped choppy correction.

Last week brought a number of reversals. The macro and fundamental picture suffered a number of setbacks, which creates a number of longer term concerns. On the other hand, a review of the technical conditions showed considerable improvement.

Macro wobbles

The macro reversals came mainly from signs of decelerating economic growth momentum. One major concern came from the Q4 GDP revision report released Friday. Q4 GDP growth was revised upward from 0.7% to 1.0%, but the report was marred by indications of building inventory and a slight slowdown in real consumer spending.
 

 
The report was negative enough that the Atlanta Fed’s GDPNow estimate of Q1 GDP growth slid from 2.5% to 2.1% because of the effects of the inventory buildup.
 

 
New Deal democrat, who monitors real-time economic releases, noted that a second week of growth deterioration:

Several recent reversals intensified this week. Real M1 has decelerated to the point where it is barely positive. Withheld taxes also decelerated even further to less than +1% YoY, suggesting payrolls have turned negative. On the other hand, both rail carloads and steel production YoY have turned positive or almost positive, strongly suggesting they have bottomed.

Among long leading indicators, interest rates for corporate bonds are neutral, while treasuries, real estate loans, mortgage applications, Real M2, and mortgage rates are positive. In fact, mortgage rates and applications are now strongly positive. Real M1 has decelerated to the point of being only slightly positive.

Among short leading indicators, the interest rate spread between corporates and treasuries remains very negative, although it has improved in recent weeks. Jobless claims remain positive. Oil and gas prices, and usage, remain very positive. Commodities, while negative, appear “less worse” on a YoY basis. The US$ as against major currencies has turned neutral while on a broad basis it remains quite negative.

Among coincident indicators, bank rates, staffing and shipping remain negative, Consumer spending was positive although Gallup was down slightly this week. The big news here is that withholding taxes have deteriorated badly, suggesting that payrolls, or at least hours worked, have turned negative. On the other hand, steel production has almost turned positive, and rail transport actually positive on a YoY basis, suggesting these have bottomed.

The bifurcation of decent consumer economy, poor industrial economy (at least that portion tied to commodity extraction and exports) that began one year ago, looks to be changing. Negatives have spread to withholding taxes, and money supply has weakened. But commodity production and transportation look like they have turned positive.

Rising inflation = More hawkish Fed

Another ominous sign for equities came from the Personal Consumption Expenditure (PCE) report. Core PCE (ex-food and energy) and Trimmed Mean PCE jumped up to 1.7% and 1.9% respectively, which are getting very close to the Fed’s 2% inflation target. Core PCE is the Fed`s favorite measure of inflation and this latest data release points to rising inflationary pressures, which is supportive of the case for a faster pace of interest rate hikes.
 

EPS growth uncertainty continues
 
In past cycles, the negative effects of Federal Reserve induced rate increases have been offset by the positive effects of better earnings growth. While that may still be true, the short-term earnings growth outlook remains uncertain.

My inner investor got very excited last week when forward 12-month EPS rose and he eagerly awaited this week’s forward EPS update for confirmation that the increase in consensus earnings estimates was not a data blip. Alas, John Butters of Factset reported that forward EPS fall back in the latest week. The Street’s outlook for earnings growth remains wobbly.
 

 
A recent research note by UBS strategist Julian Emanuel also highlighted a trend of rising EPS estimate volatility, which indicates rising uncertainty over the earnings outlook (via Business Insider):
 

 
Until we see a consistent pattern of rising forward EPS, stocks will find it difficult to stage a sustainable advance.
 

Technical healing

While these indications of macro and fundamental setbacks represent bad news for the bulls, they have been offset by signs of healing on the technical front. First, the stock market rally last week saw the SPX stage an upside breakout through resistance and its 50 day moving average (dma). Equally encouraging were signs of global technical healing. Both the FTSE 100, which “should” be struggling with uncertainty over the upcoming Brexit referendum, and the cyclically sensitive industrial metals also rose to regain their 50 dma levels.
 

 
We are also seeing sporadic signs of technical healing in Asia as well. Even though the Shanghai Composite struggled, the stock indices of a couple of China`s major Asian trading partners, namely Taiwan and the cyclically sensitive South Korea, rallied above their 50 dma levels.
 

 
As a consequence of these improvements in the technical tone of the markets, the Trend Model’s readings has been upgraded from risk-off to neutral. As the trading model keys off changes in the direction of the Trend Model, it has changed from bearish to bullish.

A market bottom next Wednesday?

Looking to the week ahead, the chart from IndexIndicators shows that the stock market is overbought after the recent strong advance. However, there are signs that this represents a “good” overbought condition where the market remains overbought as it rallies, much like what occurred when the market rose off the September 2015 bottom.
 

 
I wrote last week that the market had until last Friday to flash a Zweig Breadth Thrust buy signal (see Mind the gaps), which it failed to do so. However, Simon Maierhofer, writing in Marketwatch, alerted us last week to an equally bullish “kickoff” signal, in which the SPX rose for 1.5% or more for three consecutive days. He pointed out that such conditions have represented a bullish impulse in the past where stocks were substantially higher a year later.
 

 
I went back to 1950 and studied past “kickoffs” where the SPX rose for three consecutive sessions of 1.5% or more. I found 11 episodes (other than the most current) and the results are summarized in the chart below. Indeed, stock prices were typically higher one, two and three months later, but the market tended to pull back about 10 days after the “kickoff” date. Even though the index was higher 82% of the time after three months, with a median return of 4.2%, the median maximum loss during that period was 6.9%, indicating heightened volatility during past “kickoff” episodes.
 

 
As returns seem to dip after 10 days, I paid particular attention to the post-“kickoff” return period of between 5 and 15 day. The top panel of the chart below shows that returns were volatile, but if we focus on the % positive metric shown in the bottom panel, the market tended to bottom out 10 days after kickoff.
 

 
With the caveat that the “kickoff” study has a very small sample size, that conclusion makes sense in the current circumstances. As the chart below shows, the SPX staged an upside breakout through resistance and its 50 dma, which are intermediate term bullish. On the other hand, market conditions are overbought and the 5-day RSI has flashed a negative divergence, which is bearish from a short-term trading perspective. If history were to repeat itself, the market is likely to pull back after its breakout and bottom out next week on Wednesday March 2, or which represents 10 trading days after the “kickoff” date of February 17, 2016.
 

 
My inner investor is still constructive on stocks and he remains in accumulation mode. He is casting his lot with the “smart money” insiders, who are still doing more buying than selling (via Barron’s).
 

 
My inner trader missed the trading model signal change from bearish to bullish because I conducted this review on the weekend after the market closed. He has a small SPX short position, but he expects to cover his short next week and reverse to the long side.
 
Disclosure: Long SPXU

Mind the gaps

Posted by Cam Hui -

Mid-week trading update: This morning started off well for the bears – until oil prices began to rally. I wrote on the weekend that while my inner investor was constructive on stocks, my inner trader still believed that downside risk remained. Those views are unchanged.

Here is where the SPX stands today. The rally was unable to overcome technical resistance earlier in the week at 1950 and at the 50 day moving average (dma). Moreover, the 5-day RSI flashed a sell signal by moving from an overbought reading (above 70) and then falling below 70. Two overnight gaps (shown in yellow) had the potential to get filled as the market weakened. The first gap got filled this morning, but stocks rallied intra-day.

 

As of the close on Wednesday, breadth readings from IndexIndicators show that the market is still overbought (red dot my estimate), which may serve to limit any short-term upside.

On the other hand, the setup for a Zweig Breadth Thrust buy signal remains in play and the market has until this Friday to move the ZBT Indicator from 0.615 to trigger a buy signal (for full details see Bingo! We have a buy signal!). Readers who want to follow along at home can click on this link for intra-day updates on the progress of this signal.

Prepare for more volatility

My interpretation of these technical cross-currents is traders should be brace for more chop, at least in the short run. Neither the bulls or bears have been able to demonstrate that they can seize control of the tape.

For the bulls, they need to either rally the market sufficiently to either generate a ZBT buy signal or overcome resistance at the 50 dma and 1950. The bears, on the other hand, need to push prices down to at least fill the second gap at 1865-70, or at least alleviate the overbought readings.

Until that battle is resolved, both camps will find directional bets frustrating. My inner trader is still leaning short with a small SPX short position.

Disclosure: Long SPXU

Why you can’t believe Shiller on LT equity returns

Posted by Cam Hui -

Recently, Business Insider featured a chart of long-term equity returns based on data from Bob Shiller.

The lesson was, the longer your time frame and the more patient you are, equities win. That`s been a lesson taught to generations. Based on this data, equities has become the foundation of any portfolio for anyone building a long-term investment plan.

While I would not necessarily disagree with equities being a major portion of a long-term portfolio, I would content that Shiller`s analysis is at best, exaggerated because of survivorship bias, and at worst, deceptive. It is reminiscent of glossy brochures and offering memorandums promising great things, but leaving out key details.

Survivorship bias exaggerates returns

I always laugh whenever someone cites the history of US equities as a template for calculating future equity return expectations. The latest Credit Suisse Global Investment Return Yearbook 2016 provides some perspective. The chart below shows the relative sizes of equity markets in 1900 and in 2015. The top 5 markets in 1900 were (in order): UK, US, Germany, France and Russia. In 2015, the size of the American market dwarfs all other markets.

How would you feel if you found out that someone sold you an investment by citing the most successful market (or stock) in the last 115 year? Would you feel ripped off?

Here is how Credit Suisse characterized the returns of US equities. If you had invested $1 in 1900, you would have received $1,271 after inflation in 2015. Sounds good?

Let`s consider how you might have fared had you invested in the fifth largest stock market in 1900, Russia. For a Russian holding stocks during that period, the depletion of your portfolio would have been the least of your worries after about 1917.

What if you had invested in the largest market in 1900? A terminal portfolio value of 465 after 115 years wouldn’t be bad, but it dramatically lagged the terminal value of a US portfolio at 1271.

For completeness, here are the other two major markets in 1900, namely Germany…

…and France, both of which suffered dramatically during the Second World War. Just like the Russian example, there were periods when the devastation of your stock portfolio would have been the least of your worries.

 

Imagine the next 100 year

This little exercise illustrates my point about survivorship bias in returns data. I am not questioning the accuracy of the return data of US equities during the 20th and 21st Centuries, but to hold them up as the model template for what investment returns might look like in the next 100 years is, at best, guesswork.

There is another level of survivorship bias that a lot of analyst neglect, namely survivorship bias at the asset class level. At the dawn of the 20th Century in 1900, most investments went into the bond market. Stock markets were relatively immature and equity investment culture was not well developed. If you went back in time to 1900 and knew nothing about financial markets, would you necessarily put a major portion of your portfolio into what amounted to an under-developed asset class?

Consider the following scenario 100 years from now. China becomes the dominant global economic power, after a number of fits and starts. Maybe someone 100 years from now will be showing a chart like this, but for Chinese real estate. Maybe real estate becomes the dominant asset class and takes over from equities. After all, we learned in Econ 101 that the three classic factors of production are Labor, Capital (stocks and bonds) and Rent (real estate). Why not property as a major asset class?

There are several morals to this story:

  • Beware of survivorship bias
  • Consider asset classes beyond the stocks and bonds when forming an investment plan
  • Diversify, diversify, diversify

Dear Morgan Stanley, here is the bull case

Posted by Cam Hui -

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 seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” 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 this model has shown turnover rates of about 200% per month.

 

 

The signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Risk-off
  • Trading model: Bearish

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

Here is the bull case

Last week, Morgan Stanley strategist Adam Parker admitted defeat. He conceded that “our portfolio advice has been pretty horrendous lately. As my 90-year old Latin teacher used to tell the class in 1985, `son, you are in left field, without a glove, with the sun in your eyes.`” (via Zero Hedge). Beaten and battered, he concluded that the only bull case for stocks was there was no bull case:

What’s the bull case? The positives are this: no one is articulating a bull case for US equities with conviction. Earnings expectations are potentially low. There is some fiscal stimulus this year (vs. drag previous years). The Presidential candidates don’t appear to be multiple expanders now, but they will get more centrist and the riffraff will be removed in a few more weeks. Sentiment is low (two weeks ago an investor on a panel we moderated said “It is a multi-variable world and every variable is negative”.) The US probably looks relatively better than other parts of the world. So maybe, the bull case is just that no one can articulate a bull case.

If Parker had read my commentary last weekend, he would have understood the bull case (see Profit by thinking like Big Money). To put it very simply, the bull case for stocks can be summarized in two words: “Growth surprise”.

So bearish it’s bullish

In a way, Adam Parker was correct in the sense of everything is so bearish it’s bullish. Sentiment readings have been deteriorating to a crowded short position, which is contrarian bullish.

The latest BoAML Fund Manager Survey, whose sample consists mainly of global institutional managers, show that they are thrown in the towel on the macro outlook. As the chart below shows, growth expectations have tanked…

As a consequence, cash positions have spiked to an extreme high…

…and portfolio positioning has become highly defensive with a concentration in cash and severe underweight in cyclical stocks (annotations in red are mine).

Not only are institutions bearish, so are retail investors. Individual market timers, as measured by Rydex traders, have also moved to a crowded short. If history is any guide, similar readings have put a floor on the market in the past.

 

Here comes the growth surprise

The good news is that, with sentiment and market positioning so bearishly stretched, we are starting to see elements of a positive growth surprise. I wrote before that consensus forward EPS estimate revision is the most important metric to watch during the current period of uncertainty (see If I had to watch just ONE THING), If it does turn up, it would be an indication of a revival of fundamental and macro momentum, which has the potential to propel stock prices to new highs.

The latest report from John Butters of Factset shows that forward EPS had ticked up last week after several weeks of decline. Could this be the long awaited turnaround? A single week rise could be a blip, but if forward EPS estimates were to improve again next week, my inner investor is ready to take that as a confirmation that the correction is over and sound the all-clear signal.

To be sure, the bond market isn`t quite ready to jump on the growth surprise bandwagon just yet. The gap between the 10 year Treasury and the 2 year Treasury yields continues to narrow, indicating a flattening yield curve and expectations of decelerating growth.

However, the Citi Economic Surprise Index (ESI), which measures whether high frequency economic releases are beating or missing expectations, is showing signs of a bottom and turnaround. The ESI (gold line) has been positively correlated with the 10-year Treasury yield (blue line). A rising ESI could push up 10-year yields, which would likely steepen the yield curve.

