Explaining the lack of capitulation (and what it means)

Posted by Cam Hui -

Dana Lyons recently wrote a terrific piece about the level of complacency in the current bout of stock market weakness. The SPX had fallen over 9% in two weeks, but the VIX Index was barely challenging its December highs and it was nowhere near the highs set during the August/September selloff.

 

He found that past instances of where the market fell a lot but the VIX did not respond in a corresponding fashion foreshadowed further stock market weakness.

 

Where is the wash-out?

I had also been concerned about the apparent lack of panic during the latest market slide. My Trifecta Bottom Model, which was first described here, uses three somewhat uncorrelated components to spot short-term market bottoms:

  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 Trifecta Bottom Model has been uncanny in spotting bottoms in the last three years. The chart below shows the record of this model in the last year, where the blue vertical lines indicate that two of the three components have been triggered (Exacta signal) and the red line indicates that all three were triggered. All marked short-term bottoms. The latest bout of stock market weakness saw TRIN hit a high of 1.97 (not quite 2.0) and the OBOS reach a low of 0.52 (not quite 0.5). Are these readings close enough to trigger a buy signal?

 

 

The answer is a qualified yes.
Nevertheless, I am highly concerned that TRIN never moved above 2.0. To explain the math in a simple way, TRIN is calculated by dividing the advance/decline volume by the advance/decline ratio. Imagine a day where declining stocks outnumbered advancing stocks by 2 to 1 and declining volume outnumbered advancing volume by 2 to 1. In that case, TRIN would be 1. Now imagine a case where the advance-decline stock ratio was the same, but the declining volume to advancing volume was 4 to 1, which results in a TRIN of 2. This would mean that there was much more down volume than up volume than what would be normally expected – a sign of capitulation, or wash-out
Past market bottoms have seen this kind of wash-out, which is typified by price insensitive selling by margin clerks and risk managers. We have barely seen this kind of behavior during the current sell-off, which is somewhat disturbing.

A volatility mystery

However, the lack of capitulative sell-off can be explained by the behavior of volatility. As all good traders know, the VIX Index is a measure of implied option volatility of stock prices. The higher the index, the higher the perceived volatility. But as this chart from ivolatility.com shows, implied volatility has tracked historical volatility very well. The reason why VIX hasnt spike higher is because historical volatility is lower than it was during the August-September selloff.

 

 

More importantly, historical volatility is a key input into the Value-at-Risk, or VaR, models used by risk managers. Imagine that you are a risk manager, or the manager in charge of a trading desk. You use metrics like VaR as a tool to properly size the capital commitment of your trading book. Since volatility, or vol, is a key input, too much noise in vol will cause your book to expand and shrink at a rapid pace. What you need is a relatively stable vol estimate.
The chart below shows the evolution of rolling realized historical one-month and one-year volatility. As you can see, monthly realized vol is far too noisy to be useful as an input into a VaR model, but the one-year vol is relatively stable. As I understand it, most desks uses one-year rolling vol the input to their baseline VaR risk estimates.

 

 

You will also notice that the one-year rolling vol spiked during the August selloff and then flattened out. This means that Value-at-Risk estimates did not change very much during the latest stock slide. Hence, there was no need for risk managers to order traders to reduce their position sizes, which would have triggered a price insensitive selloff that drives TRIN above 2.
In effect, the hedge funds and trading desks were not forced to sell by their risk control discipline. I know that I’ll get lots of comments from the last sentence, but don’t forget that most trading desks are hedged in some fashion with long and short positions. Higher VaR estimates (from higher realized vol estimates) would require them to shrink both sides of their book.
To make a long story short, flat historical vol estimates meant that trading desks did not have to sell. Therefore there was no price insensitive capitulative selling.
What does this mean near-term for stock prices? I am not sure. Readings from the Trifecta Bottom Model got close enough to trigger a buy signal, so I am giving the bull case the benefit of the doubt. However, I would not characterize this signal as unabashedly bullish and I will be carefully watching the quality and breadth of the advance, should it continue.

Where my inner investor is bottom fishing

Posted by Cam Hui -

I thought that, as a change of pace, I would write about where my inner investor is finding opportunities, instead of focusing on the daily gyrations of the stock market and whether it has found a short-term bottom, which is a topic I will cover in a post this weekend.

The art of bottom fishing requires a strong constitution, which is suitable for people like my inner investor who has a longer time horizon. You have to go into the exercise thinking that you don’t care that you catch the exact bottom, but with a mindset that Mr. Market has put a sale price on an investment. You may buy X at $10, see it fall to $7, but be ultimately rewarded in several years when it rises to $20, $30 or $40 (note that these are just examples and not return forecasts).

With that framework in mind, here are a couple of opportunities identified by my inner investor.

 

Value stocks

Jim Paulsen at Wells Capital Management recently wrote a terrific article about the valuation differences between the high momentum stocks (top quintile of rolling 12 month return) vs. the low momentum stocks (bottom quintile). He called these groups Popularity and Disappointment. The chart below shows the P/E ratios of the two groups, whose spread is getting a bit stretched.

 

The chart below shows the relative P/E of the Popularity vs. Disappointment (solid line) with the SPX (dotted line).

I make the following two observations based on the above chart:

  • The relative P/E ratio is nearing levels where it has reversed in the past; and
  • Reversals in relative P/E ratios have either been associated with bear markets or changes in market leadership, which usually occurs during transitions between bull and bear markets.
I am on record as believing that the bull market isn’t over, but it is in the process of topping out (see The road to a 2016 market top). The second alternative of a simple leadership change is therefore my base case scenario. Incidentally, analysis from JP Morgan (via Business Insider) shows that, despite all of angst over the narrowness of the leadership of FANG stocks (Facebook, Amazon, Netflix, Google), market leadership is by no means dangerously narrow by historical standards.

 

 

Jim Paulsen went on to show that the unloved “Disappointment” portfolio was overweight in Energy, Industrials, Telecom and Utilities, which is consistent with my view that the US economy is undergoing a late cycle expansion.

 

 

The way my inner investor is choosing to play this theme is to buy into value stocks. If you are going to play value, then why not go with the Oracle himself and buy Berkshire Hathaway (BRKb)?  I have written before about BRKb has shown only so-so performance in the last few years and underperformed the market in 2015 (see Is Warren Buffett losing his touch?). The chart below shows the relative performance of BRKb against the market. As the chart shows, BRKb is seeing a minor revival in relative performance, which indicates that 2016 may mark the start of a new Renaissance in value investing.

 

 

Energy stocks

Within the most unloved and washed out parts of the stock market, energy stocks are a stand out. Sure, the supply-demand fundamentals of oil look awful and it seems that every day, analysts are scrambling all over themselves to downgrade their oil forecasts. Here are just a few examples:
  • Citigroup (Ed Morse): Oil could drop as low as $20 (via Bloomberg)
  • Standard Chartered: Oil could hit $10 (via The Telegraph)
  • Dennis Gartman: Oil could sink as low a $15 in a panic (via CNBC)
Then you have this Andrew Thrasher tweet, which is reflective of the washed-out sentiment.

 

 

On the other hand, there are a number of bullish signs for the energy sector. From a technical perspective, the recent action oil prices is constructive as it is experiencing a positive RSI divergence.

 

 

Scott Grannis pointed out that oil prices are extremely cheap when compared to gold. If I am correct about the late cycle expansion, then cost-push inflationary pressures will start to rise and begin to lift the entire commodity complex. The most oversold major commodity in the complex is energy.

 

 

Trying to value energy stocks is tricky at this point, because the E in the P/E ratio is volatile and fading fast. An alternative technique is to consider the P/B ratio, as book value is more constant and useful for valuing integrated oil companies. As Lawrence McDonald pointed out, the sector is cheap on a P/B basis.

 

 

From a tactical viewpoint, I have no idea if the decline stops at $30, $20 or $10. Valuations are sufficiently cheap and the risk-reward ratio is sufficiently attractive for my inner investor to go bottom fishing in the sector. My main focus in the large integrated oil companies that are well-capitalized enough to survive a downturn in oil prices.
My choice in this sector is Suncor, largely because of my inner investor`s innate laziness and the Suncor position in the Berkshire Hathaway portfolio as a signal of its value (see The right way to ride Warren Buffett`s coattails). However, virtually any well-capitalized large cap integrated energy company is probably suitable as a vehicle and so is a well-diversified ETF like XLE.
In effect, my inner investor is make a double bet on Berkshire Hathaway. For someone with a long term time horizon, that`s probably not a bad position to take.

 

Disclosure: Long BRKb, SU

A modest proposal for the PBoC

Posted by Cam Hui -

The specter of currency wars and competitive devaluation is in the air. Evan Soltas recently penned a post at FT Alphaville addressing the issue of how petrostates can solve their fiscal woes. The answer was either fiscal austerity or devaluation. The Telegraph reported that the World Bank was urging Saudi Arabia to use its currency reserves to defend the USD-riyal peg and resist the siren song of devaluation.

 

The Chinese elephant in the room

The elephant in the room of competitive devaluation is China. With the latest release of China PMI is looking a bit on the weak side, another round of stimulus would not be surprising at all.

As Sober Look pointed out, there is room for the PBoC to ease monetary policy:

If the Chinese central bank were to undertake any steps to stimulate the economy, however, it would have the effect of putting downward pressure on its currency, which could stoke fears of a currency war. Business Insider reports that Charlene Chu of Autonomous Research has suggested that China needs as much as USD 5 trillion in credit injections in order to have a similar effect as the shock-and-awe campaign of 2009. If Beijing were pursue that course of action, I have a modest proposal for the PBoC.

Hire Ben Bernanke.

Bernanke recently wrote a blog post addressing criticism that the Federal Reserve started a currency war during his tenure as Fed Chair:

A “currency war” (also known as competitive depreciation or a “beggar-thy-neighbor” policy) occurs when a country eases monetary policy specifically to depreciate its currency, with the ultimate objective of cheapening its exports and gaining unfair competitive advantage in international trade. (My discussion here applies only to exchange-rate changes linked to monetary policy. Gaining trade advantage through trade barriers like tariffs or through intervention in foreign exchange markets raises quite different issues.) When a currency war is prosecuted, exporters in other countries may complain that they are being undercut, and foreign policymakers may object to what looks like a diversion of demand away from their own economies, possibly leading to increased unemployment.

After going through various analytical exercises, Bernanke concluded that the Fed was just trying to stimulate the American economy and the purpose of its policies wasn’t to start a currency war:

Overall, I find little support for the claims that the Fed has engaged in currency wars. Although the Fed’s monetary policies of recent years likely put downward pressure on the dollar, the effect of the weaker dollar on U.S. net exports was largely offset by the effects of higher U.S. incomes on Americans’ demand for imported goods and services. Indeed, recent years have seen neither an increase in U.S. net exports nor any sustained depreciation of the dollar.

This is precisely the sort of rhetoric that central bankers use when they engage in monetary stimulus. Now that the Chinese have a favorable (conditional) response from the IMF about the inclusion of the yuan in the Special Drawing Rights (SDR) basket, otherwise known as the “Big Boys Club”, the PBoC can use the same kind of language to justify its monetary stimulus.

In that case, why not hire the best? Engage Ben Bernanke as a “special advisor” on monetary policy? With Bernanke at its side, Beijing would gain the kind of political cover it needs with the likes of the US Congress and the IMF to deflect criticism of engaging in a currency war, or deliberate devaluation.

Beijing has shown a stop-start pattern of reform and stimulus over the last few years. Another round is stimulus is due. So why not just hire Bernanke now for political cover? It will be money well spent.

 

Why this is a correction and not a bear market

Posted by Cam Hui -

Trend Model signal summary
Trend Model signal: Risk-off (downgrade)
Trading model: Bearish

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.

A glass half-full, or half-empty?

Wow! I realize that when I tactically turned negative on stocks last week, this kind of downdraft would happen (see The road to a 2016 market top). Regardless, David Rosenberg had an excellent piece of advice with his “Breakfast with Dave” last week for investors (for traders, it’s another story):

I have three pieces of advice of my own to all the nervous nellies out there, not to mention the nattering nabobs of negativity, turn off the television, focus on the big picture, and review your asset mix.

I agree. During these times of market turmoil, I ask myself if any of the following triggers for a bear market are in place:
  1. Are we facing a war or revolution that will cause the permanent impairment of capital (e.g. Russian revolution, World War II, US Civil War, etc.)?
  2. Is a recession on the horizon?
  3. Is the Fed being overly aggressive and tightening the US economy into a recession?

The answer to the first question is obviously no.

I also see minimal risk of a US recession (see my Recession Watch page). Using the framework used by New Deal democrat’s approach of adopting the Geoffrey Moore long leading indicators, recession risk is low. As well, Georg Vrba`s work also comes to a similar conclusion.

As for the third question, the Fed is just starting a tightening cycle and they have made it clear that they plan on being slow and gradual. Moreover, various Federal Reserve officials have indicated that they are tolerant of inflation being slightly over target in order to bring the economy back to full employment. So the Fed can hardly be characterized as being aggressive.

In short, the triggers for a bear market are not there. But what`s spooking the markets? I can summarize the worries as:

  • Geopolitics: The North Korean H-bomb test and rising tensions between Saudi Arabia and Iran;
  • China; and
  • Slowing growth.
I will address each of these issues one at a time, based on a bull vs. bear, or glass half-full or half-empty framework. Finally, I will touch on the market outlook in a more tactical fashion, based on the readings from sentiment models and technical analysis.

 

North Korea

The North Korean H-bomb test was, at best, a one-day wonder for global markets. Seismic analysis indicates that it probably wasn’t even a full H-bomb. A full H-bomb test would have generated a more powerful earthquake (via the BBC):

 

 

In any event, we have to ask ourselves about the market implications of this event. North Korea is a rounding error in the size of the global economy. Even if North Korea had developed a H-bomb, would their soldiers flood south over the DMZ? Are they going to nuke Seoul or bombard it with artillery? If not, why should the markets care?

