A cautionary tale for quants and systems traders

Posted by Cam Hui -

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

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

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

 

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

The trouble with science

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

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

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

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

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

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

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

 

 

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

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

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

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

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

I don`t know

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

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

I

Don’t

Know

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

Why?

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

Which is the better indicator?

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

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

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

 

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

 

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

I don’t know.

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

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

I’m not sure.

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

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

What’s spooking the stock market?

Posted by Cam Hui -

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

 

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

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

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

 

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

Waiting for the turn in China

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

 

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

 

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

Rising Brexit risks

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

 

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

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

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

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

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

 

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

 

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

 

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

Prepare yourself accordingly.

A better way to trade the China slowdown

Posted by Cam Hui -

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

 

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

 

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

Coming off a sugar high

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

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

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

 

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

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

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

Comrade Xi speaks: Enough is enough!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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

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

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

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

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

Investment implications

Here is my takeaway of what Xi wants:

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

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

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

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

 

 

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

Waiting for the storm to pass

Posted by Cam Hui -

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

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

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

 

The latest signals of each model are as follows:

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

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

Don’t panic, it’s only a correction

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

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

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

Investors just have to wait out the storm.

The earnings recession is over

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

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

Like, right now.

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

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

 

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

 

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

 

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

An equity friendly Fed

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

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

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

Stalling employment growth

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

 

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

 

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

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

So stock investors have little to worry about.

The storm from abroad

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

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

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

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

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

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

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

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

 

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

 

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

 

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

 

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

 

A shallow correction

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

 

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

 

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

 

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

 

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

The “tell” from sector leadership

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

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

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

 

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

 

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

 

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

 

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

 

Waiting for a bottom to develop

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

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

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

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

 

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

 

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

The week ahead

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

 

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

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

 

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

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

Disclosure: Long SPXU

Tactically taking profits in the commodity and reflation trade

Posted by Cam Hui -

Mid-week market update: Regular readers know that I have been bullish on the commodity and reflation trade (see A possible generational low in oil and energy stocks and The road to a 2016 market top). On the weekend, I postulated three separate short-term scenarios for the stock market  (see *Sigh* Another growth scare): The growth […]

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When will the market start to discount a Trump presidency?

Posted by Cam Hui -

Let me make myself very clear. As a Canadian, I have no horse in the American presidential race, but Donald Trump is a clown. He is a loose cannon on deck. He could also become the next president of the United States.

So when does the market start to discount the potential effects of a Trump presidency?
 

 

Fiscal and monetary policy

While Donald Trump`s statements tend to go all over the place, it is useful to evaluate a Trump Administration within a fiscal and monetary policy framework. There are some things that we do know.

Trump likes to spend. He also likes debt – a lot. In an interview with CNBC, he stated that he was not afraid of debt:

Asked whether the United States needed to pay its debts in full, or whether he could negotiate a partial repayment, Mr. Trump told the cable network CNBC, “I would borrow, knowing that if the economy crashed, you could make a deal.”

He added, “And if the economy was good, it was good. So, therefore, you can’t lose.”

We know that fiscal policy is likely to be expansionary and deficit enhancing (see Analysis: Trump’s tax plan will cost $9.5 trillion). Debt will skyrocket, but Trump is also willing to threaten default in order to “make a deal” and reduce the national debt load. What about the Federal Reserve? Won’t that kind of expansionary fiscal policy mean a tight monetary policy, which might be reminiscent of the loose fiscal-tighten money of the Reagan era, which saw the USD soar?

Not necessarily. Trump has also stated that he is likely to replace Janet Yellen as Fed chair (via CNBC):

It’s not that Janet Yellen is doing a bad job. The Fed’s longstanding easy-money policy — with a federal funds rate now at 0.25 percent — is to Trump’s liking, he told CNBC on Thursday. “I love the concept of a strong dollar,” he said, but it creates havoc in markets and trade, while higher rates would make it more expensive for the country to service its debts.