The relative performance of cyclically sensitive equity sectors and industries are also signaling a possible growth surprise. The chart below shows the relative returns of different cyclical sectors and groups. Industrial stocks have been the strongest and they staged a rally and upside relative breakout; Semiconductors having bottomed on a relative basis and now consolidating sideways; Metals and Mining have broken out or a relative downtrend; and Energy is the only sector that is in a relative downtrend, though it does seem to be bottoming.

My inner investor is getting very excited. He has been accumulating stocks with overweight positions in the resource sectors. He is ready to go all-in should he get confirmation of a cyclical upturn should forward EPS revisions continue to improve next week.

The week ahead: Unfinished downside business?

My inner trader is cognizant of the positive news from forward EPS and he was tempted to close out his small SPX short position on Friday (see Why I tactically shorted stocks today). In the end, his analysis of the technical picture led him to believes that the market may still have some unfinished business to the downside before the current corrective episode ends.

From a technical standpoint, the short-term outlook for stocks still looks iffy. The 5-day RSI indicator flashed a sell signal by moving above 70, an overbought reading, and then falling below. The chart below shows the instances in the past year when the same sell signal was triggered. The red vertical lines marked instances when the market fell right away and the blue lines marked instances when they did not. There were far more red lines than blue lines and even the blue lines were followed shortly by market declines. I am also concerned about the two downside gaps depicted in the chart below, which are just asking to get filled in the next few days.

Further, breadth indicators like this one from IndexIndicators shows that the market is overbought, which will make it difficult for equities to advance next week.

In addition, Nautilus Research pointed out that the kind of strong rallies off a bottom that we saw last week tends to be typical of a bear market rally and prone to further weakness.

The only short-term hope that the bulls have is the market could flash another rare Zweig Breadth Thrust buy signal (ZBT) which has had an uncanny bullish record (for full details see Bingo! We have a buy signal!). The chart below shows the ZBT signal in the top panel, the ZBT Indicator and real-time estimate of the ZBT Indicator in the bottom two panels. The ZBT Indicator has 10 trading days to move from 0.40 to 0.615 to trigger a buy signal. The clock is ticking and time is quickly running out. (Interested readers can follow the progress of the ZBT signal by using this link.)

Based on the combination of my macro, fundamental and technical analysis, a more likely scenario would see SPX weaken again to test the lows again before a sustainable advance begins. My inner trader is short the SPX, but he is using the ZBT Indicator as his stop loss. Should we get a ZBT buy signal, he will cover his short and go long. Otherwise, he will wait for oversold conditions before taking profit on his short position.

Disclosure: Long SPXU

Why I tactically shorted stocks today

Posted by Cam Hui -

Regular readers recognize that my inner investor is bullish on stocks, though my inner trader remains a little leery and expects further market choppiness (see Profit by thinking like Big Money). Despite my longer term bullishness, I tweeted this morning that I had tactically taken a small, underline the word “small”, short position in SPX in my trading account.

 

I did it for the following reasons:

  • The market was due for a bounce – and bounce it did;
  • The market moved quickly from oversold to overbought; and
  • The technical structure of market action is a bearish structure.

 

Market due for a bounce

Last week, the selling had become so unrelenting that the market had become sufficiently oversold for stocks to stage an oversold rally. Trade Followers, who monitors Twitter breadth, summarized conditions this way:

The most compelling sign comes from stock market sector sentiment generated from the Twitter stream. In bull markets when every sector was positive on a weekly basis it almost always marked short term tops. We’re now in a bear market and all sectors are negative. I view this as a capitulation of sorts, where traders and investors are selling everything. This is the first time since we’ve been collecting the data that I’ve seen this condition, but the track record of all positive sectors in a bull market gives some credence to the current condition being short term bullish.

 

 

From oversold to overbought

Other measures of market breadth, like this one from IndexIndicators, tell a similar story. Readings had become gotten oversold that a rally was more or less inevitable (red dot my estimate for today). However, the chart also shows that the market had quickly moved from an oversold condition, which bottomed out last Thursday, to an overbought condition today in the space of three trading days.

Intermediate term (1 week horizon) readings also gave the same picture of an overbought condition.

Looking even shorter term, the 5 hour RSI on the SPY chart went over 90 today. It never stays that overbought for long and a retreat is likely. Moreover, there are a couple of downside gaps that potentially need to get filled.

 

Bear market structure

I was speaking to my former Merrill Lynch colleague and technical analyst Fred Meissner, of The Fred Report, on the weekend. He said that, technically, he believed that the tone of the market is a bear market structure, characterized by poor breadth participation and a pattern of lower highs and lower lows. Fred graciously invited me to quote from his work and he wrote in his latest sector report that he is maintaining his defensive posture:

SPY is down around 1.50 points since the last Sector Review, but it has been a good bit lower throughout the month. Caution flags are out. We will leave sector weightings the same for now – the market may be making a tradable bottom and if so we may make changes intra-month…

We still believe that deflation and China weakness (and now devaluation concerns) are the “elephant in the room”. This could exacerbate the bear market structure we are already in. We were one of the first to propound this view. It still bears watching, as Japan’s recent negative reaction to negative rates suggests.

While Fred and I don`t always agree on everything, I have a great deal of respect for his technical views. He also reminded me that this week is option expiry (OpEx), which tends to have a bullish bias. As a reminder, here is a slightly dated table from Rob Hanna of OpEx performance. February tends to be slightly positive, but not as positive as other months. If OpEx weeks have bullish biases, statistics also show that the week after OpEx tend to be mean reverting and display a bearish tendency.

Another well respected technician, Peter L. Brandt, recently made the case that US indices are forming potential tops. I won`t go through all of his charts, but here is the Dow as a sample of his thinking.

Note that Brandt qualified his opinion as “potential tops”, because as every good technician knows, a head and shoulders formation is incomplete until the neckline breaks.

Regular readers will also recall that I have fretted over a lack of capitulation selling during this latest market downturn. TRIN has stubbornly refused to spike above 2, which is indicative of “margin clerk” price insensitive selling that are the typical of a washout bottom (also see Bracing for more pain). Just compare recent TRIN readings to the behavior of TRIN during the last sell-off in August and September:

 

Defining my risk

I would underline the fact that my SPX short position is a tactical trading call. As with all trading calls, I am defining my risk in terms of a potential Zweig Breadth Thrust (ZBT) that may be forming (for details of a ZBT see Bingo! We have a buy signal!). The chart below shows the ZBT signals on the top panel, the ZBT indicator in the third panel, which has 10 days from day 0 (last Thursday) to move from below 0.40 to 0.615. As Stockcharts can be a little slow in updating their signals, I have approximated a real-time ZBT indicator in the bottom panel.

Readers who want to follow along at home can use this link for real-time updates of this chart. While I am not holding for a ZBT signal, as they are extremely rare, I am keeping an open mind and using it to define the risk of my short position.

Disclosure: Long SPXU

Worried about a China devaluation and currency war?

Posted by Cam Hui -

I had been meaning to write about this earlier, but I didn`t find the time. Kyle Bass caused a stir last week with his letter to his investors when he wrote that China was on the verge of a major devaluation and financial blow-up (via Valuewalk):

Our research suggests that China does not have the financial arsenal to continue on without restructuring many of its banks and undergoing a large devaluation of its currency. It is normal for economies and markets to experience cycles, and a near-term downturn that works to correct the current economic imbalances does not qualitatively change China’s longer-term growth outlook and transition to a service economy. However, credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world. What we are witnessing is the resetting of the largest macro imbalance the world has ever seen.

Then on the weekend, PBoC Governor Zhou Xiaochuan said in a Caixin interview that claimed that everything was fine and there was no basis for continued CNY devaluation. In response, CNYUSD rallied by 4.5% on Monday, which was the biggest move since 2005.

What’s the real story? How serious is the capital flight problem in China and what’s the likelihood of a major Chinese devaluation?

Kyle Bass: All roads lead to devaluation

Let’s start with the Kyle Bass letter. He began by exposing in detail the severe imbalances and debt buildup in China, a problem that is well known. China’s USD 3.3 trillion may not be enough to insulate her from the coming storm, according to Bass. Firstly, Chinese foreign exchange (FX) reserves has been dropping dramatically and peaked at USD 4.0 trillion in June 2014. As well, the IMF estimates that, for a trading nation like China, minimum reserve adequacy is USD 2.7 trillion, which is not that far off the current level of USD 3.3 trillion given the rate of decline of USD 100 billion per month.

Bass further made adjustments to the USD 3.3 trillion, based on the availability of funds, and concluded that current FX reserves is actually below the magic USD 2.7 trillion deemed adequate by the IMF.

 

Bottom line, Beijing has few options left. None of them are good:

  1. Cut interest rates to zero and let the banks “extend and pretend” bad loans – lower interest rates will force more capital abroad putting downward pressure on reserves and the currency.
  2. Use reserves to recapitalize its banks – this will reset the banking sector, but wipe out the limited reserve cushion that China has built up, and put downward pressure on the currency.
  3. Print money to recapitalize its banks – this will reset the banking sector, but the expansion of the PBOC’s balance sheet will lead to downward pressure of the exchange rate.
  4. Fiscal stimulus to revive the economy – this will help some chosen sectors of the real economy, but at the expense of higher domestic interest rates (if not done in conjunction with Chinese QE). The 2009 fiscal stimulus was primarily executed through the banking sector so a similar program would require a properly capitalized banking sector. Also, any increase in Chinese investment would reduce China’s trade surplus and ultimately pressure the currency.
All roads lead to a major devaluation. To put the situation into context, this chart from Benn Steill shows the precipitous rate of FX reserves leakage out of China.

 

 

Yikes! A major Chinese devaluation has the potential to spark a currency war and cause havoc in the global financial markets.

 

Not as bad as it looks

I was prepared to get very bearish on China, then I came upon this analysis by Eric Burroughs, the Reuters financial correspondent for China. Burroughs dissected the funds flow and came up with several causes for the so-called “capital flight”:
  • The strong USD effect on FX reserves;
  • Chinese entities paying down USD denominated external debt;
  • A reversal of speculative hot-money inflows;
  • Hedging; and
  • Actual capital flight.
Let’s go through these components, one by one. Burroughs pointed out that Chinese FX reserves have fallen by roughly USD 700 billion since its peak in June 2014. Since FX reserves are denominated in USD and the USD has been strong against major currencies around the world. With about 25-30% of FX reserves held in euros, about USD 200 billion of the “outflows” are attributable to exchange rate movements.
So we still have about USD 500 billion in outflows to account for. In a previous post (see Why China won`t blow up the world (this year)), I had referenced a Barron`s article indicating that Chinese corporations were paying down corporate debt. The chart below from Burroughs suggest that foreign currency debt has dropped by about USD 200 billion.

 

 

Based on the analysis so far, roughly USD 400 billion of the USD 700 billion in outflows are benign.
We still have about USD 300 billion “capital flight” to explain. For those of us with short memories, Burroughs reminded us that it wasn`t that long ago that the market was in a crowded long on CNY. There was a ton of derivative contracts betting on a rising CNY written in places like HK and Taiwan back in 2012-13 that are now coming back to haunt speculators (annotations in purple are mine).

 

 

Should the market be freaked out about speculators getting hurt? Isn’t that what capitalism is all about?
Then we get into the murky part of the fund flows analysis. The blogger Concentrated Ambiguity took at look at the invoicing flows from Chinese trading companies in and out of China. Here are the figures from State Administration of Foreign Exchange (SAFE) for 2015, in which the gross flows are shown before netting.

 

 

Bottom line, most of the outflows came from the categories “services” and “capital account residual”. But the figures for these accounts were already negative were already in 2014! The biggest change was an inflow for “goods” in 2014 turned slightly negative in 2015.

 

 

There are two possible explanations. The more sinister explanation is over-invoicing, where corporations are trying to get their money abroad. A more benign explanation is corporations were hedging their currency exposures by holding more USD offshore in anticipation of a falling CNYUSD, which was a reversal of their position in 2012-13 when they over-invoiced to move more funds into CNY in anticipation of a rising CNYUSD (the hot money effect). In reality, it’s probably a little of both, but we’ll never know how much.

Since China is still notionally a communist country and notionally a command economy, one possible remedy suggested by Concentrated Ambiguity is to force Chinese companies to repatriate their profits from abroad (imagine what that would do to the likes of Apple and the US fiscal position). Dan Harris at China Law Blog reports that some heavy handed implementation of administrative measures are already taking place and it is very difficult to get money out of China these days:

Well if there is a common theme, it is that China banks seem to be doing whatever they can to avoid paying anyone in dollars. We are hearing the following:

1. Chinese investors that have secured all necessary approvals to invest in American companies are not being allowed to actually make that investment. I mentioned this to China attorney friend who says he has been hearing the same thing. Never heard this one until this month.

2. Chinese citizens who are supposed to be allowed to send up to $50,000 a year out of China, pretty much on questions asked, are not getting that money sent. I feel like every realtor in the United States has called us on this one. The Wall Street Journal wrote on this yesterday. Never heard this one until this month.

3. Money will not be sent to certain countries deemed at high risk for fake transactions unless there is conclusive proof that the transaction is real — in other words a lot more proof than required months ago. We heard this one last week regarding transactions with Indonesia, from a client with a subsidiary there. Never heard this one until this month.

4. Money will not be sent for certain types of transactions, especially services, which are often used to disguise moving money out of China illegally. This is not exactly new, but it appears China is cracking down on this. For what is ordinarily necessary to get money out of China for a services transaction, check out Want to Get Paid by a Chinese Company? Do These Three Things.

5. Get this one: Money will not be sent to any company on a services transaction unless that company can show that it does not have any Chinese owners. The alleged purpose behind this “rule” is again to prevent the sort of transactions ordinarily used to illegally move money out of China. Never heard this one until this month.

 

It`s not you, it`s me

Putting it all together, what do we have? Of the approximately USD 700 billion in “capital flight”, about USD 400 billion is benign, accounted for by a falling euro and Chinese corporations paying down their USD external debt. The remaining USD 300 billion can be explained by a combination of the reversal of hot money flows, trade flows and actual “capital flight”.

Even the term “capital flight” has highly negative connotations, but how real is that? One man’s capital flight is another man’s portfolio diversification. Could this all be a tempest in a teapot?