 

Saudi Arabia-Iran

The world was jolted last week by the Saudi decision to execute a Shiite cleric. The ensuing protests, in both KSA and Iran, reverberated throughout the region.  As a consequence, Saudi Arabia broke off diplomatic relations and trade ties with Iran and a number of her other Gulf State allies also downgraded relations with Tehran too.
For the markets, these kinds of regional tensions are a concern and undoubtedly raise the risk premium on asset prices. On the other hand, oil prices spiked for one whole day and fell back. If the oil market doesn’t view this as significant, should you?

China

The biggest scary headlines for the markets last week came from China. But Cullen Roche put the concerns over China into context. Firstly, the Chinese stock market is a big casino dominated by small uninformed retail punters. Moreover, its movements are not very correlated with the US equity prices.

Chinese GDP growth rates are not correlated with US stock prices either.

The biggest worries are stem from Beijing initiating a program of competitive devaluation, to the detriment of her Asian trading partners, or if the Chinese economy unravels into a hard landing.

First, while it is true that the offshore yuan (CNHUSD) exchange rate spread against the onshore yuan (CNYUSD) has widened considerably, which is pressuring CNY downwards and thus the risk of whole devaluation is rising, that may be the wrong perspective to take. Menzie Chinn at Econbrowser pointed out that the trade weight yuan has actually been appreciating over the past year so a downward adjustment is not unwarranted at all.

As for the concerns over a slowing Chinese economy, it is difficult to see that Beijing would stand idly by and watch the Chinese economy crater into a hard landing when the PBoC has a lot of ammunition left in its monetary holster. Interest rates are nowhere near zero bound and the reserve ratio (RRR) is still high at 17.5%. If push came to shove, the PBoC also has the option of engaging in quantitative easing (QE).

If the PBoC were to engage in shock-and-awe scale monetary stimulus, however, it would put downward pressure on the yuan, everything else being equal. But everything else isn’t equal, because this kind of policy action would be positive for the growth outlook and therefore yuan bullish.

So is the glass half full or half empty?

Weak growth

The last major worry that seems to be bothering the markets is the prospect of slowing growth. The Atlanta Fed GDPNow nowcast of Q4 growth has fallen to 0.8%.

Much of the slowdown has been driven by weakness in manufacturing, as exemplified by the weak ISM Manufacturing release. However, Charlie Bilello pointed out that ISM Manufacturing has had a spotty record of forecasting recessions in the past (also see these comments from David Rosenberg).

My own analysis found that the USD is inversely correlated with ISM (note ISM is shown in an inverted scale in the chart below).

So we are back to the story of a strengthening USD holding back the US economic and profit growth outlook again. Indeed, the latest update from John Butters of Factset shows that forward EPS revisions have been roughly flat in the last few weeks. In short, that may be the main reason spooking stock prices.

There are a number of reasons to be more optimistic in the next few months. The Dollar is starting to weaken as growth differentials narrow. China is undoubtedly poised to unleash another round of stimulus, which should boost growth rates. The outlook for European growth is also getting better. Eurozone unemployment and confidence have improved to 2011 levels…

and PMIs have been rising as well.

In his weekly monitor of high frequency US economic releases, New Deal democrat is starting to discern an inflection point in growth rates:

The bad news is, the downturn in coincident data is now so drastic that I suspect we are going to get a negative GDP print either for Q4 2015 or Q1 2016. Meanwhile, there are some interesting things happening at the margins of the data. My suspicion is that we are getting close to the longer term bottom in the commodity collapse, and it is interesting that aside from oil, industrial commodities did not make a new low this week. The decline in wholesale inventories is the first sign that a liquidation may be beginning (one reason why I think we may get a negative GDP print). The further big pulse down in rail transport may also be a sign of a beginning of inventory liquidation via a big downturn in new orders (also shown in the ISM manufacturing release). Tax withholding for December wobbled a little bit, and YoY Real M1 decelerated to a new 5 year low. On the other hand, lower mortgage rates will give a little boost to the housing market. I still see this as a global trade driven inventory correction rather than the onset of a recession. Housing permits and Q4 residential investment will be particularly important when they are released later this month.

Putting this all together, I interpret the current stock market environment as corrective and not the start of a major bear market. Corrections happen all the time. Investors shouldn’t be overly worried.

Technically cautious

For traders, it’s a entirely different ball game. I wrote on Monday that while the stock market appeared to be oversold, I expected further downside for the week (see Oversold, but…). What I didn’t expect was the magnitude of the downdraft. On Thursday, I fretted that while short-term indicators were at oversold extremes indicating a bounce was at hand, but I was concerned that signs of fear and capitulation were not fully evident. I concluded that any rally would likely be short-lived (see A tradeable bottom?).

Mark Hulbert came to a similar conclusion. There just isn’t enough fear out there.

Brett Steenbarger also observed that his cycle indicators are not yet at levels seen at intermediate term bottoms yet.

I don’t mean to imply that everything looks bearish as there are some constructive signs for stocks. As an example, the relative performance of junk bonds is actually doing much better an tracing out a positive divergence against stock prices.

As well, the CNN Money Fear and Greed Index is nearing the top of its capitulation zone where durable bottoms have been found in the past.

Based on these readings, two scenarios are in play next week. The stock market could either sell off further into a capitulative sell-off, or the market could stage an oversold rally. The first scenario would represent a durable intermediate term bottom. On the other hand, an oversold rally next week would likely set the stage for a weak rebound, with further weakness into a final panic bottom some time in the near future.

My inner investor remains invested in equities, with a tilt toward natural resource sectors. My inner trader got (painfully) caught long last week. He is waiting to see how the market develops next week. If it does rally, he will be fading strength. On the other hand, he will see further weakness as an opportunity to do some bottom fishing, especially if sentiment readings reach a crowded short extremes.

Disclosure: Long SPXL TNA

A tradeable bottom?

Posted by Cam Hui -

After the market closed yesterday (Wednesday), I tweeted a series of charts indicating that the market appeared to be oversold, but fear levels weren’t extreme yet:

  1. The market was oversold on % of stocks over the 10 day moving average based on the breadth charts from IndexIndicators;
  2. The market was oversold on net 20 day highs – lows;
  3. The market was showing a positive RSI divergence on the hourly SPX chart; but…
  4. The CBOE equity only put/call ratio was only at average levels, which indicated no signs of fear from the option market; and
  5. My Trifecta Bottom Model was nowhere close to a buy signal (described here), which was another sign of complacency.
I had concluded that a bottom was near, but we may need a further wash-out before a tradeable bottom could be seen. The stock market weakened further on Thursday and a number of fear metrics spiked.
Is the market near a durable bottom?

Extreme oversold readings

It depends on what you mean by “durable” and “tradable”. The market is definitely very oversold and due for a reflex rally. Consider the following breadth metrics from IndexIndicators (red dots are my estimates). Here is the % of stocks above their 10 dma, which is a good overbought/oversold indicator over a 1-3 day time horizon:
Here is the net 20-day highs-lows, which is a OBOS indicator over a 1-2 week horizon:
Other breadth measures, such as the % of stocks with RSI less than 30, is also at an oversold extreme:
The stock market should bounce from here, but how far?

Fear rising, but is it enough?

Rob Hanna at Quantifiable Edges expressed similar concerns as I did about the lack of fear. He wrote this morning that he was also seeing the oversold conditions, but he was concerned that his Capitulative Breadth Index (CBI) was only 0, which is a very low reading. He went on to show statistics for past returns when the market was oversold and CBI was 0. The results suggest a very short-term bounce, followed by more weakness.
If CBI were to rise to the 1-5 range, which indicates a higher level of fear, returns improve. After 20 trading days, the average return is 1.5%, which is reasonable, but not tremendously exciting.
Contrast the above results when the market is oversold and CBI is over 10, where the average 20 day return is over 5%.
I don’t know what goes into CBI are, but I can make an educated guess as to what counts for capitulation. Here is the latest CBOE equity only put/call ratio. Readings are elevated but not extreme.
Here is my Trifecta Bottom Model (for description see Sell Rosh Hashanah?), which has had a remarkable record of spotting bottoms in the last three years (blue lines = 2/3 triggered, red lines = 3/3 triggered). The term structure of the VIX was inverted today. The TRIN Index, which shows capitulative selling when readings spike above 2, closed yesterday (Wednesday) at 1.96. So do current readings count as hitting the exacta? Well, kinda, sorta, but the signal is very marginal.

One constructive sign is the VIX Index spiked today to test its December highs. As well, it also rallied about its Bollinger Band, which is usually a sign that a bottom is near.

What to make of all this? My conclusion is that the market is poised for a relief rally. As the signs of capitulation can only be described as marginal, the rally is likely to be relatively weak and near-term market action choppy. The study from Rob Hanna with CBI at the 1-5 range might be a reasonable expectation of returns over the rest of January.

Revealing the secret behind trend following models

Posted by Cam Hui -

The blogger Jesse Livermore at Philosophical Economics recently wrote another brilliant post about the use of trend following models and market timing. He found that trend following models work very well on diversified stock indices, but didn’t really understand the mechanism of how they worked. As I pride myself on being a left and right brained quant, I am going to try and explain why these classes of models work and why they perform poorly on individual securities.

Here is the summary of Jesse Livermore`s analysis:

In the current piece, I’m going to conduct a comprehensive backtest of three popular trend-following market timing strategies: the moving average strategy, the moving average crossover strategy, and the momentum strategy. These are simple, binary market timing strategies that go long or that go to cash at the close of each month based on the market’s position relative to trend. They produce very similar results, so after reviewing their performances in U.S. data, I’m going to settle on the moving average strategy as a representative strategy to backtest out-of-sample.

The backtest will cover roughly 235 different equity, fixed income, currency, and commodity indices, and roughly 120 different individual large company stocks (e.g., Apple, Berkshire Hathaway, Exxon Mobil, Procter and Gamble, and so on)…

The backtest will reveal an unexpected result: that the strategy works very well on aggregate indices–e.g., the SP 500, the FTSE, the Nikkei, etc.–but works very poorly on individual securities.

He tested Mebane Faber’s moving average strategy, which he called MMA, and found that it worked well by avoiding large losses:

What the table is telling is that the strategy makes the majority of its money by avoiding large, sustained market downturns. To be able to avoid those downturns, it has to accept a large number of small losses associated with switches that prove to be unnecessary. Numerically, more than 75% of all of MMA’s trades turn out to be losing trades. But there’s a significant payout asymmetry to each trade: the average winning trade produces a relative gain of 26.5% on the index, whereas the average losing trade only inflicts a relative loss of -6.0%.

He tested a couple of other strategies, namely crossing moving averages and momentum and found that results were quite similar. The MMA results are summarized below:

 

Here are the maximum drawdowns statistics for MMA:

The missing piece of the puzzle is why these strategies work:

The point I’m trying to make, then, is not that the successful implementation of a strategy necessarily requires a strong analytic understanding of the strategy’s mechanism, but that such an understanding is highly valuable, worth the cost of digging to find it. We should not just cross our fingers and hope that past patterning will repeat itself. We should dig to understand.

In the early 1890s, when the brilliant physicist Oliver Heaviside discovered his operator method for solving differential equations, the mathematics establishment dismissed it, since he couldn’t give an analytic proof for its correctness. All he could do was put it to use in practice, and show that it worked, which was not enough. To his critics, he famously retorted:

“I do not refuse my dinner simply because I do not understand the process of digestion.”

His point is relevant here. The fact that we don’t have a complete analytic understanding of a strategy’s efficacy doesn’t mean that the strategy can’t be put to profitable use. But there’s an important difference between Heaviside’s case and the case of someone who discovers a strategy that succeeds in backtesting for unknown reasons. If you make up a brand new differential equation that meets the necessary structure, an equation that Heaviside has never used his method on, that won’t be an obstacle for him–he will be able to use the method to solve it, right in front of your eyes. Make up another one, he’ll solve that one. And so on. Obviously, the same sort of on-demand demonstration is not possible in the context of a market timing strategy that someone has discovered to work in past data. All that the person can do is point to backtesting in that same stale data, or some other set of data that is likely to have high correlations to it. That doesn’t count for very much, and shouldn’t.

Trend Following Models spot macro trends

In this day and age, investment consultants use a standard 4Ps framework to dig behind investment managers to understand whether a performance record is repeatable, so a response of “I do not refuse my dinner simply because I do not understand the process of digestion” is unlikely to cut it. The 4Ps are:

  1. People: Who are you
  2. Performance: What are the returns, though past returns is no guarantee of future performance
  3. Philosophy: Why do you think you have an alpha
  4. Process: How do you implement your investment philosophy
For the purposes of the current discussion, the first two points are not relevant. I am going to focus mainly on point 3, philosophy, and 4, how I use trend following models in my work.
To answer the question of how trend following models work, I start with a story. A number of years ago I was hired to run an equity market neutral portfolio at a hedge fund. The hedge fund was primarily known as a Commodity Trading Advisor (CTA) which used trend following models. Even though I knew nothing about the specific details of the trend following models, I knew that  they used multiple moving averages.
I naturally asked the question, ”Why do these models work?” No one gave me a satisfactory answer, not the research director, not the marketing people, no one. They all shrugged, ”I don;t know. It just works.”
Days and weeks passed. I noticed that the futures traders in the next room trading the trend following models would sometimes be totally white knuckled. Even though the models were supposed diversified over a number of different contracts, the positions would end up as one big macro bet at the end of the day – whether it would be on the direction of interest rates, foreign exchange, inflationary expectations, etc. If a key economic statistic that gets released the next day, such as the Employment Report, goes the wrong way, the fund would suffer substantial losses.
A light came on in my head. The reason why this class of model work is because they identify macro-economic trends, which tend to be persistent. Trends show up in commodities, e.g. the USD, commodities, interest rates, but the trends are all correlated with a specific macro trend – and these trends are persistent. For example, when the Fed begins a tightening cycle, the action in the next FOMC meeting is either no action or to raise rates. The likelihood of a rate cut is minimal. That represents a trend, which can be profitable if exploited correctly.
If we go back to the framework of investment philosophy and process, we can then state that the source of alpha, or investment philosophy, of a manager that uses trend following models is the identification and exploitation of macro-economic trends.