Instead, Trump says he would invoke his TV catch phrase from “The Apprentice” to tell Yellen “You’re fired” simply because she’s not a Republican.

Supposing that Trump does replace Yellen, what kind of candidate could he find to become the Fed chair? Assuming that he doesn’t pick someone who is totally unqualified, such as his one of his offspring, for the job, he needs a mainstream economist who is sympathetic to the idea of helicopter money where fiscal and monetary policy work together to stimulate the economy (see We are all helicopter pilots now). How about someone like Richard (“balance sheet recession”) Koo, the Taiwanese-American who is now the Nomura chief economist whose policy prescriptions amount to “spend until it hurts…and then spend some more”?

Given such a fiscal and monetary policy framework, many parts of the market reactions are quite predictable. The price of hard assets, like gold and collectibles, would soar. The USD would tank. The path of equity prices is less clear, but large cap multi-nationals would act like inflation hedges as foreign currency denominated earnings would boost growth, while small caps and companies focused on the domestic economy could face considerable headwinds.

I`ve been monitoring the USD Index, which breached an important support level and bounced, but remains in a downtrend. Should the market start to seriously discount the prospect of a Trump presidency, watch for the greenback to fall considerably further. Such a development would be commodity friendly and, initially, equity friendly as USD weakness would boost the multi-nationals doing business overseas.
 

 

This scenario is predicated on the assumption that there are no severe disruptions from an unpredictable foreign policy.

Can Trump win?

How likely is this scenario? Could Trump actually win? Conventional electoral math indicates that Hillary Clinton has a large lead over Donald Trump (via the NY Times):
 

 

Trump would have to improve his margin by 10% points to win:
 

 

That possibility is more likely than you might think. Nate Silver pointed out that the country hasn’t seen an election where both candidates have such high unfavorable ratings, so electoral results could be highly unpredictable. Now that the primary season is winding down, the polling margin between Clinton and Trump could swing all over the place.
 

 

There have been no shortage of opinions of how Trump could win:

  • Michael Moore, who is no Trump fan, thought that he just needs to win the midwesterners.
  • Jonah Goldberg thought that Trump just needs to become the mythic protagonist in a more entertaining story: “And, more to the point, The Hillary Story is far less entertaining than The Trump Story.”
  • Scott Adams, the creator of the Dilbert cartoons, stated in a Washington Post interview that he thinks Trump will win in a landslide because “he is running on our emotion…and sly appeals to our own irrationality.”
    1. Trump knows that people are basically irrational.
    2. Knowing that people are irrational, Trump aims to appeal an an irrational level.
    3. By running on emotion, facts don`t matter.
    4. If facts don`t matter, then you can`t really be “wrong”.
    5. With fewer facts in play, it`s easier to bend reality.
    6. To bend reality, Trump is a master at identity politics – and identity is the strongest persuader.

Be prepared

I have no idea of who is going to win, but the perception of a possible Trump presidency is not in the market yet. So when do the capital markets start to react and discount that possibility?

As well, how might the Fed react? Imagine that it`s August or September. The domestic and global economic situation is not very much changed from today. Trump has edged up in the polls and within striking distance of Clinton. Gold catches a bid and the USD weakens. Would the Fed slam on the brakes ahead of an election in what might be perceived as a political act, especially when they focus on inflation ex-food and energy and the hard asset price spikes could be “transitory”?

I don’t know. But investors and traders have to be prepared for such a scenario.

For my American friends who are totally horrified that Donald Trump might become president, I offer Maple Match as a possible personal solution to your angst (not sure if this is even a serious website):

 

 

You can come to Canada, a far more tolerant country where even recent Syrian refugees have opened up their meager pockets to help the evacuees from the recent Fort McMurray wildfires.