We have all heard about the phrase “it’s not you, it’s me” in a relationship breakup. Is falling CNYUSD reflective of capital flight out of China, or just a strong USD? The chart below shows that the trade-weighted Yuan has been fairly steady since March 2014.

 

Is it you? Or is it me? You decide.

Profit by thinking like Big Money

Posted by Cam Hui -

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 seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” 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 this model has shown turnover rates of about 200% per month.

The signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Risk-off
  • Trading model: Bearish

 

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent.

The value of an investment process

In the past few weeks, I have heard from many worried investors and traders as stock prices fell. These difficult period illustrate the need for an investment process. In bull phases, no one needs a process because the market is rising, When the market declines, however, investors and traders need to have laid out a decision process that details an analytical framework of what to do ahead of time. Otherwise, they wind up panicking because they either under or over-react to the bear story du jour.

In the current case, the bear story du jour description is apt because there is no clear fundamental reason why the stock prices are falling (see the different explanations advanced in this Reuters story, What`s behind the global stock market selloff?). This decline began over concerns about falling oil prices and their possible effects on junk bonds, then it was China, then the excuse of the day became worries about European banks…and so on.

Don`t get me wrong. There are some very valid reasons to de-risk a portfolio, but unless you have laid out the proper analytical framework ahead of time, you can easily get lost.

Think like an institutional investor

A sustainable bear market needs valid fundamental and macro reasons for equity prices to retreat. That`s because, after the fast money hedge funds and nimble traders sell, the slow institutional behemoths still have to evaluate the situation and act.  Institutional funds represent the Big Money. While they may not make investment shifts very often, when they do move, the fund flows are enormous, unrelenting and glacial.

As an exercise, imagine being an analyst at an institution manager with $10 billion in US equity assets. Our analyst is part of the Strategy and Asset Allocation group. The Investment Committee is meeting next week to consider what to do in light of the current market turmoil. Our analyst has been asked to prepare a report and make recommendations.

Here is some more background about the firm. It is a value oriented stock picker and typically holds between 50-100 stocks in its portfolio. The investment universe is the top 2,000 names by liquidity and market float. Its cash position is currently 7% and cash can vary between fully invested and 40%. Portfolio turnover has historically varied between 20-60% a year.

Now consider the constraints the portfolios operate under. If the portfolio holds between 50-100 stocks, then the typical position is between 1% and 2%. A 2% position in a $10 billion portfolio is a $200 million position. The smallest stocks in the investment universe will vary between $3 billion and $5 billion in market cap. A 1-2% position in a $5 billion market cap company represents between 2-4% of the outstanding shares. Even if the position is 1% of the outstanding, trading in and out of smaller positions will not be easy and the time to implement trading decisions can take weeks, maybe months. We simply cannot use the kinds of trading techniques used by the fast money traders because trading costs will crater portfolio returns.

We therefore need a longer time horizon to make our investment decisions. Based on that background of firm capabilities and constraints, here is what we observe.

Valuation: Stocks are cheap

First, let’s start with market valuation. A quick-and-dirty way of determining valuation is the Morningstar fair value estimate, which shows stocks at 13% below fair value (h/t Callum Thomas). Compared to post 2008 corrective episodes, that’s cheaper than the trough in 2010 but not as cheap as the bottom in 2011 (annotations in purple are mine).

Another way of thinking about valuation is to analyze the stock market using the P/E ratio. Dissecting the P/E ratio reveals two components, the E and the P/E multiple. Data from John Butters of Factset shows that the forward P/E multiple has been falling. At 14.7, it is just above its 5 and 10 year averages of 14.4 and 14.2 respectively. If we were to exclude the troubled Energy sector, the forward P/E ratio would drop to 14.0, which is below the historical index 5 and 10 year averages (red annotations in chart are mine).

If we were to use a trailing P/E metric, market P/E is 15.9 and just above its long-term 5 and 10 year averages.

How should we interpret those P/E multiples? Are they cheap or expensive? A trailing P/E ratio of 15.9 translates to an earnings yield (E/P) of 6.3%, which compares favorably against the 10-year Treasury yield at 1.75%. Another way of thinking about the fair value using P/E is the Rule of 20, which states that an approximate fair value for the P/E ratio is 20 minus the inflation rate. Based on that rule, the market is cheap.

What about the likely trajectory of the P/E ratio based on macro developments? Analysis from Ed Yardeni shows that the P/E multiple (red line) has an inverse relationship with the Misery Index (blue line), which consists of the inflation rate + unemployment rate.

We break down the the components of the Misery Index in the chart below. Both inflation (blue line, core PCE) and unemployment (red line) have been falling, which are conducive to P/E multiple expansion. In terms of magnitude, unemployment has been falling much fast than PCE inflation. (As an aside, this observation is consistent with my view that recessions are deadly for stock prices, because unemployment spikes during recessions, which then pressures P/E multiples as risk aversion rises.)

OK, unemployment has been falling, but so what? It’s not a big surprise. The Fed has made numerous noises about watching employment statistics for signs of rising inflation pressures. Does that mean that inflation is likely to rise, which would have a downward pressure on P/E multiples? Ummm…take a look at this chart of the inflationary expectations of the bond market.

Based on this analysis of the Misery Index, the P/E multiple is far more likely to expand than to contract.

What about how the E in the P/E multiple? The latest update from John Butters of Factset shows that the growth of forward 12-month EPS is wobbly (annotations in red are mine). Until forward EPS start to improve, the tone of stock market price action is likely to be sloppy as well.

 

Green shoots of recovery?

Despite the reports of wobbly forward EPS estimates, we can see some green shoots of a possible cyclical rebound from the macro data. The Atlanta Fed’s GDPNow nowcast of Q1 2016 real GDP growth has been steadily rising. The latest reading stands at 2.7%, which is well above the Blue Chip economist consensus.

The latest update from New Deal democrat, who monitors high frequency economic releases, agrees with that assessment. New Deal democrat believes that macro conditions are rapidly becoming “less worse”.

Among short leading indicators, the interest rate spread between corporates and treasuries got even more negative. Jobless claims remain positive. Oil and gas prices remain very positive, while usage, which was negative for 5 weeks, turned positive. Commodities remain a big global negative, although they appear “less worse” on a YoY basis. The big story this week, however, was that the US$ as against major currencies turned from negative to neutral. The broad US$ remains quite negative, but is also rapidly becoming “less worse.”

Among coincident indicators, steel production, shipping, staffing, and rail transport all remain negative, but all of these except for shipping have turned much “less bad. ” Consumer spending remains positive.

It is a little over one year since the downturn in coincident indicators began. The bifurcation of decent consumer economy, poor industrial economy remains. Yesterday retail sales confirmed what the weekly consumer spending measures have shown: the US consumer is alright. Meanwhile heightened inventory to sales ratios show that producers and sellers as a whole have a backlog to be worked off. But the big news is that the majority of coincident indicators have become significantly “less worse,” although none enough so for me to declare that they have bottomed.

We see a similar message from the character of market leadership. Industrial stocks have formed a relative saucer bottom and they`ve staged a relative breakout. Outside of the still dismal Energy sector, resource stocks like Metals and Mining appear to be trying to form a bottom in relative performance. Industrial metals are also bottoming, aided by weakness in the USD Index, which is inversely correlated to commodity prices.

We can also make a couple of observations about global tail-risk from Europe and China from the above chart. The behavior of the USD is a constructive signal that tail-risk from European banks may be limited. If the market was truly panicked over the outlook for Deutsche Bank, Intesa, etc., then the USDEUR should be rising, as traders pile into Treasury assets as a safe haven. Instead, the euro has strengthened against the Dollar (can anyone explain that puzzle to me?). In addition, a falling USD is helpful for US earnings growth, as the rising Dollar had been squeezing the operating margins of US exporters in the past year. Currency weakness should therefore translate into better operating earnings growth in Q1 and Q2. The market is may be poised for a growth surprise.

As well, the bottoming price action seen in industrial metals could be interpreted as a signal that deceleration in Chinese growth is also bottoming. At a minimum, things are getting less worse in China.

Supportive sentiment

A review of sentiment models is supportive of higher prices in the next few months. Insiders, who represent a group of smart and patient investors with a long investment horizon, are buying (via Barron’s).

By contrast, the public is very bearish, which is contrarian bullish. The chart below depicts sentiment from AAII investor survey (black line) and Rydex trader fund flows (green line). Both are flashing crowded short readings, which suggest limited downside risk for stocks.

To summarize, our analyst recognizes that his institutional employer cannot react to every blip in the market because of liquidity constraints.  It has therefore adopted an investment horizon of several years. He presents his reports based on the data cited above and makes a recommendation that they put some money to work in equities for the following reasons:

  • Valuations shows stocks to be cheap relative to bonds and macro conditions;
  • Earnings multiples are likely to expand further, or stay flat at worse;
  • The fundamentals look a bit uncertain right now, but there are some early signs of a cyclical rebound;
  • Macro tail-risk from Europe and China are limited; and
  • Investor sentiment is at or near panic levels, which is contrarian bullish.

I went through the above exercise as an illustration of an investment process favored by institutional investors. While individual portfolio managers and analysts can over-react and panic just like the rest of us, large organizations strive to put in place a process, or a framework for evaluating all market conditions and so that they know how to react ahead of time.

I would further point out that $10 billion in equity assets in this example does not represent an especially large institution, but it is big enough to show the kinds of constraints that these organizations operate under. In other words, a $10 billion institution is a medium sized elephant. Now imagine a stampede of similar sized elephants, which leads to my final point…

The most compelling reason for studying institutional investment decision processes is they represent the Big Money. Big Money move markets.

As a result of this analysis, my inner investor remains constructive on stocks. He continues to opportunistically bottom fish at these levels,

Inner trader: Just a dead cat bounce

My inner trader is appreciative of my inner investor’s analytical approach, but he has a much shorter time horizon. Unlike the slow moving institutional behemoths, my inner trader try to be the fast money that times the short-term squiggles in the market.

He doesn’t like what he is seeing. True, the stock market did stage an oversold rally late last week, but it looks like a dead-cat bounce. This chart from IndexIndicators shows that short-term breadth metrics had gotten sufficiently oversold for stock prices to rise.

The readings from a longer term (1-2 weeks) breadth indicator of net 20-day highs-lows are more disturbing. The market rallied off a mild oversold condition last week, but it is now on the overbought side of neutral and it would become overbought on any sort of mild advance. This suggests that the upside potential of the current rally is very limited.

Further, my inner trader worries about the lack of panic selling (see Bracing for more pain). Admittedly, Rydex and AAII are showing crowded short conditions (see above commentary), but sentiment models are not very useful as short-term trading tools. The latest update of the NAAIM Exposure Index, which surveys of RIAs, indicates that investment advisors were buying in the face of market weakness, which also suggests a lack of capitulation.

Here are the short-term challenges facing the market next week. The SPX hourly chart shows an overbought condition on RSI 5 and nearby overhead resistance. At a minimum, the bulls have to show sufficient follow-through and overcome that resistance zone to be in control of the tape.

The daily chart appears a bit more constructive. We are seeing positive divergences in 5 and 14 day RSI. The initial target for the rally, after it overcomes any of the aforementioned resistance levels, is the first Fibonacci retracement level at about 1833-1835.

My inner trader is skeptical that the bulls can pull off a win next week. Until the bulls can show they have sufficient control of the tape to overcome resistance at 1835, he is staying in cash. Ideally, he would like to see a final panicky selloff, where the market craters and his social media feed is full of “OMG! Next stop for the SPX is 1760” comments. His base case scenario calls for further market choppiness until we either start to either see a trend of improving fundamentals in the form of rising forward EPS estimates, or a capitulation selloff.

He tells my inner investor, “Feel free to bottom fish, but don’t expect the stock market to rocket upwards next week.”

Disclosure: No trading positions

The price of success

Posted by Cam Hui -

Last year, my Valentine’s Day post was about how Facebook analyzed the behavior of who fall in love (see Falling in love, the Facebook version). This year, I thought that I would highlight the price of success for hedge fund managers.

I highlight a research paper entitled Limited Attention, Marital Events, and Hedge Funds. Here is the abstract (emphasis added):

We explore the impact of limited attention on investment performance by analyzing the returns of hedge fund managers who are distracted by personal events such as marriage and divorce. We find that marriages and divorces are associated with significantly lower fund alpha, during the six-month period surrounding the event and for up to two years after the event. Relative to the pre-event window, fund alpha falls by an annualized 8.50 percent during a marriage and 7.39 percent during a divorce. Busy fund managers who manage larger funds and engage in high tempo investment strategies are more affected by marriage. Fund managers who depend on interpersonal relationships in their investment strategies are more affected by divorce. We show that behavioral biases may partially explain the connection between inattention and performance deterioration. The difference between the proportion of gains realized and the proportion of losses realized widens during a marriage and a divorce, indicating that inattentive hedge fund managers are more prone to the disposition effect. Taken together, our findings suggest that limited investor attention can hurt the investment performance of professional money managers.

To be successful, hedge fund managers should consider staying away from personal relationships, any of them.

Ah, the price of success!

Bracing for more pain

Posted by Cam Hui -

In theory, stock prices should be poised to rally. The SPX is testing a key support zone dating back to October 2014 and it is experiencing positive divergences on the 5 and 14 day RSI. If it did bottom here, the initial target would be the first Fibonacci retracement level at about 1935, with further resistance at about 1975 and 2010.

 

The bulls are set up for some short-term disappointment. I wrote on Sunday that I expected further stock market weakness ahead for this week because momentum was weak and readings were not oversold (see Waiting for the market to heal). Monday’s market action did not disappoint that forecast.

The omens were positive for for a bullish reversal on Wednesday. Overnight, the shares of Deutsche Bank soared on a rumor of a buyback of its senior debt as a demonstration of its balance sheet strength and European bourses rallied in sympathy. At one point, ES futures were up over 1% in the overnight market. By the time the dust settled at Wednesday’s close, the SPX was flat on the day.

Bears still in control

For now, the bears remain in control of the tape. From a technical viewpoint, two factors are ailing stocks on a short-term (1-5 day) time frame. First, the market is insufficiently oversold for a durable bottom. The chart below from IndexIndicators shows that breadth is oversold, but readings are not at levels seen at previous bottoms (red dot is my estimate of Wednesday’s close).