This reason behind why trend following models work is not that difficult, but suffers from a persistent cultural bias. The vast majority of users of trend following models, or moving averages, come from a technical analysis background. The vast majority of institutional investors tend to be fundamentally oriented – and the two groups have never really mixed well. It took a quant like me, who understood both technical analysis, macro analysis and quantitative analysis to put it all together.

Today, I apply trend following techniques to global stock indices and commodity prices to spot trends in global reflation and deflation to arrive at a risk-on or risk-off reading for timing US equities. Results have been reasonably good, as the chart below of out-of-sample signals show.

 

 

Jesse Livermore’s result that trend following models don’t perform well for individual securities is not surprising. If the investment philosophy is to utilize trend following models to spot macro-economic trends, applying these models to individual stocks dilutes the effect of these models and creates excessive noise in the form of stock specific risk,

Oversold, but…

Posted by Cam Hui -

I would like to think that my last post, The road to a 2016 market top, panicked the market into a vicious sell-off on the first trading day of the year, but I can’t think of many people with have the hubris to make that kind of suggestion. As the market closed, the SPX was down 1.5% and it was off over 2% at the worse point of the day. What`s next?

At the close, the SPX managed to stay at a key support zone, with RSI 5 at an oversold reading on roughly average trading volume. These readings appear to be constructive and suggest that downside is limited from these levels.

 

 

Other key metrics are also flashing oversold readings, but I would warn that oversold markets can get more oversold and my initial take is that there may be some further minor downside risk from these levels.

Oversold markets can get more oversold

Consider these breadth measures from IndexIndicators, where the red dot is my estimate of the intra-day low and the green dot my estimate of the close today. The % of stocks above their 10 day moving average is certainly at an oversold level consistent with a short-term bottom.

 

 

Similarly, the same could be said of net 20-day highs-lows:

 

Not enough panic?

Other sentiment measures are at elevated levels of fear, but not enough to warrant to be called “panic” levels. Two of the key metrics that I watch for are the term structure of the VIX Index (spot vs. 3 month forward) and TRIN, both of which are key components of my Trifecta Bottom Indicator (describe in Sell Rosh Hashanah? and last discussed in Do you believe in Santa Claus?).

The chart below shows the hourly chart of the VIX term structure and TRIN. The VIX/VXV ratio inverted briefly early in the trading day by spiking above 1, but TRIN did not rise above 2, which is an indication of panic selling.

 

 

My main takeaway from these readings is that the market is oversold, but it may not be oversold enough for a durable short-term bottom to take place. In all likelihood, the market is going to be volatile this week and we are back to watching how the Chinese stock market performs overnight.

My inner trader unfortunately got caught on the long side as the market sold off. He is looking to do some bottom fishing in the next few days should we get signs of capitulation.

The road to a 2016 market top

Posted by Cam Hui -


Trend Model signal summary
Trend Model signal: Neutral
Trading model: Bearish (downgrade)

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.

I am not bearish!

First of all, I want to set the record straight. Despite the headline about a possible US stock market top in 2016, I am not intermediate term bearish on stocks right now.

There is an adage amongst technical analysts that while bottoms are events, tops are processes. The purpose of this post to outline the process of how the US equity market is likely to top out in 2016. I don’t mean to convey the impression that I believe that equities go down right away. In fact, there is likely some upside left before the market makes its ultimate top before turning down. Let me explain.

Historically, US equity bear markets have begun for two reasons:

  • A recession
  • An overly aggressive Federal Reserve tightening the economy into a recession
The most recent readings from my Recession Watch show the recession risk in the next 12 months is low. However, I am far more concerned about the possibility of an overly aggressive Fed in 2016. A reflationary storm is appearing on the horizon. The Fed could easily find itself behind the curve. Monetary policy then becomes tighter and faster than anyone expects, which will spook markets and possibly push the economy into a recession.

My base case scenario calls for the equity market to top out in either Q2 or Q3, but that projected timing is at best a wild-eyed guess. There are too many moving parts and too much uncertainty for my scenario to be a definitive forecast.

The anatomy of a late cycle top

In the past few weeks, I have repeatedly made the case that the US economy is undergoing a late cycle expansion. This post is really a way of putting all pieces of the puzzle together and to show how a late cycle expansion transitions into an economic slowdown.I wrote about Jim Paulsen’s analysis of how market sector leadership changes to reflect rising inflationary expectations once the unemployment rate falls to 5.0%, which is where it stands today (see The 2016 macro surprise that no one talks about). This approach has spotted five of the last six market downturns since 1968.

I have also highlighted analysis from Scott Grannis about how the market is underpricing inflation risk (see Markets may be underestimating inflation).

With core CPI running at about 2%, current inflationary expectations of 1.25% is in effect discounting further declines in oil prices, which seems to be an unrealistic assumption. From a technical perspective, oil prices are falling but it is experiencing a bullish RSI divergence. If the credit market is extrapolating further oil weakness, it may be in for a rude surprise in the near future.

I also documented how the current economy and market environment are evolving into a late cycle expansion, where inflationary pressure start to rise (see Profiting from a late cycle market and How the market can rise (and commodities rally)). However, market expectations indicate that the current trend of USD strength and falling commodity prices will continue. A recent post detailed the latest BoAML Fund Manager Survey indicating that global institutional fund managers are in a correlated and crowded disinflationary macro trade, consisting of long USD, short commodity stocks and short emerging market equities (see Do you believe in Santa Claus).

Indeed, the latest analysis from Dana Lyons confirms the crowded trade and shows that gold speculators have all but given up on the precious metal.

When I put it all together, it suggests that the market and the economy is in for an unexpected inflationary shock. As the market adjusts to the new reality in 2016, the big question is how the markets and the Fed react to these developments.

The Fed wildcard

The Fed is what I am most worried about. The risk of policy error is high. Tim Duy recently penned a post about uncertainty over the Fed`s reaction function to the shape of the yield curve, which reflects market expectations of monetary policy and expected inflation. Duy indicated that the Fed`s reaction function to backward looking economic statistics such as employment and inflation are fairly well known, but he was unsure of how it is likely to react to changes in market expectations:

While much attention is placed on the Fed’s failure to respond more aggressively to slowing activity and deteriorating financial conditions in 2008, I lean toward thinking the more grievous policy error was in the first half of 2006 when the Federal Reserve kept raising short rates after the yield curve first inverted in February of that year:

and despite clear evidence of slowing economic activity and increasing financial stress.

If inflationary pressures tick up, what will the Fed do?

The China wildcard

There is another major wildcard: how will currency markets will react to global developments. Bloomberg featured a terrific interview with David Woo, the chief currency strategist at BoAML (starts at about the 4 minute mark). I summarize the points that Woo made as follows:

  • The US deleveraging episode after the Great Financial Crisis (GFC) was the result of its export of deflation to the rest of the world. It delevered by forcing the rest of the world to take on more debt. In the next downturn, the global economy will still have to deal with the debt overhang created by the export of US leverage.
  • The inclusion of the RMB in the SDR basket now gives China the cover to engage in monetary stimulus and therefore devaluation. Before the IMF’s decision to include the yuan in the SDR basket, Beijing felt pressure to “behave” and maintain currency stability. The story has changed in the aftermath of the IMF SDR decision. The chart below showing the spread between the onshore yuan (CNY) and the offshore yuan (CNH) has been widening, which is a market signal of further yuan weakness. In the face of weakening Chinese growth, Woo believes that the PBoC has lots of ways it can stimulate the economy. (Cam: Depending on how it`s implemented, PBoC stimulus could be either be seen as highly reflationary for commodity prices and represent a positive surprise for the markets, or the markets could freak out and undergo a major risk-off episode on the prospect of a CNY devaluation and possible currency war.)

 

 

  • Past experience has shown that the USD and US equities weaken after an initial rate hike. (Cam: If the USD weakens, it would be a boost for commodity prices as the two are inversely correlated. I am fairly agnostic on the issue of what happens to stocks after a rate hike, though).

 

Whither the USD?

David Woo’s highlights another important unknown: What will the USD do in the next few months? The USD is also an important driver of stock prices. Many US companies have cited USD strength as a headwind in their earnings calls in the last year. As the chart below of the Trade Weight Dollar shows, those headwinds should significantly diminish in Q1. Should the USD begin weaken, currency effects would turn into a tailwind for earnings and therefore be bullish stock prices.

I have also been closely monitoring the following chart as an important indicator of market direction. The USD (top panel, inverted scale) and the relative performance of Materials stocks (bottom panel) are range-bound, while the relative performance of energy stocks (middle panel) is still in a downtrend. I am watching carefully for signs of upside breakout in each of these charts before making a serious commitment to a trade.

 

 

A roadmap, not a forecast

To summarize, what I have sketched out is the process of a market top. This not a forecast, but a roadmap as there are too many moving parts and the timing of each element is too uncertain.Here is how I think 2016 will play out. Cost-push inflationary pressures tick up in the form of higher wages, which feeds into higher commodity prices, This reflationary development is  positive for stock prices as it would alleviate some of the anxiety over the poor performance of junk bonds, especially if the USD declines and boosts the earnings of US exporters. Over time, rising inflationary expectations spooks the bond market and the Fed reacts. The Fed perceives that monetary policy is behind the curve and tightens aggressively, perhaps to the point of a yield curve inversion, which results in a recession.Should the economy roll over into recession, I highlighted in past posts that possible landmines planted in the current cycle. The next recession could be very ugly (see Why the next recession will be very ugly and Cheap or expensive? The one thing about equity valuation that few talk about).

The big unknowns are timing and amplitude. My base case scenario calls for a stock market top in Q2 or Q3, but that’s nothing more than a guess at this point. Ambrose Evans-Pritchard laid out a similar case of reflationary pressures, but portrayed 2016 as the “sweet spot” for growth and postulated the ugliness won’t happen until 2017. His scenario is also well within the realm of possibility.

The biggest question to be answered is the reaction of the USD to market and economic developments. If greenback strength continues, then it could dampen the volatility and stretch out the length of the topping process. Commodity inflationary pressures would be more muted and the Fed’s response will be as well (because a strong USD would be a form of monetary tightness). On the other hand, if my base case scenario of a USD pullback, commodity inflation comes true, then rising inflationary expectations will become far more evident and it will create pressures for a stronger response from the Fed.

What happens next? I have no idea. My crystal ball is out at the shop for repairs. All I can do is to watch for signs of a change in the character of the markets, in the form of market leadership (late cycle sectors, value vs. growth, etc.) and monitor how the bond and currency markets evolve over time.

The week ahead

As I peer into the first week of 2016, the market action last week was highly disappointing for the bull camp, especially in light of the fact that the market was undergoing a period of positive seasonality,. Santa came and left, but his presents weren’t all that exciting. Moreover, the vaunted January Effect of a small cap rebound has been fading in the past few years, so don’t expect much in the way of fireworks there (see The reason why the bulls should be cautious about a January hangover).
Despite these bearish headwinds, it is difficult to envisage a serious pullback of 5% or more as sentiment is likely to put a floor on stock prices. The latest NAAIM survey of RIAs show that advisors have become increasingly bearish, which is contrarian bullish.

 

 

On the other hand, the latest data from Barron`s show that “smart money” insiders continue to buy stocks.

 

 

In the meantime, breadth indicators from IndexIndicators show the market to be retreating from an overbought condition. Readings are neutral but momentum is negative, which tells me that the bears are in control of the tape.

 

 

Current market conditions are suggestive of choppiness in the days ahead, which will be frustrating for both bulls and bears alike.
My inner investor remains invested with a tilt towards resource sectors. My inner trader is long equities, but he is seeking to sell on strength and buy on weakness should the market get to an oversold extreme.

 

Disclosure: Long SPXL, TNA

My hits and misses of 2015

Posted by Cam Hui -

As 2015 draws to a close, this would be a good time to review how I did during the year. As regular readers know, I have two personas, my inner investor and my inner trader. My inner investor had a decent year, while my inner trader had a year that he would rather forget.

 

What went right

First the good news, I was mostly correct in calling both the top and the bottom in 2015. I was cautious in the spring. My bearishness was contrarian enough that I got a ton of hate mail. In response, I wrote a post entitled Why I am bearish (and what would change my mind) in May 2015 (red arrow below).

As the stock market weakened in August, my fundamental models identified the episode as a correction and not the start of a bear market, which was contrary to the atmosphere of panic at the time. See Relax, have a glass of wine (blue arrow below) and Why this is not the start of a bear market (purple arrow below). All turned out to be prescient calls.

 

 

What went wrong

By contrast, 2015 was a difficult year for my inner trader, who used the trading model of my Trend Model. To explain, the Trend Model applies trend following principles to global equity and commodity prices to arrive at a risk-on (buy) or risk-off (sell) signal on US equities. Further, I found that changes in Trend Model readings, e.g. a “buy” signal getting less strong or a “sell” signal getting less weak, can identify short-term market turning points – and that formed the main basis for the trading model. In addition, I supplement trading model signals with overbought-oversold and sentiment indicators to spot market extremes.

The chart below of past trading model signals shows the limitations of this approach. When the market is trending, the trading model had superb results. In a sideways choppy market, trend following models get whipsawed, as it did during the summer of 2015. Worse was the behavior of the trading model during the August sell-off. Despite my general bearishness throughout the summer, sentiment models moved to a crowded short reading in the initial phase of the decline. As a consequence, my inner trader was “long and wrong” during this period.

 

 

To be sure, my inner trader did spot the Zweig Breadth Thrust and correctly bought into the subsequent rally (see Bingo! We have a buy signal!). However, those gains weren’t enough to offset the damage caused by the combination of the summer market whipsaws and being “long and wrong” during the August sell-off.

 

Lessons learned

As a result, both my inner investor and inner trader learned some valuable lessons in 2015.

My inner investor learned that once you have constructed a well thought out macro case for taking a position, the amount of pushback and hate mail can be a positive contrarian sign that you are likely correct, though early in your analysis.

My inner trader learned that not all models work all the time. He learned that all models have limitations. Trend following models are known to perform poorly during sideways markets like the summer of 2015. Moreover, overbought-oversold models identify market extremes, but overbought markets can get more overbought and oversold markets can get even more oversold. My inner trader learned both those lessons in 2015.

Both learned the valuable lesson of model diversification in portfolio construction.