 


 

*Sigh* Another growth scare

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model 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 latest signals of each model are as follows:

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

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

Price vs. fundamental momentum

The stock market got another growth scare last week when it weakened last Tuesday, after a dismal set of PMI reports, and ended with a Non-Farm Payroll miss in the US Employment report. I was reminded of an article by Kurt Feuerman and James Tierney Jr. of AllianceBernstein entitled Don`t Confuse Price with Business Momentum:

Momentum is a funny thing. Share price momentum isn`t necessarily an indicator of business momentum. Sometimes a stock is falling simply because investors are taking profits after its outperformance or because a portfolio is changing its risk profile in a volatile market. There are countless reasons why share prices move.

Last year’s narrow market is a case in point. Investors might assume that the underperformance of a large swath of the U.S. stock market means that most companies are in bad shape. There is, however, another plausible interpretation: It could also mean that there are a lot of buying opportunities in undervalued companies, ones that have a much better business than is widely believed.

In other words, don`t confuse price momentum with fundamental momentum. So what’s the trend in macro and fundamental momentum?

Oh PUH-LEEZ! How real does the latest growth scare look to you?
 

 

The latest update from New Deal democrat, who keeps an eye on high frequency economic releases, shows an economy that is recovering from the mild industrial recession in Q4 and Q1:

The has been a broad improvement to neutral or outright positive among a number of a variety of indicators in the last month or so. The negatives are reduced to rail, Harpex, and bank lending rates, with even staffing turning less negative – and staffing is coming up to an important negative inflection point from late last May.

A report from Gavyn Davies indicated that his nowcasts of global economic growth remains healthy.
 

 

Davies went on to state that their nowcasts show that global growth is recovering, with Japan and UK being the weak spots:

In the last edition of our monthly report card on Fulcrum’s global nowcasts, we commented that economic activity had turned a corner in the US and China, but this was offset by continued weakness in several key economies, including Japan and the UK. A similar pattern is apparent in this month’s nowcasts. Global recession risks, which seemed elevated in January and February, have now receded, but the world economy is far from robust.

We therefore leave the overall verdict unchanged from last month: global activity growth is somewhat better, especially in the emerging economies, but it is still a long way from being satisfactory.

What about China, whose April PMI readings missed expectations and spooked markets?

In China, the recovery in the mini-cycle is alive and well, despite a slightly weaker PMI in April. A sharp easing in fiscal and monetary policy has resulted in an early rebound in activity, as it has done many times in the past. Activity growth is now well above the official target at 7.5 per cent, but this is based on a renewed rise in leverage in the public and private sectors, and a further delay in the rebalancing of the economy away from reliance on excessive investment spending.

In other words, China’s economy faces many challenges and things may not end well, but a hard landing is not imminent.

Forward EPS still rising

The work by ECRI, New Deal democrat and Gavyn Davies form a top-down perspective of the global economy. The bottom-up view from John Butters of Factset shows that forward 12-month EPS is still rising, which is another sign of positive fundamental momentum. With 71% of SPX companies reported, The Q2 Earnings Season interim report card shows that the EPS beat rate at 71%, well above its 5-year average, though the sales beat rate slipped to 53% from 55% last week (chart annotations and weekly changes in forward estimates are mine).
 

 

Another positive sign came in the form of corporate guidance. Bespoke pointed out that the difference between positive and negative company guidance recently turned positive (via Brian Gilmartin). While such a development may be interpreted bullishly as positive fundamental momentum, the downside is this just sets a higher bar for future EPS expectations.
 

 

Technical picture still constructive

The article from AllianceBernstein adheres to a strictly fundamental viewpoint of equity analysis and totally ignores the technical element. There is certainly much to be said for using a multi-faceted approach to market analysis and I don’t discount the technical picture.

So what does the technical picture look like? Let`s consider the internals.

It is always instructive to see how the market reacts to good and bad news. Friday’s Employment Report of 160K jobs fell far short of expectations at 200K, though there were suggestions that the shortfall was weather related. The knee-jerk reaction of the bond market was to take any prospect of a June rate hike off the table.
 