 

 

My observation is confirmed by this tweet from Trade Followers, whose specialty is to monitor the breadth of Twitter sentiment:

 

 

No panic

In addition, we have not seen the kind of panicky capitulation wash-out that are the characteristic of V-shaped market bottoms. The readings my Trifecta Bottom Model, which has had an uncanny ability to spot bottoms in the last three years (full description here), is disturbing. The Trifecta Model consists of the following three components:

  1. VIX term structure inversion: Which measures rising fear in the option market much better than the absolute level of the VIX Index;
  2. TRIN: When TRIN is above 2, it is often an indication of capitulative price-insensitive selling, otherwise known as margin clerk market; and
  3. OBOS: This is an intermediate term oversold indicator which indicates an oversold condition when the indicator falls below 0.5.

The chart below shows the Trifecta Model readings today. The term structure of VIX inverted briefly on Monday, which indicates rising panic among option traders. However, the medium term OBOS model is nowhere near an oversold reading. More importantly, TRIN is showing zero evidence of price insensitive selling, where traders get taps on the shoulder from their risk managers to reduce position sizes and individual investors are forced to sell by margin clerks.

Throughout this period of market weakness in 2016, I have felt a sense of unease over the lack of capitulation (see Explaining the lack of capitulation (and what it means)). Michael Batnick at The Irrelevant Investor also made the same observation about the lack of market panic.

Maybe we will get the flush or maybe we won’t. Maybe we get a flush, consolidation, then more flushing. Who knows? There is no formula for markets like this, which is what makes it so fascinating to watch. In the short term, fundamentals mean literally nothing and lines in the sand are drawn and erased daily. Psychology takes over and selling begets more selling until….”and then just like that, somebody turned off the rain and the sun came out.”

Bottom line: The bulls tried to push prices up today and failed. The bears remain in control of the tape. My inner trader is staying in an all-cash portfolio and bracing for more market pain ahead.

If I had to watch just ONE THING…

Posted by Cam Hui -

During periods of market turmoil like the one we are experiencing, it’s important to keep your eye on the ball and not to get overly distracted. If I had to just had to watch just one thing, it would be how forward 12-month EPS are evolving. That’s because Ed Yardeni found that forward EPS is highly correlated with coincidental economic indicators. In that context, the current market weakness makes sense because what`s really bothering the market is a lack of growth. If the growth outlook were to improve, stock prices would stabilize and start rising again.

The chart below shows the latest update from John Butters of Factset. Consensus forward EPS still looks a bit wobbly, but its weakness is nothing like the 2008 bear market (annotations in red are mine).

 

Before you write me about how annual or quarterly EPS estimates are falling as a way of bolstering the bear case, this analysis from Ed Yardeni shows that EPS estimates for any single fiscal year tend to start high and decline over time. The way to normalize the falling estimate effect is to calculate a continuous forward 12-month EPS, which is far more stable.

If you don`t have access to a database with consensus EPS estimates to calculate an aggregate forward 12-month EPS, you can get it from Factset. Unfortunately, Factset only updates their estimates weekly on Fridays. If you are impatient, there are a number of ways of monitoring how growth expectations are changing in real-time.

The yield curve as growth proxy

One simple way is to monitor the changes in the shape of the yield curve. One of the explanations for differing interest rate levels is the expectations hypothesis (via Wikipedia):

This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants’ expectations of future interest rates. It assumes that market forces will cause the interest rates on various terms of bonds to be such that the expected final value of a sequence of short-term investments will equal the known final value of a single long-term investment.

Using this, futures rates, along with the assumption that arbitrage opportunities will be minimal in future markets, and that futures rates are unbiased estimates of forthcoming spot rates, provide enough information to construct a complete expected yield curve. For example, if investors have an expectation of what 1-year interest rates will be next year, the current 2-year interest rate can be calculated as the compounding of this year’s 1-year interest rate by next year’s expected 1-year interest rate. More generally, returns (1+ yield) on a long-term instrument are assumed to equal the geometric mean of the expected returns on a series of short-term instruments:

where ist and ilt are the expected short-term and actual long-term interest rates.

In other words, a steepening yield curve would reflect higher growth and inflationary expectations, while a flattening yield curve would indicate market expectations of slower growth and more muted future inflation.

Since the Fed and other global central banks have pushed short rates down to zero, or near zero, we use the difference between the 10-year and 2-year US Treasury yields as to measure the shape of the yield curve. As the chart below shows, the yield curve has been flattening since last summer.

 

Bank stocks as a growth proxy

Another indirect way of monitoring market growth expectations is to watch the performance of bank stocks. There has been much anxiety about the dismal performance of the financial sector, both in the US and Europe. As I write these words, Bank of America (BAC) is trading at a price/book ratio of 0.5, Citigroup (C) at 0.5, Morgan Stanley (MS) at 0.7 and Goldman Sachs (GS) at 0.8. But did anyone notice how the market relative returns of the financial sector are correlated to the shape of the yield curve? In effect, the financials benefit from a steeper curve, where they can borrow short and lend long. A flat curve hurts profitability of this sector.

In Europe, there has been much hang wringing over the dire performance of Deutsche Bank (for some perspective see this Bloomberg article). Moreover, concerns are rising over the growing risk levels in the European banking sector.

Here is a puzzle for you: The chart below depicts the relative performance of European financials (black line, top panel), the Bund 10-year yield as a measure of financial anxiety (green line, top panel) and the EURUSD exchange rate. Sure, European financials have tanked on a relative basis in line with falling Bund yields, but if the eurozone banking system is in such distress, why is the euro so strong? Shouldn’t investors be buying the USD as the safety trade?

A far more simple explanation of European financial underperformance would be a combination of a flatter yield curve and the ECB`s policy of negative interest rates charged on excess reserves, both of which hurt banking profitability. In short, the banks are tanking because growth expectations are tanking. If the growth outlook were to improve, so should European bank stocks.

Bottom line: Watch for signs of growth. My preferable and most direct measure is the Street consensus forward EPS. Other real-time metrics include the shape of the yield curve and the relative performance of the financial sector. If and when those indicators stabilize or turn up, the ensuing rally is going to rip the face off the shorts.

Waiting for the market to heal

Posted by Cam Hui -

Model signal summary
Ultimate market timing model: Buy equities
Trend Model signal: Risk-off
Trading model: Bearish (downgrade)

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.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

 

Update schedule: I generally update model readings on my blog on weekends and tweet any changes during the week at @humblestudent.
 

Forming a bottom

Despite the recent recession scare that’s been spooking markets, I have been saying for the past few weeks that disciplined macro and fundamental analysis do not support a recession call (see Bottomed, but wait for a re-test of the lows). So equities should rise in the absence of a recession, right? Wrong! From a macro and fundamental perspective, much damage has been done to risk appetite by the recent episode of industrial weakness in the US. In parallel, we have also seen a lot of technical damage in the charts. The market needs time to heal before stock prices can rise again in a sustainable way.

The stock market is only undergoing a correction. The key difference between a correction and a bear market is how fundamentals develop. In the beginning, the first leg down is driven by the fast money, composed of the hedge funds and nimble individual traders, That initial decline could be sparked by no fundamental reason (as an example, see The Ebola correction? Oh, PUH-:LEEZ!). For selling pressure to become sustainable, the big money institutions need to feel the need to sell That depends on a deteriorating fundamental and macro backdrop, which is not present right now (see Why this is a correction and not a bear market). To the contrary, intermediate term indicators are bullish, although these indicators are not very useful in calling market direction in the next few days or weeks.

The latest constructive macro data point comes from the Employment Report, whose internals of were generally positive, despite a miss on the headline Non-Farm Payroll figure. These are signs of macro healing:

  • All of the gains were private sector jobs, government jobs shrank slightly
  • The average manufacturing workweek rose (recall that manufacturing has been the weak spot in the economy)
  • Manufacturing jobs up by 29K
  • Construction jobs up by 19K (and housing is one of the most cyclical elements of the economy).
  • Rising average wages and aggregate hours
  • Part time unemployment for economic reasons continues to fall
  • The labor participation rate ticked up again

The intermediate term technical outlook is bullish as well. If I had to point to a single thing, it would the Mark Hulbert observation that his sample of best market timers are bullish, while the worst timers are bearish.
 

 
Sentiment models are also telling a tale of limited downside risk and intermediate term upside potential. The chart below of Rydex fund flows is showing a crowded short among Rydex traders, which is contrarian bullish. Such conditions have tended to resolve themselves with sideways consolidations, followed by rallies. This is nothing like 2008 when Rydex traders bought stocks as they declined.
 

 
The market is also intermediate term oversold as measured by the McClellan Oscillator. In the chart below, I have shown the Common Stock only measure in the middle panel and the more popular NYSE McClellan Oscillator in the bottom panel. Both are telling the same story. The market should bottom in the next few weeks.
 

 
These are all intermediate term indicators, however. None of them have much insight on how the stock market will behave tomorrow, or next week.

Short-term weakness ahead

By contrast, the short-term technical condition of the market is weak. Consider this SP 500 chart as a window on market internals. The index is in the process of testing a support zone that stretches back to last August. Last week, it broke down through a short-term uptrend and the weakness is also evident in the breakdowns in the 5 and 14 day RSI. Readings are not oversold and I would expect more downside next week as negative momentum pushes the market to test the support zone again.
 

 
The technical condition of the market also appears problematical from a sector leadership viewpoint. The chart below shows the market relative performance of selected sectors. The leadership sectors are defensive in nature (Consumer Staples and Utilities, middle panel), while Financial (top panel) and resource oriented stocks (bottom panels) underperform.
 

 
An analysis of the other major sectors show a more mixed picture. Industrial stocks seem to have bottomed and appear to be staging an upside relative breakout (top panel) and the Technology relative uptrend continues (third panel). However, the relative performance of the Consumer Discretionary stocks are rolling over and breaking down on a relative basis, which is worrisome as consumer spending has been the linchpin of economic growth (second panel). The high flying biotech stocks are also breaking down (green line, bottom panel), though the relative performance of the Health Care sector appears to be stable.
 

 
Could these be the early signs of a cyclical revival? Well…

Another way of analyzing sector rotation is through the use of Relative Rotation Graphs (RRG). RRG charts, which show the  Julius’ Relative Strength Ratio indicator on the horizontal axis and Relative Strength Momentum indicator on the vertical axis. An idealized sector leadership rotation would see sectors move in a clockwise fashion, from a weakening position in the bottom right quadrant, rotating to lagging (bottom left) to improving (top left) and to finally a leading position (top right).

The chart below shows the RRG of US sectors. Leading sectors (in green) are the defensive Consumer Staples and Utilities. The only sector in the improving category (blue) is Health Care. This is a bearish picture for the stock market outlook from a sector rotation analytical framework.
 

 
If we analyze the RRG chart by country, however, the technical picture looks brighter. (Note that these are all US-listed ETFs so their performance are all measured in a single currency.) US stocks have moved from the leading to weakening quadrant, though the deterioration is very minor (more on that later). The most problematical region is Europe (eurozone and UK), while China related plays and resource producing countries are showing the greatest level of improvement, which are suggestive of a global cyclical rebound.
 

 
Here is the relative performance of US and European stocks relative to the MSCI All-Country World Index (ACWI). US stocks remain in a relative uptrend, while European stocks are in relative downtrends.
 

 
The picture for resource and China related Asian markets point to a story of global healing. The relative performance of resource-rich and China-sensitive Australian market is turning up (top panel). So are Canada and Latin America (80% combined weights in resource heavy Brazil and Mexico, middle panel). The stock markets of China`s major regional trading partners are consolidating sideways relative to ACWI (bottom panel), indicating that diminishing short-term tail-risk from a China hard landing. The Apocalyptic scenario of a Chinese devaluation starting a currency and trade war seems to be off the table. Even the perennially bearish site Zero Hedge has thrown in the towel on that story, at least in the short-term.
 

 
Here is the big questions in the days and weeks ahead: The global markets are showing signs of healing, when will that start to show up in US sector leadership? Until it does, expect further uncertainty, volatility and choppiness.
 

The week ahead

As we approach the week ahead, further stock market weakness is the most likely outcome. Breadth indicators from IndexIndicators are falling. Readings are only neutral and not oversold, but momentum is negative.
 

 
As well, analysis from Trade Followers show that Twitter breadth is negative, which is bearish, and bearish tweets are overwhelming bullish tweets, which are also bearish (annotations in red are mine).
 

 
My inner investor remains constructive on stocks as he believes that this recession scare presents a buying opportunity. He is long equities with an overweight position in the resource sector.

My inner trader is anticipating more choppy markets in the near term. He was stopped out of his long position on Tuesday and he is staying in cash. He is wary of going short except opportunistically for a brief trade. The combination of crowded short sentiment readings and positive intermediate term macro and fundamental backdrop means that any good news could see a rally that could rip the face off any short-seller.

His base case scenario for the upcoming week postulates a re-test of the recent lows with a possible undercut of major support, which would create a panic among traders and give the bulls the sentiment shakeout that`s been lacking in the current decline. If that were to happen, it would be a major buying opportunity. (Don`t even try to ask about downside target levels, because my inner trader has no idea and he will be watching for extreme oversold readings to step up and buy.)
 
Disclosure: No trading positions

Is the Fed tightening too much?

Posted by Cam Hui -

Regular readers will know that I have been relatively constructive about stock prices longer term, though I am bracing for further short-term volatility. However, the level of anxiety among my readers is high and I have had to play a game of whack-a-mole with bearish themes (as an example see Why China won’t blow up the world (this year)).

One of the more recent explanations for the current bout of stock market weakness is that the Federal Reserve is engineering an extraordinary level of tightening, as measured by the Shadow Fund Funds rate (SFF). Such Fed action, it is said, is creating a high degree of stress in the financial markets and causing stocks to tank and risk appetites to shrink (annotations are mine).

How concerned should we be about this development?

What is the Shadow Fed Funds rate?

To properly analyze the significance of the SFF, it’s important to understand what it is. I will try to explain the SFF model, but without getting overly geeky.

The basis for the calculation of a SFF rate when Fed interest rate policy originally came from the late Fischer Black. James Bullard, President of the St. Louis Fed, explained it this way in a series of slides. You can derive the option value of holding cash from the yield curve.

 

You can then calculate the SFF rate by subtracting the option value of holding cash from the nominal Fed Funds rate.