The reason why the bulls should be cautious about a January hangover

Posted by Cam Hui -

In my last post, I wrote about the possible appearance of a rare Zweig Breadth Thrust buy signal this week (see The 2016 macro surprise that no one talks about). Tuesday was the last day in the 10 day window for the ZBT buy signal to be triggered. Alas, it doesn’t seem to have happened.

 

 

So where does that leave us? The near term outlook for the bulls is still constructive, as the market has rallied through a key downtrend line (shown above). Moreover, we are still in a period of seasonal strength.

However, bullishly oriented traders should be wary about overstaying their welcome. The Santa Claus rally was nice but the party is starting to get out of hand. The neighbors have called the cops and they are due to arrive very soon.

What January effect?

One of the arguments for a continued near term bullish impulse is the so-called January effect, which is explained by a snap back from tax-loss related selling in December. This CNBC article document was written last year and it is slightly dated, but it nevertheless documents the diminishing power of the January effect. In short, most of the outperformance in January occurred in the 1980’s and 1990’s. January returns in the last 10 years have been nothing to write home about.

I went back to 1987 and studied the average returns of the SP 500 large caps (SPX) and Russell 2000 small caps (RUT). I found that while the markets seemed to have benefited from a December Santa Claus rally, January returns have been fairly ordinary.

What about a snap back from tax loss selling? Could stocks perform better if we had a down year? I studied average stock returns based on whether the RUT was positive or negative on a YTD basis as of November 30. What I found was highly unexpected. Small cap stocks performed better in December as a whole and paradoxically did worse when November YTD was negative. In effect, ther was no small cap January effect. However, there was a minor large cap January effect as the SPX did perform better when RUT was negative YTD to November. That results seems somewhat dubious and illogical and I would attribute it to noise in the data.

What about small cap outperformance in January? If there was tax loss selling, could small caps perform better in January?

The chart below shows the small – large cap return spread in December and January, based on RUT YTD returns to November 30. The data shows that average small vs. large cap spread actually perform worse in January when RUT is down YTD to November.

So much for the January effect.

Fewer buybacks

In addition, bullish traders face additional headwinds in January. This chart from Goldman Sachs (via Business Insider) shows that the pace of share buybacks tend to drop dramatically in January. That removes another key source of demand for equities during this period.

 

Don’t overstay the party

In conclusion, had another ZBT buy signal been triggered, my inner trader would have gone all-in on the long side of the market. Instead, he is turning more cautious. While the combination of short-term seasonal strength, a bullish impulse that broke both a downtrend line and the 50 and 200 dma are to be respected, the market is nearing overbought readings, as measured by RSI5.

As well, this chart from IndexIndicators of the net 20 day highs-lows is in the overbought zone (red dot is my estimate), which is an indication that upside is probably limited.

Bottom line: The bulls shouldn’t overstay their welcome during this seasonal rally. Start edging towards the door before the cops show up and raid the party.

The 2016 macro surprise that no one talks about

Posted by Cam Hui -


Trend Model signal summary
Trend Model signal: Neutral
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.

 

The boy who cried wolf

We all remember the story of the boy who cried wolf. The villagers got one false alarm after another, which made them increasingly annoyed. When the wolf finally came, his warnings were ignored and he suffered the consequence.

I want to tell a more modern story of the boy who cried wolf. In this case, the wolf is inflation. In the wake of the Great Financial Crisis (GFC), there was a cacophony of voices (myself included) who warned that all the QE and money printing would eventually result in runaway inflation and USD devaluation. Even Warren Buffett was caught up in that frenzy when he penned his “unchecked greenback emission” NY Times Op-Ed in 2009:

Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Despite these dire forecasts of doom,  the USD has rallied in the wake of the GFC and gold prices are roughly flat from that period. That thesis of secular runaway inflation turned out to be wrong.

Today, a different kind of inflationary wolf pack stalks the landscape. Instead of the specter of secular runaway inflation, the cyclical inflationary wolves are gathering. When they descend on the flock in 2016, it will be the macro surprise that almost no one is talking about.

Jim Paulsen and the Phillips Curve

Jim Paulsen, who had been very good in calling the turn in the spring of 2015, is out with another piece of analysis that investors should pay attention to. The title says it all: Full Employment Typically Brings a Sector Rotation.

Underlying the macro assumption of Paulsen`s analysis is the Phillips Curve, which postulates a short-term policy tradeoff between inflation and unemployment. Today, the effects of the Phillips Curve are seemingly global. Not only are wage pressures rising in the US, CNN Money reported that a Korn Ferry Hay Group survey concluded that Chinese and Indian workers are expected to get 8% and 10% raises respectively in 2016. So much for the benefits of offshoring.

Paulsen went back to all the way back 1948 and observed that once the headline unemployment rate falls below 5%, which is the latest reading for US unemployment, the equity market undergoes a significant change in leadership.

For completeness, here are the sector definitions from his study:

The above performance chart shows the results of Paulsen’s study. First of all, I would point out that there is no need for panic. An annualized market return of 7.39% is still quite respectable. Paulsen found that market leadership shifts to late-cycle sectors where inflationary pressures start to rise as capacity utilization hits its limits. Therefore the best performing sectors are clustered in energy (note mining is not really mentioned in the sector definitions) and capital goods sectors like business equipment and manufacturing.

I was unable to reproduce Paulsen`s study going back to 1948, but I was able to find data that went back to 1970. The chart below shows the relationship between the unemployment rate (dotted black line) and the returns of energy stocks relative to the market (blue line). There were six episodes when unemployment fell to 5% or below during this study period. In all occasion except for one, energy stocks began a period of better market performance, which is reflective of the increased inflationary pressures. The sole exception occurred during the Tech Bubble of the late 1990s when market participants went overboard for internet related stocks to the exclusion of everything else in the market.

As the headline unemployment rate falls to 5% today, the stock market is poised for the appearance of rising inflationary pressures. As I pointed out last week (see Do you believe in Santa Claus?), the latest BoAML Fund Manager Survey shows a crowded macro trade of long USD, short resource stocks and short emerging market equities. When inflationary pressures start to tick up in 2016, it will be the macro surprise that will catch the market off guard, much like the metaphorical wolf who attacked the flock in the story of the boy who cried wolf.

However, it is probably tactically early for traders (though not investors) to buy into that trade. A glance at the breadth indicators of the energy ETF (XLE) shows a bearish pattern of lower lows and lower highs.

By contrast, the breadth indicators of materials stocks (XLB) is a bit more constructive as it is displaying an uptrend in % bullish indicator, though the advance-decline line is roughly neutral.

My inner investor is accumulating positions in energy and materials, while my inner trader is waiting for better internals or some signs of an upside breakout before committing to the long side on this macro trade.

Market outlook remains bullish

In the meantime, the stock market outlook remains tilted bullishly. The latest update from John Butters of Factset shows that the Street continues to revise forward EPS upwards, which is supportive of high stock prices.

The latest update from Barron’s show that the “smart money” insiders are still buying:

I want to address the concerns over the poor performance of US high yield, or junk, bonds (HY). The chart below shows the Chicago Fed’s National Conditions Financials Index and the St Louis Fed’s Financial Stress Index. Even though stress levels are ticking up, they are anywhere near danger levels.

Another way of measuring the level of anxiety in the HY market is to compare its yield spread to Treasuries vs. emerging market (EM) bond spreads. Such a comparison is especially useful as the latest round of concerns over default risk is coming from resource extraction industries like energy and mining – and EM economies tend to be more commodity sensitive. As the chart below shows, EM spreads suffered in the wake of the “taper tantrum” of 2013, when then Fed Chair Ben Bernanke floated a trial balloon that the Fed might start to taper down its QE purchases. As a result, EM bonds suffered disproportionately, though US HY did not get hurt as badly. Today, the spreads between US HY and EM bonds is just going through a normalization process where the spreads are returning to a more normal range.

I would be more concerned if EM spreads against Treasuries are blowing out, but that market remains fairly calm at the moment.

The week ahead: Another Zweig Breadth Thrust buy signal?

As I look forward to the volume light week ahead, two opposing forces are playing out in the US stock market. On one hand, we are entering a period of positive seasonality. This analysis from Ryan Detrick showed that the last week of December tends to be bullish.

Detrick also tweeted the following on December 24, indicating that the Santa Rally tends to last until January 5:

More importantly, the stock market may be on the verge of another Zweig Breadth Thrust (for full details and implications of the ZBT see A possible, but rare bull market signal and Bingo! We have a buy signal!).  As the chart below indicates, the Zweig Breadth Thrust Indicator (bottom panel) has two more days (until Tuesday) to rally and move above 0.615. Should that occur, it would trigger another rare buy signal for stocks that foreshadows further significant gains.

Can the market achieve another ZBT during this seasonally positive period? I have an open mind but I am not counting on it, largely because ZBTs are extremely rarely buy signals that have occurred only 15 times since 1945. In addition, breadth indicators from IndexIndicators show that the market is either overbought or near overbought and vulnerable to a pullback.

Overbought markets can get more overbought. Compare current readings of net 20-day highs-lows compared to the readings at the last ZBT, which occurred in early October:

My inner investor remains long equities with a tilt towards resource sectors. My inner trader is giving the bull case the benefit of the doubt and he is long large and small cap equities in anticipation of a continuation of the Santa Claus rally.

What happens next? Stay tuned.

Disclosure: Long SPXL,TNA

Is Warren Buffett losing his touch?

Posted by Cam Hui -

How would you evaluate a manager with this kind of 10-year investment performance? Terrific? Or Meh!

 

 

It depends on when you got in. Sure, the 10 year numbers look terrific, but he is roughly flat with the benchmark over five years and he had a difficult 2015.

What if I told you this track record was none other than the legendary Warren Buffett? The chart represents the relative performance of Berkshire Hathaway B (BRKb) against the market. It’s how ordinary mortals like you and me participate with Buffett in his management of BRK.

The Buffett track record in context

The five year track record looks positively ordinary. What happened to Buffett the investment giant? The Oracle of Omaha?

This longer term chart puts the relative performance of BRKb into context. BRKb has had an excellent long term track record, though the shorter term five-year record can best be described as so-so (top panel). As Buffett is well known to be a value investor, his struggles reflect the difficulties that value investing has experienced (bottom panel). In fact, BRKb has actually performed quite well against other value managers, as measured by the Russell 1000 Value Index, over the last five years (middle panel).

 

When viewed in the context of an underperforming value style, Berkshire’s 5-year market matching returns looks positively stellar.

How patient are you?

The struggles of Buffett and others bet the question of whether the value style is dead. No, you just have to be patient and recognize that the market goes through value and growth or momentum cycles where each style dominates returns. Consider this Cliff Asness discussion about his experience with value investing. At first, value factors backtested very well (via Alpha Architect).

Asness was unfortunate enough to implement the strategy just as the Tech Bubble was getting started:

The truth of the matter is, the value style has been facing severe headwinds for over five years, which is beyond the time horizon of many investors and fiduciaries. This chart from Morgan Stanley tells the story. The underperformance of global value stocks is as severe as it was at the height of the NASDAQ Bubble in 2000.

 

With the style so out of favor, value appears to be poised for a rebound. Indeed, The Telegraph reported that a UK based fund using Buffett like principles returned 25% this year.

Trading vs. investing

The moral of this story is, there is a big difference between the kind of time horizon favored by traders and investors. Traders would not tolerate the kind of relative drawdowns experienced by Buffett in the last year. Even a legend like the Oracle of Omaha is not perfect. Jeff Matthews recently criticized Berkshire for two bad acquisitions, namely the purchase of Precision Castparts for 20 times what may (or may not) be peak earnings and Hudson City Bancorp.

Not everyone is good at everything. For the last word, consider Mark Hulbert’s tribute to the late Richard Russell. Hulbert detailed how Russell had been correctly bearish in the early 1970’s and then called the turn at the bottom of the bear market in 1974. Russell went on to presciently turn bearish in August 1987, two months before the Crash. Admittedly, he wasn’t the best at trading calls:

In contrast to catching these and other momentous changes of major trends, Russell’s timing advice for the market’s shorter-term trends was less impressive. This was especially the case over the past decade, when his daily blog sometimes descended into what struck some subscribers as a stream of consciousness and, on occasion, contradicted itself from day to day.

But advisers who are good at catching changes in the market’s major trend rarely excel at short-term market timing, and vice versa. And though neither pursuit is easy, the former — Russell’s specialty — is far rarer. According to the Hulbert Financial Digest, Russell’s market-timing advice in the 1980s and 1990s was at or tied for the best performer among all monitored market timers.

Russell’s enduring legacy may therefore be that catching even some of the market’s major trend changes can make up for many missteps involving the shorter-term trend. And to catch those major trend changes, you must be willing to go against strongly and widely held opinions.

The secret of investment success is to know your own core competencies, sticking to your guns and learning to be patient.

 

Disclosure: Indirectly long BRKb

Do you believe in Santa Claus?

Posted by Cam Hui -

Trend Model signal summary

Trend Model signal: Neutral
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.

Hitting the Exacta

Regular readers know that I have been bullish on stocks for a couple of months now. While I had expected a seasonal Santa Claus rally, Santa hasn’t been around and stock prices have been weakening. In one way, Old St. Nick may have left a present for the bulls under the tree as the recent sell-off has left the market oversold. As a result, two of my Trifecta Bottom Model indicators have flashed a buy signal. I call this hitting the Exacta.

My Trifecta Bottom Model (which was described in a past post Sell Rosh Hashanah?) consists of the following three conditions, which must occur closely (within a week) of each other:

  1. VIX term structure (VIX/VXV ratio) inversion
  2. NYSE TRIN more than 2
  3. My favorite intermediate term overbought-oversold model, which is the ratio of % of SPX stocks over their 50 day moving average (dma) / % of SPX stocks over their 150 dma less than 0.5
Each of these conditions, by themselves, are indicators of high levels of market fear. When used in conjunction with each other, they have been uncanny at calling short-term market bottoms. The chart below shows past instances of the market has hit the Trifecta (vertical red lines, triggered all three conditions) or the Exacta (blue vertical lines, two of three) in the last three years. The only failure of this model was the sell-off in August 2015, where an oversold market became more oversold. In all other instances, the market have rallied off these buy signals.