 

For comparison purposes, just look at how far implied probabilities have evolved since May 2:

 

 

Even as short-term interest rates fell in response, I tweeted the unusual reaction of a steepening yield curve. Wait a minute! Why are short yields falling (a logical response to lower expectations of an immediate rate hike) but long rates rising (reflecting expectations of rising growth and inflation)?
 

 

Here is a longer term chart of Treasury yields, the yield curve and the relative performance of deep cyclical sectors like the resource stocks. As the stock market weakened last week, yields fell, the yield curve flattened and cyclical stocks pulled back. On the other hand, the longer term trend of a steepening yield curve and resource stock market leadership remains intact, In short, Mr. Market is still expecting a growth rebound.
 

 

The message from market breadth is telling a similar story of a short-term setback in a longer term uptrend. The chart below shows various flavors of market breadth, namely the SPX Advance-Decline Line (an apples-to-apples analysis of breadth that dispels any discussion about the differences between the more conventional NYSE A-D Line and other indices), % bullish, % above the 50 day moving average (dma) and % above the 200 dma.
 

 

Looking at the different breadth metrics, here is what I found by observing the divergences between the short-term trend, as measured by April support (dotted lines), and longer term trend, as measured by the November highs (solid lines):

  • A-D Line was positive on a short and longer term basis. The A-D Line recently made an all-time high and showed a higher low when SPX pulled back to its April support at about the 2040 level.
  • % bullish had a short-term negative divergence but longer term positive divergence. When the market pulled back, % bullish broke down through its lows in April, but it remains above its November highs.
  • % above 50 dma had a short and longer term negative divergences. This breadth measure deteriorated badly in the latest pullback and remains below the November highs.
  • % above 200 dma had short and longer term positive divergences.
In summary, the longer term breadth indicators are holding above their November highs, but shorter term momentum (% above 50 dma) is weak. I interpret these readings as a correction or consolidation in a longer term uptrend.

Sentiment: A lack of bulls

I have been saying for weeks that sentiment models have been showing a lack of bulls, which is supportive of an intermediate term advance as it is unusual to see such muted sentiment after the rally off the February bottom. Readings this week continue to be neutral to slightly bearish (contrarian bullish). As the chart below shows, Rydex and AAII sentiment surveys remain in neutral, though bullish sentiment has retreated a bit. NAAIM exposure, which measures RIA sentiment, has been the most bullish of the bunch but pulled back last week.

 

 

The chart below depicts the 10 day exponential moving average of the CBOE equity only put/call ratio. With the exception of the market downdraft last November, readings at past current levels have seen limited downside risk.
 

 

In addition, Mark Hulbert pointed out that NASDAQ timers are throwing the towel, which is also contrarian bullish. However, NASDAQ timer sentiment has not fallen to capitulation levels, which may indicate further near-term choppiness ahead.

 

 

The week ahead

In my last mid-week market update, I highlighted seasonality analysis from Rob Hanna indicating that the days following the first day of May tended to be weak and the historical pattern suggested that the market would bottom out Friday (see What’s the pain trade?). That script has been largely correct as the market made a closing low Thursday and recovered Friday, though it is unclear whether that will be a durable low.

 

 

My base case scenario continues to be a market experiencing a corrective episode in an intermediate term uptrend. The SPX topped out on April 20 at 2102 and has retreated about 2.5%. The pullback has been relatively shallow and the bears were showing signs of exhaustion late last week.

I tweeted the following chart last Thursday, indicating that the market was starting to see oversold conditions, in the form of the VIX Index testing its upper Bollinger Band, and nearby SPX support at the 50 dma at around 2040. Just get oversold, test support and get it over with!

 

 

This chart from IndexIndicators shows that stocks may be about to undergo an oversold rebound.
 

 

Life (and trading) is never that easy. One of the key tests will come next week, as any rally will define the relative strength of the bulls and the bears. If the bears are truly exhausted, we will see a V-shaped recovery to test the old highs. If the growth scare continues, we may see a up-and-down trading range for the next few weeks. With readings looking oversold, downside risk is likely to be low from current levels, but the market may need a final flush and capitulation before the current corrective episode is over.