The work by Fischer Black and (later) Leo Krippner of the Reserve Bank of New Zealand on this topic, the calculations to derive SFF was mathematically and numerically difficult because of some of the assumptions involved. It wasn`t under later that Cynthia Wu and Dora Xia came up with a simplified version of the model. More importantly, the output of the Wu-Xia model showed a high level of correlation with actual macro-economic variables as the actual Fed Funds rate. It was a way of validating the Wu-Xia model.

However, I would caution that SFF is a theoretical concept derived from the yield curve. Despite its recent negative values, it is not an actual rate that anyone can transact in. (If you tried to call up the structured products desk at a major brokerage house like Morgan Stanley or Goldman Sachs and asked for a derivative contract based on SFF, they would snicker at you.)

Jim Hamilton, who taught both Wu and Xia, had these comments on the model:

The suggestion is that we then might use the shadow rate series as a way of summarizing what the Fed has been doing with its unconventional policy measures such as large-scale asset purchases and forward guidance. If the Wu-Xia framework is correct, these unconventional policies can all be summarized in terms of what effect they had on the shadow short rate.

In other words, the Wu-Xia rate is a shorthand way of summarizing the Fed`s unconventional monetary policy by observing what was happening to expectations reflected in the yield curve.

Here is THE BIG QUESTION. Is a rising SFF a reflection of tighter Fed policy, or is it a reflection of market expectations of a better growth outlook? The former interpretation is bearish, while the latter is bullish. I would argue that, since the SFF is not an actual rate that you can actually realize and trade on, that it is an indicator of better growth expectations shown in the yield curve.

Are rising negative rates good or bad?

Think about it another way. Ever since the Bank of Japan (BoJ) announced their negative interest rate policy (NIRP), we have seen a lot of hang wringing over the spread of NIRP among global central bankers.

Let’s start with Zero Hedge, who breathlessly reported that NIRP amounted to a failure of QE and central bank policy in the post crisis era:

Over the last week, though, the “central banks to the rescue” narrative has also resurfaced. Not only has the BoJ embraced NIRP policies for the first time, but the ECB has strongly hinted at QE3 in March, and the Fed has added a dovish tinge to its outlook. “Yield”, as a secular theme, continues to stand tall, a full 7yrs after the GFC event. While the growth of negative yielding assets is now well flagged, it’s the other side of the coin which is talked about less: namely the decline in positive yielding opportunities.

And yet, the market’s response to the salvo of central bank action lately has been a shallow bounce. On Friday, the Nikkei’s intra-day performance was up/down/up. And in Europe, our equity team’s “low risk” dividend basket has been lagging behind the jump in negative yielding government debt lately.

 

 

What John Mauldin wrote in his essay Tokyo doubles down more or less amounts to the same thing:

The entire world has been watching the European experiment. Four countries in Europe are now at negative rates (see graph below). Two others are so close that it hardly makes a difference. The Federal Reserve and the Bank of England are both at 0.5%.

 

 

Switzerland, Denmark, and Sweden all lowered their rates to make their currencies less attractive, since the franc, the krone, and the krona had appreciated too strongly against the faltering euro. Meanwhile, the ECB is trying to stimulate the Eurozone economy and create inflation. The question is, exactly how many unintended consequences will there be with negative rates?

(For the record, to my knowledge none of the banks charge negative rates on required reserves, just on excess reserves. Excess reserves are defined as money on deposit at a bank in excess of whatever the regulators think is necessary to fund the bank’s operations. The concept of excess reserves is a totally artificial one. Aggressive banks will keep reserves as low as possible in order to make maximum returns, and conservative banks will of course hold more reserves. Where do you want to put your money? Then again, if you’re looking to borrow money, which bank do you go to?)

The people that NIRP (negative interest rate policy) hurts the most are those who are living on their savings or trying to grow their retirement accounts, but apparently our all-wise central banks have decided that a little pain for them is worth the potential for growth in the long run. Savers in both Germany and Japan have to buy bonds out past seven years just to see a positive return. Some 29% of European bonds now carry a negative interest rate. Recently we have seen Japanese corporate bonds paying negative interest.

Wait a minute. If negative interest rates amount to a failure of central bankers to re-ignite growth, which is bearish, but a rising Shadow Fed Funds rate (which is a theoretical rate and not an administered actual rate) is bearish….

I’m confused.

The truth is, there is a lot of bearishness out there, as shown by the crowded short of Rydex investors. This sounds like a case of deciding on the conclusion to be bearish first and then manufacturing a reason for the bearishness.

The bears can’t have it both ways. Either a rising SFF is bearish, or it’s a reflection of a better growth outlook and a move away from negative interest rates.

A tactical note on NFP

While we are on the topic of Fed policy, this Friday’s Employment Report will play a critical part in the Fed’s decision on whether to raise rates in March. That’s because most of the key members of the FOMC are believers in the Phillips Curve, which postulates a short-term tradeoff between inflation and unemployment (higher employment = higher inflation). I would highlight this tweet by Urban Carmel, who pointed out that excessively high employment prints, which we saw in the December data, tend to be followed by mean reverting low extremes.

I have no idea how the market might react should we see a headline jobs report of under 100K, but investors and traders should be prepared for that possibility.

Why China won’t blow up the world (this year)

Posted by Cam Hui -

I had a response to my last blog post in which I indicated that the contagion effects from a China slowdown had been contained (see Bottomed, but wait for a re-test of the lows). A reader pointed to comments by Worth Wray worried aloud about the possible catastrophic of a RMB devaluation. While I had initially dismissed Wray as a permabear, the combination of these concerns and a report of further weakness from China’s Manufacturing PMI meant that these concerns deserve a more complete and detailed answer.

Let me be clear. I don’t deny that China faces many problems because of its stalling economic growth rate. Despite all of the hand wringing by western observers, however, Beijing has many tools at its disposal to mitigate the immediate downside risks facing China and the global economy. The China growth story will probably not end well, but it will not end today.

What western analysts get wrong

Let’s consider what western analysts are getting all wrong when they look at China. Here is Worth Wray outlining the problem:

It’s no secret that China is slowing under a massive debt burden. After the financial crisis of 2008, China went on one of the biggest debt binges in modern history. There are very few parallels and any close examples have ended in hard landings. These kinds of rapid debt growth periods never end well and lead to broad based misallocation; it leads to a lot of bad assets and non-performing loans in the banking sector (even if they’re hidden in China right now). It’s a problem that’s draining liquidity from the banks; it’s sapping growth potential. And so China’s economy is naturally slowing. Now a slowdown is something that you’d expect anyway in China because you’re seeing that economy get much bigger and you’re seeing real GDP per capita grow—you always see economies slowing like that as they develop. But this is a different matter. This is largely debt-induced and China has exhausted the growth model that’s driven it for so long which is largely reliant upon credit, upon investment, and that can’t go on any longer.

Here is the critical error that he makes by assuming that the system has to come crashing down:

The trouble here is that making the transition to a new economic model driven by consumption and services and technology, it sounds fantastic but it’s going to require a cleaning out of the banking system, a cleaning out of bad debt—t’s going to require a tremendous amount of upheaval in these old-economy sectors like infrastructure, construction, real-estate, mining and I’m afraid China is past the point of no return. I don’t think it can pursue that rebalancing plan without Beijing losing an extraordinary amount of control, probably without a hard landing.

China = Argentina, Thailand, Russia?

Here is what many analysts are really thinking when they look at China, “OMG! A gargantuan episode of debt-fueled growth! Asian Crisis! Russia Crisis! Mexico! Argentina!”

The analysis is superficially correct, but the critical piece that is missing is that the template of past EM crisis has been a pattern of excess borrowing in foreign currencies, usually USD. The global economy hits a speed bump, the overly indebted EM economy is forced to devalue its currency, which exposes the country and its corporate borrowers to a negative currency shock. Those EM countries were left vulnerable because of a combination of excessive external debt and a current account deficit.

By contrast, the Chinese economy was fueled mainly by RMB-denominated debt (minimal foreign exchange exposure) and China is running an enormous current account surplus. Consider the level of aggregate Chinese foreign debt exposure and tell me why we should be worried. This story from Barron’s indicated that China has external debt of USD 1.7 trillion, which sounds high. But upon closer examination, about half of that is denominated in RMB:

As of the end of June 2015, China had USD1.68 trillion of external debt, of which USD823.7 billion was denominated in RMB. About half of China’s total external debt, therefore, does not carry the currency risk of foreign currency-denominated external debt (FX debt). Not only do exchange-rate swings not affect the burden of servicing RMB-denominated debt, but also, in the most adverse scenario, the central bank can act as lender of last resort and print money to help borrowers.

How worried should we be about a country with about USD 800 billion in foreign currency (FX) external debt when it has over USD 3 trillion in reserves? Clearly, the analytical framework of overly indebted EM crisis countries misses the mark.

Moreover, the trend in external FX debt is improving. Figures from BNP Paribas shows that Chinese external FX debt has been falling in the past few quarters (annotations in red are mine):

 

 

So why are you so worried?

Beijing is not out of options

Nevertheless, Chinese economic growth continues to decelerate. Worth Wray thinks that Beijing is out of options and therefore it needs to devalue its currency, which has the potential to spark a currency war of Apocalyptic proportions:

What really matters right now is the renminbi…but I’m concerned that Beijing is running out of options, they won’t be able to defend the renminbi for very much longer and they may have to let it float. That may end up leading to a better outcome for China long-term…but it’s a very nasty development for global growth, for global economic stability and threatens unleashing huge deflation in the developed world, a very strong dollar, and I think maybe the next global financial crisis.

What I’m concerned about when it comes to the global financial system is it’s really about the interaction of the dollar and the renminbi. You have about 10 trillion dollars in dollar-based debt or credit extended to the world…the stronger the dollar gets, the weaker the commodity prices get, the more pressure gets put on a whole range of emerging market economies. If you get a stronger dollar, which I think you are already in a position to get if we get more European Central Bank competitive easing, more Bank of Japan competitive easing, then the dollar can go up easily another 10%, maybe a little more. But if the renminbi goes, if that happens, then I think you’re setting up for a very big dollar rally so the pressure on commodities, the pressure on dollar-debts, that gets amplified at the same time that there’s a big shock to global manufacturing competitiveness and there’s a wave of deflation that comes over the world.

George Magnus, who has expressed also serious concerns about China, put a RMB devaluation into context this way:

The real threat of a Yuan devaluation is more about what it would signify. The Chinese authorities could be forced into such a policy, for example, because of a looming or actual banking crisis, and or because economic growth had collapsed to, say, 2 per cent or into a recession. Under these circumstances, economic growth around the would probably stall or fall, spurring new urgent discussions about what on earth central banks might do—so-called helicopter money policies have already been aired—and whether governments might have to abandon current budget strategies.

A yuan devaluation would be a policy of last resort:

A Yuan devaluation would almost certainly be reflected in further across-the-board US dollar appreciation bringing new financial stress to both commodity producers, and to non-financial companies that have borrowed in US dollars. Both topics have figured prominently on the IMF’s financial instability watch-list for some time.

At the moment, it is most likely that the Chinese authorities, conscious of all these risks, and eager to convey a positive impression in its financial diplomacy will try to keep the Yuan relatively stable. The internationalisation of the Yuan, membership of the Special Drawing Right, and the success of the Asian Infrastructure Investment Bank, for example, hinge on a stable and credible currency. The even more important economic rebalancing agenda at home also requires the Yuan to remain relatively firm, provided the authorities are willing and able to address debt and overcapacity problems and use fiscal and social security policies appropriately, and by way of compensation.

If Beijing were to choose the devaluation path, it would be an admission of failure of their economic policies and mean a tremendous loss of face after all the efforts it made to get the yuan into the IMF SDR basket. Moreover, China can kiss its dream of a New Silk Road goodbye and the prestige of leading the AIIB turn into dust (see China’s cunning plan to revive growth).

If growth were to really tank, China has many other policy tools at its disposal. The Required Reserved Ratio (RRR) is currently 17.5%. If push came to shove, there would be lots of room for the RRR to fall.

In addition, the PBoC could resort to unconventional monetary policy, or quantitative easing. Here is what quantitative easing might look like: The PBoC decrees that it will buy $1 trillion in local government debt from the banking system and banks are free to submit any local government debt to the PBoC for sale. Such an move would free up $1 trillion in room for the banking system to lend.

Would these actions spur more of the same credit induced growth of building white elephant airports and port facilities? Certainly. Would such a policy mean that things would end badly for China? Undoubtedly. Is this just an exercise of kicking the can down the road? Yes, but kicking the can down the road works as long as you have a long road – and the Chinese still have a long road.

Put it another way. Imagine that you knew ahead of time that the PBoC will lower the RRR by an astounding 4% and enacted QE to throw a trillion or two USD at the economy. Would you want to buy Australia, Taiwan, South Korea, or would you short everything in sight? Now ask yourself if Beijing out of bullets?

No immediate crisis

Despite all of the anxiety over the growth deceleration in China, signs of stabilization are starting to appear. Andrew Batson explained the Chinese growth slowdown very simply. It’s all about real estate and construction:

It’s not like it’s a secret. From about 2003 to about 2010 China had the biggest construction boom of modern times and probably in all of human history. Then in 2011-12 the construction boom ended. That’s it. Really, that’s all you need to know. Well, you might need one more fact: housing and construction account for as much of a third of China’s GDP, once all their indirect linkages to other sectors are considered. I think a housing downturn explains very well the timing, severity and distribution of the economic slowdown that has actually occurred.

But property prices in China are recovering, which should alleviate much of the pressures on the financial system (via Ambrose Evans-Pritchard):

 

 

Tom Orlik at Bloomberg confirmed this observation with this recent tweet:

 

 

What about the tanking stock market? The Chinese stock market is dominated by retail punters with minimal financial sophistication and lacks the professionalism of institutional sponsorship, which serves to put a damper on the wild volatility that stock prices have experienced. That’s another way that many western observers have failed when analyzing China – they think that they’re still in the US. Linking Chinese economic performance to the Chinese market is like trying to forecast the American economy by observing the results of the Kentucky Derby.

Explaining capital flight

What about the risk of capital flight? Even if the Chinese economy holds itself together, the PBoC is running an inappropriate monetary policy and faces the Impossible Trinity of stable exchange rates, free capital movement and an independent monetary policy. Every month, we are confronted with the news of billions leaving China.