 

Trifecta Bottom Model

 

Last week, the market hit the Exacta again as the VIX term structure inverted and TRIN spike to over 2 within a week of each other. The question is whether this is August 2015 all over again, or a run-of-the mill instance of a short-term bottom.

No recession on the horizon

To answer that question, let`s consider the macro and fundamental backdrop to measure the risk of a major leg down in stock prices. First and foremost, is there is any significant risk of a US recession? Recessions are triggers for major bear markets.

I use a framework used by New Deal democrat to spot recessions a year in advance. He utilizes seven long leading indicators, which you can keep track of at my Recession Monitor. Currently, I would classify the indicator this way (links are to FRED graphs and comments from New Deal democrat are shown in parenthesis):

Positive, indicating little or no recession risk:

  • Housing starts (Housing starts peaked at least one year before the next recession)
  • 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)
  • 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)

Cautionary: Corporate profits have peaked and proprietors income have flattened. Call this a slight negative.

  • 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.”)

Negative, but this indicator is somewhat unreliable as corporate bond yields have made lows as much as four years before a recession.

  • Corporate bond yields (Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession)

Not relevant in the current environment

  • Yield curve (The yield curve inverted more than one year before the next recession about half the time)
Of the six relevant indicators, the no-recession camp is winning at 4-2 (and it’s a very qualified 2). So we can take the tail-risk of a bear market caused by a recession off the table.

Forward EPS growth still positive

One of the key drivers of equity returns is forward EPS revisions. If the Street isn’t revising EPS upward, then it can be a sign of trouble. Ed Yardeni analyzes the evolution of forward EPS by market cap and he found the large caps forward EPS is still rising (annotations in purple are mine):

 

 

Mid-cap forward EPS are also being revised upward:

 

 

Though small cap forward EPS ticked down in the week:

 

 

Oh well, two out of three ain’t bad. Given the magnitude of the changes, with large cap forward EPS revisions at +0.09%, mid-caps at +0.11% and small caps at -0.05%, the average change is still positive.

Insiders are buying

What are the “smart money” insiders doing? The latest report from Barron’s indicate that insiders are still buying heavily:

To summarize, there are no macro or fundamental reasons for a major bear market to be starting here. Risk levels are relatively low.

Will the USD give bulls a second wind?

I wrote last week that the US Dollar is the key to providing the bulls a second wind to the bull market (see The only market indicator that matters in 2016). So far, the jury is out and we are still waiting for the verdict in the form of an upside or downside breakout from a trading range.

Here is what I am watching. Should the USD weaken, then it provide a boost to the earnings of US companies operating overseas – hence the second wind for the bulls. So far, that hasn’t happened yet. One other benefit of a weaker USD would be stronger commodity prices, as the two are inversely correlated with each other. The top panel of the chart below shows that the greenback has strengthened a little but it has been volatile in the post-FOMC decision period, but remains in a sideways consolidation phase. The next two panels show the relative performance of energy and materials stocks against the market. While energy remains in a relative downtrend, materials stocks have been consolidating sideways on a relative basis.

 

One bright spot for commodity bulls comes from the strengthening AUDCAD currency cross rate. This cross rate is important as both Australia and Canada are major commodity exporters, but Australia is more exposed to China while Canada is more exposed to the US economy. Another key difference is Australian commodity exports are tilted towards bulk commodities like iron ore, while Canadian exports are higher weighted in energy. As the bottom panel of the chart above shows, AUDCAD has been rallying, which is a possible indication of renewed Chinese growth. The AUDCAD rally cannot be explained by the bulk vs. energy differential as the solid line showing the the relative performance between mining stocks and energy stocks is weakening.

I continue to believe that the USD is poised to weaken and the implications of that reversal will be bullish for stocks and commodity prices.

The latest results from the BoAML Fund Manager Survey of global institutional managers is revealing. When asked what they though the most crowded trade was, institutional managers cited long USD, short commodity stocks and short emerging market (EM) equities – in that order. Since those three themes all correlated to each other, the top three most crowded trades is in effect the same macro trade (annotations in purple are mine):

When asked what their own portfolio position was, the answer was about the same. Global managers have a crowded long in the USD:

 

Yet, they thought that the USD is overvalued. So why are they in a crowded long USD macro trade?

 

When asked what phase they thought the global economy is in, the consensus seems to be shifting from mid-cycle to late-cycle, which is the phase when inflationary pressures start to manifest themselves and commodity prices rise.

 

 

Setting up for a late cycle market

In effect, the 1H 2016 market is setting up for a late cycle expansion, when inflationary pressures start to rise. Scott Grannis believes that the market is in for an upside surprise in inflation:

The collapse of crude oil prices since mid-2014 has not only devastated the oil industry, it has also sowed confusion over the issue of inflation. Since crude prices started falling in the summer of 2014, headline inflation fell from 2% to essentially zero for most of this year. Yet if we exclude energy from the calculation, inflation has been fairly steady at 2% for a long time. This bears repeating: if not for the big decline in oil prices in the past 18 months, the underlying trend of inflation at the consumer level would have been 2% for the past 13 years.

Energy prices are not going to fall forever; once they simply stabilize, then headline inflation should bounce back to 2% fairly quickly. The Fed understands this, but—arguably—markets do not, since key measures of inflation expectations over the next 10 years range from 1.25% to 1.8%, and those expectations assume that oil prices will decline substantially further in the next year or so.

The market expectations of forward inflation is 1.25%, which is in effect discounting further declines in energy prices:

The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market’s expectation for the annualized rate of CPI inflation over the next 5 years. Currently about 1.25%, it is significantly less than the prevailing rate of ex-energy CPI inflation. Either the market is correctly anticipating more and substantial declines in energy prices, or it is seriously underestimating future inflation.

The Fed understands these dynamics, and that was made evident in a recent speech by Janet Yellen:

Regarding U.S. inflation, I anticipate that the drag from the large declines in prices for crude oil and imports over the past year and a half will diminish next year. With less downward pressure on inflation from these factors and some upward pressure from a further tightening in U.S. labor and product markets, I expect inflation to move up to the FOMC’s 2 percent objective over the next few years.

On the other hand, I would not be overly concerned about an overly aggressive Fed in 2016. In the latest round of post-meeting Fedspeak, Reuters reported that San Francisco Fed president John Williams indicated that the Fed plans on running a higher pressure economy for a while (translation: tolerant of higher inflation):

Though much more optimistic about the economy than in prior years, Williams said that at the end of this week’s meeting, there was no round of high-fives among the 17 policymakers at the table.

“We are not done: we still have inflation unquestionably running stubbornly low due to mostly, I think, global factors,” he said.

To keep job creation strong, rates will need to stay low, rising only modestly next year, he said, adding: “We are going to run a higher-pressure economy for a while.”

The scenario that I envisage for 2016 involves a transition to a late cycle market. Inflationary pressures rise, the USD falls and interest rates rise. For the stock market, this translates to a topping process with the following characteristics:

  • A change in leadership to late cycle resource and capital goods plays
  • A short-term boost to earnings and therefore stock prices because of the falling Dollar
  • Followed by a faster than expected pace of Fed tightening, which will eventually unsettle markets (as per Grannis)

Readers might gasp at my use of the term “topping process”, as I have been relatively bullish recently. I would qualify that term by stating that it would be overly premature to be selling out now, as investors will miss the last boost to the market from the tailwind of the effects a falling USD in boosting EPS growth. The key is to watch for downside risk by monitoring signs of impending recession with my Recession Monitor.

Even the recent carnage in the US junk bond market is nothing to freak out about. It is a source of concern, not a cause for alarm. While I am well aware of the bearish conclusions drawn by other analysts from the sell-off seen in junk bonds, there hasn`t been an adequate explanation as to why EM bonds are outperforming US junk. The chart below shows the relative price performance of US junk to their duration equivalent Treasuries (UST) compared to the relative price performance of EM bonds to their duration equivalent UST paper. If the stress in US junk market is so high, shouldn’t they be even be higher in emerging markets?

 

 

The week ahead: Waiting for Santa Claus

Looking to the remainder of the year, I indicated earlier that the market is oversold and my Trifecta Bottom Model has flashed an Exacta buy signal. A more conventional technical analysis of the technical conditions of the SPX comes to a similar conclusion. The market is testing support at its lower Bollinger Band and RSI 5 (top panel) is showing a bullish positive divergence during this test. As well, the market is exhibiting the typical seasonal pattern of small cap outperformance (bottom panel).

 

 

Despite the dismal returns shown by small cap stocks this December, analysis from Dana Lyons show that they have historically shown a remarkable tendency to snap back from December drawdowns.

 

In addition, analysis of Twitter breadth activity from TradeFollowers is also supportive of the bull case. Even as the market declined, bullish Twitter breadth remained strong while bearish Twitter breadth weakened, which is indicative of bullish market internals (purple annotations are mine):

 

My inner investor remains fully invested with an overweight in the resource sectors. My inner trader got stopped out of his long position in gold stocks last week, but he is still long large and small cap equities in anticipation of a seasonal rally.

 

Disclosure: Long SPXL, TNA

Why the next recession will be very ugly (repeat)

Posted by Cam Hui -

There appears to be some glitch with the formatting of the previous post. Here it is again:

In a recent post, I was relatively upbeat about the near term market outlook but warned that the next recession could be very ugly (see A major bear market in 2016?). To explain, I have found three possible time bombs that are set to go off at the next recession:

  • The Fed’s balance sheet;
  • A possible financial crisis in China because of her inability to re-balance its economy fast enough; and
  • Possible blowups lurking in the global financial system.

Let me preface my comments by saying that I am not predicting an imminent disaster. Each of the risks that I outline are just that – risks. None of them are necessarily destined to blow up in our faces, but if any of them do, they will exacerbate the magnitude of the next downturn.

With those caveats in mind, let me go through each of the risks.

 

The Fed’s unbalanced balance sheet

The first source of financial vulnerability was identified by David Merkel, an actuary turned professional investor. He pointed out that the Fed has a mismatched balance sheet:

The pristine balance sheet of 2008 was very short in its interest rate sensitivity for its assets – maybe 3 years average at most. Now maybe the average maturity is 12? I think it is longer…

Does anybody remember when I wrote a series of very unpopular pieces back in 2008 defending mark-to-market accounting? Those made me very unpopular inside Finacorp, the now-defunct firm I worked for back then.

I see three hands raised. My, how time flies. For the three of you, do you remember what the toxic balance sheet combination is? The one lady is raising her hand. The lady has it right – illiquid assets and liquid liabilities!

In a minor way, that is the Fed now. Their liabilities will reprice little as they raise rates, while the market value of their assets will fall harder if the yield curve moves in a parallel shift. No guarantee of a parallel shift, though – and I think the long end may not budge, as in 2004-7. Either way, though, the income of the Fed will decline rapidly, and any adjustment to their balance sheet will prove difficult to achieve.

The Federal Reserve is not just any bank, it’s a central bank. Therefore a mismatched balance sheet, e.g. borrowing short and lending long, won’t hurt the Fed in the same way as it does other financial institutions because central banks cannot go bankrupt. Nevertheless, Merkel pointed that any fallout doesn’t just magically go away:

As a result of the no-mark-to-market accounting, the Fed won’t show deterioration of its balance sheet in any conventional way. But you could see seigniorage – the excess interest paid to the US Treasury – go negative, and the dividend to its owner banks suspended/delayed for a time if rates rose enough. Asking the banks to buy more stock in the Federal Reserve would also be a possibility if things get bad enough – i.e., where the future cash flows from the assets could never pay all of the liabilities. (Yes, they could print money together with the Treasury, but that has issues of its own. Everything the Fed has done with credit so far has been sterile. No helicopter drop of money yet.)

Of course, if interest rates rose that much, the US Treasury’s future deficits would balloon, and there would be a lot of political pressure to keep interest rates low if possible. Remember, central banks are political creatures, much as their independence is advertised.

Merkel concluded that there is a clear and present danger, especially now that the Fed has begun to normalize rates:

Ugh. The conclusions of my last two pieces were nuanced. This one is not. My main point is this: Even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.

The key here, is the shape of the yield curve. Use these tools from the Treasury and Stockcharts to monitor the changes in the yield curve.

 

Will China rebalance quickly enough?

I am indebted to Michael Pettis for pointing out this second source of global systemic vulnerability. Here is what we know about China:

  • Its GDP growth rate is slowing;
  • The blistering pace of the old growth rate was driven by credit driven infrastructure growth, which is unsustainable, but…
  • The driver of growth is slowly changing from infrastructure and building sector to the consumer and household sector, which is more balanced and sustainable source of growth.
I have written before about ways to monitor the progress of the economic rebalancing theme in real-time by watching a couple of pairs trades (see Two better ways to play Chinese growth). So far, the New China consumer sensitive ETFs are handily beating the Old China finance heavy ETFs.

 

 

The question that Pettis tried to answer is, “Is China rebalancing fast enough?”Even under relatively optimistic assumptions, China does not have sufficient time to rebalance its economy before running into serious trouble on its debt:

In order to answer the question of how much time China has I thought it would be useful to work out a simple model for the growth in debt to see how plausible it is to assume that China has another 10-15 years in which to manage the adjustment without implementing far more dramatic transfers of resources, either to pay down debt or to raise household wealth. The model shows pretty clearly that China does not have that much time unless we make extremely implausible assumptions about the country’s debt capacity and, just as importantly, about market perceptions about this debt capacity.

The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.

Most Chinese debt is RMB denominated debt, so as long as the PBoC can print more RMB, a China slowdown is unlikely to trigger a global financial crisis. However, someone still has to pay for any debt writedown. In the past, the government has socialized the losses. So that means that it is ultimately the household sector would pay the price. In that case, you can kiss the idea of further rebalancing goodbye.

Now imagine the following scenario. The global economy experiences a slowdown. Chinese exports shrink as a result. The pace of rebalancing slows, growth slows and debt burdens rise. The Chinese economy hits the wall and experiences a debt crisis. Even though it may not bring down the global economy, the global financial system is already fragile from the global slowdown and a Chinese debt crisis exacerbates the scale of the downturn.