The hourly SPX chart shows a falling trend line with resistance at 2075-2080. While this scenario is highly speculative, a head and shoulders pattern may be forming and a bear case would see the market break support with a measured downside target of 1970-1980, but a good chartist knows that these formations are not confirmed until the neckline shows a definitive break.
 

 

My inner investor remains bullish, with an overweight position in the resource stocks. He is getting ready to buy should the growth scare get worse.

My inner trader is also long equities, with a stop loss just under the 50 dma (on a closing basis). He has an open mind and he is watching the character of the market should it rebound next week.

Disclosure: Long SPXL

What’s the pain trade?

Posted by Cam Hui -

Mid-week market update: In the short run, the SPX has pulled back and appear to be about to test its 50 day moving average (dma) at 2040, while experiencing a positive divergence on RSI-5.
 

 

The SPX saw a Golden Cross last week – and the right way to trade these signals is to use the faster moving average as a trailing stop. Until the 50 dma is breached in a definitive way, my inclination is to give the bull case the benefit of the doubt.

In addition, the charts below show that the growth recovery theme is intact. The top panel shows that the yield curve (green line) is steepening, which is an indication that the bond market expects better growth and higher inflation. In addition, the relative performance of the financial sector, which is highly correlated to the shape of the yield curve, confirms that expectation. As well, the relative performance of the cyclically sensitive energy and mining stocks also point to a cyclical turnaround.
 

 

Finding the pain trade

In the current environment, positioning is an important consideration for near-term returns. Steve Cohen recently attributed the February selloff to crowding by hedge funds:

Billionaire investor Steven Cohen said that too many hedge funds placing the same types of bets contributed to sharp losses for his $11 billion Point72 Asset Management earlier this year.

“One of my biggest worries is that there are so many players out there trying to do similar strategies,” Cohen said Monday, speaking at the Milken Institute Global Conference in Los Angeles.

“If one of these highly levered players had a rough run and took down risk, would we be collateral damage?” Cohen said. “In February we drew down 8 percent which for us is a lot. My worst fears were realized.”

So what`s the pain trade here? After such a dramatic recovery in stock prices, shouldn’t sentiment be more euphoric?

Consider how the latest AAII sentiment survey showed a retreat by the bulls from very low levels (via Bespoke):
 

 

…and the bears coming out of the woodwork:
 

 

Can someone please explain to me why the TickerSense Blogger Poll is showing more bears than bulls after a huge market rally?
 

 

 

Fund flows data confirms the level of market cautiousness, as investors have been abandoning equities.
 

 

The level of bearishness may be reaching a crescendo. Barron`s reported that option players are making a massive “Sell in May” bet by buying VIX calls and hedging them out with long call positions in the SP 500 Index. Is this an example of a Steve Cohen style levered trade?

For a different perspective, Josh Brown recently pointed out that that low-volatility ETFs have been receiving the lion’s share of fund flows. In effect, market participants have been getting “chicken long” the stock market – buying in, but hedging their bets in a defensive fashion. The chart below shows how the low-vol ETF (USMV, green line) has outperformed SPY (red line). Cautiousness is the now new crowded trade. That’s where the pain trade is likely to be when it reverses.