Louis Gave of Gavekal had some perspective on this supposed capital flight: Anecdotal evidence does not suggest panic behind the CNYUSD weakness:

My problem with this line of thinking is that there is little evidence on the ground that this [the Chinese losing confidence in their own government] is what is actually taking place. Sure, Chinese people have been taking money out of China. But that is nothing new. Ask anyone in Vancouver, Sydney, Auckland, Hong Kong, or Bordeaux. Chinese money has been coming in for years. Macau was built as one huge conduit to get money out of, and sometimes into, China.

The big question today is whether many more Chinese people are taking their money out, and whether they are doing it on a scale large enough to overwhelm China’s US$600bn trade surplus. The recent contraction in China’s reserves suggests that this is what is happening, and of course this is what the media are latching onto. But I am troubled by the fact that at the anecdotal level, there are few signs of these massive capital outflows. For example, one easy way for Chinese people to send money abroad is through the Shanghai-Hong Kong Stock Connect scheme (which channels funds indirectly into the Hong Kong dollar); but this has barely been utilized. Meanwhile, real estate transaction volumes in the markets typically favored by Chinese buyers—Vancouver, Hong Kong, Macau, Sydney, Auckland—have fallen recently (although prices have proved more sticky). So if the Chinese are shipping their money out of China, where is that money going? In what asset markets can we see volumes and prices rising?

Instead, he attributes CNYUSD and CNHUSD weakness to hedging by exporters:

This brings me to my next point. Maybe the drop in the renminbi is not primarily linked to the Chinese public panicking over the value of their currency and deciding, en masse, to buy US dollars. Perhaps it has more to do with large numbers of Chinese exporters adjusting their currency exposures and hedging their positions as they have been caught up by the general global US dollar buying panic. To me this seems a much more plausible explanation. And it is one for which there is anecdotal evidence. A number of Hong Kong-based friends in the import-export business have recently told me that they are now hedging their foreign exchange exposure for the first time. If this is what is happening on a general scale—and admittedly it is a big “if”—we should probably not read too much into recent market moves, as they will have been the result of short term panic-buying by corporates, rather than the start of wholesale capital flight out of China.

I would also add that, as Chinese external FX debt has been falling, some of the “capital flight” can be attributable to the paying down of FX debt.

A ticking time bomb?

None of this post is meant to suggest that China is not sitting on a ticking time bomb. Their economy faces serious imbalances, which cannot be easily corrected. While the authorities are taking positive steps to rebalance the economy toward consumer-led growth, I had highlighted analysis from Michael Pettis that the rebalancing process is not happening fast enough.

In all likelihood, it will all end very badly for China someday, it just won’t be today (see Why the next recession will be very ugly).

Bottomed, but wait for a re-test of the lows

Posted by Cam Hui -

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

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.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

 

 
Update schedule: I generally update model readings on my blog on weekends and tweet any changes during the week at @humblestudent.
 

Confirmation of limited tail-risk

Whew! Q4 GDP came in at 0.7%, which was below expectations of 0.8%, but growth was still positive and well above some of the Apocalyptic calls for a negative print. This week, we saw further confirmation that macro tail-risk is limited. The US economy is not headed for a recession and the downside risk from China has also been contained.

Nevertheless, the stock market remains jittery and will likely remain so for a little longer. The main source of anxiety is coming from the earnings outlook. The interim report for Q4 Earning Season is out and it got a bare passing grade. With 40% of the SPX having reported, the latest update from John Butters of Factset shows that the EPS beat rate coming in at above average, but sales beat rate below average and, most importantly, forward 12-month EPS continuing to slide (annotations in chart below are mine).
 

 

No recession on the horizon

Until forward EPS starts to turn up, stock prices are likely to remain range-bound and trade in a sloppy fashion. From a macro perspective, the greatest anxiety comes from the weakness in industrial production and ISM Manufacturing, as exemplified by the disappointing capital goods order release last week.

However, I would point out that the share of the industrial sector of the economy has been in secular decline, so the importance of its weakness is diminished.
 

 
As for the rest of the American economy, George Pearkes of Bespoke recently pointed out that consumer confidence has been healthy. Recessions simply do not start with consumer confidence on the rise like this.
 

 
Tim Duy noted that even within the so-called “weak” industrial sector, the weakness isn’t very broad based. He pointed to work by Josh Lehner indicating that the decline in industrial activity is not well dispersed across the sector:
 

 
Analysis from Deutsche Bank confirmed Duy’s point.
 

 
Most of the weakness observed in industrial production, as well as forward EPS, has been related to the resource sectors. Analysis from Citi showed that EBIT margins on remains healthy on an ex-energy basis. In short, operating margins are not turning down despite the headwinds posed by a rising USD.
 

 
So relax. The US economy is highly unlikely to roll over into recession. The SPX earnings outlook is healthy, especially if you exclude the troubled energy sector.
 

China: Is this as bad as it gets? 

What about the concerns over a China slowdown? Could that drag the US into a recession?

The transmission mechanism of apparent economic weakness in China has been through lower commodity prices, which has also tanked the emerging market (EM) economies.

Ed Yardeni recently explained it this way: EMs borrowed too much USD because of an easy post-GFC Fed and the recent rally in the trade weighted dollar is largely attributable to a short-covering rally by EM borrowers:

The Fed’s easy monetary policies at the beginning of the previous decade certainly contributed to the subprime mortgage mess. This time, the Fed’s easy money in recent years encouraged borrowers in emerging markets (EMs) to borrow lots of money from banks and in the bond markets to expand commodity production. A significant amount of that debt was in dollars. The prospect of the tightening of US monetary policy after so many years of near-zero interest rates caused EM borrowers to scramble to sell their own local currencies to buy dollars to pay off their dollar-denominated debts…

From this perspective, the 23% increase in the trade-weighted dollar since July 1, 2014 is to a large extent a massive short-covering rally by EMs. The soaring dollar increased the local currency prices of commodities priced globally in dollars. It’s likely that the plunge in commodity prices might have been triggered by the short-covering dollar rally combined with the tightening of credit for EMs. Of course, the supply-led glut of commodities only made things worse.

He concluded that contagion risks are limited because of the low level of leverage in the financial system related to EM and commodity-linked debt . In this case, there is no financial contagion.

My relatively optimistic spin has been that the dollar borrowing by EMs has been largely financed in the capital markets, which are better able to absorb shocks and losses than banking systems. Loans to EMs haven’t been sliced and diced into different tranches of credit derivatives as were subprime mortgages.

Of course, there are many high-yield bonds that were priced too cheaply and have seen their yields soar since mid-2014. However, they were never rated as anything other than junk. EMs and junk bonds have been great shorts recently, but I doubt there will be a sequel to “The Big Short” based on them.

In other words, this is as bad as the fallout from China gets. Weak commodity prices and weak EM economies may shake up risk appetite a little, but they’re not bringing down the global economy.

In fact, there are signs that the commodity price downturn is starting to stabilize. The chart below shows industrial commodities (top panel) and oil prices (bottom panel). Notwithstanding the headline grabbing decline in energy prices, industrial commodity prices seem to be putting in a bottom. They have flattened out in the last few months and actually rallied through a downtrend line last week. Equally constructive has been the action in oil, which has strengthened to test a downtrend.
 

 
Is the worst over? I don’t know. I will be monitoring these charts carefully. At a minimum, the situation in Commodity-Land is getting less worse. Should we start to see commodity prices bottom and strengthen, then pressures would start to come off the junk bond market. Such a development has the potential spark a surprise rebound in risk appetite.
 

Waiting for the re-test

With downside risk from a US recession and contagion risk from China contained, my inner investor concludes that the market has bottomed and Mr. Market has in effect running a post-Christmas sale tag on equities. He believes that this represents an excellent time to be accumulating positions in stocks that he likes.

My inner trader, however, isn’t convinced that the market is ready to take off just yet. He is waiting for a re-test of the lows. The technical damage done by the decline is too great and the general level of anxiety is still too high to support a V-shaped market recovery.

From a longer term perspective, the market appears to be undergoing a bottoming process. This chart of Rydex sentiment, which measures what people are doing with their money rather that just expressing their opinions in a poll, is flashing a crowded short reading. If the historical pattern holds, the market should undergo a multi-week sideways and choppy consolidation. This isn’t 2008, where the general public bought the market weakness as stock prices weakened. Downside risk is limited.
 

 
In addition, Barron’s reports that insiders have displayed a continuing pattern of buying. Prolonged bear markets simply do not begin with sentiment readings at these levels. At a minimum, I would be extremely cautious about being short for any period of time except for a quick trade.
 

 
On the other hand, this chart from Trade Followers shows significant technical damage from deteriorating Twitter breadth and a crossover of bullish and bearish stock counts. Such damage typically cannot be repaired with a V-shaped bottom. Such conditions tend to resolve themselves with a basing period of sideways consolidation (annotations are mine).
 

 
These breadth charts from IndexIndicators show that the market is overbought and vulnerable to a pullback (annotations in red are mine).
 

 

 
To be sure, there is still a remote possibility that the market is about to experience a Zweig Breadth Thrust (for a full explanation of the ZBT see Bingo! We have a buy signal!). While I am watching this carefully and we have another four days for the signal to be triggered, I’m not holding my breadth for that outcome. (For readers who want to follow along at home, use this stockcharts link for a real-time update).
 

 
I wrote last week that I had been expecting a short-term market rally and that I would be carefully watching the quality of the rebound. The jury is out as to whether this is a V or W shaped rally, but the weight of the evidence calls for a basing period after such a sharp drop. My inner trader began to scale out of his long positions on Friday. He remains open to the possibility that a V-shaped bottom has occurred, but he is maintaining tight stops on the remainder of his long positions. His preferred scenario calls for a re-test of the recent lows, with a possible violation of those lows as a way of flushing out any remaining bulls to form a capitulation bottom.

My inner investor, by contrast, is convinced that a bottoming process is occurring based on the constructive macro backdrop. He is long equities in anticipation for higher prices later this year, with an overweight position in the resource sector.

Disclosure: Long SPXL

It’s a savings plan!

Posted by Cam Hui -

In the past several weeks, I have been seeing rising levels of angst in social media as the stock market tanked. While anxiety is certainly appropriate for traders, this kind of volatility shouldn’t be a concern for investors as long as they have a plan.

Learning to redefine your objectives

Here is what I mean by having a plan. In a past post (see The ABCs of financial planning), I outlined an idealized cash flow projection for a young couple with a child, with the black bars representing savings and red bars representing withdrawals from their savings.

An idealized savings plan

 

If this hypothetical couple has their portfolio structured properly and their cash flow objectives are met, why should they care if the stock market corrects by 10% if their long-term objectives are satisfied?

Don’t fight the last war

Ben Carlson at A Wealth of Common Sense wrote a terrific piece about how even endowment funds, which have a perpetual time horizon, can get gripped by short-termism. He went on to outline the problems of over-reacting to short-term market fluctuations with long-term assets:

  • You constantly change your strategy and chase past performance.
  • You ignore any semblance of a long-term plan.
  • You end up being reactive instead of pro-active with your decisions.
  • You incur higher fees from increased trading, due diligence and switching costs.
  • You lose sight of your actual goals and time horizon.
  • You end up with a portfolio that’s built to withstand the last war, not the next one.
  • You lose out on much of the long-term benefits that come from diversification, rebalancing and mean reversion.
The worst sin of over-reacting to market moves is not just the problem of chasing past performance and incurring excessive fees, it’s the syndrome of fighting the last war. In the last war in 2008, the critical failure was diversification. Bond prices did not react as expected and they went down along with stock prices. Consequently, it was not unusual to see well-constructed balanced portfolios down 20% in the crisis.

I have tried to address those issues by working on market timing, otherwise known as dynamic asset allocation techniques (see Building the ultimate market timing model), as a way of mitigating those effects. But make no mistake, my models do not represent the Holy Grail and these kinds of strategies should only be part of a well-balanced portfolio.I have always considered the term “investment plan” to be a misnomer and overly confusing. It`s not an “investment plan”, but a “savings plan”. Learn to re-define your objectives as meeting your cash flows. Learn to trust the power of the market. Then relax.

Building the ultimate market timing model

Posted by Cam Hui -

I’ve been giving much thought about the investment philosophy behind the post over at Philosophical Economics about the GTT market timing model. To understand what`s behind his investment philosophy, let`s start back with first principles of equity investing.

The equity claim represent the “stub” claim behind debt, or bond financing in a company and therefore represent greater investment risk. Financial theory holds that higher risk should be rewarded with higher expected (average) return. While equities earn more than bonds, on average, they will be subject to higher levels of risk.

The Philosophical Economics GTT model is a way of mitigating some of the risks of equity investing. When it spots an unfriendly market environment for stocks, it imposes a greater degree of risk control with the use of moving average based trend following models. That way, the investor can avoid the worst of downside risk while capturing upside return.

But what represents an unfriendly market environment? Jesse Livermore at Philosophical Economics defines it as recession, but I have repeatedly said that prolonged bear markets are caused by one of the following:

  1. War or rebellion causing the permanent loss of capital;
  2. Recession; or
  3. An overly aggressive central bank tightening monetary policy.
If we ignore the risk of war and rebellion for the moment, the Jesse Livermore GTT model only addresses a recession risk forecast, but ignores the risks posed by excessively tight monetary policy. His GTT model would have stayed long equities during the Crash of 1987, when the Fed raised rates twice in September to defend the dollar. A proper asset allocation model also needs to consider the effects of central bank policy. Here is where I think I can add value to that modeling framework.

What constitutes an aggressive Fed?