I would emphasize the point that this dire scenario is unlikely to happen today as Chinese and global growth remain robust (see A major bear market in 2016?). But when the next recession arrives, watch out!

 

Evaporating paper financial assets

The story behind the third source of vulnerability is a little complicated. It begins with a mystery and ends with some possibly chilling implications for the global financial system:

Izabella Kamanska at FT Alphaville outlined the mystery this way. The assets and liabilities in the global financial system aren’t adding up:

As per Gabriel Zucman’s book, The Hidden Wealth of Nations, the world’s financial liabilities are worth about $7.6 trillion more than the world’s financial assets. Roughly $6.1 trillion of these extra liabilities take the form of equity and long-term debt, with the other $1.5 trillion held in low-yielding deposits and money-market funds.

You can read the article for yourself, but I won`t bore you with all the twists and turns of the mystery. One explanation is much of the missing $6.1 trillion in extra liabilities is attributable to the value added by the global financial system in the form of “financial rent”:

As noted earlier, financial rent began to be featured as a value-add component in GDP in the 1960s, according to Mazzucato. Even so, the methodology behind this inclusion — which focuses on the net interest margin — has always been strongly challenged. Some have argued, for example, that because the interest margin includes a risk premium, a large amount of what’s being counted as value add might very well be being over-estimated. The counter argument, of course, is that the core value-add service banks provide is screening for investor risk and hunting out information advantages.

This brings up the point that there are all these offsetting assets and liabilities floating around the global financial system in the form of “financial rent”. No doubt, a substantial portion are offshore assets. So what happens when the global economy turns sour and someone has to take losses?

Once everything is squared up, after all, that’s tantamount to a significant number of non-asset-backed liabilities in the system, funded as it were by yet-to-be created future value rather than existing capital — a factor exaggerated by rising interest rates and the capacity of offshore centres to obscure unfunded liability creation.

So what happens when “yet-to-be created future value rather than existing capital” evaporates in a downturn? Now you know what I mean when this is an accident waiting to happen.

 

Don’t run for the hills (yet)

Despite the dire nature of the scenarios that I have outlined, I would to underline the point that this post is most emphatically not a bearish call to run for the hills. Warren Buffett famously said that when the tide goes out, you can see who is swimming naked. The vulnerabilities that I outlined just identifies who could be swimming naked, but silent on the timing of the tide table.

However, when the tide does go out (and it will eventually), those naked swimmers are going to scare a lot people.

Why the next recession will be very ugly

Posted by Cam Hui -

In a recent post, I was relatively upbeat about the near term market outlook but warned that the next recession could be very ugly (see A major bear market in 2016?). To explain, I have found three possible time bombs that are set to go off at the next recession:

  • The Fed’s balance sheet;
  • A possible financial crisis in China because of her inability to re-balance its economy fast enough; and
  • Possible blowups lurking in the global financial system.

Let me preface my comments by saying that I am not predicting an imminent disaster. Each of the risks that I outline are just that – risks. None of them are necessarily destined to blow up in our faces, but if any of them do, they will exacerbate the magnitude of the next downturn.

With those caveats in mind, let me go through each of the risks.

 

The Fed’s unbalanced balance sheet

The first source of financial vulnerability was identified by David Merkel, an actuary turned professional investor. He pointed out that the Fed has a mismatched balance sheet:

The pristine balance sheet of 2008 was very short in its interest rate sensitivity for its assets – maybe 3 years average at most. Now maybe the average maturity is 12? I think it is longer…

Does anybody remember when I wrote a series of very unpopular pieces back in 2008 defending mark-to-market accounting? Those made me very unpopular inside Finacorp, the now-defunct firm I worked for back then.

I see three hands raised. My, how time flies. For the three of you, do you remember what the toxic balance sheet combination is? The one lady is raising her hand. The lady has it right – illiquid assets and liquid liabilities!

In a minor way, that is the Fed now. Their liabilities will reprice little as they raise rates, while the market value of their assets will fall harder if the yield curve moves in a parallel shift. No guarantee of a parallel shift, though – and I think the long end may not budge, as in 2004-7. Either way, though, the income of the Fed will decline rapidly, and any adjustment to their balance sheet will prove difficult to achieve.

The Federal Reserve is not just any bank, it’s a central bank. Therefore a mismatched balance sheet, e.g. borrowing short and lending long, won’t hurt the Fed in the same way as it does other financial institutions because central banks cannot go bankrupt. Nevertheless, Merkel pointed that any fallout doesn’t just magically go away:

As a result of the no-mark-to-market accounting, the Fed won’t show deterioration of its balance sheet in any conventional way. But you could see seigniorage – the excess interest paid to the US Treasury – go negative, and the dividend to its owner banks suspended/delayed for a time if rates rose enough. Asking the banks to buy more stock in the Federal Reserve would also be a possibility if things get bad enough – i.e., where the future cash flows from the assets could never pay all of the liabilities. (Yes, they could print money together with the Treasury, but that has issues of its own. Everything the Fed has done with credit so far has been sterile. No helicopter drop of money yet.)

Of course, if interest rates rose that much, the US Treasury’s future deficits would balloon, and there would be a lot of political pressure to keep interest rates low if possible. Remember, central banks are political creatures, much as their independence is advertised.

Merkel concluded that there is a clear and present danger, especially now that the Fed has begun to normalize rates:

Ugh. The conclusions of my last two pieces were nuanced. This one is not. My main point is this: Even with the great powers that a central bank has, the next tightening cycle has ample reason for large negative surprises, leading to a premature end of the tightening cycle, and more muddling thereafter, or possibly, some scenario that the Treasury and Fed can’t control.

The key here, is the shape of the yield curve. Use these tools from the Treasury and Stockcharts to monitor the changes in the yield curve.

 

Will China rebalance quickly enough?

I am indebted to Michael Pettis for pointing out this second source of global systemic vulnerability. Here is what we know about China:

  • Its GDP growth rate is slowing;
  • The blistering pace of the old growth rate was driven by credit driven infrastructure growth, which is unsustainable, but…
  • The driver of growth is slowly changing from infrastructure and building sector to the consumer and household sector, which is more balanced and sustainable source of growth.
I have written before about ways to monitor the progress of the economic rebalancing theme in real-time by watching a couple of pairs trades (see Two better ways to play Chinese growth). So far, the New China consumer sensitive ETFs are handily beating the Old China finance heavy ETFs.

 

 

The question that Pettis tried to answer is, “Is China rebalancing fast enough?”Even under relatively optimistic assumptions, China does not have sufficient time to rebalance its economy before running into serious trouble on its debt:

In order to answer the question of how much time China has I thought it would be useful to work out a simple model for the growth in debt to see how plausible it is to assume that China has another 10-15 years in which to manage the adjustment without implementing far more dramatic transfers of resources, either to pay down debt or to raise household wealth. The model shows pretty clearly that China does not have that much time unless we make extremely implausible assumptions about the country’s debt capacity and, just as importantly, about market perceptions about this debt capacity.

The model shows that even making fairly optimistic assumptions and accepting the lower end of debt estimates, debt cannot stabilize unless growth slows very sharply. If growth does slow sharply enough—to an average of 3% over the next five years – and if at the same time the financial sector is reformed so rapidly that within five years China’s economy is able to grow with no increase in debt (so that China actually begins to deleverage), debt can remain within a 200-220% of GDP range.

Most Chinese debt is RMB denominated debt, so as long as the PBoC can print more RMB, a China slowdown is unlikely to trigger a global financial crisis. However, someone still has to pay for any debt writedown. In the past, the government has socialized the losses. So that means that it is ultimately the household sector would pay the price. In that case, you can kiss the idea of further rebalancing goodbye.

Now imagine the following scenario. The global economy experiences a slowdown. Chinese exports shrink as a result. The pace of rebalancing slows, growth slows and debt burdens rise. The Chinese economy hits the wall and experiences a debt crisis. Even though it may not bring down the global economy, the global financial system is already fragile from the global slowdown and a Chinese debt crisis exacerbates the scale of the downturn.

I would emphasize the point that this dire scenario is unlikely to happen today as Chinese and global growth remain robust (see A major bear market in 2016?). But when the next recession arrives, watch out!

 

Evaporating paper financial assets

The story behind the third source of vulnerability is a little complicated. It begins with a mystery and ends with some possibly chilling implications for the global financial system:

Izabella Kamanska at FT Alphaville outlined the mystery this way. The assets and liabilities in the global financial system aren’t adding up:

As per Gabriel Zucman’s book, The Hidden Wealth of Nations, the world’s financial liabilities are worth about $7.6 trillion more than the world’s financial assets. Roughly $6.1 trillion of these extra liabilities take the form of equity and long-term debt, with the other $1.5 trillion held in low-yielding deposits and money-market funds.

You can read the article for yourself, but I won`t bore you with all the twists and turns of the mystery. One explanation is much of the missing $6.1 trillion in extra liabilities is attributable to the value added by the global financial system in the form of “financial rent”:

As noted earlier, financial rent began to be featured as a value-add component in GDP in the 1960s, according to Mazzucato. Even so, the methodology behind this inclusion — which focuses on the net interest margin — has always been strongly challenged. Some have argued, for example, that because the interest margin includes a risk premium, a large amount of what’s being counted as value add might very well be being over-estimated. The counter argument, of course, is that the core value-add service banks provide is screening for investor risk and hunting out information advantages.

This brings up the point that there are all these offsetting assets and liabilities floating around the global financial system in the form of “financial rent”. No doubt, a substantial portion are offshore assets. So what happens when the global economy turns sour and someone has to take losses?

Once everything is squared up, after all, that’s tantamount to a significant number of non-asset-backed liabilities in the system, funded as it were by yet-to-be created future value rather than existing capital — a factor exaggerated by rising interest rates and the capacity of offshore centres to obscure unfunded liability creation.

So what happens when “yet-to-be created future value rather than existing capital” evaporates in a downturn? Now you know what I mean when this is an accident waiting to happen.

 

Don’t run for the hills (yet)

Despite the dire nature of the scenarios that I have outlined, I would to underline the point that this post is most emphatically not a bearish call to run for the hills. Warren Buffett famously said that when the tide goes out, you can see who is swimming naked. The vulnerabilities that I outlined just identifies who could be swimming naked, but silent on the timing of the tide table.

However, when the tide does go out (and it will eventually), those naked swimmers are going to scare a lot people.

A major bear market in 2016?

Posted by Cam Hui -

As stock prices have recently weakened, I have received some comments regarding the start of a bear market in 2016. To put it into context, bear markets start for one of three major fundamental reasons:

  1. War or revolution leading to a permanent loss of capital (think Confederate war bonds, or German panzers smashing through French lines on their way to Paris in 1940);
  2. An overly aggressive central bank tightening and tipping the economy into recession (you have got to be kidding me); or
  3. An economic recession.
Since the first two points are highly unlikely to cause a bear market in the near future, I will focus on the likelihood of a recession. My framework of analysis is examine the economies of the three major trade blocs in the world, namely the US, Europe and Greater China.

 

No sign of a US slowdown

For reference, I have set up a page called Recession Watch on the site for readers to monitor the risks of a US recession:

 

To watch for signs of an impending recession, I am grateful to New Deal democrat for his long leading indicator framework, which he adapted from Geoffrey Moore (see his post where he outlined his methodology here). New Deal democrat monitors seven long leading indicators (click on links for the latest FRED charts):

In addition, I also use Georg Vrba’s work as another way of watching for possible recessions on the horizon:

Right now, these indicators are showing not any signs of an imminent US recession in the 12 months.

Europe in recovery
The common perception of Europe is a region that is mired in a slow or no growth scenario for the foreseeable future. In reality, the eurozone is starting to see growth tailwinds after years of struggling with austerity. Consider the chart below showing the Eurozone Purchasing Manager Index (PMI) to be rising smartly, as is GDP growth.

Jeroen Blokland also helpfully pointed out that the harsh austerity programs of EU states are ending, which ends the fiscal drag imposed on economic growth:

Member EU states are starting to spend again. Indeed, FT Alphaville highlighted research from GfK that the refugee crisis has a positive short-term effect on GDP growth:

The persistently high influx of asylum seekers has seen economic optimism fall further, and has also had a detrimental effect on the income expectations indicator, which has also experienced losses. In contrast, the propensity to consume is currently bucking this trend and, despite the general economic downturn, actually increased this month.

Despite the falling economic and income expectations recorded in November, the willingness to buy indicator increased this month. After five very moderate drops in succession, the indicator has risen by 3 points to a total of 48.9 points. This extremely high level provides evidence that the propensity to consume is still very pronounced despite the economic uncertainty. This is also proven, for example, by the particularly positive development of retail sales, which, according to data from the German Federal Statistical Office, rose by 2.7 percent in the first nine months of this year.

Further in the FT Alphaville post is an estimate from Morgan Stanley indicating that the refugee crisis could boost German GDP growth by between 0.25 and 0.50% as government support for refugees translate into a direct shot in the arm for the consumer economy.

There is even good news from Greece. The Tsipras government in Greece has enacted tough reform-for-aid measures. In July, I speculated that Alexis Tsipras could become the Greek Lula. It appears that he is well down that path as Greece begins to heal while remaining in the eurozone.

Bottom line: Tail-risk is diminishing rapidly in Europe as growth returns.

What about China?
China has been an enigma to outsiders, largely because of the lack of transparency in policy and economic statistics. As the rate of Chinese growth has fallen, it has prompted periodic forecasts of an implosion, either in the Chinese economy or financial system.

While I would not rule out such a catastrophic scenario, such a downturn is unlikely to happen in the near future. The outlook for 1H 2016 appears bright. As per Tom Orlik, the Bloomberg growth proxy for China is ticking up:

 

The latest economic releases (via Reuters at Business Insider) show that factory output, fixed-asset investment and retail sales all accelerated and beat expectations. Looking forward, Tom Orlik highlighted the fact that Chinese growth is likely to be buoyed by more fiscal stimulus in 1H 2016.

 

The Chinese growth story may very well end badly one day, but that day isn’t going to come in the next 6-12 months.

A bear market someday
In conclusion, a review of the economies of the three major trade blocs show no signs of imminent recessionary risk. Therefore I would not be overly concerned about the start of a bear market. This does not mean, however, that stock prices cannot experience a run of the mill 10% correction, nor does it mean that they can’t go sideways – just that they are unlikely to go down in a major fashion.