 

Downside risks

To be sure, the bulls face a number of risks:

  • A more hawkish Fed: Bloomberg reported that Atlanta Fed President Dennis Lockhart and San Francisco Fed President John Williams both indicated that the June meeting remains “live” for a rate hike. In a separate report, Lockhart toned down his hawkishness by stating that the Brexit vote, which occurs after the June FOMC meeting, “looms large”. If the Fed is intent on signaling that they are likely to raise in June, watch for more hawkish Fedspeak in order to “correct” the market’s perception.
  • A growth scare: Bloomberg reported that global PMIs are stalling, which may spook the markets. However, New Deal democrat recently concluded that the shallow industrial recession is ending. Similarly, the nowcast analysis from Gavyn Davies came to a similar conclusion about the US economy. However, we may have to wait a few more weeks for more definitive signs of a turnaround.
  • Presidential campaign mudslinging: Now that it appears that the presidential election will be a Trump vs. Clinton contest, prepare for lots of mudslinging, which could have unknown effects on market psychology.
Rob Hanna recently highlighted a seasonal pattern showing that the days after the first trading day of May tend to be weak and the market may be following that pattern right now. If history is any guide, the current episode of weakness will reach its nadir on Friday.
 

 

Until I see greater confirmation that the bears have seized control of the tape, such as a definitive break below the 50 dma, my base case scenario is that the US equity market is seeing a pullback in the context of an intermediate term uptrend. I am inclined to agree with the assessment of Jeff deGraaf that you shouldn’t be shorting this market, at least for now.

Disclosure: Long SPXL

Will an oil spike kill the market bull?

Posted by Cam Hui -

I recently wrote about my scenario for a market top in 2016 (see My roadmap for 2016 and beyond), which goes something like this:

  1. Unemployment is now at 5.0%, which is a point at which the economy historically started to experience cost-push inflation.
  2. Inflation edges up, which is already being seen in commodity prices.
  3. Initially, the Fed is content to let inflation run a little “hot” because of what it perceives to be slack in the labor market, but as inflation and inflationary expectations tick up…
  4. The Fed finds that it is behind the curve and responds with a series of rapid rate hikes.
  5. The economy slows and goes into recession.
  6. Stock prices fall as the probability of a recession spikes and a bear market begins.
The biggest variable is timing. I believe that we are roughly at phase 2 of this process. Despite the possibility of a market top on the horizon, it is too early for investors to get overly defensive right now. There is still money to be made as growth expectations ramp up (see How the SP 500 could get to 2400 this year).
Then I came upon a note from a reader, who used a rule-of-thumb of an 80% run-up in oil prices as a precursor signal to a recession and bear market. 80%??? Crude oil bottomed in February at about $27 and we are nearly there! (He later amended that comment to an 80% year-over-year change in oil prices.)
The discussion led me to the work of James Hamilton, who showed that oil shocks have tended to precede economic recessions. If that is indeed the case, then how far is the American economy from a recession now that oil prices have spiked?

It’s not oil, it’s the Fed

This is a case of correlation does not equal causation. The framework of that question is actually incorrect. It isn’t rising oil prices that cause recessions, it’s the Fed’s response to rising oil and other commodity prices that slow the economy.

The chart below shows the relationship between industrial commodity prices (blue line) and the Fed Funds rate (black line). In each of the recessionary episodes, we have seen Fed Funds rise in response to signals of rising inflationary pressures from higher commodity prices.
 

 

With commodity prices still falling on a YoY basis, it is far too early for the Fed to be overly hawkish about its interest rate normalization policy. But that begs the question, “When will the Fed become more aggressive in raising interest rates?”

Consider the chart of the CRB Index below. Assuming that commodity prices rise modestly by Q4, the CRB will be positive on a YoY basis by then. How far does it have to rise before the Fed turns decidedly hawkish?
 

 

Commodity prices, and oil prices in particular, may rally more than anyone expects. Bloomberg recently highlighted research from Rystad Energy, the Norwegian energy consultancy, indicating that oil supply and demand is coming into greater balance. The market may be in for a shock later this year as all the extra oil in storage recedes.
 

 

Monitoring Fedspeak for clues

We return to the key question of Fed interest rate policy. I interpreted the April FOMC statement as the Fed’s attempt to tell the market that the June meeting is “live”, though data dependent. But the Yellen Fed’s communication policy is to avoid surprising the markets and the markets shrugged off the April statement and the market implied probability of a June hike barely budged.