Here is my investor market timing model: If the market environment is friendly, buy and stay long stocks. If it is unfriendly, as defined by moderate or high recession risk or an overly aggressive monetary policy, then use a moving average based trend following model for to better tactically control risk.
The question then becomes, “How do you define an overly aggressive monetary policy?”
If you ask ten economists that question, you will get ten different answers. As a first order approximation, I focus on the Taylor Rule as a way of defining a neutral Fed Funds policy rate. While the Taylor Rule can have several assumptions in its inputs, the FRED blog conveniently showed the way by calculating the Taylor Rule rate based on a 2% inflation target and a constant 2% real interest rate.
I began my analysis by downloading the aforementioned target Taylor Rule rate, the actual effective Fund Funds rate from FRED and added monthly SPX returns. As the actual level of the Taylor Rule target depends on input assumptions, I defined three monetary policy regimes as follows:
  • Neutral: Fed Funds (FF) within 0.5% of the Taylor Rule target
  • Easy: FF at 0.5% or more below the Taylor Rule target
  • Tight: FF at 0.5% or more above the Taylor Rule target
Here are the SPX monthly returns under the three monetary regimes. Surprisingly, median monthly returns are higher under a tight monetary policy regime than an easy one, though the worst drawdown occurred under a tight policy regime. This initial analysis doesn’t give us many answers about risk management under different monetary policy regimes.
We see more interesting results if we further segregated the sample to rising and falling Fed Funds within each monetary policy regime. It was not a surprise to see that equity returns are higher when FF is falling than rising, but we can also observe that drawdowns seem to be worse in each category under a tight regime. Moreover, median monthly returns fall monotonically as monetary regime goes from easy to neutral to tight, even when FF is falling. It seems that downside equity risk is heightened under a tight monetary regime.
That observation about the higher risk characteristics of a tight policy regime is confirmed by the following chart showing the % of months the SPX is positive. Within each rising FF or falling FF grouping, a tight monetary regime underperforms its peers.

Market tail-risk and monetary regime

Recall the objective of this exercise is to measure the risk of an investment environment so that we can impose some extra risk controls to mitigate drawdowns. One way of measuring risk is kurtosis, which measures the fatness of the tails of a return distribution.
Here is the explanation of kurtosis for non-geeks. When kurtosis is 0, it is an indication that a distribution is normally distributed (like diagram A). The higher the kurtosis, the fatter the tails. To give a better real-life interpretation of this measure: A risk-manager at a hedge fund once explained to me that once the kurtosis of an investment strategy gets above 2 or 3, he starts to get concerned about unusual fat-tailed events.
The chart below shows the kurtosis of monthly SPX returns under different monetary regimes. SPX return kurtosis rises as monetary regime changes easy to neutral to tight. It was highest when FF was rising under a tight regime.
In other words, what this analysis tells us is that when monetary policy is tight, the chances of outsized moves are much higher than normal, especially when the Fed Funds rate is rising.

A new market timing model

When I put the work by Jesse Livermore at Philosophical Economics and my analysis of equity returns under different monetary policy regimes together, we can come up with the following market timing model:
  1. Use a trend following model to tactically control risk when macro risks are high, which is defined as:
    • High recession risk, or
    • The Fed Funds rate exceeds the Taylor Rule rate by 0.5% or more
  2. Otherwise stay long equities.

What is the market timing model telling us now?

Jesse Livermore and I have slightly different ideas of what constitutes recession risk (see my Recession Watch monitor), but our conclusions won`t be that different in the long run. Currently, recession risks are low (see the discussion in my last post Bullish or bearish? What’s your time horizon?). As for the monetary policy regime test, the Taylor Rule target rate is about 2.3%, which is well above the current effective FF rate, indicating an easy monetary policy.
Conclusion: The panel is green, investors should stay long equities. The current bout of weakness is only a correction, which can happen at any time and without much reason (as an example, see The Ebola correction? Oh, PUH-LEEZ!).
This discussion about corrections does bring up an important caveat to this market timing model. This model is designed for investors who want avoid the kind of large drawdowns that are the result of prolonged bear markets. It is definitely not designed to avoid every single 10-20% correction that comes along. As the above analysis shows, even under neutral and easy monetary regimes, single month drawdowns of about 10% can and do occur.
Equity investors have to be able to accept those kinds of risks, as they just come with the territory. Otherwise if you can’t stand the heat, stay out of the kitchen.

Why the Saudis will either blink…or collapse

Posted by Cam Hui -

As Saudi Arabia`s budget has come under pressure from low oil prices, I see that the Kingdom (KSA) has announced a diversification initiative into IT, healthcare and tourism (via CNBC):

Saudi Arabia outlined ambitious plans on Monday to move into industries ranging from information technology to health care and tourism, as it sought to convince international investors it can cope with an era of cheap oil.

A meeting and presentation at a luxury Riyadh hotel was held against a backdrop of low oil prices pressuring the kingdom’s currency and saddling it with an annual state budget deficit of almost $100 billion – the biggest economic challenge for Riyadh in well over a decade.

Top Saudi officials said they would reduce the kingdom’s dependence on oil and public sector employment. Growth and job creation would shift to the private sector, with state spending helping to jump-start industries in the initial stage.

“It’s going to switch from simple quantitative growth based on commodity exports to qualitative growth that is evenly distributed” across the economy, said Khalid al-Falih, chairman of national oil giant Saudi Aramco.

The competitve advantage of nations

What KSA faces is a classic problem in development economics. How do you create new industries and employment in an economically depressed region?

For that answer, I turn to Michael Porter, the author of The Competitive Advantage of Nations, and Jane Jacobs, whose work included The Economy of Cities and Cities and the Wealth of Nations. Porter`s analysis is more businesslike and his analysis was at the national level, while Jacobs was more academic while her unit of analysis was the city-state, but the message was the same. Porter`s framework of how countries moved up the value-added chain is highly instructive, with examples like Japan and South Korea leveraging their competitive advantage of low-cost labor to eventually become high value-added designers (think Samsung and Sony). Further, Porter wrote about the importance of industry clusters in spurring innovation.

What can Saudi Arabia offer? Do they think they can build a Silicon Valley or a biotech or healthcare behemoth in the desert? What are the competitive advantages and industry clusters that they can build on?

Sure, I can understand tourism as a growth driver, as Mecca is a magnet of steady visitors on the Hajj. Beyond pilgrims, however, Saudi Arabia doesn’t sound like a natural spot for tourism.

The idea of state spending to jump-start these initiatives are likely to fail. I am not necessarily saying that government shouldn’t use fiscal policy to spur growth, but the underlying approach is wrong. As an example, the US government has put military bases in fairly remote spots to boost employment and appease the local Congressional representative, but few of those efforts has built long lasting employment beyond services dependent on the base. On the other hand, selective efforts such as the combination of academic-private partnerships and initiatives like the DARPA challenge has yielded innovation.

There is a right way and wrong way to design industrial policy. Saudi Arabia is going about it the wrong way. A more sensible way is to encourage industries where KSA has a natural competitive advantage and build on it. Tourism is one. Others might include the encouragement of an industry cluster in energy services, either in the form of oil extraction engineering services or refining and processing.

Remember Chinese rebalancing?

What KSA is attempting is a form of economic rebalancing through industrial policy, which is a very tough road to take.Consider China, which has largely gotten the direction of policy right in their strategy of rebalancing growth away from credit-driven infrastructure growth to a more sustainable consumer-led growth model.

As my chart of New (consumer) China vs. Old (financial) China pairs show, rebalancing is continuing. Given the kind of market angst that surround the outlook for Chinese growth right now, this road isn`t exactly a smooth one.

 

 

I can only conclude that the Saudi economic diversification initiative is likely to fail. If KSA persists in its policy of maintaining low oil prices and believe that diversification will cushion the blow, it risks a collapse of its fiscal house and perhaps a political collapse of the House of Saud as well.

Bullish or bearish? What’s your time horizon?

Posted by Cam Hui -

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

 

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

Two views of the market

As the market has been experiencing a high degree of volatility, this week’s post will be split into two parts, which reflect the divergent views of my inner trader and inner investor. While my inner trader believes that the markets will be volatile and treacherous for bulls and bears alike, my inner investor thinks that concerns are overblown. Investors shouldn’t feel paralyzed like mid-Atlantic Americans are by the Jonas blizzard this weekend, as those fears will all melt away by spring, if not before.

The first part of this post analyzes the market within the context of a long-term framework. The second outlines my most likely near-term scenario for stock prices. The analytical framework I will use is a modified one based on a post by Jesse Livermore at Philosophical Economics. It is consistent with my belief that extended bear markets are caused by one of the following:

  1. War and rebellion that causes the permanent loss of capital;
  2. Recession; or
  3. An overly aggressive central bank tightening monetary policy, which often pushes the economy into a recession.

Watching for recession risk

Since the immediate threat of war and rebellion are highly unlikely, I will focus mainly on the risk of recessions. I use a modified approach to the one proposed in Jesse Livermore, where he outlined an asset allocation model for timing the stock market. First, he showed a hypothetical perfect foresight strategy of switching to cash one month before the onset of a recession and then buying back into the stock market a month before the end of a recession. This strategy would have beaten a buy-and-hold benchmark by avoiding the bear market losses that coincide with those economic downturns. I would point out, however, that this strategy wasn’t perfect as it did not sidestep the 1987 stock market crash (though calendar year 1987 stock market returns were slightly positive).

He went on to propose a strategy called Growth Trend Timing (GTT), which does not require any foresight, that nearly matches the performance of the perfect strategy.

His post is rather long, but well worth reading in its entirety. For the impatient, I’ll just cut tot the chase. The GTT strategy is based on a conditional assessment of the economic environment. When recession risk is low, buy and stay long the stock market. When recession risk is high, utilize a moving averaged based trend following strategy on the market to avoid losses. His proposed time recession risk indicators consist of the following:

  • Real Retail Sales Growth (yoy)
  • Industrial Production Growth (yoy)
  • Real SP 500 EPS Growth (yoy), modeled on a total return basis.
  • Employment Growth (yoy)
  • Real Personal Income Growth (yoy)
  • Housing Start Growth (yoy)

What is GTT saying now?

Readers probably want to know what GTT is saying about the market right now. The answer is predictably mixed. Real retail sales growth, employment growth, real personal income growth, and housing start growth are all healthily positive, reflecting strength in the domestic U.S. household sector. If you choose to build GTT on those signals, then you will be long right now, even though the market’s current price trend is negative. Of course, weakness in the energy sector, China, and the global economy more generally win out in the current tug of war with domestic U.S. strength, then the strategy, in failing to sell here, or in failing to have sold at higher levels, is going to take deeper losses.

At the same time, real Total Return EPS growth, industrial production growth, and production proxies that might be used in place of industrial production growth (e.g., ISM readings), are flashing warning signals, consistent with known stresses in the energy sector and in the global economy more generally (especially emerging markets), which those signals are more closely tied to. If you choose to build GTT using those signals individually or in combination with others, as I chose to do at the beginning of the piece, then given the market’s current negative trend, you will be in treasury bills right now–especially if you are using the daily version of the strategy, which is advisable, since the daily version shrinks the strategy’s gap losses at essentially no cost. Bear in mind that if strength in the domestic economy wins out in the current tug of war, then the strategy on this construction is likely to get whipsawed.

In effect, most indicators are green, except for real EPS growth and industrial production.

Cam here: I would tend to discount both of those readings because they are distorted by the effects of USD strength, which should abate Q1 or Q2. To put the concerns about EPS growth into context, the latest update from John Butters of Factset shows that forward 12-month EPS is looking a little wobbly. However, recessionistas should note that the decline is nothing like the experience of 2008, when expectations of EPS growth cratered (annotations in red are mine).

How worried should we be about the decline in forward EPS? Analysis from Goldman Sachs Investment Management put a different spin on the situation. The decline in EPS growth and margins is entirely attributable to weakness in the energy sector. As energy prices stabilize and perhaps turn upwards, the earnings outlook should improve (also see my last post A possible generational low in oil and energy stocks).

Another way of thinking about the decline in forward EPS is that it is related to the weakness in industrial production (blue line below), which has gone negative and has raised cautionary flags. On the other hand, the softness in industrial production seems to be highly correlated to the direction of the USD (note inverted scale for the trade-weighted dollar indices).

Upward momentum in the trade weighted dollar is petering out. Barring another significant USD rally, we should start seeing much better YoY comparisons in Q1 and Q2 – and that should be helpful for the earnings outlook going forward.

Last week’s release of Markit PMI, which is a timely proxy for industrial production, beat expectations and turned up. That`s another constructive sign for a growth revival.

 

Same philosophy, different implementation

The approach advocated by Jesse Livermore of staying long stocks based on macro-economic indicators of recession risk and then switching to a more risk-controlled investment process using trend following models is a highly useful technique for investors.

I like his investment philosophy, but prefer to implement it differently using a different set of recession indicators. As regular readers know, I maintain my own set of Recession Watch indicators, which are primarily based on the work by New Deal democrat and his interpretation of insights of Geoffrey Moore. These indicators are designed to spot an economic slowdown a year in advance. By and large, most of them are not showing any signs of recession risk. Here are ones flashing green, signaling continued economic expansion (links are to FRED charts):

  • Housing starts (Housing starts peaked at least one year before the next recession)
  • Real money supply growth (In addition to the 1981 “double dip,” on only 2 other occasions have these failed to turn negative at least 1 year before a recession)
  • Yield curve (The yield curve inverted more than one year before the next recession about half the time)
  • Residential real private investment (Aside from the 1981 “double-dip,” and 1948, it has always peaked at least one year before the next recession)
  • Real retail sales (It has peaked 1 year or more before the next recession about half of the time)
There is one mixed signal, with corporate profits turning down but proprietors`income flat. Keep in mind, however, corporate profits are thematically related to real EPS growth and industrial production (see discussion above):
  • Corporate profits and Proprietors` income, which can be a more timely proxy for corporate profits (Corporate profits have peaked at least one year before the next recession 8 of the last 11 times, one of the misses being the 1981 “double-dip.”)
There is one cautionary signal. but this has a tendency to be early by as much as 2-3 years:
  • Corporate bond yields (Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession).

Based on these metrics, recession risk remains low. New Deal democrat summarized current conditions this way in his weekly monitor of high frequency economic releases:

The economy is experiencing a very severe downturn in energy production and export-related goods production and transport. On the other hand, the manufacturing portion of industrial production is only flat, not down, and the 70% of the economy reflective of domestic consumption remains positive.

There has been a bounce to “less bad” readings in a number of commodity related indicators in the last few weeks, but due to seasonality, let’s give it another couple of weeks before arriving at any conclusions.

In addition, Georg Vrba’s work is also showing low recession risk:

What about the risk cited by many recessionistas, such as David Levy in the WSJ and Barron’s, that weakness in emerging market (EM) economies would drag us into a global recession? In order for an EM slowdown to spillover into the US, the most likely contagious would be rising financial stress. But financial stress doesn’t appear out of nowhere. Even the Lehman Crisis was preceded by signs of rising stress in the credit markets and so were the Enron and Adelphia Communications bankruptcies from the previous cycle. Today, measures of financial stress are still low and nowhere near the danger zone. So relax.