No doubt, there will be a bear market someday. In the meantime, don`t worry so much (and stop reading so much Zero Hedge).

In a future post, I will detail the reasons why the next recession could be a real doozy.

The only market indicator that matters in 2016

Posted by Cam Hui -

Trend Model signal summary
Trend Model signal: Neutral
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.

The Dollar and euro’s most excellent adventure

I had expected that the markets might become little sloppy as we approached the FOMC meeting (see Waiting for the whites of their (oversold) eyes), but I didn’t expect the kind of risk-off tone seen last week. Despite the market weakness, I could tell you that:

  • Fundamentals, such as forward EPS revisions, remain constructive
  • The US economy is strong with no sign of a recession on the horizon
  • The market is oversold
  • Sentiment is showing a crowded short reading, while insiders are buying
  • Seasonality is bullish for stocks

None of that matters very much, as the signals from the Federal Reserve next week will set the market tone, not just for the rest of the year, but for most of 2016. If I had to focus on one key market indicator coming out of FOMC meeting, it would be the reaction of the US Dollar to the Fed decision.

A December rate hike is pretty much a done deal. The market’s focus has shifted from the timing of the first rate hike to the trajectory of subsequent rate hikes. That’s where the FOMC statement and post meeting press conference will be of utmost importance. A hawkish message would send the USD soaring, which would serve to depress US exporter competitiveness and push equity and commodity prices downwards. On the other hand, a more dovish message would push the USD down, provide a better earnings growth for US companies, lift commodity prices and be equity market friendly.

 

 

In many ways, market expectations leading up to the December FOMC meeting is similar to the sentiment backdrop leading to the recent ECB meeting. The market believed that Mario Draghi would implement more QE carpet bombing of the eurozone economy, but instead it came away disappointed as EURUSD soared by over 2% on the day. Marc Chandler highlighted some insightful comments from Yves Mersch of the ECB on how market expectations got wildly overblown. To make a long story short, Mersch indicated that the market misunderstood how a consensus gets formed in the Governing Council. Moreover, the prevailing belief at the ECB was that the current stimulus measures were already effective. Therefore there was no need to take the kind of extraordinary measures expected by the market and it could afford to adopt a wait and see attitude.

 

All eyes on the Fed

As we approach the key December FOMC meeting, past Fedspeak has indicated that the Yellen Fed is a big believer in the Phillips Curve, which postulates a tradeoff between inflation and unemployment. So with unemployment falling and wage pressures rising, it`s no big surprise that the Fed wants to raise interest rates to dampen inflationary expectations (chart via Jereon Blokland, NAIRU = Non-accelerating inflation rate of unemployment, or the unemployment rate at which inflationary pressures start to set in).

 

 

Central bankers know that monetary policy operates with a lag, so that they have to try anticipate future path of inflation. The key question then becomes, how quickly will the Fed raise rates? Janet Yellen and other Fed officials have made it clear that this rate hike cycle will be very different from previous ones as the pace of increases will be much slower and *ahem* data dependent. If the Fed`s message is perceived to be at or below the light blue line, watch for the markets to rally hard.

 

 

Watching the USD for direction

The key to the markets isn’t just the trajectory of interest rates, but the effect on the USD. The fate of the USD has broad cross-asset class return implications as currency strength has been a headwind to equities and commodities for most of 2015. A strong USD has held back the earnings of US companies selling into foreign markets. As well, commodity prices are inversely correlated to the USD and a reversal would alleviate much of the angst surrounding the financial stress caused by resource companies in financial distress plaguing the junk bond market.
As we approach the FOMC meeting, market sentiment is heavily skewed to long USD, short commodity and equity positions.

 

 

Current market psychology is therefore setting up for an ECB like market reaction to the FOMC announcement. As a reminder, this is what happened to the euro after the ECB meeting:

 

 

Right now, the market is laser focused on the divergence in monetary policy. The Fed is tightening while every other major central bank in the world is accommodative. This divergence trade has created expectations that supports USD strength because of expectations of a widening interest rate gap. However, Fundstrat pointed out that a long USD position hasn’t always been a winning trade in the past when the Fed started a tightening cycle with the Fed and ECB diverged in monetary policy. In fact, the USD has weakened three out of five times such conditions have occurred (via Value Walk):

 

 

Moreover, Dana Lyons pointed out that the Dollar Index appears technically vulnerable to a bearish reversal:

 

 

To put the longer term technical picture into context, the chart below shows the USD Index (top panel, inverted scale) consolidating sideways and possibly starting to reverse itself. The next two panels show the relative performance of energy and materials stocks against their markets (US market in black, European market in green). These sectors also appear to be in various of consolidation and bottoming.

 

 

If the Fed’s message is even mildly dovish compared to expectations, the resulting rally will rip the face of many dollar bulls and equity and commodity bears.

 

Reasons to be bullish

Notwithstanding any consideration of Federal Reserve policy and the effects on exchange rates, there are a number of other reasons to be bullish on stocks. John Butters of Factset reported that forward EPS estimates to be rising (annotations in red and estimates are mine):

 

 

Analysis from Ed Yardeni indicates that forward EPS is highly correlated with coincidental economic growth. Therefore the trajectory of forward EPS serves as a confirmation of economic strength or weakness. Peering into the crystal ball, New Deal democrat’s monitor of long leading economic indicators show that there is no sign of a recession 12 months from now:

Among long leading indicators, interest rates for treasuries, corporate bonds, and mortgages all are neutral. Money supply, mortgage applications, and real estate loans are still positive.

His conclusion is that the American economy is currently undergoing a soft patch caused by USD strength.

As anticipated due to Thanksgiving Day seasonality, coincident readings improved from absolutely horrible to merely bad. The US economy continues to be buoyed up by housing and cars, with a continued though smaller than anticipated boost in consumer spending. I continue to anticipate further near term weakness in the US economy, although the growing service/consumer sector continues to overbalance the deepening industrial recession brought on most of all by the further strengthening in the US$.

So what happens to the economic outlook if the Dollar reverses course next week?

 

A constructive technical picture

Aside from positive macro fundamentals, the technical condition of the stock market is oversold, which is bullish. The top panel of the chart below shows that RSI5 has flashed an oversold reading but exhibits a positive divergence. The second panels shows the SP 500 testing a support zone, as well as support at its lower Bollinger Band (BB), which can limit downside risk. The third panel shows the VIX Index, a sentiment indicator, is now above its upper BB where it has seen reversals in the past. The bottom panel shows that the term structure of the VIX is inverting, which is an indication of high fear levels. These are all signs of an oversold market, with the caveat that oversold market can get more oversold in the short run.

 

The reverse of investor and trader sentiment is the action of “smart investors” like insiders. The latest update from Barron`s show that insiders have been heavily buying stocks, for several weeks which is another bullish sign for equities.

Another bullish tailwind is the positive seasonality typically experienced by the markets. Ryan Detrick pointed that that December positive seasonality tends to manifest itself in the last half of the month and starts on the 15th, which happens to be the start of the two day FOMC meeting.

 

Detrick also pointed out that the market is oversold based on the McClellan Oscillator:

 

Indeed, other breadth metrics from IndexIndicators are flashing oversold signals, such as the % of stocks above a 10 day moving average (dma):

And net 20-day highs-lows:

Next week is option expiry (OpEx) week, which has historically had a bullish bias as traders tend to try to temporarily move stock prices and indices to their advantage for option expiry at the close on Friday. Further, Rob Hanna at Quantifiable Edges showed that not only does the market show a positive bias during December OpEx week, but the positive seasonality extends further into the next three weeks.

 

What about junk bonds, China?

Despite all of these bullish tailwinds, my inner bear is worried. He sputtered, “But what about the carnage in the junk bond market and the risk of a Chinese devaluation sparking a trade war?”

There is no question that the level of anxiety in the US junk bond market has been rising. The Marketwatch story “Why the junk bond selloff is getting very scary” provides a useful summary. In effect, trouble in the US high yield (HY) market has foreshadowed downturns in stock prices.

 

 

There is no question that misbehaving HY bonds is an area of concern. However, much of the trouble in HY is attributable to distress in energy and materials.

 

Should we get a dovish message from the Fed and the USD weakens, it should alleviate most of the stress evident in these sectors. Moreover, I pointed out before (see Profiting from a late cycle market) that such credit market developments are typical of a late cycle market where stresses start to appear. Rising credit spreads have historically been very early warnings of recessions so it is premature to panic. In other words, be concerned, but don`t get bearish too early.

 

 

Another risk to the market was the freak out last week over the prospect of another Chinese devaluation, which has the potential to spark a round of competitive devaluation leading to a trade war.

 

 

As this Bloomberg story indicates, the PBoC adjustment in the RMB is largely a technical move to peg the RMB against a basket of currencies, rather than just the USD, as the Dollar has been so strong.

 

In the meantime, the Bloomberg proxy for Chinese GDP growth ticked up, which also alleviates some of the worries that the Chinese economy is tanking (via Tom Orlik). So relax, the Chinese economy is doing fine and there is no need for them to engage in competitive devaluation.

 

Bottom line: If the USD were to weaken in response to Fed next week, which a big if, many of these bearish concerns plaguing the market would evaporate.

 

Place your bets for the week ahead

Early last week, I had forecasted a sloppy stock market, but to wait to buy until readings got to an oversold extreme (see Waiting for the whites of their (oversold) eyes). As stock prices weakened, my inner trader nibbled away to buy some small cap positions on Wednesday and added to long equity positions on Friday as readings became more oversold. By contrast, my inner investor ignored all these gyrations and remained long equities with a tilt towards commodity sensitive sectors.

Both are betting on a dovish FOMC statement and a reversal of USD strength. If the Fed message were to become hawkish – well, that’s what stop loss orders are for.

Disclosure: Long NUGT, SPXL, TNA

 

What’s wrong with South Africa?

Posted by Cam Hui -

The study of emerging markets is a useful exercise in examining our assumptions about economies and markets because they sometimes operate by different rules than developed economies. As an example, Bloomberg reported today that the markets are freaking out over the firing of the finance minister:

South African markets were thrown into turmoil after President Jacob Zuma fired the finance minister, strengthening his grip on power amid differences over government spending.

The rand weakened for a sixth day in the longest streak of losses since November 2013 and bond prices dropped the most on record, pushing yields to their highest levels since July 2008. The country’s bank stocks tumbled the most in more than 14 years following the dismissal late on Wednesday of Finance Minister Nhlanhla Nene. The cost of insuring South African debt against default rose to the highest in more than 6 1/2 years.

As the chart below shows, South African assets are indeed tanking. The top panel shows the South African ETF (EZA), which is priced in USD. The bottom panel shows the relative performance of the South African Rand relative to the Aussie Dollar, which is another commodity currency.

 

What’s wrong with South Africa?

 

A deeper malaise
I am not going to address the short-term problems with the South African Rand or its equity markets. The problems with South Africa reflect a deeper malaise that go back many years and it will take many years to fix.

Dani Rodrik wrote a paper in 2008 that is still relevant today. He attributed South Africa’s economic woes of high unemployment and low growth to a neglect of non-resource tradables. Here is the abstract:

South Africa has undergone a remarkable transformation since its democratic transition in 1994, but economic growth and employment generation have been disappointing. Most worryingly, unemployment is currently among the highest in the world. While the proximate cause of high unemployment is that prevailing wages levels are too high, the deeper cause lies elsewhere, and is intimately connected to the inability of the South African to generate much growth momentum in the past decade. High unemployment and low growth are both ultimately the result of the shrinkage of the non-mineral tradable sector since the early-1990s. The weakness in particular of export-oriented manufacturing has deprived South Africa of growth opportunities as well as of job creation at the relatively low end of the skill distribution. Econometric analysis identifies the decline in the relative profitability of manufacturing in the 1990s as the most important contributor to the lack of vitality in that sector.

While Rodrik’s by-the-numbers economic viewpoint does offer a useful framework for analysis, the bigger question is why these policies and orientation evolved. I was a portfolio manager covering South Africa in the mid-1990’s and I can offer my insights this way.

 

A shortage of human capital
Two important policies during the Apartheid Era shaped the face of modern South Africa and contributed to its malaise. First was the imposition of foreign exchange controls, where capital couldn’t leave, except in relatively small scale and after paying a heavy black market price. The second was the policy of racially segregated schooling. According to The Economist, the government spending ratio on white vs. black education was 16 to 1 (though I had heard figures of 8 to 1 in the 1990s). It was therefore no surprise that modern South Africa experienced a shortage of educated blacks to take up technocratic positions that is sorely needed in both business and government.

The reaction of the whites during the Apartheid Era was different. Foreign exchange controls meant that financial capital couldn’t leave, but human capital could leave – and they did. Many went to English speaking countries like the UK, Australia and Canada. Even in Vancouver, I am not surprised to hear someone speaking with a South African accent.

The result was a country that was sadly lacking in human capital. My general impression of numerous company and government visits in the 1990`s was a management structure composed of a very small group of talented individuals at the top (CEO and possibly the CFO), but with middle management talent that was uncompetitive with developed world standards. In other words, while the generals might have good plans, the troops couldn’t execute them.

 

Financial engineering over operational excellence
The reaction of the 1% under a regime of exchange controls was to construct vast conglomerates in order to maintain control of their empire in an oligopolistic or monopolistic way. In the post-Apartheid Era, black enterprises unfortunately adopted the same conglomerate structures and engaged in financial engineering with a much lessor focus on proper corporate strategy in operational excellence.

At the same time, the asset management industry was dominated by a few players with very large pools of capital. They couldn’t diversify internationally because of exchange controls. As these were very large institutions, they couldn’t beat the market because they were the market. One approach to add value would have been to become activist investors to prod company managements to add value. A combination of a lack of talent and a culture of cozy and incestuous relationships prevented that course of action.

That explanation is a long roundabout way of explaining Dani Rodrik`s thesis of South African neglect on non-resource tradables. In effect, several generations of Apartheid Era policies created conditions that rewarded financial engineering and brain drain emigration.