Tim Duy thinks that the Fed is about to become more hawkish:

They can change their story within the scope of six weeks. Just like they did from the December to January meetings. And they have the one good reason to change the story: The dramatically change in financial market conditions.

The tightening in financial markets during the winter was the proximate cause of a more cautious Fed. The data didn’t help, to be sure, but more on that later. The combination of a surging dollar, collapsing oil, and a stock market headed only south signaled that the Fed’s policy stance has turned too hawkish, too fast. The Fed relented and heeded the market’s warnings.

But things are different now. US stock market rebounded. The dollar is languishing. And oil is holding its gains, despite disappointment with the lack of an output agreement.

This improvement will not go unnoticed on Constitution Ave. Even among the doves.

We shall see. I will be waiting and watching the tone of the Fedspeak in the days and weeks to come, starting with the Atlanta Fed conference on market liquidity this week.

My base case scenario calls for the Fed to get serious about tightening monetary policy late this year as the commodity prices start to pressure monetary policy. At that point, watch for the narrative to change to “the Fed is behind the curve”.

On the other hand, the turning point could come soon, or later. My inner investor is watching developments and keeping an open mind.

Don’t go away in May

Posted by Cam Hui -

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

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

My inner trader uses the trading component of the Trend Model 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 latest signals of each model are as follows:

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

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

Strong momentum = Bullish

Call it what you want: momentum, broad based breadth, price trend. Despite the short-term consolidation shown by the stock market, the signs of positive momentum make it difficult to be intermediate term bearish.

I can see it in the trading signals of my Trend Model, which turned bullish soon after the February bottom. The prolonged length of the signal is indications of momentum, trend and powerful breadth thrust.
 

 

It is also manifested in broad based breadth participation. The chart below shows upside breakouts to all-time highs by different flavors of the Advance-Decline Line. In addition, the % of stocks above their 200 day moving average (dma) has strengthened out of a downtrend, which is another indication of breadth improvement.
 

 

Strong breadth readings have been a characteristic of the rally off the February bottom. Dana Lyons observed that the stock market experienced a strong positive breadth day last Tuesday but without any significant overall advance. Such episodes have seen further gains in the past, though the sample size is a bit small to make definitive conclusions.
 

 

The surge in stock prices has been persistent enough to manifested itself in a Golden Cross, where the SPX 50 dma has crossed above the 200 dma from below. As an avid user of trend following models, I believe that most of the public interpret golden crosses and its inverse dark crosses incorrectly. The cross shows the trend, which in this case is bullish. What many traders is they failed to use the shorter and faster moving average as a trailing stop to manage risk. Regardless, here is the BoAML on the better than average historical returns that occur after a Golden Cross.
 

 

Nautilus Research also pointed out that the market recently experienced a 50-day price surge and those episodes have led to better returns in the past.
 

 

As well, I wrote last week about the broad based signs of rising risk appetite globally and across different asset classes (see How the SP 500 could get to 2400 this year). In short, we are seeing a broad based surge in asset prices across the board that is difficult to ignore.

Improving growth outlook

In addition to technical momentum, I am also seeing signs of better fundamental momentum in the form of a better growth outlook. Notwithstanding the disappointment exhibited by large cap technology stocks like AAPL last week, the interim report card for the current Earnings Season is coming in with a solid passing grade. The latest update from John Butters of Factset shows an EPS beat rate of 74%, which is well above the historical average, and a sales beat rate of 55%, which is roughly in line with history. Equally important to the growth narrative has been the evolution of forward EPS, which continues to recover after the growth scare earlier this year (annotations in chart are mine).
 