To summarize, my version of GTT concludes it would be premature for investors to even think about a bear market. Downside risk is limited, with the caveat that the next few months will likely be choppy for stock prices until uncertainties over earnings growth and the trajectory of the USD resolve themselves.

Investors should stay long the market and not panic. This is just a correction.

 

Trading the correction

For traders with shorter time horizons, it`s a very different ball game. Having established that the long-term macro and fundamental outlooks remain constructive and that this is not the start of a major bear market, my inner trader believes that the current bout of market weakness is a corrective period that will take several weeks, perhaps months, to play out.
The chart below tells the story. Much technical damage has been done to the market by the uptrend violation last year and the SPX is now testing a key zone of support. Readings are in extreme oversold territory and sentiment readings are showing an off the charts crowded short. While a V-shaped bottom is always a possibility, my base case scenario calls for a bounce, followed by a choppy range-bound consolidation of unknown length, much like the bottoming process seen in the summer of 2011 and in September 2015.

 

 

The decline should stop here in the short run. At a minimum, I would not want to be short the market today. Numerous sentiment models are at bearish extremes, which is contrarian bullish. The CNN Money Fear and Greed Index fell to single digits last week before reversing itself. Urban Carmel pointed out that past low reading episodes have signaled stock market recoveries in the past.

 

 

Rydex cash flows and AAII sentiment surveys are also at or near bearish extremes where bullish reversals have occurred in the past.

 

 

In addition, Hedgopia pointed out that hedge funds have panicked and gone net long VIX futures. The last time this happened, the market bottomed.

 

 

The Citi Panic-Euphora Index is solidly in panic territory.

I could go on, but you get the idea.

V or W shaped bounce?

In light of these stretched sentiment readings, an oversold relief rally is pretty much a foregone conclusion. The bigger question is the shape of the bounce. Will it be a V or W?

Given the ups and downs of earnings season and the fact that most of the anxiety over fundamentals have not been fully resolved, a W-shaped period of sideways consolidation makes sense. My trading plan calls for fading the bounce and waiting for a re-test of the lows. Further, I would not necessarily discount further market weakness that undercuts the most recent lows.

Ultimately, we just have to see how the reflex rally evolves and here is what I am watching. One key indicator to watch is how overbought market breadth gets on a short-term basis, as measured by this chart from IndexIndicators. If the markets of 2011 and September 2015 are my most likely templates for the current retracement, then I would look for readings to get overbought and reverse at the rally target zones.

If, on the other hand, I am wrong and the market does experience a V-shaped recovery, then that scenario would imply a powerful reversal in psychology and market breadth. In that case, a rare Zweig Breadth Thrust (ZBT) buy signal would likely get triggered (for a full explanation of the ZBT see Bingo! We have a buy signal). The most likely trigger for such a move would be an unexpected dovish message from the Fed next week.

The chart below shows the SPX, the ZBT signal (top panel), the ZBT indicator (3rd panel) and ZBT indicator estimate (4th panel, because stockcharts tends to be slightly late in updating their ZBT indicators). As the chart shows, a ZBT was triggered last September, which led to a month of market strength. We saw a ZBT setup last week, with Thursday as day 0. The market now has 10 days to get the ZBT indicator up from 0.4 (setup level) to 0.615 (buy signal level).

My inner investor is accumulating positions at these levels, with an overweight position in the resource sectors, much in the way that insiders have been doing for the last few weeks (via Barron’s).

My inner trader has been long the market, but he is carefully watching the daily OBOS readings. He will likely start to scaling out of his long positions should the market get short-term overbought.

Disclosure: Long SPXL, TNA

A possible generational low in oil and energy stocks

Posted by Cam Hui -

The bad news just doesn’t stop coming for oil. It all began when Saudi Arabia had turned on the production spigots to counter growing production from American frackers, and now it has to contend with the geopolitical dimensions of the growing power of Russia and Iran in the Middle East. The calls are growing for $20 oil and even $10 oil as there seems to be no prospects of an end to the oversupplied market.

For some long-term perspective, keep in mind this chart from of supply and demand from Jeff Gundlach (via Business Insider). While it is true that there is a significant gap between supply and demand right now, demand has steadily risen and that excess supply will eventually get absorbed:

 

What about China? Could a slowdown in China put a brake on oil demand? Gundlach had an answer for this as well. The chart below depicts the Chinese share of global commodity demand. You would be much more worried about Chinese demand if you were a producer of iron ore or thermal coal than an oil producer:

In that case, why is the Australian Dollar rallying against the Canadian Dollar when Australia is more sensitive to bulk commodities and Canada is more sensitive to oil prices?

As well, why is the gold to oil ratio show oil to be so cheap relative to gold in a multi-decade time frame (via Scott Grannis)?

We may be approaching a generational low for oil prices and energy stocks. These kinds of events will be easy to identify in retrospect, but investors may be gripped by either fear (oil) or greed (Tech Bubble top) at the moment.

In 10 years, some of us will look back at this moment and say, “I should have seen it!” Bloomberg reported that the price on certain grades of oil had actually gone negative:

Oil is so plentiful and cheap in the U.S. that at least one buyer says it would pay almost nothing to take a certain type of low-quality crude.

Flint Hills Resources LLC, the refining arm of billionaire brothers Charles and David Koch’s industrial empire, said it offered to pay $1.50 a barrel Friday for North Dakota Sour, a high-sulfur grade of crude, according to a corrected list of prices posted on its website Monday. It had previously posted a price of -$0.50. The crude is down from $13.50 a barrel a year ago and $47.60 in January 2014.

And Josh Brown was joking around about a new variation on the Mad Max movies:

With Iranian oil about to hit the market, I have no idea where oil prices might go in the short term. I do know that oil demand will rise (recall the Gundlach supply-demand chart above) to absorb the excess supply. I do know that oil prices are experiencing a positive RSI divergence, which indicates that downside risk is low on a multi-year time frame.

 

I also know that anyone who is willing to look over a potential valley and buy well-capitalized large cap integrated oil companies, whose refining operations are natural hedges to lower oil prices, should be very happy with their decision a few years from now.

Disclosure: Long SU

Buy! Blood is the streets!

Posted by Cam Hui -

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish (upgrade)

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. 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 model component of the Trend Model seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

How worried should you be?

Well, the stock market certain took a fright last week! At this point, we have to ask ourselves the question of how worried should we be about the market outlook.

For investors, the answer to that question depends on your time horizon. Do you need the money next month, next quarter or next year? If you need the money in such a short period, then did your asset allocation reflect those circumstances? I would contend that as your anxiety level should be falling as your time horizon lengthens.

In this week`s review, I will cover the following topics, starting from long term framework to a shorter one:

  • What is the downside tail-risk for stock prices?
  • What’s the upside potential?
  • What does the near-term risk-reward environment for stock prices?

How worried should you be, tail-risk edition

To evaluate tail-risk, I start with the following two questions. First, is there an immediate risk of the permanent loss of capital? Have German panzers broken through French lines and are they on their way to Paris, as they did in 1940? Have Soviet paratroopers seized key bridges across the Rhine and the Soviet 3rd Shock Army poured through the Fulda Gap and joined up with them?
Ummm, no. In those cases, the value of your portfolio would be the least of your worries.

What about recession risk? Is the US, or the world, on the verge of a recession? Recessions have always been stock market killers and fears have been rising. Jeff Miller put a lot of these recession calls by these so-called experts into context:

  • We are seeing a rash of “instant experts” on recessions. Most of them are cherry picking a single variable. Those with stronger methods do data mining to fit several variables. There are at least a half dozen sources currently preaching doom and gloom. ◦Many of the sources are from “credit desks” writing to their current clients. They are selling bonds.
  • Some sources are singing an old tune, enjoying their fifteen minutes of fame.
  • None of the confident voices have any record at recession forecasting. CNBC posts their “street cred” but never shows a track record on this key subject.
  • The most successful recession forecasts get very little visibility. I did a massive search five years ago, inviting nominations. One key source, Bob Dieli, has had the best real-time forecasts for decades. Other top analysts have analyzed past data with great care to avoid data mining. I have a helpful resource on recessions here, and update the key information weekly.

In other words, none of the analysts with disciplined, robust frameworks and track records are calling for recession. There have been a lot of people talking their own books (economic bears = bull bulls) trumpeting overblown calls of imminent slowdowns.

I have a Recession Watch page, whose indicators are showing low recession risk. It mainly uses the framework favored by New Deal democrat of using the indicators used by Geoffrey Moore to forecast recessions about a year in advance. I have been impressed by how New Deal democrat separates high frequency releases into coincidental, short leading and long leading indicators, which are the key metrics to watch. Here is what NDD said in his latest weekly review. Long leading indicators look fine, which suggests that there will be no recession in the next 12 months.

Among long leading indicators, interest rates for treasuries, corporate bonds are neutral, while money supply, real estate loans, and mortgage applications are positive, and mortgage rates turned more positive.

But the economy is going through a temporary soft patch:

The economy is experiencing a very severe downturn in energy production and export-related goods production and transport. On the other hand, the manufacturing portion of industrial production is only flat, not down, and the 70% of the economy reflective of domestic consumption remains positive. Q4 GDP might even be negative, and Q1 perhaps more so as excess inventories undergo further liquidation. But there simply is no broad, economy-wide downturn.

Still not convinced? Menzies Chinn at Econbrower is also find low levels of recession risk. Tim Duy came to similar conclusions based on his review of employment data and the yield curve.

Looking globally, Gavyn Davies is not finding any signs of decelerating growth:

So far, our regular monthly “nowcasts” of economic activity, which are updated in full here, have not picked up any decline in global growth, compared to the average recorded in recent quarters.

The overall growth rate in global activity is now running at roughly 3 per cent, which is actually slightly higher than than the growth rate recorded in 2015 Q3, the date of the previous global market scare. This conclusion is strengthened by the latest industrial production data, which show that the global IP growth rate has rebounded to about 2 per cent, compared to -2 per cent about a year ago.

What about China?

Another major source of angst has been over the outlook for China, whose fears seem to be overblown. Menzies Chinn broke out the sources of global growth and found that while Chinese growth does form a major component, it isn’t a critical component of growth.

What about the possibility of a major yuan devaluation setting off a currency war? Reuters reported that Premier Li Keqiang reassured markets that China has no intention of using a cheaper yuan to boost exports. Further, recent PBoC intervention has narrowed the onshore (CNY) and offshore (CNH) yuan markets and reduced the near-term risk of a major devaluation (via Bloomberg).

As well, the underlying economy seems to be performing better. Research from Fielding Chen and Tom Orlik of Bloomberg Intelligence indicated that there are several pieces of good news from the most recent Chinese trade data release:

  • China is taking a bigger slice of the global export market;
  • It is exporting more computers and few clothes, which indicates that…
  • China is making the shift to high value added products.

Apocalypse not yet,

How worried should you be, US growth edition

So what is the market so worried about?

In a word, earnings. The latest update from John Butters of Factset shows that forward EPS is looking a little wobbly, which is what’s really spooking the market.

Indeed, Ed Yardeni once found that forward EPS is highly correlated with coincidental indicators.

Notwithstanding the above analysis from New Deal democrat about how the US economy is going through a temporary soft patch, the bigger question is whether the weakness is likely to continue. One keys to the outlook hinges on the US Dollar. Indeed, Factset reports that currency strength has been an important feature in company earnings calls in the past year. Urban Carmel recently featured two pieces of analysis from ISI to put the USD strength story into context. First, USD strength lowered US exporters revenues by about 7%:

Such episodes of currency induced weakness are not unprecedented. We saw a similar mid-cycle slowdown about 1985, which is consistent with New Deal democrat`s thesis of a temporary slowdown, but no recession in 2016.

There are reasons to be optimistic. The chart below shows that upward momentum in the Trade Weighted Dollar has been falling. In the past, falling USD price momentum have coincided with economic recoveries from recessions. Unless the USD were to rally strongly from current levels, currency related headwinds to corporate earnings should start to subside in Q1 and Q2.

Here is another silver lining for earnings growth and USD weakness. During the recent market sell-off, investors did not bid up USD assets as a safe haven, which may be a sign that the USD has rallied as far as it can.

Another reason for optimism is the low level of expectations for earnings reports. With forward EPS estimates falling, Paul Hickey of Bespoke believes that the bar has been set too low as we head into Q4 earnings season. As the chart below shows, the spread between positive and negative Q4 estimate revisions has been very ugly.

On the other hand, recent market history has shown that quarters highly negative estimate revisions have seen positive returns. In fact, the only quarter that saw negative returns occurred when estimate revisions were positive heading into earnings season.

The stage is set for a potential FOMO (fear of missing out) rally.

Selling exhaustion at hand?

So far, I have addressed the question of downside tail-risk (relatively low) and upside potential (hopeful because of the USD and low expectations heading into earnings season). Looking more shorter term, I am seeing numerous signs that, when put together, form a mosaic picture of seller exhaustion.

I had shown concern that even as the market fell and technical indicators became oversold, market psychology was not showing signs of washing out, or panic selling (see Oversold, but…). I tried to explain the lack of a capitulation because historical volatility, which is a key input into Value-at-Risk models, was still fairly stable and therefore did not prompt risk managers to force traders to reduce their positions (see Explaining the lack of capitulation (and what it means)).

We finally saw numerous signs of a downside wash-out on Friday. Consider, for example, this 10-year chart of AAII bears-bulls (black line) and Rydex bear to bull fund flows (green line). Past spikes in either indicator to the current elevated levels have marked bottoms in the past.

As well, the CBOE equity only put/call ratio also spike to levels on Friday indicating panic selling. This is another sign of capitulation.

Chris Prybal also pointed out that put volume on small cap stocks hit an all-time record on Friday:

The NAAIM survey of RIA opinion also shows a high level of bearishness.

By contrast, Barron`s report of insider activity show that this group of informed investors have continued to buy in the face of market weakness.

Last but not least, here is the Drudge Report headline on Friday, which has been a good contrarian headline indicator to fade in the past.
 

 

We can discount the readings from any single indicator, but when I put all of these together, it spells capitulation.

To summarize, tail-risk is at minimal levels. Panic is setting it and blood is in the streets, it`s time to step up and buy.

My inner investor remains invested, with positions in the value theme and energy (my full portfolio is broad, but see Where my inner investor is bottom fishing for some flavor). My inner trader was caught long in the downdraft, but he is looking to add to positions next week.

Disclosure: Long SPXL, TNA