Despite its problems, today`s South Africa presents opportunities. As an investor, those conditions led me to look beyond the standard financial metrics of ROE, margins, etc. to invest in human capital – companies with management teams with a record of excellence.

For individuals, it also presents opportunity that recalls an anecdote from my days at Batterymarch. On occasion, Batterymarch founder Dean LeBaron would be asked by fresh graduates of what career advice he would have for them for entering a career in finance. Instead of giving them the usual expected spiel about getting a job at a large firm like Goldman Sachs or Morgan Stanley and working their way up, Dean would advise them to move to an emerging market country like Russia, China or Brazil because that`s where the opportunity was. That`s when you could see their faces fall.

I would repeat the same advice about South Africa. If you are talented, then go where there is a lack of human capital.

Waiting for the whites of their (oversold) eyes

Posted by Cam Hui -

I received a couple of comments to my last weekend post that it was somewhat lacking in a short-term trading outlook (see 2016: Time to get bearish and go “Zero Hedge”?). As my previous view that the US equity market would grind up until year-end hasn’t worked out, it would be appropriate to update the short-term stock market conditions.

Still bullish for December
I remain constructive on stock prices for the remainder of the year based on the following analytical framework. Firstly, the latest update from John Butters of Factset shows that forward EPS estimate revisions were flat on the week, which is constructive in the context of the positive seasonality described below.

 

From a seasonal viewpoint, Ryan Detrick showed that December returns tend to have an upward bias and not to get overly worried about mid-month drawdowns:

 

As well, Detrick also showed that the typical December pattern shows a mid-month dip with a bottom around the 15th, so there is no need to freak out about a minor pullback.

 

Given the likely big news coming out of the FOMC meeting next week, I would not be overly surprised if stock prices remained choppy for the next few days. Extreme market weakness should therefore be viewed as a gift from the market gods.

 

Not oversold enough
Tactically, however, the current bout of weakness may not have fully run its course as the market hasn’t reached the kinds of oversold conditions typically seen at short-term bottoms. The SPX chart below shows that RSI5 hasn’t yet flashed oversold readings (top panel); nor has the VIX Index reached the top of its Bollinger Band (bottom panel). In addition, the SPX remains right in the middle of its own Bollinger Band, indicating a short-term neutral condition with negative price momentum.

 

Other indicators, such as the Fear and Greed Index, are showing similar signals of weak price momentum, but not extreme oversold readings.

 

My brief survey of breadth indicators from IndexIndicators is also telling the same story. This chart of the % of stocks in the SPX above its 10 dma is weak, but not oversold (red dot indicates my estimate at the end of day Tuesday).

 

The % of stocks with RSI5 less than 30 has spiked but could go a little higher before reaching an extreme reading. Should this indicator move higher, I would interpret that as a short-term buy signal.

 

Similarly, this intermediate term (1-2 week horizon) indicator of net 20-day highs-lows isn’t ready to flash an oversold buy signal just yet either.

 

I could go on, but you get the idea. The stock market is weakening, but it is not at an oversold extreme yet.

 

Positioning for a seasonal rally
Based on the Ryan Detrick`s analysis and supporting evidence from Factset about the EPS outlook, I am still anticipating a decent year-end rally to test or possibly exceed the all-time SPX highs before year-end. I have pointed out before that small cap stocks tend to outperform in December (see Waiting for Santa Claus) and this year is unlikely to be an exception. The chart below of the small to large cap ratio shows that small caps are testing a relative support zone and oversold, which represents a decent entry point once the stock market flashes oversold readings.

 

As the markets are likely to get buffeted by anticipation of Federal Reserve action next week, stock prices will probably be sloppy and range-bound for the next few days. My inner investor remains long stocks in anticipation of a year-end rally. My inner trader got stopped out of his energy long positions on Monday and nibbled at some gold equities on Tuesday. He is very lightly committed but he won`t be buying stocks until he sees the whites of their (oversold) eyes.

Disclosure: Long NUGT

2016: Time to get bearish and go “Zero Hedge”?

Posted by Cam Hui -

Trend Model signal summary
Trend Model signal: Neutral
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.

 

My worries for 2016
As the above chart shows, I have been pretty bullish on equities since the market bottomed in September. As I peer into 2016, however, ominous signs are starting to appear. For my inner investor, the key question is whether to go full Zero Hedge*and turn bearish on the outlook for 2016. Here is my list of worries:

  • The credit markets are behaving badly, which is a warning of falling risk appetite.
  • As the Fed starts its tightening cycle, the fallout could be considerable:
    1. The banking system is tightening credit and the combination of rising rates and credit rationing would be a double whammy for economic growth.
    2. Housing, which has been a key driver of employment growth, is starting to stall.
  • Excessive equity valuation is showing up in the form of shrinking takeover premiums.
  • Stock buybacks, which had long been a driver of stock returns and EPS growth, are losing their power.
Let me go through these points, one by one and give my reaction afterwards.
* For the uninitiated, Zero Hedge is a website that is dedicated to the bear case and features end-to-end Apocalyptic forecasts.
Mis-behaving credit
The credit market is one of the key barometers of global risk appetite and it is flashing ominous signals. Zero Hedge recently asked rhetorically if something is blowing up the junk bond market:
Similar problems are showing up in leveraged loans as well. which is also a vulnerability identified by Jesse Felder.
The problems in the credit market are not just confined to the energy sector. LeveragedLoans.com reports that EBITDA growth fell in the quarter ex-energy, even as energy EBIDTA growth rates improved, or got less bad, in the same period.

Bloomberg reports that the upheavals in the junk bond market are warning signs for markets:

Investors are shunning the lowest-rated junk bonds. That is underscored by the extra yield that investors are demanding to hold CCC rated credits relative to those rated BB. This has jumped to the most in six years.

With confidence slipping in the strength of the global economy, there are fewer investors to take the opposite side of a trade in the riskiest parts of the market, according to Oleg Melentyev, the head of U.S. credit strategy at Deutsche Bank.

“These are all small dominoes in one corner of the market,” Melentyev said. “In the early stage, all of this looks random when there is no underlying news to support the big moves. But eventually a narrative emerges — maybe we have turned the corner on the credit cycle.”

 

Is the Fed tightening into a recession?
Remember that this is all happening even before the Fed has begun its tightening cycle, which is worrisome. The WSJ recently reported that banks are tightening small business lending standards, which is pushing this class of borrowers into more expensive sources of credit, such as credit cards:

The biggest banks in the U.S. are making far fewer loans to small businesses than they did a decade ago, ceding market share to alternative lenders that charge significantly higher rates.

Together, 10 of the largest banks issuing small loans to business lent $44.7 billion in 2014, down 38% from a peak of $72.5 billion in 2006, according to an analysis of the banks’ federal regulatory filings.

Through August, banks this year originated 43% of business loans of up to $1 million, down from 58% for all of 2009, according to PayNet Inc., a tracker of small business credit.

The change has opened the door to higher-cost alternatives: Nonbank lenders increased their market share to 26% from 10%, with corporations that lend to their business customers or suppliers making up the balance.

“At least 60% of our borrowers would fall into classic bank lending criteria,” said Rob Frohwein, chief executive of online lender Kabbage Inc., which charges rates that average about 39%, versus the typical 5% to 6% or so that banks charge small firms with good credit.

At some big banks, the credit card has become the default loan source for small businesses. Rates on cards issued to small businesses average 12.85%, according to Creditcards.com.

In the past two economic cycles, the trough in bank lending criteria has occurred after the Fed started raising interest rates and the growth outlook was robust enough to deal with tougher standards. This time, tougher lending standards have appeared well before the start of the tightening cycle. In effect, the Fed is raising rates even as the economy is becoming more fragile.

 

 

The lumber market warning
The lumber market, which is a key barometer of the housing market, is also flashing red. Tom McClellan recently wrote about the warning signs from lumber:

There are a lot of leading economic indicators in use these days, but the one I like the best is lumber futures prices. Perhaps this is because almost no one else seems to pay attention to them as an economic gauge. Lumber prices tell us pretty reliably and ahead of time about what is going to happen to real estate prices and activity, plus interest rates. They can even tell us about what unemployment is going to do.

He concluded:

Here we are, facing a likely start to Fed rate hikes at the Dec. 15-16, just as lumber is saying that a downturn in economic activity is coming. We know from watching the 2-year T-Note yield that the Fed should have started this process a long time ago. So now they appear to be finally getting around to doing the right thing, at the wrong time.

 

Valuation headwinds
So far, we have signs that the US economy is fragile and the Fed is about to start raising rates. Does that mean that stock prices would necessarily have to go down? In this case, downside risk may be exacerbated by a signal of high valuation from the record level of takeovers.

We can argue until we are blue in the face about whether stock prices are under, over or fairly valued. One of the more important clues come from informed corporate buyers. As Bloomberg reports, takeover premiums are shrinking even as M+A activity is rising:

The biggest wave of takeovers ever to sweep the U.S. is failing to ease investors’ anxieties about rising stock valuations.

While a booming market for mergers and acquisitions is often viewed as good
for equities, the impact may be diminishing. Caution can be seen in how much the stocks of takeover targets rise the day after deals are announced. In 2015, the average increase is 16 percent, the smallest gain for any year since 2007, according to data compiled by Bloomberg on deals of at least $200 million. Share price reactions are closely tied with the premium companies are willing to offer, which is also at its lowest since 2007.

 

Buybacks: Mining lower grade ore
One of the reasons for the lower takeover premiums could be explained by the buyback financial engineering effect, which is not relevant to a corporate buyer. Analysis from Deutsche Bank (via Business Insider) shows that Q3 EPS growth would be flat without buybacks:

 

Another source of concern is that companies have been relying on external financing for buybacks. In other words, they have been borrowing to buy back their own shares (via Sober Look).

 

The chart below shows that as more and more companies have turned to buybacks to boost EPS and share prices, this financial engineering trick is becoming stale. The bottom panel shows the relative performance of a high buyback ETF (PKW) against the market. The relative performance of buyback stocks have been rolling over, indicating this corporate strategy is mining lower and lower grade ore.

 

No need to panic…yet
What should we make of these bearish factors as we peer into 2016? Is it time to hunker down and get more defensive after the seasonal Santa Claus rally?

I have said it before and I will say it again. I love Zero Hedge in the same way that I love scanning the tabloid headlines at the supermarket checkout. ZH has built a considerable franchise in trumpeting the doomster bear case, but we need to put these bearish factors into context.

First of all, there is no question that tanking US high yield market is worrisome. However, the chart below shows the relative price performance of US high yield (blue) and Emerging Market bonds (green). The fact that EM paper is performing much better than US junk is an important sign that not everything in the credit markets are falling apart.

 

Morgan Stanley surveyed the state of the credit markets through the lens of a variety of indicators. As the chart below shows, the indicators are split roughly evenly between red (danger), yellow (caution) and green (benign). These reading suggest to me that while credit conditions are deteriorating, they are not at levels where it is time to panic and turn bearish on the stock market.

BoAML analyzed the equity markets in a similar way by comparing current conditions to previous market tops. The biggest outliers are:

  • Non-existent inflation, which is a trigger for an aggressive Fed;
  • An upward sloping yield curve, which is also an indication of an aggressive Fed, but could be excused because of the unusual zero interest rate policy today;
  • Falling commodity prices, whereas past peaks have featured rising commodity prices, which is a sign of rising inflationary expectations (see above comment about non-existent inflation and see Chris Ciovacco’s comment about how falling commodity prices are not stock market killers); and
  • The BoAML Sell-Side Indicator, which is a measure of Street strategist sentiment, remains cautious, which is contrarian bullish.

 

Late cycle, not bear phase
My interpretation is current economic and market environment represent a late cycle expansion, where market excesses and cracks start to appear. The negative factors cited are just some of cracks and excesses that are typical of a topping process that will likely take 6-12 months to complete. New Deal democrat recently reviewed some of the signs of deterioration in the economy and he concluded:

This also suggests that we are getting later in the cycle, but interestngly, durable goods are holding up much better than nondurable goods.

At the same time, none of these have turned negative — just less positive. There is no imminent threat of a downturn.

It is premature to get overly bearish right now as there is plenty of money to be made in late cycle markets, which is characterized by rising commodity prices, market excesses and a blow-off in inflationary expectations (see my previous post How to energize returns even as momentum fades). The stock markets of the 1968-1969 and 1980 can serve as approximate road maps for 2016.

We can see an example of an inflationary blow-off market in the price of gold in 1980 when it reached its previous all-time high of $850. As history doesn’t repeat but rhymes, the 1979-1981 era was very different from today and featured runaway inflation and a Volcker Fed that stomped on the monetary brakes.

The price of gold had been fixed until 1971 and therefore we cannot gauge past inflationary expectations using gold. We can, however, going further back into history by using other indicators such as the 10-year Treasury yield, which does respond to inflationary pressures. The chart below shows that we can see evidence of an inflationary blow-off in the 1968-1970 market, as evidenced by rising yields on the 10-year note. As well, the 1979-1981 episode also saw a spike in yields.

Here is the clincher for anyone who wants to turn bearish and go “Zero Hedge” now. This chart of the NYSE Composite shows that US stock prices saw substantial gains in 1968 and 1980 during the inflationary blow-off episode. Though I wasn’t a market participant in the late 1960’s, I did learn from some of mentors who were in the market then that while gold prices were fixed in 1968, gold stocks soared in that period as inflation took off.

For the last word on this topic, I turn to Macro Man in point 7 of his Thanksgiving post:

2016 is finally shaping up as a year of divergence, macro imbalances, and, dare we hope, a return of the thinking man’s investment style.

One of the key risks of a late cycle market is overstaying its welcome as the economy keels over into recession. I am therefore keenly aware that recessions are bull market killers and signal the start of bear markets. I will be relying on a broad set of Recession Watch indicators used by New Deal democrat and Georg Vrba, neither of which are flashing warnings of an imminent recession on the horizon.

My inner investor therefore remains long equities with a tilt towards resource oriented issues. My inner trader took some profits in his long SPX positions but he is still long his energy and gold positions. He is opportunistically seeking to buy US small cap exposure in anticipation of a seasonal rally into year-end.

 

Disclosure: Long ERX, NUGT