 

When analyzing earnings estimates, I prefer to use a continuously rolling forward 12 month EPS metric because analysts have shown a tendency to be overly optimistic in their estimates, which drop over time. The forward 12 month normalization process corrects for the downward revision bias. Even if we were to use just quarterly estimates as a metric, John Butters showed that their decline pattern so far has been “less bad” as they dropped 1.8%, which is better than the 5-year average of 2.2% and 10-year average of 2.3%:

During the month of April, analysts lowered earnings estimates for companies in the SP 500 for the quarter. The Q2 bottom-up EPS estimate (which is an aggregation of the EPS estimates for all the companies in the index) dropped by 1.8% (to $28.90 from $29.43) during this period. How significant is a 1.8% decline in the bottom-up EPS estimate during the first month of a quarter? How does this decrease compare to recent quarters?

During the past year (4 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.8%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.2%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first month of a quarter has been 2.3%. Thus, the decline in the bottom-up EPS estimate recorded during the first month of the second quarter was smaller than the 1-year, 5-year, and 10-year averages.

Viewed through this lens, the results this Earnings Season are not awful. In fact, they have been pretty good.

The verdict from the bond market

I wrote last week about how to interpret the FOMC statement (see What happens if the Fed gets less dovish?). One of the key indicators that I said to watch was the shape of the yield cuve. As the chart below shows, the 2-30 year curve wobbled a bit after the FOMC meeting, but the steepening trend continued. In effect, the bond market is in effect expecting higher economic growth and rising inflation.
 

 

I am no permabull, but it`s hard to get overly bearish in the face of this combination of improving breadth, momentum, golden crosses and better growth outlook. This is not a freight train that I want to stand in front of.

Skeptical sentiment

It would be easier for me to get more cautious about the stock market if sentiment models showed that traders and investors weren’t so skeptical about this rally. Normally, you expect that sentiment would get absolutely euphoric after a 15% surge in stock prices. Instead, the latest reading from AAII and Rydex show that sentiment is still stuck in neutral.
 

 

In fact, Bespoke highlighted that the percentage of AAII bulls edged down this week:
 

 

…and AAII bears ticked up:
 

 

Skepticism is evident not only for individual investors, but institutions as well. I pointed out last week that surveys show that both global institutional investors (BoAML Fund Manager Survey) and US institutions (Barron’s Big Money Poll) show that fund behemoths are cautious and under-invested in US equities (see How the SP 500 could get to 2400 this year). The only group that has embraced this rally are the RIAs, as measured by the NAAIM survey.

This equity rally is by no means hated, but there is a high degree of disbelief in the face of a breadth and momentum surge. These readings are setting the stage for a Fear of Missing Out rally should price and fundamental momentum continue upwards, especially if the SPX were to break out to new all-time highs, which isn’t that far away from current levels.

Sell in May seasonality

What about the well-known “Sell in May and go away” negative seasonality for stock prices over the next six months? Should that be ignored?

While I do pay attention to seasonal patterns, current conditions are far more important than the historical pattern. Urban Carmel recently wrote a post (see Sell in May and buy back higher in November) that put the “Sell in May” returns into context. As the table below shows, the May-November has shown an weaker than usual average return, but the spread in median returns between summer and winter weren’t that far off. Further analysis showed that average returns were pulled down by a greater downside volatility during the May-November period.
 

 

While returns over the next six months may have been subpar, they were nevertheless positive.
 

 

So do you want to sell in May and buy back higher in November?

The week ahead

The equity bull case I have outlined so far is an intermediate term outlook. There is no assurances that stock prices must go up next week. In fact, the market is facing an important short run technical test for bulls and bears alike.

The weakness late last week has left the market mildly oversold. We can see that using these charts from IndexIndicators. Based on % of stocks above their 10 dma, the market has retreated to levels where it has bounced in the past.
 

 

Similarly, net 20-day highs-lows breadth has retreated to levels where the decline was arrested in the current rally episode.
 

 

Looking over a 1-3 day horizon, the 5-day RSI has dipped into oversold territory. Moreover, the VIX Index tested its upper Bollinger Band, which is another oversold indicator. VIX tests of the upper BB have been periods where downside risk has limited in the past year, with two exceptions. These two exceptions appeared in the August 2015 and January 2016 declines. In other words, oversold markets can get more oversold.